Chinese Premier Blames Recession on U.S. Actions

Chinese Premier Wen Jiabao squarely blamed the U.S.-led financial system for the world's deepening economic slump, in the most public indication yet of discord between the U.S. government and its largest creditor.

Leaders in China, the world's third-largest economy, have been surprised and upset over how much the problems of the U.S. financial sector have hurt China's holdings. In response, Beijing is re-examining its U.S. investments, say people familiar with the government's thinking.

Watch excerpts of Chinese Premier Wen Jiabao's keynote speech at the World Economic Forum in Davos, Switzerland.

Mr. Wen, the first Chinese premier to visit the annual global gathering of economic and political leaders in Davos, Switzerland, delivered a strongly worded indictment of the causes of the crisis, clearly aimed largely at the United States though he didn't name it. Mr. Wen blamed an "excessive expansion of financial institutions in blind pursuit of profit," a failure of government supervision of the financial sector, and an "unsustainable model of development, characterized by prolonged low savings and high consumption."

Chinese leaders have felt burned by a series of bad experiences with U.S. investments they had believed were safe, say people familiar with their thinking, including holdings in Morgan Stanley, the collapsed Reserve Primary Fund and mortgage giants Fannie Mae and Freddie Mac. As a result, the people say, government leaders decided not to make new investments in a number of U.S. companies that sought China's capital. China's pullback from Fannie and Freddie debt helped push up rates on U.S. mortgages last year just as Washington was seeking to revive the U.S. housing market.

To be sure, China's economy now is so closely intertwined with the U.S.'s that major, abrupt changes are unlikely. The U.S.-China economic relationship has become arguably the world's most important. China has been recycling its vast export earnings by financing the U.S. deficit through buying Treasurys, helping to keep U.S. interest rates low and give American consumers more spending power to buy Chinese exports.

China now has roughly $2 trillion in foreign exchange reserves, and has continued to buy U.S. government debt -- surpassing Japan in September as the biggest foreign holder of Treasurys, by one official U.S. measure. China must continue to recycle its trade surplus if it doesn't want its currency to appreciate too quickly.

Still, the relatively smooth financial ties between the two powers that underpinned the global economic boom of recent years are being tested. As both sides survey the wreckage of the U.S. housing bubble and credit crunch, mutual recriminations are raising doubts about the relationship.

The Chinese premier's remarks came a few days after Treasury Secretary Timothy Geithner fanned the flames when he accused China of "manipulating" its currency during his confirmation process. That was widely seen as an escalation of long-standing U.S. complaints that China artificially depresses the value of the yuan to bolster its exports, and prompted strong denials from Beijing. The Obama administration has since played down the statement's significance.

More Friction

Frictions between the two countries began to worsen long before Mr. Obama took office. The Chinese central bank last year stopped lending its Treasury holdings for fear the borrowers will go bankrupt, according to people familiar with the discussions -- a decision that disrupted the functioning of the Treasury market. Beijing rejected pleas by Washington to resume its lending of Treasurys, the people said.

Meanwhile, China -- for years the largest foreign investor in bonds from Fannie Mae and Freddie Mac -- has been sharply trimming its holdings of that debt. After making direct net purchases of $46.0 billion in the first half of 2008, China's government and companies were net sellers of $26.1 billion in the five months through November, according to the latest U.S. data.

Weak demand for such debt from China and other foreign investors helped prompt the Federal Reserve to announce in November that it would take the step of buying up to $600 billion in debt from Fannie, Freddie and two other U.S. government-related mortgage businesses.

While Chinese officials have generally been circumspect in public, some Chinese commentators have sharpened their rhetoric in recent weeks. Washington "should not expect continuous inflow of more cheap foreign capital to fund its one-after-another massive bailouts," said a December editorial in the government-owned, English-language China Daily. Officials at the newspaper said the commentary wasn't ordered by the government.

Cash-rich Chinese financial institutions are under withering criticism at home for investments in the West that have lost money, such as a $5.6 billion stake in Morgan Stanley purchased by China's sovereign wealth fund, China Investment Corp., 13 months ago. The U.S. company's shares have dropped around 60% since then. Chinese institutions have rebuffed entreaties to invest in struggling U.S. companies even as investors from Japan and the Middle East have stepped up.

