Commentary

Have patience with Beijing

This article originally appeared in the Australian Financial Review on July 25, 2005.
The sudden move by the People’s Bank of China to end its decade-long peg to the US dollar and switch to a “managed floating exchange rate regime based on market supply and demand with reference to a basket of currencies” may please Washington, but it will have little immediate impact on the US current account deficit.

The new currency regime, which allows the yuan to appreciate against the $US but still maintains exchange rate stability relative to a basket of currencies, will not be as transparent as the previous system, which held the yuan at 8.28 to the $US.

But it will take some pressure off Beijing, which is sending an important signal that its promise to reform the exchange rate system and move towards a more adaptable arrangement is credible.

As with all of China’s economic reforms since 1978, the movement towards greater flexibility will occur step by step.

Initially, the People’s Bank of China will let the yuan appreciate by only 2.1 per cent, disappointing those in the US Congress who have been demanding a much stronger move. Whether this step will suffice to quiet the anti-China crowd on Capitol Hill remains to be seen.

It appears that under the new arrangement, the official or parity value of the yuan will be a weighted average of several currencies, with the $US obviously the dominant one.

The PBC did say the exchange rate would be “more flexible based on market condition[s] with reference to a basket of currencies”. But it is not clear exactly how the new mechanism will work.

This arrangement is a far cry from the free-market system advocated by US Treasury Secretary John Snow, but it is in line with Premier Wen Jiabao’s goal of developing “an exchange rate system that is more market-oriented and flexible”.

Its success will depend on whether China relaxes exchange and capital controls and liberalises interest rates.

Washington should be patient with China. Only 10 per cent of US imports come from China, so even a 20 per cent appreciation of the yuan would only reduce the trade-weighted value of the $US by 2 per cent.

Slapping prohibitive tariffs on the Chinese, on the other hand, would dramatically shrink world trade and seriously endanger US-China relations and world peace.

It is in China’s interest to move towards a system allowing flexibility and convertibility and a monetary regime capable of ensuring long-run price stability.

The pegged system may have looked stable, but that was an illusion. To maintain the rate, the PBC had to continuously increase its purchases of dollars. During the first half of this year, net inflows of foreign exchange increased by 50 per cent from the first half of 2004.

If that trend continued, the PBC’s reserves would reach $US913 billion ($1.2 trillion) by the end of this year and surpass $US1 trillion by the end of 2006, according to Stephen Green, an economist with Standard Chartered Bank in Shanghai.

Such a large increase in foreign exchange reserves implies an undervalued yuan and could cause a large increase in the monetary base (currency in circulation plus bank reserves), unless the PBC withdrew most of the increase by selling bills or government bonds in the open market.

Green reckons only 68 to 71 per cent of foreign exchange inflows in the first half of 2005 were sterilised, and inflationary pressures are growing.

Rather than continue to peg the yuan at an unrealistic rate, pile up US dollars that could yield higher returns in the private sector (including the acquisition of Unocal) and suffer the threats of protectionism and inflation, China’s leaders have wisely ended the old currency regime. But they have not yet embraced the market.

We will have to wait to see how the new currency regime evolves. My bet is that the government will allow further appreciation of the yuan, embark on more rapid privatisation of the banking system, and slowly liberalise interest rates and allow full convertibility of the yuan.

Such institutional changes will be good for China, strengthen the world economy and improve US-China relations. Even so, the short-run transition could be difficult.

James Dorn is a China specialist at the Cato Institute.