China's refusal to let market forces determine the foreign exchange value of the yuan and to liberalize capital markets has meant that the People's Bank of China must continue to accumulate foreign reserves. Official reserves now stand at more than $514 billion compared to less than $350 billion only 18 months ago. With most of those reserves held in U.S. government bonds, there is an increasing risk of substantial losses to the Chinese economy as the dollar loses its international purchasing power.
Since early 2002, the dollar's value has fallen by 35 percent against the euro and by 17 percent against a broader basket of currencies on a trade-weighted basis. The dollar's slide is due to an unsustainable U.S. current account deficit that is now about $600 billion, nearly 6 percent of GDP. Moreover, the U.S. is running a sizeable budget deficit, has trillions of dollars of unfunded liabilities associated with Social Security and Medicare, and has a saving rate close to zero. Happily for U.S. consumers and taxpayers, foreign central banks are financing the bulk of the twin deficits at low interest rates.
Currently foreign central banks hold dollar-denominated assets worth about $2.3 trillion, with Asian banks holding more than $1.8 trillion. The attractiveness of those "investments" will eventually decrease if the dollar continues to slide. As Federal Reserve Chairman Alan Greenspan recently warned, "A diminished appetite for adding to dollar balances must occur at some point."
Given China's current-account surplus and large capital inflows, including speculative inflows in anticipation of an upward revaluation of the yuan, the PBOC's foreign reserves are growing too fast. To keep the yuan pegged at 8.28 per dollar, the PBOC must buy excess dollars, which can lead to inflation unless the PBOC withdraws the new domestic currency by selling securities. Doing so, however, diverts capital from more productive uses in the private sector.
The problem is that China will not be able to increase its dollar reserves indefinitely without serious inflationary consequences, which will cause social and political instablity. China's capital controls are porous, with billions of dollars flowing into the Mainland through black-market channels. As those funds are converted into local currency, there will be increasing upward pressure on the yuan-dollar exchange rate -- unless the PBOC pumps out more and more yuan to buy the excess supply of dollars.
The larger the capital inflows, the more difficult it will be for the PBOC to fully offset or "sterilize" them by selling bonds to state-owned banks and individuals. The fact that consumer price inflation has gone from zero to more than 4 percent this year, and producer prices rose by 8.4 percent in October from a year earlier, means there is too much money chasing too few goods. The recent increase in the PBOC's benchmark interest rate is a clear signal that Beijing is worried about overheating.
If China moved to a more flexible exchange-rate regime, perhaps by first tying its currency to a basket of currencies, which would allow the yuan to move in a wider range against the dollar, and eventually float the yuan, the PBOC could concentrate on what a central bank is best able to do -- namely, control the growth of base money (currency held by the public plus bank reserves) to achieve price stability. Of course, China would also have to decontrol interest rates and speed up privatization of state-owned banks.
With a truly floating exchange rate, there is no need to hold large foreign reserves, so the PBOC could slowly reduce its dollar assets and its exposure to future exchange-rate losses. Floating the yuan would be a hedge against over reliance on the dollar and would lead to a more rational use of China's vast savings.
If China continues on the current course, reserves will continue to grow and put increasing pressure on the yuan-dollar peg. As Wang Zili, deputy governor of the Guangzhou branch of the PBOC, noted at a private meeting of bank officials and other experts last month, "The yuan is indeed facing very big pressure to appreciate, and the main reason is that China's foreign reserves are growing too fast."
Expect to see further capital account liberalization in 2005 to relieve pressure on the yuan, and a slow movement toward widening the peg or adopting a currency basket. The PBOC will then have greater freedom to focus on domestic monetary policy aimed at long-run price stability.