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China’s slow but sure shift to yuan flexibility – Straits Times 01/08/07
August 1, 2007, 2:10 am
Filed under: current affairs

Succinct article on the yuan, covering the major concerns and points. I have posted the article but I shall summarise the article in point form below:

  • China is seeking to exit the yuan peg through a two-prong approach.
  • China is gradually moving towards a flexible exchange rate, but eschews revaluations.
  • Stability is a priority as opposed to great changes.
  • China’s problem today is of excess liquidity and economic imbalances due to forex buildup.
  • However, China is stronger today in terms of economic resilience. The banking industry is stronger after reform, the labour industry is more robust with industries moving up the value chain and a more efficient private sector after structural changes.
  • The benefits of a cheap yuan has been eroding. The cheap yuan has induced a concentration on exports in the economy and this goes against the government’s plans to boost domestic demand and reduce external risks.
  • The rigid yuan also attracts speculators, betting on its appreciation. The hot money inflow distorts capital allocation, generates excessive liquidity in the domestic financial system, boosts asset-price inflation and risks broader price inflation.

China’s slow but sure shift to yuan flexibility

By Chi Lo, For The Straits Times

US TREASURY Secretary Henry Paulson is visiting China this week. At the top of his agenda is the bulging US trade deficit with China and, of course, Beijing’s currency policy.

While many American politicians remain frustrated with the yuan’s crawling-peg regime, Beijing has in fact embarked on a gradual, twoprong approach to exit the yuan peg. It is apparently making moves to unlock the capital account and is loosening its grip on the exchange rate.

Why is Beijing doing this at this time? To be sure, its move is not just in response to US lawmakers’ threat to implement trade penalties. China is also realising that changes to its currency policy are needed because the economic costs of an inflexible exchange rate are outweighing the benefits.

But it is not practical for Beijing to move fast on exiting the yuan peg due to institutional and political constraints. The point to note is that China is slowly shifting to a flexible exchange rate, but will eschew revaluations.

The yuan’s crawling peg and the consequent rapid build-up of foreign reserves have led to excessive liquidity growth and created serious economic distortions, notably in the asset markets, where asset-price inflation has been rampant first in the property sector, and now in equities. These imbalances could lead to vulnerabilities like the massive capital inflows, credit boom, excessive investment and economic bubbles that were seen in the run-up to the Asian crisis 10 years ago.

Still, this is not to say that Beijing will change its currency regime quickly. But it has certainly been working on a gradual pace of change. The reasons are simple enough.

Beijing has long argued that a stable currency is in the best interest of the country. The argument evolved in recent years into curbing the yuan’s appreciation despite massive balance-of-payments surpluses. But times have changed. Fears of a sharp rise destabilising the banking system and economy, leading to capital outflow and depleting the foreign reserves, are outdated.

Today, China’s problem is of too much foreign reserves creating excess liquidity and causing economic imbalances. Its banking system is much stronger after years of reform. The labour market is also more robust, as creative destruction has moved Chinese industries up the value chain.

Structural changes have also delivered a more efficient Chinese corporate sector, with a strong ability to sustain profit growth in the face of weak pricing power. All this suggests that China’s labour market and corporate sector are better positioned to face a stronger yuan in the policy transition and structural adjustment process.

On the other hand, the benefits of keeping the de facto yuan peg have been eroding. The cheap currency has induced an expansion of the external sector and made the economy increasingly export-driven. This goes against Beijing’s expenditure-switching strategy of boosting domestic demand and reducing the reliance on exports as the key growth driver.

The rigid yuan has also created a moral hazard, with speculators riding a one-way bet on the currency’s appreciation. The resulting hot money inflow has distorted capital allocation both in the Chinese and world financial systems. It has also added pressure by generating excessive liquidity in the domestic financial system, boosting asset-price inflation and risking to ignite broader price inflation down the road.

The biggest domestic distortion is in monetary policy. The central bank’s interest-rate policy tool has been severely blunted at a time when excess liquidity is causing economic imbalances. Distorted interest rates are increasing savers’ incentive to shift funds into the asset markets from bank accounts.

The one-year deposit interest rate (at 3.33 per cent) is out of sync with rising expectations on earnings and economic growth. For example, expected returns from the stock market is more than 30 per cent. This huge gap between the risk-free rate and expected investment return has boosted stock prices into bubble territory.

On the trade front, since China’s productivity will continue to grow faster than most of its trading partners in the medium-term, a fixed yuan will only aggravate the competitive stress on global trade. China’s bulging trade surplus has now created friction with both developed markets and some Asian ones.

Allowing market forces to set the yuan’s exchange value is a natural way of preventing currency distortions that inflict excessive volatility in the Chinese and global financial systems. The current low-inflation, strong corporate profitability and steady demand-growth environment indeed provides a favourable backdrop for making a policy shift.

Beijing’s long-term plan is to gradually allow a rising portion of liquid yuan assets to be freely convertible into foreign assets. The move will not only help improve China’s domestic capital allocation efficiency, but will also contribute to a more effective functioning of global markets.

Arguably, American pressure on China to liberalise the capital account and the yuan is consistent with China’s self-interest in reducing domestic economic distortions and its dependence on exports as a growth driver. So, with or without protectionist threats, China is moving towards a convertible currency. Slowly, but surely.

This is the message Mr Paulson should take back to Capitol Hill.

The writer is investment research director of Ping An of China Asset Management (Hong Kong).

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