Mar 17, 2010 06:30 PM

Cost-Sharing for Appreciation of the Yuan

(Caixin Online) No one doubts that the export sector is vital to China's economic growth and a huge source of jobs. And it's clear that China's huge pool of foreign reserves must be properly managed.

These key conditions have affected China's attitudes toward the yuan's value, encouraging policymakers to hold back exchange rate reforms. But now, these conditions are changing, and appreciation is getting a closer look.

Exports have rebounded with positive growth since December. Some say that means the economy could survive an appreciation.

Others disagree. According to China CITIC Bank Global Financial Market Analyst Liu Weiming, the recovery is fragile and unlikely to be sustained after an appreciation of the yuan.

But State Information Center Economic Forecasting Department Director and Chief Economist Fan Jianping said while an appreciation of the yuan in the short-term would increase exporter costs, falling import costs would offset any negative impact.

"The combined effects of the yuan's appreciation on imports and exports would be reflected after an economic cycle," he said.

Processing trade goods account for more than 40 percent of China's total export volume. In the processing trade, an enterprise first imports raw materials and auxiliary parts for processing and/or assembling before finished goods are exported. As a result, losses incurred from an appreciation of the yuan could be partially offset by decreases in the prices of imported raw materials.

Nevertheless, an appreciation of the yuan in the short term would have a significant negative effect on manufacturing industries, low-profit industries, and exporters with relatively little bargaining power.
Reserves Management

Others worry a yuan appreciation would cause China's foreign exchange reserves to shrink substantially. At the end of 2009, China's forex reserves stood at US$ 2.39 trillion.

A researcher at the Institute of World Economics & Politics Chinese Academy of Social Sciences, Yu Yongding, said that "when weighted against the indicators for a declining U.S. dollar, capital losses for China's forex reserves are unavoidable. China's forex reserves face a triple threat: a decline in the purchasing power of the U.S. dollar, the inherent downside risk of U.S. Treasury securities, and the threat of long-term inflation."

China needs to gradually reduce the growth pace of its forex reserves, Yu said. To prevent excessive growth of forex reserves in the future, he said, the country has three options: stimulate internal demand through direct fiscal methods and, thus, reduce the surplus in current and capital accounts, decrease the central bank's level of intervention in the foreign currency market and give the yuan exchange rate more room to float; or encourage capital outflow.

"If these three measures can be simultaneously adopted, the costs of an appreciation of the yuan can be dispersed," said Yu.

Also worth considering are the after-effects of 2005 exchange rate reform. Some think small fluctuations and mechanisms that accompanied that appreciation trend initiated market expectations of a consistent appreciation of the yuan, leading to a large inflow of speculative capital.

"Implementing policies to prevent an asset price bubble when the yuan appreciates is beneficial for realizing a shift in the mode of economic development and controlling inflation," said Ha Jiming, Chief Economist at China International Capital Corp. Ltd.  "Just as these policies can prevent an asset price bubble from forming, they can also avoid attracting more hot money."

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