Time for RMB appreciation?

09:44, June 09, 2010      

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Editor's Note: To revalue the yuan or not? This has been one of the hottest topics for the past decade and it has become an issue not only for Chinese policymakers but other governments around the world. The upcoming G20 summit of leaders from major developed and developing economies and the worsening of the European sovereign debt crisis have complicated the discussion of the yuan's appreciation, with Chinese economists divided on the timing of the process. While some argue that appreciation would do more harm than good, others urge the opportunity be seized to accelerate the process of making the yuan fully convertible.

Financial experts debate the pros and cons of calls for China to revalue its currency

It is not time for yuan appreciation. Although the leaders at the upcoming G20 summit are expected to discuss the issue, it should be up to China to decide.

Yuan appreciation would benefit China's imports of products from machinery to resources, but the benefit would be limited compared with the damage to the overall economy. China has, for example, suffered from overcapacity in sectors such as iron and steel, and cheaper imports as a result of yuan appreciation would only worsen the situation.

Yuan appreciation will benefit rich people in China, but it will do little to help improve the livelihoods of the poor. It would only widen the gap, which would contribute to social problems.

If the yuan appreciates against the dollar, expectations of further gains in the value of the yuan would lead to increased capital inflows, which would bring financial instability and would endanger China's financial security.

What has largely been ignored by many people is that yuan appreciation would facilitate imports of agricultural products, which would be disastrous for China's more than 500 million farmers. Although the country's entry into the World Trade Organization did not have a major impact on domestic farming, yuan appreciation would have a more adverse effect on the industry, leading to more job losses.

China must make relevant policies based on its own well-being, not others' directions.

The sharp decline of the euro against the dollar and other major currencies means that the yuan has effectively appreciated. Many people no longer expect the yuan to resume its appreciation against the dollar, at least not in the next few months. We have also adjusted downward our expectations of yuan appreciation against the dollar, to about 3 to 4 percent this year. Moreover, if European markets do not calm down in the near future, then concern over a more serious financial contagion could take the yuan move off the table.

However, as long as the markets calm down and the euro stabilizes, we think China could still start to de-link the yuan from the dollar. The move would most likely be a return to some sort of a basket with a widening trading band against the dollar. Initially we expect the yuan to appreciate against the dollar, but the increased flexibility could allow the exchange rate to move both ways, giving China more room to maneuver in the future.

A recent news report about China reviewing its euro debt holdings prompted market moves and the Chinese government's assurance of its faith in the euro and European government bonds. We believe that if Asian central banks including China hold on to their euro holdings but reduce their future purchases, the euro would weaken still further.

When China and the United States clash over yuan appreciation, some analysts have cited the Plaza Accord of 1985 as a warning to China against revaluation.

At that time, Western countries joined together to force Japan to raise the value of the yen and finally caused its domestic economic bubbles to burst. Then Japan fell into recession for over 10 years and is still struggling to recover.

The so-called "lost decade" led many to suspect that the US is readily pushing China on the currency issue to suppress the rise of the nation. China should firmly refuse to revalue the yuan to avoid repeating Japan's tragic mistakes.

However, Takatoshi Ito, a well-known Japanese economist, pointed out that the major reason for the fall of Japan's economy was that the bubbles burst too abruptly; at the beginning of bubble formation, the Japanese government didn't address it properly and in a timely manner, sowing the seeds for an irreversible future disaster.

A moderate appreciation of the yuan will not harm China's export competitiveness. If we look back to 2005, when the currency rose by more than 20 percent after the country reformed its exchange rate regime, we would see that China's economy has maintained a consistent growth rate, instead of being battered. A huge trade deficit did not form either.

But will disputes over the trade deficit be solved if the yuan is appreciated? The answer is clearly no. The solution to the problem lies with the implementation of significant and sustained changes in the competitiveness of Chinese products in relation to those of other countries.

The European sovereign debt crisis has led to a significant rise in the yuan's effective exchange rates against non-dollar currencies, as this passive appreciation soothed pressure on its appreciation. Therefore, the crisis provides an accidental opportunity for reform of the yuan's exchange rate formation system.

It is no longer the optimal method for China to stick to a yuan peg to the dollar if it wants to reduce exchange rate risks for import or export enterprises and stabilize foreign trade.

From the macroeconomic point of view, the yuan's peg to the dollar means giving up independent monetary policy, making China's domestic liquidity directly subject to the impact of policies by the US Federal Reserve Board.

Notably, no matter whether it is pegged to a basket of currencies or a single currency, the yuan is in a position as a secondary currency. And no matter how well a secondary currency could perform, it is just a substitute for other currencies, which means it could only consolidate the international status of others but have little chance of becoming a major international currency.

If China wants to be a strong currency power, the ultimate goal of its currency system reform should not be pegging the yuan to a basket of currencies, but free floating of the yuan on the market, or the full convertibility of the yuan. Even if a free float of the yuan cannot be realized in the short term, it must be a long-term goal.

The biggest risk of a currency system shift from managed to free float is that the currency's value would be completely uncontrollable, probably fluctuating dramatically and causing an unpredictable impact on the country's economic and financial markets.

Thanks to a rise in the real value of the yuan against non-dollar currencies, its fluctuation would be reduced since it could be closer to real market levels and there would be less impact on the domestic economic and financial markets. In this sense, the European debt crisis has provided the opportunity for China to reform its currency system.

Nearly five years have passed since China adopted a more flexible exchange rate regime in July 2005.

Since then the yuan has appreciated about 20 percent against the dollar.

Largely due to that, China saw large sums of international capital inflows and abundant liquidity, the "dual surpluses" of international balance of payments, as well as rising foreign exchange reserves.

Seventy percent of China's $2.5 trillion foreign exchange reserves were generated during the past five years. A one percentage point appreciation of the yuan against the dollar will attract about $5 billion in capital inflows per month, according to studies based on data between 2006 and 2009.

Again, China is facing pressure from the United States and other countries to let the yuan rise, but no one has provided persuasive evidence on the alleged undervaluation of the currency.

Goldman Sachs' model showed the yuan was undervalued by about 20 percent five years ago but it has approached a reasonable level through previous appreciation.

However, an exchange rate regime lacking flexibility and solely fixed to the dollar was not in line with the purpose of China's exchange rate regime reform.

As soon as the external clamor fades away, the reform of Chinese currency is likely to restart and the yuan may move up again in the context of China's economic growth.

Though Japan suffered a lot from a big surge in the yen in the 1980s, some still call for a one-off appreciation of the yuan. It would be very dangerous if such a view influences policymakers.

Given the high capital inflows in China, a major exchange rate move of above 10 percent will lead to a large proportion of international capital quickly flowing out to profit from the currency gain.

The move will cause unusual fluctuations in China's capital and property markets, damaging the health of China's economy.

Expectations are growing stronger for yuan appreciation and international capital inflows are likely to move faster. The currency rate should remain relatively stable for a period while a small and gradual appreciation is in line with China's industrial and economic situation.

Source: China Daily


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