The Political Economy of a Stronger Yuan
C. H. Kwan, Senior Fellow, Research Institute of Economy, Trade
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 county'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
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 is preferably 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 partly because the
leaders newly appointed during the latest Communist Party Congress
and National Peoples Congress will take time to consolidate
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.