China buys time to stave off devaluation

China buys time to stave off devaluation

By Bill Savadove

SHANGHAI (Reuters): China has bought itself some time to hold off a currency devaluation with a new economic stimulus plan, but economists feel the real test will come next year.

Beijing said last week it would issue 60 billion yuan (US$7.2 billion) in bonds to fund infrastructure development and would tax interest on bank savings to flush money out of accounts and into the stores.

The aim is to stimulate an economy which grew 7.6 percent in the first half of this year, above a target of 7.0 percent for 1999, but below last year's 7.8 percent.

Those figures look good, but they mask stubborn deflation. The benchmark retail price index has fallen for 22 months.

China has said repeatedly it would not devalue the yuan and has launched a state spending spree on infrastructure to compensate for flagging exports and weak consumption.

"We are expecting a devaluation in the first quarter of next year," said Kate O'Donoghue, regional economist for Barclay's Capital in Singapore.

"It is almost inevitable because of the imbalances in the Chinese economy caused by current methods of attempting to support growth."

"By trying to engineer an investment-led growth, you're seeing overcapacity worsen which then means that deflationary pressures are also worse," O'Donoghue said.

Beijing must loosen monetary policy further and tackle persistent deflation to avoid a devaluation which would help boost exports and spur imported inflation, economists said.

For now, China is still protected by massive foreign exchange reserves of over $147 billion which help maintain the stability of the yuan, they said.

China reported a healthy trade surplus of $11.3 billion in the first seven months of this year, though this was down from $26.7 billion in the same period last year.

Actual foreign direct investment was $21.49 billion in January-July, down 10 percent on the same 1998 period.

"Nothing is going to happen this year," said Steven Xu, regional treasury economist for Standard Chartered Bank in Hong Kong. "Even from a policy perspective, the market wants to give the new package the benefit of the doubt."

"My own perception is that there is no compelling reason to change (the exchange rate)," he said. "Having said that, there is no compelling reason for a huge economy like China to peg its currency to the U.S. dollar perpetually."

Technically, China has a managed float system, but in practice the central bank has kept the yuan firmly pegged at around 8.28 to the U.S. dollar.

Amid the range of views on if and when China might devalue, there is consensus on one issue -- Asian economies are better prepared for such a move than a year ago.

Chinese officials have previously cited fears of another round of regional currency devaluations as a justification for keeping the yuan stable.

"If the renminbi (yuan) were to devalue some time next year, there will still be a negative shock on the region's currency markets, but that shock will be very short lived," said Chi Lo, chief Asia economist for HSBC Markets in Hong Kong.

"For all the Asian economies, the fundamentals have improved quite dramatically," he said. "Even in the event of a yuan devaluation, the Hong Kong peg will stay."

Hong Kong is a Special Administrative Region of China and its currency is pegged to the U.S. dollar. Beijing has vowed to protect the financial stability of Hong Kong.

Chinese officials still insist the yuan will not be devalued, at least for now.

"The renminbi (yuan) is stable," said Ji Xiaohui, vice president of the Shanghai branch of the Industrial and Commercial Bank of China, a state-owned commercial bank. "The situation has not changed."

But central bank officials have left the door open for change by saying the exchange rate would depend on China's balance of payments -- the record of a country's trade, services and capital flows with the rest of the world.

"The significant change this year, from the government perspective, is that discussing the exchange rate is no longer taboo," said Xu of Standard Chartered.