Urgent Advice to Beijing Jude Wanniski July 10, 1998

Memo To: To Yu Jun
From: Jude Wanniski
Re: Yuan Devaluation

[I had lunch July 2 with Mr. Yu, the executive assistant to the Chinese Ambassador to the United States, Li Zhoxing. I've known the ambassador and Mr. Yu since they were posted in Washington earlier this year, and our lunch was a happy one, given the great success of President Clinton's visit to China. On the other hand, I did explain to him that Beijing's commitment NOT to devalue its currency, the yuan (also known as the renminbi), meant that they were permitting the Federal Reserve to manage the controlling feature of their monetary system. The following memo, written and sent to him this week, was simply intended to give him and his government my precise words in expressing concern for them. I have a number of times alerted our clients about this danger to China, but otherwise there has been no report of it anywhere in the world press, as far as we can tell.]

What I tried to make clear to you during our wonderful lunch (thank you again), was that Beijing should understand that its open-ended commitment to “not devalue” the yuan is an extremely dangerous one, because it puts you at the mercy of Federal Reserve policy. Why? Because you are pledging not to allow the value of the yuan to fall relative to the dollar, which has no definition in real terms. That is, because the dollar is floating against gold, the most important monetary commodity, China is completely giving up its sovereignty in monetary policy by promising not to allow its unit of account to diverge from the dollar.

As you can see in the week since we met for lunch, there are many reports in the western press that China’s export industries are pleading for a devaluation. I see reports all day long that a yuan devaluation is in the cards. I urge you to convey to Ambassador Li the seriousness of my argument that if the price of gold in dollars falls further, from its current level at $294, it will produce great distress throughout your youthful market economy. Millions of people may have to be unemployed because of the wreckage this deflation inflicts upon your new financial system.

Because of your solemn commitment to President Clinton, it now becomes a problem for your government. You won’t devalue against the dollar!!! One way out of this bind would be to add yuan liquidity to the banking system -- printing yuan or adding bank reserves -- at a tiny rate every day, so the devaluation is not obvious. If the markets understand that you are loosening very, very gradually, they will reward you with higher asset values and a sense in the population at large that the government knows what it is doing and is at least bringing relief gradually.

The problem in Hong Kong is of course serious too. The HK dollar has been deflating against the US dollar at almost the same rate as your yuan. The correct medicine would be to adjust the HK dollar to a gold price about 10% higher than where it is. No more, no less. If the HK dollar were re-pegged in this fashion, the Hang Seng index would climb rapidly -- as long as the government informed the markets that this was being done for the sole purpose of adjusting the HK dolllar/gold rate. If you devalue without telling the market the correct reason, you will be punished with capital flight. If you give the correct reason, you will be rewarded by a capital inflow.

I hope you understand this, Yu. If you have any questions, large or small, please ask. I will put my answers in writing so you will be able to accurately convey my ideas to Beijing. There is always the small chance that I will be understood and my ideas acted upon. I hope you agree that it does not hurt to add my opinion to all other opinions your government is getting.