China in Transition

Foreign Exchange Policy Needs to Change with the Times

Chi Hung KWAN
Consulting Fellow, RIETI

Calls are mounting from abroad for the yuan to appreciate, while market pressure for a stronger yuan is also rising, as symbolized by China's rising foreign exchange. However, Chinese authorities repeatedly stress that there is no need for a stronger yuan, while the Chinese media have kept warning that such demands by Japan and other countries may be a "conspiracy" to block China's economic development. The time seems to be ripe for a revaluation of yuan, so why does China continue to refuse to let it happen?

Firstly, the successes of the past have turned into obstacles to new thinking. At the time of the Asian currency crisis of 1997-1998, China worked to stabilize the yuan using its abundant foreign exchange reserves, and thus prevented the crisis from affecting it. By keeping the competitive devaluation among Asian nations in check, this also won China global praise. Chinese authorities have thus come to treat the pursuit of currency stability and accumulation of foreign exchange reserves as ends in themselves rather than policy means.

Secondly, the fundamentals of the Chinese economy remain sound, and authorities do not feel the need to alter macroeconomic policy. Rising foreign exchange reserves usually increase the money supply, leading to higher inflation. The usual prescription for such a situation is to have the currency appreciate in order to stabilize prices. However, in China's case, the economy is in a deflationary state, with prices falling rather than rising. Furthermore, in contrast to a situation when a currency is forced to devalue under downward pressure, with foreign exchange reserves now rising, authorities do not find it urgent to take concrete actions.

Thirdly, even if the yuan's appreciation is beneficial for the nation as a whole, those groups that will be adversely affected by such a move will oppose it. Specifically, a stronger yuan means that Chinese products will become more expensive in dollar terms, and their international competitiveness will decrease. In contrast, because import prices will fall in yuan terms, sectors at a comparative disadvantage in competition with imports, such as agriculture, as well as inefficient state-owned sectors will likely be adversely affected.

Finally, demands from abroad, including Japan, for the yuan to appreciate have turned foreign exchange policy from being a domestic economic issue into an international political matter.

However, as I have repeatedly stressed in this column, now that economic circumstances both at home and abroad have greatly changed, the time has come for a review of the foreign exchange policy that has so far worked so well. By pointing out the errors of judgment in the points mentioned above, I would like to present my case as to why the yuan should appreciate.

Firstly, at the time of the Asian currency crisis other countries wanted the yuan to be stable, that is, to not depreciate. However, at present, the international community is criticizing the yuan's stability - the fact that it is not appreciating. As Japan, Europe and the United States see their trade imbalance with China grow, especially with the U.S. trade deficit vis-a-vis China exceeding $100 billion in 2002, China will pay the price of its efforts to try to block the yuan's rise in the form of intensified trade friction.

Secondly, China's foreign exchange reserves currently stand at more than $300 billion, double that at the time of the Asian currency crisis. When we also take into consideration the fact that the returns on its investments of those reserves are much lower than domestic investment, the amount of foreign exchange reserves China has is probably much higher than the "optimum level." In addition, a sharp increase in foreign exchange reserves is already making it difficult for authorities to control money supply and is aggravating the bubble in real estate markets.

Thirdly, growth in exports has remained solid since China's entry into the World Trade Organization, and it is unlikely that exporters would object strongly to the yuan's appreciation. Essentially, the aim of foreign exchange policy should be restricted to the stabilization of the macroeconomy, especially the balancing of external accounts. If it is forced to serve other purposes, such as the protection of comparatively disadvantaged sectors, authorities must be prepared to accept huge side effects. Industrial policy and the creation of safety nets for the socially weak should be undertaken through more direct means such as fiscal policy.

Lastly, China must not become emotional over demands from other countries for a stronger yuan. Foreign exchange policy should be decided calmly, based on the interests of one's own country. In fact, up until just a while ago, calls for the yuan's appreciation were often seen in the Chinese media. However, as external pressure mounted, such calls have completely been replaced by objections to the idea. Such government-led formulation of public opinion will only serve to restrict the policy tools available to authorities and will not serve China's interests.

In the first place, there is a tendency in any country for a policy or system to continue to exist once implemented, even if it has become obsolete, and China's exchange rate policy is no exception. In an effort to put an end to this sort of inertia, President Jiang Zemin said in his report to the 16th National Congress of the Communist Party of China in the fall of 2002 that in order to implement reforms "we should continue to emancipate our minds, seek truth from facts and keep pace with the times." Indeed, this sort of spirit is also needed when reviewing China's exchange rate policy.

March 28, 2003
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March 28, 2003