When Currencies Collide

By JOSHUA COOPER RAMO

Last week in Hong Kong, a multibillion-dollar game of chicken was being played out. Currency speculators--the kind of financial gamblers whose cold-bloodedness could freeze mercury at 10 paces--made a run at the Hong Kong dollar, essentially trying to force its value vs. the U.S. dollar lower by manipulating the supply. It's the type of monetary maneuvering that doesn't mean much to most of us. Yet had the speculators won--and the game isn't over--the economic damage could have been huge, and the already wobbly U.S. stock market would have understood the true meaning of the word correction.

It seems illogical that a group of money sharps acting half a world away could have any effect on the seemingly bulletproof U.S. economy. But the stock market's swoon--the Dow industrial index was off some 450 points in the past two weeks--is directly linked to the deepening trouble in Asia, which represents only 30% of American exports but about 100% of American worries. Cheaper Asian goods, made possible by currency devaluations, have caused the U.S. trade deficit to balloon: America is buying more from the Pacific rim and selling less. While that's good for companies like Wal-Mart and allows shoppers to buy lawn furniture and kids' clothing cheaper, economists are concerned that Asia is sucking at America's economic resilience. With Asian markets shrinking, farmers in Montana can't export as much wheat, so prices have crashed. Companies like Coca-Cola, which makes almost 80% of its profits in foreign markets, are seeing earnings hurt.

The currency speculators, having knocked off Asia's weaklings, such as the Thai baht and the Malaysian ringgit, are now taking on the region's Godzillas: the Japanese yen, the Hong Kong dollar and the Chinese renminbi. The three are relatively stable, buttressed by huge economies and, in the case of the renminbi and the HKD, by solid "pegs" to the U.S. dollar that the Chinese government has pledged to defend--even at tremendous national cost.

That cost is growing. Last Tuesday the yen hit a new low--about 147 to the U.S. dollar--and the region hiccuped with pain. The cheap yen was a strong signal to investors who were betting that Asia has farther down to go before it takes any steps up. On international markets, it was the yen slip that triggered the attack against the HKD. During a weeklong run-and-gun battle between speculators and the Hong Kong Monetary Authority, the peg remained firm. (The HKD is pegged to the U.S. dollar at a ratio of 7.8 to 1.) A defiant Joseph Yam, head of the HKMA, vowed in the press conference, "I am going to hit them [speculators] where it hurts." But the defense cost Hong Kong billions (the government had to buy Hong Kong dollars with U.S. dollars) and did little to discourage speculators.

The currency link between China and Japan has spooked the markets in Hong Kong and other Asian capitals, which expect a massive depreciation of the yen to hurt China severely. While some analysts think the ability of the yen to wreak havoc on the Chinese economy is exaggerated--for one, there is little overlap between the two countries' export commodities--the markets seem to disagree. In theory, a deeply cheap yen could lead to Chinese exports' losing markets to less expensive Japanese goods, Japanese consumers' buying less Chinese goods and Japanese companies' investing less in China. These losses, in turn, might cause Beijing to loosen the renminbi. That could trigger a nightmare: economic collapse across Asia followed by unquenchable social unrest. And America, which has remained above the turmoil so far, would be pulled along for the ride.

Japan, for its part, has tried to stop the slippage in the yen, but with little success. In the past nine months the Bank of Japan has officially spent about U.S.$20 billion battling currency traders. Japan has $205 billion in its reserves, but its defense of the 150 level is slowly eating at that healthy hoard. Some analysts are predicting a 200-yen dollar by year's end, but they do not believe it will stay there. The consensus bet is for 150 to 155 by mid-September.

