China in Transition
Time to Float the Yuan
Chi Hung KWAN Consulting Fellow, RIETI
The recent sharp fall of the U.S. dollar against the Japanese yen and other major Asian currencies has made the Chinese yuan look cheap relative to China's trading partners. People wonder if Beijing would take this opportunity to abandon the de facto dollar peg system now in place, and allow the yuan to appreciate against the dollar.
Following the Asian currency crisis in 1997, the Chinese yuan has been kept around 8.28 yuan per dollar. Thanks to the fluctuations in the dollar-yen rate and many Asian countries' having shifted to a managed floating exchange rate system, however, the yuan's stability against the dollar has been accompanied by instability against other currencies. This, in turn, has destabilized China's overall trade and economic growth.
Against this backdrop, the pros and cons of abandoning the dollar peg and shifting to a new foreign exchange system have come to be hotly debated. Many Chinese economists now share the view that China should shift to a managed floating exchange rate system based on a currency basket. But the government has yet to reveal any specific schedule for shifting to a new regime, probably, due to its unwillingness to take any policy initiative ahead of the 16th convention of the Chinese Communist Party in the coming fall.
Apart from constraints related to the political calendar, however, the preconditions for de-pegging the yuan from the dollar are now in place; China's current account balance is improving, economic fundamentals are favorable, and the yuan is under upward pressure. The Chinese economy has turned upward this year, riding on the recovery of the world economy. Supported by robust exports that surged 14.1%, China's industrial output and gross domestic product in the first half of 2002 rose 11.7 percent and 7.8 percent respectively from a year ago. The GDP growth rate for the whole year will likely exceed that of last year.
Reflecting the pattern of an export-led recovery, China's current account balance has been improving since the beginning of this year. Trade surplus in the first half totaled $13.4 billion, jumping from $8.4 billion in the corresponding period last year. At the same time, the capital account balance has been boosted by a sharp increase in foreign direct investment inflow of 20% year-on-year during the first half of this year, following China's entry to the World Trade Organization.
Reflecting the expanded surplus both in the current account and the capital account, China's foreign exchange reserves reached $242.7 billion as of the end of June, an increase of $30.6 billion from the beginning of this year. The latest figure ranks the second largest in the world only next to Japan, and is roughly equivalent to the amount of China's imports for a year. The rapid increase in China's foreign exchange reserves, by itself, implies that there is strong upward pressure on the yuan. Should China adopt a floating exchange rate system and make no intervention in the foreign exchange market, China's foreign exchange reserves would not have increased and the yuan would have appreciated instead.
The current rebound of the yen against the dollar has been followed by many other Asian currencies. As a result, the yuan's effective exchange rate, or the weighted average of the yuan's values against the currencies of China's major trade partners, has been on decline. Therefore, the yuan's rise against the U.S. dollar would not immediately hamper the competitiveness of Chinese exports. Also, if the yen's weakness put downward pressure on the yuan, as asserted by the Chinese government, the recent rise of the Japanese currency should put upward pressure on the yuan (note).
Now that economic fundamentals are improving, China should take this opportunity to reform its foreign exchange system. Unfortunately, with no crisis in sight, the cost of not implementing reform will not manifest immediately, and thus it is difficult to gather impetus for reform. But as the Chinese saying goes, it is important to be prepared for a crisis in time of peace, and the Chinese authorities should not miss this opportunity.
- The Japanese and Chinese economies are complementary with, rather than competitive to, each other, and therefore the Chinese government's view that the weak yen was a negative factor for the Chinese economy is not necessarily correct. However, as long as such argument by the government is widely accepted by the general public, it would be politically difficult to revalue the yuan when the yen is weakening.
June 7, 2002
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