WHY CHINA WON'T BOW TO BUSH NOW
By Clay Chandler

(FORTUNE Magazine) – WITH THE FEROCITY OF THE sandstorms that descend on Beijing each winter, rumors that Chinese leaders will abandon their policy of pegging China's currency to the U.S. dollar are again sweeping through global markets. The speculation, like the storms, will soon blow over.

For the past ten years China has held the value of the yuan at about 8.3 per U.S. dollar, allowing the currency to fluctuate only in a narrow band around that level. It has managed this feat, in the face of record-breaking trade surpluses with the U.S., by purchasing hundreds of billions of dollars in U.S. Treasury bonds. China now trails only Japan as the world's largest U.S. bondholder.

Since September, markets have swirled with talk that China planned to revalue its currency at a higher level against the dollar or significantly widen the trading band. U.S. and European hedge funds dumped dollars while bidding up commodities and shares of Chinese companies listed in Hong Kong. Chinese expats poured billions into Chinese banks and glitzy real estate projects in Shanghai and Beijing in the hope that Beijing would let the yuan soar, lifting the value of their investments.

Believers have found no shortage of reasons the peg must come unstuck. Many assert China wants a stronger currency to rein in exports and slow runaway growth. That's hard to square with the Chinese central bank's October decision to raise interest rates for the first time in nine years; if anything, the rate hike mitigates the need for hitting the currency brakes. Yuan bulls also cheered George Bush's reelection, noting that the administration has clamored for a stronger yuan. But given the success with which Chinese officials have shrugged off Bush's carping so far, it's hard to see why they should feel compelled to give in now. A stronger claim is that Bush has presided over record budget and trade deficits in his first term and promised more tax cuts in a second. According to this logic the prospect of ever larger U.S. deficits will weaken the dollar's appeal. Maybe. But while hedge funds may find dollar-denominated assets less attractive, Japanese and Chinese governments seem not to share their view.

Money managers betting against the peg made much of recent comments by Guo Shuqing, head of the foreign exchange department of China's central bank, that exchange-rate stability "doesn't mean not fluctuating." But Bear Stearns Asia strategist Michael Kurtz says that remark is consistent with long-standing plans for gradual exchange-rate liberalization.

Six months ago, runaway growth had China's planners worried that the economy was hurtling out of control. Since then, however, the temptation to let a stronger yuan check the expansion has all but disappeared. Administrative restrictions adopted since May--including curbs on bank lending and tighter controls on public works projects--have kept growth on track. After a November swing through Beijing, Morgan Stanley chief economist Stephen Roach concluded he had been wrong to fear a Chinese crackup. In a note to clients, he dismissed as "serious misconceptions" reports that Chinese leaders were contemplating using a stronger yuan to rein in growth.

Beijing may reconsider should the dollar plunge in currency markets. But since the other Asian countries that are China's competitors and trade partners also link currencies to the dollar--explicitly like Hong Kong or effectively like Japan--China's peg seems likely to withstand some mighty winds. -- Clay Chandler