China Leans Toward Yuan Float
(Caixin Online) The Chinese government's yuan exchange rate policy is at another critical juncture. Several quasi-government and independent research organizations have held closed-door discussions since the beginning of the year to discuss exchange rate mechanisms, and they've submitted policy suggestions to the central bank and government policymakers.
What's next? All signs indicate that China is about to resume exchange rate reforms, a process suspended in July 2008 at the start of the international financial crisis.
During a press conference March 6, People's Bank of China Deputy Gov. Su Ning said the central bank would decide when to exit its "special exchange rate mechanisms" and set a schedule according to economic situations.
"Exit" has already been interpreted by the market as a sign that the central bank will let the yuan appreciate. Rumors have been widely circulating in the market that there will soon be a one-off appreciation of the yuan by 2 to 3 percent. "Some Chinese financial institutions have already started unloading U.S. dollars," said a high-level financial industry executive based in Hong Kong.
Talk of appreciation has led to a variety of market reactions. China's export sector has been a vocal opponent of the proposed move, saying a sudden sharp appreciation of the yuan would be equivalent to slamming the brakes on global economic recovery.
Some economists say that, from a purely market-oriented perspective, there is actually no way to gauge whether the yuan should appreciate or depreciate. They recommend a fixed policy, rather than blind action, when facing uncertainty. If exchange rate reforms raise expectations for further increases in the yuan's value, the flow of hot money into China will drastically increase, they say, creating a liquidity overflow and possibly an asset bubble, and reenact the scene after exchange rate reforms in 2005.
Nonetheless, some argue exchange rate reforms should be implemented sooner rather than later. In spite of international pressure, and even though further exchange rate reforms again point to an appreciation of the yuan, there are still inherent advantages to reform.
Exports have already witnessed relatively rapid growth, as China has taken the lead in global economic recovery. Effective exchange rate mechanisms would not only lead to reasonable fixed prices for exported and imported goods, improving China's trade position, but they also have the potential to encourage normalization of price relations between tradable and non-tradable goods. This would serve to balance essential factors of production such as the domestic labor force, land and natural resources. It also would increase consumption levels and benefit the national economy.
Caixin Chief Economist Huang Yiping, a professor at Beijing University National School of Development, advocates market mechanisms. "The yuan needs market-oriented mechanisms to determine the exchange rate, but not a one-off exchange rate adjustment," Huang said.
The Chinese government's current stance on exchange rate policy is to maintain the yuan exchange rate within what policymakers consider reasonable and balanced levels. With this in mind, a senior executive familiar with foreign exchange controls said gradual moves in the future would make more sense than a sudden jump.
"One must realize that, no matter which method is chosen, exchange rate policy adjustments must be pro-active, manageable and implemented gradually. Being pro-active is the top priority," the executive said. "Exchange rate adjustments will most certainly be made gradually. One-off, sharp appreciations are impractical to policymakers."
Lu Ting, an economist for Bank of America Merrill Lynch China, is sure that an appreciation is near. "In the medium- to long-term, we will most definitely witness a free-floating and appreciating yuan," Lu said. "The issue now is which path to take."
A relatively extreme path would involve a quick and steep one-off appreciation of the yuan against the U.S. dollar, which would thereby dispel strong expectations for the yuan to appreciate. One-off appreciations ordinarily refer to increases of around 20 percent managed for three to five years.
Many experts oppose what they call radical methods. A high-level central bank official said any talk of a substantial, one-off appreciation of the yuan is only an academic exercise and impractical at the policy level. "There has never been a sizeable one-off appreciation of the yuan," the bank official said. "Enterprises could not bear it."
A more probable scenario would involve resuming conservative, floating exchange rate mechanisms used by the central bank from July 2005 to July 2008, which allowed the yuan to gradually appreciate against the U.S. dollar.
But flaws in the floating method are evident. If the market expects the yuan to unilaterally appreciate against the U.S. dollar over a long time period, capital from abroad will likely steadily flow into China, leading to jumps in foreign reserves and asset prices, and too much liquidity.
Furthermore, a combination of strong expectations for appreciation and an actual, gradual appreciation would lead to steady acceleration of the pace of the yuan's appreciation. The yuan appreciated 3.35 percent against the U.S. dollar in 2006, 6.8 percent in 2007 and 6.9 percent in the first seven months of 2008.
Some experts have advocated domestic price reforms and "moderate" inflation to replace an exchange rate reform as a better way to reach the goal of actual yuan appreciation.
On the basis of redistributing wealth through appreciation of the yuan, though, this price-hike method has been criticized as fundamentally flawed: Raising prices for the goods central to everyday life would have negative consequences.
China International Capital Corp. Chief Economist Ha Jiming said people can still rent apartments when house prices rise beyond their reach. But if food prices increase, all including people in low-income brackets are affected, threatening social stability.
A source close to the central bank said gradual adjustments are most feasible, since there is a lot of flexibility for exchange rate reforms. If conditions permit, the source said, authorities can appropriately expand the yuan's daily floating range.
Other experts said there should be a "new methodology" for determining exchange rate mechanisms, such as a currency basket technique.
Ha recommends letting the yuan appreciate based on a basket of currencies. A similar view is also shared by Ding Zhijie, dean of the School of Banking and Finance at the University of International Business and Economics, who has called for the "de-dollarization" of the yuan.
Ding recommends assigning currency weights based on the proportion of export-import trade volume on a monetary basis from each country represented in the basket to China's total trade volume. The basket should include 18 currencies, he said, with the euro weighted at 17.91 percent, U.S. dollar at 14.68 percent and other currencies making up 56.15 percent of the weighted volume. "This is very important for promoting stable trade," he said.
The source close to the central bank said authorities should determine the
weighted proportion for the basket of currencies by
first considering the proportion that the currency holds in regard to trade settlements. Currently, more than 70 percent of China's cross-border trade settlements are in U.S. dollars, while the remaining 30 percent use other currencies such as the euro and pound. Second, most of China's US$ 400 billion in foreign debt is in U.S. dollars and "borrowing money to repay money" would require holding a certain amount of dollars. Market fluctuations also would require corresponding adjustments.
Opinions vary over whether individual currencies and their respective weights in a basket should be disclosed. Lu and Huang advocate copying Singapore's exchange rate system because authorities do not disclose currencies or their weights, and yet the system allows adjustments of individual weights based on conditions.
If China takes the Singapore approach, the daily determination of a central rate for the yuan relative to fluctuations in the currency basket would revolve around fluctuations in the yuan's nominal effective exchange rate. "The advantage" of such a method "is flexibility and leeway when currencies fluctuate," said Huang.
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