Hot spots: China.(international)

Few doubt that the exchange rate of the yuan will remain pointed upward, in the future not only against the U.S. dollar, vis-a-vis it has just completed its 12th quarterly gain and has advanced by 6.6% so far this year, but also, increasingly, versus the euro. The renminbi's movements have become quite erratic, however, as the unit surged by 4.1% against the USD in the first quarter and then slowed its rise to a virtual standstill, so that it wound up for April with a gain of a mere 0.3%. In May, the appreciation was reaccelerated to 0.7% and in June it reached 1.3%.

This change in pace was by no means accidental. It was engineered by the Central Bank in an effort to bewilder speculators, for whom wagering on an appreciation of the yuan was a one-way bet. The prospect that the authorities will continue to let the yuan rise in order to fight inflation is taken as a given, and rightly so. While the consumer price climb in May, at 7.7%, showed an improvement from the peak of 8.7% hit in February, it makes it clear that the official target of getting monetary erosion down to 4.8% for all of 2008 will be missed by a big margin.

There are also strong reasons for assuming that the improvement was temporary. Granted, in the weeks immediately ahead, a moderation in the rise of food prices may blunt one of the forces that has been driving inflation upward, but Beijing has just announced a significant increase in fuel prices. With a time lag, such hikes tend to affect prices of goods and services across the board. Moreover, money supply growth measured by the broadest yardstick--M-2--jumped in May by 18.1% from a year earlier and the wholesale price index showed no slowing of its rise in May, with a year-on-year increment of 8.2%.

To counter this trend, the authorities have been talking tough about the need to tighten monetary policy, but they have not actually raised interest rates this year, after six increases in 2007. At this point, China's key one-year lending rate stands at 7.47% and the deposit rate at 4.14%, meaning that both are still substantially negative in real terms. The reasons why the government has been hesitant to move interest rates into positive territory are (a) that increased borrowing costs in China do not have the same effect on consumption and investment as they would in developed economies relying more heavily on credit and (b) that higher rates tend to make speculative capital inflows into yuan that much more attractive.

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There are not many legal ways for people to profit from a rising yuan. The most-travelled avenues are illegal, including over- and under-invoicing in international trade, as well as over-reporting inflows of direct investment capital and outbound remittances of profits and dividends. To give an idea of just how voluminous such transactions can be, while the Customs office reports that the country's foreign merchandise trade surplus contracted by 7% in the first five months of this year, largely due to a near-doubling of the bill for imports of oil and petroleum products, total official foreign exchange assets soared by a remarkable $393 billion during that period, to a grand total of $1.8 trillion [sic]. If one deducts from the increment the trade surplus and inflows of long-term foreign direct investment, one is still left with $214 billion in funds that entered the country for other reasons. If one ...