China in Transition

The Political Economy of a Stronger Yuan

Chi Hung KWAN Consulting Fellow, RIETI

As symbolized by the rapid rise in China's foreign exchange reserves, the yuan is facing upward pressure. Although a gradual appreciation of the yuan both greatly benefits China itself and responds to the wishes of the international community, there are many political hurdles to be cleared both at home and abroad before this can be realized.

Led by rising inflow of foreign direct investment and exports, China's balance of payments surplus has widened further following WTO entry in late 2001. As a result, the country's foreign exchange reserves rose by $74.2 billion (equivalent to 6% of GDP) in 2002 to reach $286.4 billion by the end of the year. This figure ranks second in the world behind Japan, and is equivalent to roughly one year's worth of China's imports.

Officially, China has a managed floating system, but ever since the Asian financial crisis of 1997, the yuan has remained stable against the dollar, and is virtually pegged to the greenback. If, as is the case now, the yuan's value is set at a level that is too low compared to its actual strength, dollar supply exceeds demand. When monetary authorities absorb excess dollars from the market, the nation's foreign exchange reserves increase as a result. If China were to adopt a floating system and authorities did not intervene at all in currency markets, its foreign exchange reserves would not have grown and the yuan would have appreciated instead.

If the authorities continue to keep the yuan at its prevailing level, China's trade imbalance and foreign exchange reserves will further increase, causing much harm to the Chinese economy. First, the surge in foreign exchange reserves will make it difficult to control money supply, and exacerbate the real estate bubble. In addition, China has already surpassed Japan as the country with which the United States has the largest trade deficit, and should the deficit widen further, it could lead to trade frictions. Finally, most of China's foreign exchange reserves have been invested in US Treasuries, and since the return on those investments is much lower than that of investments made at home, it is clear that the savings of Chinese citizens are not being effectively invested. The yuan should appreciate in order to correct such distortions.

In addition to adjusting exchange rates, reforms are also needed in the exchange system itself. First, against the backdrop of the sharp fluctuations in the yen-dollar rate and the fact that most Asian nations have shifted to a managed floating system, the yuan's stability vis-a-vis the dollar under the peg system causes large fluctuations in the exchange rate between the yuan and the currencies of its trading partners. This is a destabilizing factor for China's trade and its economy as a whole. At the same time, rising mobility of capital is making it more difficult to control money supply and interest rates, and the current de facto fixed exchange rate system should also be abandoned from the viewpoint of maintaining the independence of monetary policy.

Exiting from the dollar peg system should preferably be done at a time when economic fundamentals including external balances are good, and when there is some upward pressure on the yuan. The stage is almost set, as these preconditions have practically been met. When doing so, it is probably more realistic to condone a gradual appreciation spreading over a few years rather than implementing a steep appreciation in one step. Yet, authorities so far have remained cautious over a yuan appreciation, as well as a transition to a new exchange system, partly due to the fact that it is difficult to take the initiative in policy-making ahead of the National People's Congress in March, where the government's new leaders will be appointed.

Meanwhile, major industrial countries like Japan are calling for the yuan's appreciation, saying it would help combat global deflation and correct their trade imbalances with China. While it is true that there is room for the yuan to rise, given the reasons cited above, it is likely that the new Chinese leadership would want to avoid by all means possible a scenario in which it allows the yuan to appreciate due to external pressure. In this sense, recent remarks by Japanese financial authorities calling for a stronger yuan, such as the opinion piece that Haruhiko Kuroda and Masahiro Kawai, the vice minister and deputy vice minister of finance for international affairs, jointly penned in the Dec. 2 edition of The Financial Times, can only delay, rather than accelerate, the yuan's appreciation. Their hopes for a sharp rise in the yuan, similar to that of the yen in the wake of the Plaza Accord, must be viewed as unrealistic.

As this shows, the appreciation of the yuan is both desirable for China itself, and can also meet the demand of the international community. Nevertheless, the dilemma is that there is little prospect of this materializing because of a lack of trust among the countries concerned. In terms of its GDP and trade volume, China is now on a par with Britain, and as can be seen in the current calls for a stronger yuan, it can no longer be ignored when discussing such issues as industrial adjustments, deflation, and trade imbalances in major industrialized countries. There are limits to the extent to which current international economic policies can be effectively harmonized so long as China is left out in the cold. The time may have arrived to construct a system under which mutual trust can be further developed, such as considering China's entry into the Group of Seven.

February 10, 2003
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February 10, 2003