Tokyo's currency problems come largely from an overall weakness in Japan's economy, which makes people want to unload yen and buy dollars. "In a way, nothing the government does now is relevant," says Jeffrey Young, head of Japan market analysis at Salomon Smith Barney in Tokyo. "The underlying forces in the economy are so negative already." Those forces include a rotting banking system and an overeagerness on the part of the Bank of Japan, which is printing money as fast as it can as part of an attempt to increase capital flows in the country's markets. The country is trying to clean up the banking crisis with a "bridge bank" program, but the plan has been greeted as if it were day-old sushi. "You can't store a whole tuna in a little refrigerator," says Mitsuru Saito, a Sanwa Bank economist in Tokyo. "The bridge bank is only big enough for sardines."

The Chinese have been booing Japan's awkward adjustment loudly from the sidelines, even as they hint quietly about the dangers of a depreciating yen. On Tuesday, frustrated Chinese officials publicly slammed their Japanese counterparts: "The Japanese government's economic-reform policies lack details, and its actions are not decisive," said Beijing's Economic Information Daily. Even worse, the Chinese central bank has reportedly been selling yen, a tactic that has made life even more miserable for Japan's central bankers.

The Chinese have tremendous economic problems of their own. Growth in the once rocket-powered mainland economy has slowed from 8.8% to 7% this year. But most observers think those official numbers are as well cooked as a Peking duck: real growth may be as low as 3%, dampened in part by the flooding Yangtze River that is ravaging the countryside. The floods, which have killed at least 2,000 people and destroyed hundreds of towns, are also demolishing domestic demand and destroying the once promising foreign-investment corridor along the Yangtze. With economic damage listed at U.S.$24 billion, the floods are expected to reduce the growth rate at least 0.5%--and the rains are continuing. In Beijing, the government is trying to figure out how to deal with an overextended banking system (70% of loans at some banks are nonperforming), and in Shanghai, some investors are scrambling to get out of the collapsing real estate market.

In the end, it's these problems that have made a renminbi devaluation seem plausible. There have been hints from Beijing. In June a Chinese foreign-trade official said in an economic forum that if the falling yen puts pressure on China's exports, China might have to consider making "adjustments." But there are plenty of reasons to think China won't steeply devalue, at least in the short term. China still has a huge demand for both foreign capital and technology, both of which would get more expensive if the renminbi gets cheaper. At the same time, a cheaper yen could help China, which holds billions of dollars in yen-denominated debt. Dong Tao, senior regional economist at Credit Suisse First Boston, reckons that China, which he believes holds some U.S.$40 billion in yen debts, stands to save U.S.$4 billion in repayments if there were a 10% decline in the yen.

What is particularly frightening to investors--or invigorating, for those with a huge appetite for risk--is that no one seems to know what's coming next. Hong Kong's economic woes are so awful--they include a tumbling property market and a worried banking sector--that some correction in the HKD seems inevitable in the next year or so. But how might China structure such an adjustment? Would it try to repeg the HKD to the renminbi? Would it fix the HKD to a basket of currencies, a solution favored by some economists? In the small currency black market that is blossoming in China, the renminbi has slipped from the official 8.3 to the U.S. dollar to about 9--a sign that locals are betting some sort of devaluation is inevitable. "The black market re-emerged around the Chinese lunar new year," says a Beijing trader who prefers to be known as Mr. Wang. "Since then the renminbi has been going downward against the dollar. Who knows what the bottom level will be?"

The bottom line is that if China devalues and the yen continues to weaken, the fallout will reach the U.S. faster than a 747. And in the meantime, Boeing will be selling fewer 747s to Asia, Kodak will sell less film, and Hewlett-Packard will sell fewer computers. That will hurt profits, and eventually it will hurt jobs. That may not appear to mean much with U.S. unemployment below 5%. But as Asia has discovered, once an economy heads south, the momentum is irresistible. And currencies are the compass.

--Reported by Hannah Beech/Hong Kong, Jaime A. FlorCruz/Beijing and Frank Gibney Jr./Tokyo

With reporting by Hannah Beech/Hong Kong, Jaime A. FlorCruz/Beijing and Frank Gibney Jr./Tokyo