For years, Washington has pushed China to adopt an economic and financial system more like that in the U.S. -- arguing, for example, that China should liberalize capital flows in and out of the country. In many cases, China has moved more slowly than the U.S. desired. Beijing has resisted American pressure to let its currency appreciate in line with market forces, for example, which economists say has helped inflate China's trade surplus.

But often, U.S. suggestions had a sympathetic audience among reformers in China's government, and many of China's financial overhauls in recent decades have been inspired by the U.S. model. Now, some of these changes, and their proponents, have lost credibility in China in the wake of the financial meltdown, and recently commentators and officials in China have been increasingly critical about Washington.

Amid high-level Sino-U.S. economic talks in Beijing in early December, Chinese officials admonished the U.S. and Europe for their financial governance.

Vice Premier Wang Qishan, China's top finance official, called on the U.S. to "take all necessary measures to stabilize its economy and financial markets to ensure the security of China's assets and investments in the U.S."

A similar complaint was issued by Lou Jiwei, chairman of CIC, the government fund established in 2007 to seek higher returns on a $200 billion chunk of China's currency holdings. Mr. Lou said in a December speech that he has "lost confidence" because of inconsistent government policies concerning support for Western banks. "We don't know when these institutions will be invested in by their governments," he said.

Fate of U.S. Investments

CIC officials are especially sensitive about the fate of their U.S. investments because they have been under fire for the poor performance of earlier deals. CIC has sustained large paper losses on the $3 billion it invested in Blackstone Group LP in June 2007, as well as the Morgan Stanley stake. Staffed by officials, some western-educated, who have helped promote financial-market liberalization in China, CIC is also viewed by some Chinese as a symbol of the country's close financial ties to the U.S. -- another reason it has been in the crosshairs.

Around October, a lengthy Chinese-language essay began circulating on the Internet excoriating Mr. Lou and other top CIC officials, along with Zhou Xiaochuan, China's central bank governor, for being too close to the U.S. and then Treasury Secretary Henry Paulson. The diatribe quickly gained wide circulation in Chinese financial circles. One passage charged that Mr. Zhou "colluded with Henry Paulson to buy U.S. bonds, forced [Chinese yuan] appreciation, attached China's economy to the U.S. and broke China's economic independence."

Chinese and U.S. interests remain deeply enmeshed. Washington's huge stimulus plans will result in even heavier borrowing, and, while rising savings in the U.S. could create more domestic capital to help fund that, Chinese lending will remain important.

Japan investors, too, have been selling Fannie and Freddie debt and making other moves to limit their U.S. risk. An official at another Asian central bank in charge of managing hundreds of billions of dollars in foreign exchange reserves noted late last year that trading in some derivative instruments had factored in a slightly higher possibility of default by the U.S. government, though that prospect is still viewed by most investors as extremely low.

The alarm for Chinese leaders started ringing loudly in July and August as problems deepened at Fannie and Freddie. Senior Chinese leaders, who hadn't been apprised in detail of how China's reserves were being invested, learned for the first time in published reports that the country's exposure to debt from those two alone totaled nearly $400 billion, say people familiar with the matter.

Fearing that the U.S. government might not fully back the companies, China demanded and received regular briefings throughout the peak of the crisis from high-level Treasury Department officials, including Mr. Paulson, on the market for U.S. debt securities -- especially those of the mortgage giants.

Mr. Paulson and other Treasury officials spoke regularly with Vice Premier Wang and other senior Chinese officials to soothe their concerns.

The World Economic Forum in Davos was full of verbal tongue-lashings for the U.S. from countries such as Russia and China. The world is calling for the U.S. to get its act together. Video courtesy of Reuters.

Hit With Questions

Chinese officials often bombarded their U.S. counterparts with questions, according to people who were present at meetings.

While Mr. Paulson was in Beijing for the Olympics in August, he dined with Mr. Zhou, the central bank chief, at the Whampoa Club, an upscale restaurant that serves modern Chinese cuisine in a traditional courtyard building near the city's Financial Street.

On Sept. 7, Mr. Paulson announced that the U.S. government would seize Fannie and Freddie, but Chinese officials remained concerned.

