China quietly joins Asia's currency wars to avert deflation

China is exposed like a sore thumb as countries devalue on all sides, from Russia, to Japan, Indonesia and Malaysia

By Ambrose Evans-Pritchard, International Business Editor

7:12PM GMT 22 Dec 2014

Damaged 100 yuan banknotes are seen on a table at a branch of China Bank in Foshan

China has quietly joined Asia's escalating currency wars, steering the yuan down by 2pc against the dollar since early November Photo: Reuters
China has for the first time warned openly about the excessive strength of the Chinese yuan, a sign that the country may be shifting its exchange rate policy as deflation takes hold and currencies slide across Asia. 
Yi Gang, the deputy governor of the People's Bank of China (PBOC), said the yuan’s rise had been “very fast” over the past year as it surges in tandem with the US dollar, making it the world’s second strongest currency.
China’s real effective exchange rate (REER) has risen for six months in a row, tightening the screws on struggling exporters with wafer-thin margins. It rose 2.3pc in trade-weighted terms in November alone as countries devalue on all sides, leaving China exposed like a sore thumb. The effect is to tighten China’s monetary conditions into the downturn.
The country has quietly joined Asia’s escalating currency wars, steering the yuan down by 2pc against the dollar since early November. This looks increasingly like a move to protect itself against Japan’s dramatic devaluation and against weakening currencies in Korea and other key Asian states. 
The yuan is no longer fixed to the dollar but remains linked through a “soft peg”. It has therefore been forced sharply upwards this year even though the Chinese economy is slowing and the country is losing global competiveness.

China is also sliding uncomfortably close to deflation. Producer prices are falling at a rate of 2.7pc as excess plant in steel, cement, chemicals, coal and even solar chips lead to price wars. The headline inflation rate has dropped to 1.4pc. “China has a major deflation problem,” said Societe Generale. 
Any action to devalue the yuan has the effect of exporting China’s deflation to the rest of the world, especially to Europe where the authorities are struggling to defend themselves.
The chief currency shock comes from Japan, where the world’s most radical monetary experiment has caused the yen to plunge by 40pc since early 2012. This yen slide has become increasingly threatening over recent months as the Japan’s exporters start to cut prices rather than pocketing the exchange rate gains as higher profit.

Emerging market jitters have led to a further currency sell-off in a string of countries, from Russia to Indonesia, India, Thailand and Malaysia. The effect is to leave China stranded in a sea of devaluation.

“This is similar to the East Asia crisis in 1998 when the Japanese yen was falling like a stone,” said George Magnus, from UBS. “Given the mix of slowing growth and deflation in China, I don’t see how they can hold the line.”

Mr Yi said the recent fall in the Chinese yuan is the result of market forces as Beijing phases out rigid controls. However, there are signs that the country is once again buying foreign bonds to hold down the currency.
China stopped intervening earlier this year after purchasing $106bn of US Treasuries, German Bunds, Gilts and other bonds, in the first quarter. Premier Li Keqiang said in May that the country’s $4 trillion reserves had become burden and was making it harder to run an independent monetary policy, but he does not have the last say on the Standing Committee.
Marc Chandler, from Brown Brother Harriman, said the Chinese currency is falling under its own weight. “We don’t think the government is intervening to drive it down. Capital is leaving the country,” he said.

U.S. Economy

U.S. Economy Posts Strongest Growth in More Than a Decade

GDP Grows at 5% Rate, Supported by Consumer Spending, Business Investment

By Eric Morath And Ben Leubsdorf

Updated Dec. 23, 2014 8:06 p.m. ET

The U.S. economy is rounding out 2014 in a sweet spot of robust growth, sustained hiring and falling unemployment, stirring optimism that a postrecession breakout has arrived.

A fuller picture of the year-end trends emerged Tuesday when the Commerce Department, in separate reports, said the U.S. economy expanded at a 5% seasonally adjusted annual rate in the third quarter, its strongest pace in 11 years, and reported that consumer spending accelerated last month amid rising incomes and falling gasoline prices.

“It appears we’ve reached an inflection point,” said John Canally, economist at LPL Financial.
But while investors cheered the sense that the economy could shift to a higher rate of growth, driving the Dow Jones Industrial Average above 18000 for the first time, a big question remains: Can consumers sustain the momentum into 2015?

There still are signs the economy is far from full health. Inflation remains low and has sagged lower in recent months, largely because of falling oil prices. Low inflation and sagging commodities prices are a possible signal of weak underlying demand, particularly overseas.

