Time not Ripe for Fully Liberalized Exchange Rate

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Last updated at: (Beijing Time) Monday, May 19, 2003

Time not Ripe for Fully Liberalized Exchange Rate

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Full liberalization of China's renminbi exchange rate is inevitable, but not now.

Early this year, while many international investors bet anxiously on the timing of a possible renminbi revaluation, the subject of widening the band for the exchange rate was quietly dropped from even informal discussions by central bank officials.

Most people still agree that the renminbi is currently under pressure for appreciation.

This view could be supported by the massive inflow of foreign direct investment, significant current account surplus and accumulation of foreign exchange reserves in recent years.

Renminbi revaluation

The debate on renminbi revaluation heightened markedly late last year.

Proposals for band-widening are supported by a number of arguments.

Recent rapid improvements in the current account, capital account and foreign exchange reserves were partly induced by the under-valued renminbi.

Any delay of exchange rate correction would make future adjustments much more difficult.

More importantly, China is already one of the largest and fastest growing economies in the world.

The country needs fiscal and monetary policy freedom in order to make sensible responses to economic cycles.

For a large and dynamic economy like China, liberalization of the exchange rate is inevitable.

Meanwhile, a distorted and rigid exchange rate would affect proper pricing of domestic and international capital.

This may not only prevent the efficient use of resources but also lead to magnification of risks.

This was one of the lessons we learned from the recent east Asian financial crisis, particularly in the case of Thailand.

And finally, under-valuation of the renminbi may also generate unnecessary bilateral imbalances.

It is therefore understandable that international pressure would increase for China to revalue its currency.

Given China's increasing integration into the global economy, international pressure will also be an important factor in policy-making.

The key reason for opposition to changes to the current exchange rate regime is the concern that the current economic momentum might be harmed.

For the Chinese Government, it is much more important to maintain high growth in order to create more jobs.

Often trade officials oppose, more strongly, currency appreciation as they are deeply concerned about performance of exports and foreign direct investment.

This is because currency appreciation makes exports more expensive and imports cheaper.

Other officials also worry that renminbi revaluation could lead to re-emergence of deflation.

Flexible exchange rate

We are strong supporters of a more flexible exchange rate regime in China.

But the key reason why we think it is not yet time to liberalize the exchange rate is because China's foreign exchange market is still quite thin and imperfect.

Reforms to the exchange rate may lead to significant increases in vulnerability and instability of the market, which could harm investors' expectations.

Therefore, we believe that it is more urgent to develop the market mechanism than to free the rate.

Recent developments also suggest that the dynamism in the foreign exchange market may also change in the coming months.

Although the Iraq War has ended, we believe that growth in the industrialized world is likely to remain subpar.

Unfortunately, the Chinese economy has also been hit by the outbreak of SARS.

Highlighted by trade deficit in the first quarter of this year, external account balances could actually deteriorate in the coming quarters.

In other words, there is a possibility that the pressure for renminbi appreciation may ease soon.

International voice

International pressure has been limited so far, despite frequent reports in the media.

ASEAN was one of the loudest voices in 1998 when the world demanded China not devalue its currency.

But this time its voice is muted.

This is probably because China has been ASEAN's fastest-growing export market and ASEAN actually recorded a trade surplus with China of US$7.6 billion in 2002.

The story is probably similar for South Korea.

The country that has the largest trade deficit with China is the United States.

According to Chinese statistics, China's trade surplus with the United States reached US$42.7 billion. And according to US data it was above US$100 billion.

However, the Bush administration has been busy obtaining China's co-operation on geopolitical issues, including Iraq and North Korea tensions.

Japan issue

The only party strongly demanding renminbi appreciation just now is Japan.

The finance minister, Masajuro Shiokawa, campaigns tirelessly to press China to revalue the currency in order to help fight global deflation.

Leaving aside the credibility of the implied connection between renminbi and deflation in the world, Shiokawa's protests appear to carry little weight in Beijing.

This can also be explained in part by changing trade relations.

Japan actually enjoyed a trade surplus of US$5 billion in 2002.

The probability of a band widening for the exchange rate this year has lately been reduced significantly as external and domestic uncertainties have heightened.

But it is also important to recognize that a flexible exchange rate regime is critical in achieving efficient resource allocation and sustainable high growth.

We are somewhat bothered by the popular argument that appreciation of the yen in the 1980s was the key cause of the collapse of the Japanese growth.

While it is convenient to think a stronger yen would harm Japan's export competitiveness, there is no statistical evidence that Japan's growth slowdown in the 1990s was caused by yen appreciation.

And most experts on the Japanese economy agree that Japan's economic problems are mainly caused by structural issues.

It is, therefore, inappropriate to use the Japanese case to argue for caution in liberalizing China's exchange rate.

Overvaluation of a currency may harm the economy, but undervaluation can be equally harmful.

To prepare for liberalization of the exchange rate, we need to develop the market, through both increasing market volume and improving market institutions.

The author is the greater China economist with Citigroup, based in Hong Kong.

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