At one briefing for Chinese officials to explain the change, said people present, they questioned and debated the meaning of nearly every line of the new Treasury plan.

Then Washington allowed Lehman Brothers Holdings Inc. to collapse, further shaking Beijing's faith. One casualty was CIC's nearly $5.4 billion investment in the Reserve Primary Fund, the money-market fund that "broke the buck" in September as a result of the Lehman collapse.

CIC had placed money in the Primary Fund because "money market funds are supposed to be very safe," said a Chinese official in an interview late last year. But on Sept. 16, the Primary Fund's managers announced that they were delaying redemptions.

CIC officials emailed Reserve asking to withdraw all of its money from the fund, and promptly received a reply agreeing to the request, says the Chinese official.

CIC officials believed the agreement meant that CIC had become a creditor to the troubled fund, and therefore was entitled to all of its money.

A Reserve spokeswoman says the company doesn't comment on individual clients.

Later in the day on Sept. 16, Reserve announced that the Primary Fund's net asset value had fallen to 97 cents a share, below the standard $1.00 level.

Reserve initially said redemption requests received before 3 p.m. that day would be honored in full, but has since said that the net asset value already was down to 99 cents a share by 11 a.m.

As Reserve further delayed payments, CIC began to fear that it might not get all of its money.

The Reserve issue "is causing a lot of concern with a lot of financial institutions in China," said the Chinese official.

Some officials expected that the U.S. and its financial institutions would better protect China from loss.

"If the U.S. is treating us this way, eventually that will be enough cause for concern in the stability of the [U.S.] system," the official said.

A CIC spokeswoman declined to comment on the current status of the dispute.

ECB, After Hard Birth,
Comes of Age in Crisis

Europe Bank Gets Points
For First-Response Role;
War Games in Frankfurt

By JOELLEN PERRY, WSJ, Nov 6, 2007.

FRANKFURT -- At 12:32 p.m. on Thursday, Aug. 9, just past its ninth birthday, the European Central Bank grew up.

The summer's mounting financial crisis, sparked by rising defaults on U.S. subprime mortgages, had fully crossed the Atlantic that morning. European banks feared their counterparts were exposed to risky investments linked to these mortgages, and became unusually reluctant to lend to each other. Financial institutions were paralyzed.

Tasked with stopping such a meltdown was the European Central Bank, which sets monetary policy for 13 countries from Ireland to Greece. The institution has been dogged since inception by criticisms that it valued consensus over decisiveness. Early on, it had been called slow-footed, disorganized and prone to miscommunicating its intentions.

But that day, the ECB swooped to the rescue. The bank offered unlimited overnight loans at its policy rate of 4%. By day's end, it had lent €94.8 billion -- about $131 billion -- which was more than it had put into money markets the day after Sept. 11, 2001. The first response by a major central bank to the summer's crisis, it stunned markets for its size. It also surprised counterparts at the U.S. Federal Reserve, who followed the ECB's injection with a smaller $24 billion one of their own later that day.

Observers credit the ECB and its head, Jean-Claude Trichet, with making a trenchant decision that calmed markets. The move shored up confidence in the bank's ability to keep markets functioning for the U.S. dollar's most significant rival. With its boosted credibility, the ECB could enhance the euro's standing in world markets. Continued confidence in the currency could ultimately come at the expense of the dollar, the current favorite of big world investors thanks in part to the size, liquidity and stability of U.S. markets.

"There were always worries that the ECB would be a stereotypical European institution, slow to decide and going off in multiple directions at once," says Adam Posen of the Peterson Institute for International Economics, a Washington think tank. "Mr. Trichet has put that to rest in this situation."

The ECB now faces fresh challenges. Global stock markets are swooning as the credit-market fallout deepens, with big write-downs and CEO departures at Citigroup Inc. and Merrill Lynch & Co. spurring fears that other banks could post more big losses. European bank shares fell yesterday, helping to bring down major indexes. And, as in the U.S. and United Kingdom, the gap between the rates euro-zone institutions charge each other for longer-term loans and the ECB's target rate remains unusually wide, suggesting markets remain tense.

