Currency theory suffers from domino syndrome

PUBLISHED : Tuesday, 02 June, 1998, 12:00am
UPDATED : Tuesday, 02 June, 1998, 12:00am

Remember the old domino theory, the one that said communism would spread from China right to Australia unless checked, and therefore let's bomb Vietnam now? Welcome to its new variant. This one says that currency collapse will spread from Japan to the mainland right down to Hong Kong, and therefore place your bets against the HK dollar now.

I won't speak for the Japanese yen, but this seems to me to be another case of falling dominoes that stop at one.

It's true that if the whole world, including the population of the mainland, loses its confidence in the yuan then this currency is doomed. Such a loss of confidence could be irrational and still it would happen.

But irrationality of this sort is rare so let's deal with the rational forces on the value of the currency.

In the first place, the mainland has a closed capital account. This means that you can freely exchange the currency for trade but you need permission to exchange it for investment. It doesn't stop the forex dealers from ganging up on the yuan but it certainly makes it more difficult.

Then you have inflation, or rather, in the mainland, you don't have any. The figures show prices falling or holding steady, not rising. Studies admittedly show that inflation differences with other countries have only a weak influence on currency movements outside of periods of hyperinflation.

But they cannot be denied, and this influence is in the yuan's favour at the moment.

The mainland has had high rates of inflation in the past, but again this should be no reason for a weaker currency now. In early 1985, the yuan stood at only 2.80 to US$1 compared with its present exchange rate of about 8.28.

Take the extent by which inflation in the mainland exceeded inflation in the US since then, assume this is what drove the currency, and you get almost exactly to the present exchange rate.

But the greatest single influence on exchange rates is the balance of payments and, more particularly, the current account balance.

Take this as the merchandise trade balance and the figures show that the mainland still enjoys a rising and record trade surplus. It stood in April at a yearly average of $3.7 billion a month (see the chart below).

What is more, the record shows that devaluations of the yuan in the past coincided with periods of trade deficit, as you would expect they did.

This argues strongly that the forces on the currency at the moment are for a revaluation, not a devaluation.

Of course, the argument against the yuan holds that mainland industry will now lose its competitive edge against other Asian countries that have devalued over the past year and the trade surplus will therefore collapse.

But it hasn't happened yet, and there are good reasons why it won't. Just go to Thailand and see how well industry fares with a collapse in corporate capital and banks that are scared to finance imports of components and raw materials.

Why leave the mainland to enter this minefield? It's relative stability has made it more, not less, competitive recently.

I'm not saying it will last for ever. There is a cycle here which can go down as well as up.

But if the HK dollar's link to the US dollar is dependent on stability in the yuan, then we have a distinct plus for the link at the moment. Let the attackers think they can come to Hong Kong through the mainland again.

The defences are up this time round.



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