George Osborne is wrong about China and the yuan

British chancellor is keen to see the yuan used as an international currency, but China's trade surplus will be a major stumbling block

PUBLISHED : Friday, 21 February, 2014, 12:24am
UPDATED : Friday, 21 February, 2014, 12:24am

British government ministers do like visiting this part of the world. Prime Minister David Cameron was in China in December, attempting to promote British exports ("Do we buy anything from Britain," one mainlander asked Monitor at the time).

Next week education minister Elizabeth Truss is due to lead a delegation to Shanghai to investigate why it is that Chinese pupils perform so much better than their British peers in maths tests (even though, as Lai See explained this week, the statistical sampling errors involved in scoring these tests are so great they render the results meaningless).

And yesterday Britain's Chancellor of the Exchequer George Osborne, was in Hong Kong talking up London's prospects as a centre for yuan-denominated financial business.

You can see why they are all so eager to come here. They get to appear in the media against a backdrop of skyscrapers and economic dynamism rather lacking back at home.

Rising US rates will reduce the incentives for global firms to deal in and hold the yuan

They also benefit from an old convention that dictates rival politicians and the media should refrain from criticising government ministers when they are abroad.

Monitor recognises no such constraints, and can freely lambast Osborne for the startling misconceptions about China and the yuan he betrayed in his speech yesterday to the British Chamber of Commerce.

Consider the praise Osborne lavished on China's leadership for tackling the country's economic imbalances.

"China has not reduced its current account surplus because of external pressure," Osborne gushed, "they've done it because the Chinese understand it is in their self-interest to move away from an investment and export-led model of growth towards something more sustainable."

His analysis is spectacularly wide of the mark. It is true that China's current account surplus - the spare cash China exports to the rest of the world - has fallen from 10 per cent of the country's gross domestic product in 2007 to 2 per cent last year.

But that reduction was not the result of any domestic rebalancing. By definition a country's current account balance is the difference between what it saves and what it invests. China saves more than it needs to fund its domestic investment. The excess savings get exported. That's the current account surplus.

To rebalance China would have to save and invest less, and to spend more on private consumption. Instead, China is saving as much as ever. It's just that Beijing has ramped up investment from 39 per cent of GDP in 2007 to around 46 per cent last year (the exact figures haven't been published yet).

So China has only reduced the difference between its savings and investment by investing more. Far from rebalancing, as Osborne believes, the mainland's economy has become even more unbalanced.

The British chancellor is also wildly off-kilter when it comes to the yuan. Keen to promote London as a centre for yuan business, yesterday he announced that "what we all want to see is [the yuan] being used more and more as a currency of choice in the world".

Yes, the yuan has gained ground recently as a currency for trade settlement (although if you strip out Chinese domestic trade routed though Hong Kong the amounts are a lot smaller than the headline figures suggest).

But those gains have been propelled almost entirely by simple exchange rate and interest rate arbitrages.

The yuan has been strengthening, so people and companies offshore have been happy to hold it. Similarly, in an era of low interest rates, yields on the yuan are relatively attractive. Again, people want to hold the currency.

However, neither arbitrage is likely to last much longer. An increasing number of analysts believe the yuan is now overvalued. With Beijing keen to introduce more two-way risk into the yuan's exchange rate, the currency could easily weaken over the medium term.

Meanwhile, as China's economy slows, its equilibrium interest rate will decline. With the US Federal Reserve now talking about raising short-term US dollar rates - as the release on Wednesday of Fed minutes showed - the differential between yuan and international interest rates is likely to narrow.

That will reduce the incentives for international businesses to deal in and hold the yuan.

What's more, because China runs a trade surplus, attempting to settle more of China's trade - exports as well as imports - in yuan must drain yuan liquidity from the offshore market.

To promote the yuan as a "currency of choice", as Osborne puts it, China would have to run a sizeable trade deficit, much as the United States does today. That doesn't look probable in the foreseeable future.

As National Development and Reform Committee adviser Yu Yongding explains, "this is a fundamental problem with the People's Bank of China's roadmap for [yuan] internationalisation".

He ought to know. Just don't expect the likes of George Osborne to pay any attention.