Wage growth remains sluggish, though there have been glimpses in recent data of a potential pickup. Gains in labor productivity have been slow.

These realities present something of a quandary to the Federal Reserve as policy makers try to judge how soon a healthier economy can handle rising interest rates, even if inflation continues to undershoot their 2% goal.

“The Fed is likely to look through much of the weakness” in inflation figures “with such impressive growth,” BNP Paribas economist Bricklin Dwyer said. Most Fed officials expect to begin raising rates, which have been near zero for six years, sometime in 2015.

Driving expectations for rising rates is an economy that logged its best quarterly growth in more than a decade.

U.S. gross domestic product, the fullest measure of economic output, was shown in the Commerce Department’s third estimate to have expanded at a 5% pace in the third quarter—up from the second quarter’s growth rate of 4.6% and the strongest pace since the third quarter of 2003.

The growth was buoyed by consumer spending on health care and restaurant meals, business investment in equipment and new software, and a rise in exports.

But the economy likely hasn’t maintained the third quarter’s heady growth pace during the fourth quarter in part because the summer months were supported by an unusually large increase in military spending that analysts don’t expect to be repeated.

Additionally, weakness around the world could reduce demand for U.S.-made products, and a stronger dollar could further depress exports by making them more expensive overseas. After two solid quarters, business spending showed signs of weakening in the final months of 2014. Falling oil prices could dent some domestic drilling projects, reducing capital expenditures and employment in some areas. And the housing sector remains shaky.

Indeed, economic growth has been uneven and halting since the recession ended in mid-2009 and previous periods of seemingly strong growth during the recovery proved short-lived. The U.S. posted two strong quarters of growth in the second half of 2013, then ran aground amid harsh winter weather.

The first quarter’s unexpected GDP contraction means Fed officials expect full-year growth will come in below 2.5%, marking 2014 as only a slight pickup from recent years. But officials see growth strengthening to between a 2.6% to 3% rate in 2015, according to economic projections released last week.

Private economists see fairly healthy growth for the U.S. in the fourth quarter ending next week. J.P. Morgan Chase on Tuesday projected GDP growth at a 2.5% pace. Macroeconomic Advisers and Barclays predicted a GDP growth rate of 2.8%, while Bank of America Merrill Lynch predicted a 3% pace.

Economists’ views on fourth-quarter growth were colored by a host of economic data released Tuesday.

New orders for durable manufactured goods—products like airplanes, cars and heavy machinery that are designed to last at least three years—fell 0.7% in November from the prior month, the Commerce Department said Tuesday. Orders for nondefense capital goods excluding aircraft, a proxy for business spending, were flat last month after falling in September and October.

The housing market has yet to return to prerecession levels despite low mortgage rates and strong job growth. Sales of new single-family homes fell for the second straight month in November and are essentially unchanged this year from 2013, the Commerce Department said Tuesday.

Inflation, meanwhile, remains tame. The Fed’s preferred gauge, the Commerce Department’s personal consumption expenditures price index, slipped to a 1.2% annual gain in November from 1.4% in October. It was the 31st consecutive month that inflation undershot the central bank’s 2% target.

Falling energy prices helped drive down that inflation reading. Excluding the categories of food and energy, prices were flat in November from the prior month and rose 1.4% from a year earlier, ticking down from 1.5% annual growth for core prices in October.
But consumer spending, which generates more than two-thirds of economic output, could offer underlying strength and help the economy power through the headwinds. Household spending rose 0.6% in November from the prior month and 4% from a year earlier, the Commerce Department said Tuesday.

“The consumer drives the bus in this economy,” said Scott Brown , economist at Raymond James & Associates. Gains in household spending, he said, “should support overall economic growth in the first half of next year.”

The decline in energy prices, while dragging down overall inflation, gives consumers a boost in the form of cheaper gasoline. Fed Chairwoman Janet Yellen last week said the global plunge in oil prices is “likely to be, on net, a positive” for the U.S., comparing lower prices to a tax cut.

Yet cheaper gas is only part of the story. Job creation this year has been the strongest since 1999. The unemployment rate was 5.8% last month, down from 7% a year earlier, according to Labor Department data.

Personal income rose 0.4% last month from October and climbed 4.2% from a year earlier, the largest annual income gain since December 2012, the Commerce Department said.