A FORMER BANKER COMMENTS

"When 9/11 happened, there was some skepticism that we weren't prepared, because we were too new. We knew we could do it, but we had no track record. I think the ECB has done a perfect job."
-- Read more from former ECB board member Otmar Issing's interview with The Wall Street Journal.

This complicates the picture for ECB policy makers, who meet Thursday. Prior to the summer's credit-market unrest, robust euro-zone growth had the bank set for at least one more interest-rate rise this year. Now policy makers are caught between worries that inflation pressures are building, while the economy has yet to feel the full effect of credit-market turmoil, bank-sector write-offs and the euro's surge. In contrast to the Fed, which has cut rates by 3/4 of a percentage point since September, the ECB is likely to keep its key rate on hold Thursday. Investors see a protracted pause, but some policy makers have said the rate still could rise.

A portrait of the ECB's August response to the financial crisis emerges from documents, public statements and people familiar with the bank's workings. The ECB had been primed for a liquidity lockup, running Pentagon-style war games with such scenarios as early as April 2005. Its president, long-time French central banker Mr. Trichet, had warned loudly that investors were underestimating the danger of risky holdings. After market tremors earlier in the summer, ECB staffers who monitor markets were on high alert.

Some observers criticized the ECB for inciting panic with its intervention, saying the scope of its response suggested the bank was bracing for a catastrophe. A few still say the ECB overreacted, arguing that the offer of unlimited funds at the ECB's target rate -- the central-bank equivalent of a fire sale -- rewarded the type of risky investments that spurred the subprime debacle to start with.

The ECB still has vulnerabilities, of course, as separate events over the past three months have demonstrated. A communication gaffe by the bank left financial markets confused for days in mid-August about whether the ECB intended to raise rates. A fragmented system of bank supervision left it without detailed information about bank balance sheets at a moment of crisis. And it faces persistent sniping from politicians as it refuses to restrain a rise in the euro on foreign-exchange markets that is provoking yelps from some exporters.

Derided From Start

The ECB was established on June 1, 1998. Critics derided the institution as unworkable from the start. To shore up credibility, the ECB modeled itself after Germany's inflation-phobic Bundesbank. Like the U.S. Federal Reserve, the ECB sets a target for interest rates on overnight loans between banks. But unlike the Fed, whose dual mandate makes it attentive to both inflation and growth, the ECB's prime focus is on keeping prices stable. It aims to keep inflation at just under 2% in the 13 countries that now share the euro currency.

The ECB's rate-setting body includes the six members of its Executive Board, who oversee the bank's day-to-day operations, plus the 13 heads of the euro-zone's national central banks. Rather than voting on interest-rate decisions and publishing the minutes of their meetings, as Fed officials do, the ECB's 19 Governing Council members make decisions by consensus. The bank explains its thinking in a news conference after each decision.

The euro debuted with fanfare, and an initial value of $1.17, in 1999. Although the ECB's primary focus is inflation, not the exchange rate, a falling currency can be read as a market vote of no-confidence in an economy and its managers. Over the next 22 months, amid scattershot communication from ECB policy makers, the euro deteriorated to 83 cents.

The bank's now-deceased first president, Wim Duisenberg, initially reinforced the perception of disorganization. Although he had been an accomplished former Dutch central-bank head, the lanky policy maker with a mop of white hair became known at the ECB for a colloquial candor, uncommon in central-banking circles, that repeatedly steered markets the wrong way. British tabloids dubbed him "Dim Wim."

War Games

Since late 2003, the ECB's public face has been Mr. Trichet. A poetry buff who studied economics and mining engineering, the 64-year-old Mr. Trichet is long on practical experience, from the French Treasury to the World Bank. He was president of the Paris Club of creditor nations from 1985 to 1993, an era in which Latin American, African and Russian debts were restructured, and head of the French central bank for a decade.

By 2005, the ECB was preparing for potential market chaos. That April, at its 37-story glass-and-metal headquarters in Frankfurt, 65 participants spent two and half days in exercises aimed at honing their response to a future crisis. About a year later, some 150 people took part in a conference from their home countries to play out shocks to the financial system. In 40 teleconference calls over half a week, the group responded to various scenarios, including a prescient case in which banks sought emergency loans but policy makers didn't know whether the banks were solvent. Top policy makers were barraged by rumors, sometimes contradictory, and by actors playing inquisitive journalists.

