Download China needs a much stronger yuan

CHINA NEEDS A MUCH STRONGER YUAN
CHEN-YUAN TUNG
Taipei Times, Nov 11, 2005, p. 8
Since July 21, when the yuan appreciated 2.1 percent against the US dollar, it has
crept up another 0.3 percentage points. This modest 2.4 percent increase, however,
falls far short of the 10 to 15 percent appreciation hoped for by the US government,
and this has caused dissatisfaction in Washington. Ahead of US President George W.
Bush's visit to China on Nov. 19, the governor of China's central bank, Zhou
Xiaochuan (周小川), has said that China's economy is buoyant enough for the yuan to
withstand a floating exchange rate. Beijing seems to be showing a willingness to
submit to US pressure on this issue, and to deliver further appreciation as a "golden
hello" for Bush on his arrival.
Back at the end of April, Zhou declared that "reform of the exchange rate depends on
internal reform pressures, and international pressure will be taken into account. If this
external pressure increases, it will cause us to increase the pace of reform." Zhou's
statement is critical of Chinese economists for using over-simplistic models of how
the yuan will reach equilibrium, which he says tend to underestimate "the flexibility
of exports, the flexibility of imports and the flexibility of the domestic and foreign
economies." In fact, according to recent findings by the IMF, predicting the exchange
rate equilibrium for the yuan poses difficulties given the huge number of variables
involved, in terms of which data to use and the most appropriate research model to
adopt.
In the past, the Chinese government has insisted that adjustments to the yuan
exchange rate need to be based on considerations of China's economy, so there must
have been some research on the likely impact that changes in the exchange rate would
have. Beijing has previously held the idea that a significant change would seriously
damage the competitiveness of its exports and cause deflationary pressure, which
would result in rising unemployment and social unrest.
If this is true, it seems Zhou has managed to mitigate the Chinese government's
refusal to bow to pressure and shown them the sense of letting the yuan appreciate.
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Zhou certainly has a point here, and his approach is an improvement on the overly
cautious one taken by the Chinese government in the past concerning the appreciation
of the yuan.
First, over half of China's trade consists of processing re-export trade, and an
appreciation of the yuan against the US dollar is sure to raise the dollar value of
exports, at the same time as lowering the cost of imports, thereby balancing out the
impact of appreciation on the competitiveness of Chinese exports.
Labor costs and local materials only account for 30 percent of the costs of Chinese
manufacturing exports, and 50 percent of total export costs. Therefore, if the yuan
appreciates by, say, 15 percent, Chinese exports will actually maintain their original
price, and may even fall by 6 percent, in terms of their value in US dollars. This
means that Chinese exports will actually be more competitive, not less.
Second, past experiences also indicate that nominal exchange-rate fluctuations of the
yuan would not have a severe impact on China's export competitiveness. Between
1992 and 2003, the correlation between the yuan exchange rates and China's
export-led economic growth stood at only 15.5 percent. What's more, the correlation
between the yuan exchange rate and the US export-led economic growth turn out to
be minus 74.5 percent. That is, the yuan appreciates in inverse proportion to the
growth rate of China's exports to the US.
In fact, during the 1990s, the appreciation of the yuan actually did not bring about a
negative impact on China's economic growth. Between 1994 and 2002, although the
trade-weighted real exchange rate of the yuan appreciated by 29 percent, China's
economy still grew at the rate of 8.9 percent annually, without a single year showing
less than 7 percent growth.
Although the Chinese government has in the past overestimated its economic
adjustment costs brought about by the appreciation of the yuan, it still cannot be
overly optimistic about the current situation, because China has already passed over
the golden period when the yuan saw considerable appreciation.
At the end of 2001, China's foreign exchange reserves stood at US$212.2 billion.
However, as of the third quarter this year, this figure had climbed to US$769 billion,
an increase of US$556.8 billion, nearly half of which was the so-called "hot money"
flowing into China from around the world. Such an amount is tantamount to 15
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percent of China's GDP last year. The hot money might get remitted out of China after
it benefits from the interest arbitrage of the appreciated yuan. If this happens, it will
have a great impact on China as well as other Asia-Pacific nations.
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