Download China Must Drop Its Currency Peg

China Must Drop Its Currency Peg
Tung Chen-yuan
Taipei Times
Feb 19, 2004,P. 8
Rumors about the Chinese yuan's appreciation have once again bubbled to the
top of the business agenda. Since the end of last year, the Chinese media have
revealed many times that Beijing hopes to change the yuan's exchange rate system
from one in which the currency is pegged to the US dollar, to one where it is pegged
to a basket of currencies.
If we take the basket to be the currencies of China's top 10 trade partners, the
yuan's nominal exchange rate will rise by around 5 percent. In addition, there may
also be some adjustment to the yuan's fluctuation band -- to a margin of plus or minus
2.5 percent, for example. Overall, the Chinese government has the room to appreciate
the yuan's nominal exchange rate by 7 to 8 percent this year.
Such a major change in the Chinese government's attitude is not a matter of
yielding to pressure from international powers, but of following strong market forces,
both domestic and foreign. After 25 years of reforms, the Chinese government's
intervention in the financial system is gradually failing. Besides, large loopholes have
emerged in capital account controls. Market forces will determine policy on the yuan's
future appreciation.
On Feb. 10, Chinese Premier Wen Jiabao (溫家寶) stressed during an internal
meeting that China will maintain the "basic stability" of the yuan's exchange rate
while at the same time steadily promoting reforms in the hope of having market forces
determine the exchange rate. "Market forces" primarily mean the supply-demand
balance of foreign exchange. Foreign exchange reserves and international hot money
play crucial roles in this, but the increasing imbalance in the domestic economy puts
more direct pressure on exchange rate policy.
The steep rise in foreign exchange reserves creates a steep rise in monetary
supply and credit, which in turn causes the imbalance in China's internal economy to
increase gradually. From May to November last year, both credit and the broad
money surplus increased by amounts exceeding 20 percent. By the end of December,
the broad money surplus rose by 19.6 percent compared to the end of the previous
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year. Loans grew by 21.4 percent. Following the rapid increase in credit, commodity
prices, which had fallen by 1.3 percent in April 2002, rose gradually, posting a 3.2
percent increase last December. In less than two years, China has moved from
worrying about worsening deflation to worrying about whether the economy is
overheated.
The problems are more complex, however. China's inflation is driven by raw
materials and foodstuff prices, but 90 percent of industrial products are still in a state
of oversupply. Today, the steep rise in credit is accelerating the overheating and
overproduction in some industries, especially in the steel, cement, automobile,
electrolyzed aluminum and other raw-material sectors, pushing China to the brink of
an economic bubble and then giving rise to serious financial and deflation problems.
Eager to avoid affecting the speed of economic growth, the Chinese government
does not want to raise interest rates. It is trying to reduce investment in overheated
sectors by executive orders and exhortation to prevent an expansion of the imbalance
in its economic structure and to reduce the risk of overheating. To this day, however,
such administrative approaches have not been effective. Market forces have the upper
hand.
China's Minister of Commerce Lu Fuyuan (呂福源) was quite right when he said
at the Fifth Asia-Europe High-Level Economic Forum last July, "China's economic
situation is the most important consideration in its decision on the exchange rate. The
suggestions and concern from other countries are only of secondary importance."
China certainly has enough political prowess to resist international political pressure,
but the continued expansion of internal and external economic imbalances is an
important factor in why China may have no other choice than to consider raising the
yuan's value appropriately.
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