The real thing arrived this summer. For months, U.S. homeowners with subprime mortgages -- high-interest loans extended to high-risk borrowers -- had been defaulting in rising numbers. Investors who had bought opaque securities backed by these mortgages ran into trouble as the securities became difficult to value and thus potentially hard to trade.

By late July, there were mounting clues that continental European banks were vulnerable. On July 27, the little-known German IKB Deutsche Industriebank AG revealed it had major exposure to the U.S. subprime-mortgage market, prompting an emergency weekend €3.5 billion bailout organized by Germany's financial regulator, with contributions from major German banks.

Markets lurched into early August. Even as European business slowed for vacation, the ECB's team of market monitors -- usually about 15 people, whittled to around a dozen because of vacations -- was on alert. Working on the second floor of the bank's high-rise, the team watches everything from global stock-exchange movements to copper prices.

Some five members of the team monitor money-market rates, the interest banks charge each other for loans. In the afternoon of Tuesday, Aug. 7, rates on loans ranging from overnight to a year started rising. This was puzzling: Just that morning, the ECB had conducted its regular weekly refinancing operations. That should have provided banks with enough cash to last them the week -- and, by extension, kept the rates between banks relatively flat.

In phone calls with the market monitors, commercial bank treasurers confirmed their banks were antsy.

Wednesday brought more jitters. Though the ECB had set its target rate at 4%, overnight money-market rates continued rising above that. Investors were fleeing to havens such as two-year German government bonds. Data showed commercial banks' reserves with the central bank had fallen, another sign that banks might be hoarding cash.

U.S. VS. EURO ZONE

Projected 2007 GDP*:
U.S.: $13.794 trillion
Euro zone: $11.905 trillion

Unemployment:
U.S.: 4.7% (October)
Euro zone: 7.3% (September)

Consumer prices, growth from year earlier:
U.S.: 2.8% (September)
Euro zone: 2.6% (October)

Current account deficit as % of GDP, second quarter:
U.S.: 5.5%
Euro zone: 0.1%

Population, 2006
U.S.: 299.4 million
Euro zone: 316.7 million**

*Converted to U.S. dollars at current rate.
**Includes population of Slovenia, admitted to the euro zone Jan. 1, 2007.

Sources: IMF World Economic Outlook database, Eurostat, Bureau of Labor Statistics, Commerce Department, U.S. Census

By Wednesday evening, staffers had suggested that the six-member Executive Board consider taking the unusual step of injecting cash to restore calm. By then, Mr. Trichet and Lucas Papademos, the ECB's vice president, were in touch with U.S. Fed governors.

The ECB prefers to stage major interventions before noon, when commercial-bank treasurers are sure to be at their desks. The bank decided to wait until the morning and act if markets were still tense.

They were. At 8:30 a.m. on Thursday, Aug. 9, major French bank BNP Paribas announced it was suspending withdrawals from three investment funds because it couldn't value them amid the subprime crisis. Rumors flew that other banks were in trouble.

"I've never experienced anything like it," says Christoph Rieger, interest-rate strategist at Dresdner Kleinwort in Frankfurt. The fear "ground the market to a halt."

Extraordinary Tension

Interest rates on overnight loans between European banks soared. Typically, market monitors snap to attention if the overnight rate moves a few hundredths of a point away from the bank's policy rate. Now, rates hit 4.7%, far above the ECB's 4% target, signaling extraordinary tension.

Convening at 8:45 a.m., the ECB liquidity group decided to recommend intervening that morning and taking the unprecedented step of pre-announcing that the bank would honor every bid it received. To send a clear signal that the bank was covering the market's back, the committee settled on offering funds at the bank's 4% policy rate rather than a variable rate or a higher penalty rate. Taken together, the moves would show the ECB just how high the demand for cash was, because banks, in principle, would bid for exactly what they felt they needed. The ECB could use the information to judge future injections more accurately.

The six Executive Board members approved the move within 90 minutes.

At 10:26 a.m., the bank told markets it stood "ready to act." At 12:32 p.m., it flashed its decision on trading screens across the euro zone. The notice said the ECB would accept bids for funds until 1:05 p.m. Response was immediate. At 2 p.m., the ECB publicized the total take of €94.8 billion. The overnight rate fell back down to around 4%. In subsequent days and weeks, the ECB continued to add funds to money markets to keep the market liquid.