Consumers are ending 2014 feeling upbeat, a good omen for household spending. The final December consumer-sentiment index from the University of Michigan, released Tuesday, was 93.6, up from November’s final reading of 88.8. The report said improvement in the labor market, more than falling gas prices, is driving consumers to feel better about the economy.

Same-store sales are up 10.9% this year at Tropical Smoothie Café LLC, an Atlanta-based chain of 412 smoothie and sandwich shops. “The stock market is up, gas prices are down and even home values are coming back,” Chief Executive Mike Rotondo said. People, he said, seem “more bullish.”

—Jonathan House, Kathleen Madigan and Josh Mitchell contributed to this article.

China’s Growth Secret
Zhang Jun
DEC 26, 2014     

Chinese woman bricks

SHANGHAI – Many people are profoundly pessimistic about the Chinese economy’s growth prospects, owing to the emergence of massive debt, excessive investment, overcapacity, and so-called “ghost cities” since the 2008 global financial crisis. But these problems are not new. They have, in various forms, affected China’s economy since 1978, and were evident in East Asia’s other high-performing economies – Taiwan, South Korea, and even Japan – during their periods of rapid growth.
Nonetheless, in the 35 years since Deng Xiaoping initiated his program of “reform and opening up,” China has recorded 9.7% average annual growth. And it took only 40 years for South Korea and Taiwan to complete their transitions from low- to high-income status.
How did these economies manage to grow so fast for so long and overcome the serious problems that they faced along the way? The answer is simple: resilience.
Economic development is a convoluted process, full of challenges and risks, successes and failures, external shocks and internal volatility. And adverse effects – such as a rising debt-to-GDP ratio and excess capacity – are inevitable.
If a country fails to respond adequately to new challenges as they arise, economic growth and development stall. Many countries in Latin America and South Asia, for example, have become mired in the so-called “middle-income trap,” because they failed to adjust their growth models in a timely manner.
East Asia’s economies, by contrast, consistently adjusted their growth strategies and engaged in continuous institutional reform. The aim was not to tackle the problems they faced directly, but to induce new, more efficient activities that would help to turn debt into assets and maximize use of the economy’s capacity.
In this sense, East Asia’s economies have embraced the process of “creative destruction” described by the Austrian economist Joseph Schumpeter, whereby the economic structure is continually revolutionized from within. Moreover, by implementing incremental reforms that facilitate – and even encourage – the replacement of old, inefficient sources of growth with new, more dynamic ones, they have expedited this process.
For example, China’s productivity-enhancing agricultural reforms in the 1980s were spurred partly by growth in the non-agricultural sector, a result of policies aimed at stimulating township and village enterprises. Similarly, in the 1990s, China addressed the buildup of bad debt and unfinished construction projects – the result of state-owned enterprises’ chronic loss-making and excessive property investment, respectively – by implementing institutional reforms that stimulated growth in more dynamic sectors, thereby offsetting the SOEs’ declining return on capital.
Resilience has thus characterized the interaction between the government and markets since the introduction of Deng’s reforms. Indeed, according to the late economist Gustav Ranis, the interactive dynamic of policy and market institutions was the key to the success of the East Asian economies. For example, fiscal decentralization in China, spurred by local institutions’ demands for increased autonomy, has helped to fuel regional competition and sustain an increasingly market-oriented economic environment.
This interactive dynamic is also reflected in the formation of industrial policies. In China, though clusters of vibrant smaller manufacturers are flourishing, policymakers have done relatively little to promote industrial development and upgrading. This leaves it up to market institutions to guide the process, ensuring that they play a key role in the expanding industrial sectors.
Another source of resilience in East Asia are local governments. For starters, they are responsible for public capital expenditure, driving the improvement in China’s physical infrastructure and yielding reasonable returns for private investors. This advances the objective of helping local businesses, particularly innovative small and medium-size firms, to grow and thrive. To this end, local governments are also helping entrepreneurs gain access to global production chains. The Zhejiang and Guangdong provinces have been particularly successful in this effort – and, unsurprisingly, rank among China’s most robust regional economies.
Finally, local governments have demonstrated a willingness to support institutional innovation. This allows for the flexibility needed to address structural challenges at the local level, thereby preventing them from blocking growth.
After three years of slowing growth and rising debt, China once again finds itself at a crossroads. Fortunately, it seems to be choosing the path of flexibility and adjustment, as it pursues an ambitious reform plan that, it is hoped, will enable it to edge closer to – and eventually cross – the high-income threshold.