Wednesday 10 December 2008

In Search of Balance for a Reliable Yuan

China has been on the right track since currency reform in 2005. This is no time to be sidetracked by yuan devaluation

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In Search of Balance for a Reliable Yuan

China has been on the right track since currency reform in 2005. This is no time to be sidetracked by yuan devaluation

By Hu Shuli, Caijing
9 December 2008

The latest debates over yuan reform have strayed from the consensus since the government’s exchange rate policy overhaul in 2005 and center on an anticipated devaluation of the Chinese currency, as well as the policy’s direction.

One of two opposing views says the government should “manage” the exchange rate by nudging it down to help exports and keep economic growth on track. Others oppose boosting growth through devaluation because, despite short-term weakness tied to a functioning market, the yuan will rise over the long term. We strongly support the latter position.

An international guessing game began when the yuan’s international exchange value slipped in early December. As of December 4, the spot rate of the U.S. dollar firmed at 6.8845 yuan. Banks appeared reluctant to part with their greenbacks. One-year, non-deliverable forwards (NDF) have fluctuated between 7.24 and 7.28 yuan.

On December 3, the State Council at a regular meeting said it intends to use “a combination of reserve requirements, interest rates and exchange rates to ensure ample liquidity in the banking system for the steady growth of the money supply and credit.” But what did the State Council mean by “exchange rates?” Basically, market conjecture on the yuan’s direction is predicated on market trends for yuan exchange and any exchange policies adopted by China based on new circumstances.

Admittedly, the yuan’s movement to some degree reflects currency market fundamentals. The People’s Bank of China slashed interest rates four times over the past three months, culminating with a cut of 108 basis points November 26. The cuts narrowed the spread between U.S. and Chinese interest rates, and reduced expected returns on yuan assets. The moves also fed speculation about more rate cuts next year.

As in any market, foreign exchange traders compare expected yields when making asset decisions. Now the interest spread between yuan and the U.S. dollar narrowed and the anticipated return on yuan dominated assets decreased. This factor, against the backdrop of a U.S. dollar that’s strengthened over the past three months, put a lid on the yuan’s value in October and pushed it lower in December. These movements reflect the yuan’s flexible response and make sense from a market perspective.

But the yuan’s latest softening is temporary, not a trend. To understand the trend, one must go beyond comparing relative yields and look at long-term fundamentals. Admittedly, the Chinese economy is going through a rough period, and double-digit growth is no more. But overall the Chinese economy is still strong; its international balance of payments and trade surpluses will remain for a long time. Meanwhile, the United States is struggling in a recession and is expected to chalk up higher deficits with an increasing money supply. Thus, U.S. assets are likely to lose considerable value.

China launched exchange rate reform in July 2005 with a policy aimed at promoting flexibility in market responses. Currently, yuan exchange rates respond to market fundamentals and are adjusted to a reference based on a basket of currencies through what is called “a managed floating exchange rate system.” The gist of this “adjusted, managed” layer is to keep exchange rates stable and, as the consensus goes, enable a shift to a sustainable development model.

So far the policy has worked. Over the past three years, the steadily appreciating yuan has encouraged changes in the export industry that favor more competitive enterprises. Underpinned by positive results of the exchange rate policy, more structural changes in the export sector can be expected as the international trade environment worsens.

To be sure, structural adjustments bring pain. When economic hardships mount, a balance must be found between maintaining growth and structural reform. China will try to boost domestic consumption and reduce its reliance on exports, but will not abandon foreign markets. In the process, the government can help ease exporter pain by streamlining functions and improving services to support market order. Shoring up exports with a devalued currency would be ineffective. Moreover, turning away from the market and engineering a U-turn for exchange rate policy to support exports with a devalued currency would likely have negative side effects.

Currently, plunging international demand is the main reason for China’s export plight. Lowering the value of the yuan would not change this situation. Chinese exporters’ costs are rising for many reasons unrelated to yuan appreciation, such as higher labor costs and cuts in export tax rebates. Devaluation, while unable to resolve cost problems, runs counter to the original intent of exchange rate reform and efforts to move away from China’s export-led development.

From an international perspective, boosting exports through yuan devaluation is, in effect, subsidizing foreign consumers. The outcome is likely to incur the wrath of China’s trading partners, perhaps leading to protectionism. No one wins if the currency is artificially devalued.

Policymakers’ long-term goal for exchange rate reform is to create a floating rate mechanism and ultimately a freely convertible international currency. The yuan, riding China’s dynamic wave of economic growth and reform, could become a major currency for the international economy. Devaluation through intervention would interfere with reform and end the yuan’s international aspirations. At this juncture, we must not lose sight of reform while monitoring short-term exchange rate fluctuations. An appropriate, market-oriented exchange policy with control, moderation and pro-active steps would help the present without harming the future.