But challenges continued to arise, in part because the ECB doesn't have detailed insight into the euro zone's banks. While the Fed effectively supervises most of the biggest U.S. banks and has access to detailed information on these banks' books, the ECB cedes banking supervision to each member country.

Days after its Aug. 9 fund injection, the central bank sent commercial-bank supervisors across the euro zone a questionnaire asking about their subprime exposure. The basic question: Were banks basically sound and just having a problem with short-term liquidity? Or were some of them in deeper trouble?

Some responses were returned quickly and fully. Others came back late or without sufficient numbers. In the end, the ECB learned enough to be confident that banks were sound. But some people in and out of the ECB are unsure that the bank would get the information it needs in a bigger crisis.

In the following weeks, another old ECB problem resurfaced -- communicating intentions clearly to the market. Mr. Trichet had been getting high marks for predictability, but that changed on Aug. 22.

On the back of the ECB's continuing cash injections, overnight lending rates had fallen back to around the 4% target. But three-month interbank rates still hovered around 4.7%, a sign that banks were reluctant to lend to each other for longer periods.

At 3:34 p.m. that day, the ECB released a surprise statement saying it would hold an auction the following day, accepting bids for €40 billion in extra three-month funds. Markets greeted the announcement with relief. But the statement's last sentence caused confusion. "The position of the Governing Council of the ECB on its monetary policy stance was expressed by its president on 2 August 2007," it read.

That was a reference to a briefing held by Mr. Trichet weeks earlier, at which he indicated that the bank, at the time, was inclined to raise short-term rates at its next meeting on Sept. 6. In the intervening turmoil, however, markets had steadily revised down expectations of an ECB interest-rate rise. The late August statement seemed to put a hike back in play.

"To say markets didn't know how to interpret it is putting it mildly," says Dresdner Kleinwort's Mr. Rieger.

Crossed Signals

The communication problem was compounded two days later, on Aug. 24. Anonymous sources at several national central banks leaked word to Reuters that markets had misinterpreted the sentence about the ECB's monetary-policy intentions: ECB policy makers were not set on raising rates. Speaking in Budapest a few days later, Mr. Trichet intervened to clarify the message, essentially telling markets that policy makers hadn't decided whether to move rates.

On Sept. 6, the bank kept its policy rate unchanged at 4%.

Observers say that while the bank proved its chops with its early August moves, it still has room to master the subtle art of communicating its intent. "It's as important as moving rates well," says Luigi Buttiglione, a former Bank of Italy economist, now with New York-based investment fund Fortress Investment Group in London, who praised the August intervention. "You not only have to do the right thing, but you have to explain why this is the right thing. If you're not able to do that, then markets can take a different direction -- and you can achieve the opposite result."

Gulf States and the Dollar Link

Andrew Critchlow, WSJ:

PEGGED DOWN

• The News: Saudi Arabia, the United Arab Emirates, Qatar, Kuwait and Bahrain followed the Fed's decision to cut interest rates by a quarter percentage point.
• Background: The Gulf states' exchange rates are pegged to the dollar, whose decline has diluted the benefit of record oil prices.
• What's Next: Rampant inflation in the region has increased pressure, particularly on the U.A.E., to sever ties with the dollar, which could further add to the dollar's woes.


DUBAI, United Arab Emirates -- Oil-rich Arab sheikdoms, risking new inflation pressure, followed the U.S. Federal Reserve's lead by lowering official interest rates to keep their currencies aligned with the dollar.

Saudi Arabia, the United Arab Emirates, Qatar, Kuwait and Bahrain followed the Fed's decision to cut interest rates by a quarter percentage point.

Because their exchange rates are pegged to the dollar in fixed trading ranges, monetary policy in the Persian Gulf states must mirror U.S. moves to avoid pressures from capital drifting to the currency with the most favorable interest rates.

The moves came despite concerns over rampant inflation in the region, which suggest central banks should be raising, instead of lowering, rates. Bankers said the policy conflict is building pressure on the Gulf states to unbind from the dollar.

In European emerging markets, meanwhile, the Central Bank of Iceland raised its key rate 0.45 percentage point to a record 13.75% in an effort to slow annual inflation, running at a 4.5% rate, down closer to its 2.5% target rate. It was the 19th time since 2004 that the Icelandic central bank has raised rates to keep its economy from overheating. The Romanian central bank Wednesday raised its key rate by one-half percentage point to 7.5%, fighting a 6% inflation rate the bank blamed on soaring household income and rising public spending.

In Asia, meanwhile, sharper-than-anticipated consumer-price inflation last month -- 3% above year-earlier levels -- prompted speculation the Bank of Korea will raise its policy rate, now at 5%, in the first quarter next year. The Hong Kong Monetary Authority, also struggling to balance domestic considerations with pressures from overseas investors, has been intervening to keep its currency from rising above publicly set bands.

Nowhere in the Middle East are the strains more acute than in the U.A.E., where investors are betting on a "depegging" of the dirham as domestic inflation pressures increase.

"Speculators are definitely bidding on a depegging, and that's why they're increasing their dirham deposits," Henry Azzam, Middle East chief executive at Deutsche Bank AG, told Zawya Dow Jones Newswires in an interview.

Attracting that money are chances of a quick profit once the peg snaps. Deposits held in the emirates' banks have exceeded one trillion dirhams ($272.3 billion) for the first time, more than is deposited in the region's largest economy, Saudi Arabia, latest central-bank figures show.

"The probability of depegging has increased," said Kamran Butt, Dubai-based chief economist at Credit Suisse Group. "The market consensus is for the U.A.E. to depeg." A decision by the U.A.E. to sever ties with the dollar could alienate the U.S. and add to the dollar's woes at a time of economic uncertainty and record oil prices.

The dollar, which fell to all-time lows against the euro and 26-year lows against sterling in the aftermath of Wednesday's rate cut, was at $1.4437 against the euro, from $1.4486 Wednesday. The U.K. pound was at $2.0787, from $2.0793 Wednesday.

The dollar's slump has pushed up the cost of imports to the Gulf, fueling inflation. The dollar's decline has watered down the benefit of record oil prices in the region that is expected to accrue a surplus in excess of $500 billion this year, according to Saudi lender Samba Financial Group.

Kuwait, the region's third-largest Arab oil producer, was the first to break ranks with its Gulf peers in May when it shunned its peg with the dollar by allowing the dinar to float against a basket of currencies and in a range against the dollar. It retains a loose dollar peg and joined other states in cutting rates yesterday.

The seven emirates are Abu Dhabi, 'Ajman, Al Fujayrah, Sharjah, Dubai, Ra's al Khaymah and Quwayn.

With inflation expected to exceed 10% for a second consecutive year in the U.A.E., the emirates' ruling sheiks face the region's greatest fiscal policy challenge since the U.K. devalued sterling in 1967, forcing Gulf states to turn to the dollar as a benchmark.

When the emirates created the dirham in 1973 they linked it effectively to the dollar. Now bankers such as Deutsche's Mr. Azzam are unsure whether the U.A.E. is ready for another such change. "I don't think a depeg will happen because that's a regional decision and it has served the U.A.E. so far," he said.

China's Income Disparity

China's Gini coefficient reached 0.47, according to a survey in 2001. This is higher than the US's 0.408, Britain's 0.36, and Japan's 0.249. The comparison suggests that China's level of income inequality has surpassed these countries.

Source: Wall Street Journal Dec 18, 2006.

China's economy shifted in 10 years

Between 1995 and 2005, China's total trade has increased from 37.1% of GDP to 62.4% of GDP (Exports increased from 19.4% to 33.4%, and imports increased from 17.4% to 29%). Gross investment has increased from 33% to 41.5%. Total FDI has increased from 3.2% to 5% of GDP. Consumption, on the other hand, has dropped from 44.9% of GDP to 38%.

It is no doubt that China's economic growth now hinges more and more on two pillars: foreign trade and domestic physical investment. What is worrisome is the latter: one wonders how much of the investment is driven by the fervor of local officials, and if those projects will ever turn up any real profits. If bad projects are financed by state banks as before, more trouble is ahead.