Beijing's Bombshell: Brace for a Floating Currency
Cutting the yuan free would move China nearer a market economy

It was quite a shock. Chinese Prime Minister Zhu Rongji was meeting with a delegation of Hong Kong executives visiting Beijing in late June. Zhu told the 40 businessmen, including mogul Li Ka-shing, that the International Monetary Fund had suggested that China float its currency, the yuan. Zhu said he was considering it, perhaps before the end of this year. Zhu's audience expressed concern about the disruptive impact on China's economy as well as on Hong Kong's. But they came away from the meeting convinced that Zhu was serious about the idea--and that it's only a matter of time. ''Floating the yuan is in the cards,'' says one of the execs present at the meeting.

How China manages such a momentous transition will have a tremendous impact on the reforms it needs to pull off as it emerges into the global economy and joins the World Trade Organization. Certainly the devil is in the details. Zhu has quietly been seeking advice on floating the yuan from Hong Kong's financial community. Those who have been advising him say the Premier is considering enlarging the trading band by 10% above or below its current fixed rate of 8.3 to the U.S. dollar. With the Chinese economy now stable, Zhu is betting that he can pull off a managed float without spooking the markets, sparking capital flight, and causing financial turmoil.

That remains to be seen. While the yuan, based on current fundamentals alone, would likely appreciate up to 10% if the band is widened, unease about China's future problems and weak financial system could just as easily prompt a devaluation. Zhu's trial balloon is also cause for concern among other leaders in the region. ''It would be a disastrous decision,'' says former Japanese Finance Ministry official Eisuke Sakakibara. ''It would have the worst effects on financial markets.''

'UP AND DOWN.' Hong Kong business leaders are concerned that floating the yuan could provoke a speculative attack on the Hong Kong dollar, which is pegged to the U.S. dollar. ''Zhu asked what kind of effect it would have, and everyone was jumping up and down,'' says another businessman present at the meeting. ''Everyone in that room was so negative [about the idea].'' Still, China's last devaluation, by 10% in 1994, ended up stoking Hong Kong's economy.

By cutting the Chinese yuan free, China would move even closer to a full-throated market economy. It would open the way to ending controls on the free movement of capital, a key reform that analysts say could happen in the next three to five years. ''Once they open up the trade account, it's very difficult to keep capital controls,'' says Hong Kong-based Goldman Sachs (Asia) Executive Director Fred Hu.

Most immediately, China needs to find a shock absorber to help cushion the bumps it will feel on entry into the WTO, probably at the end of this year. Tariffs will fall, to less than 15% in most cases, exposing inefficient state companies to withering competition. A currency float would mean that policymakers won't be caught by an out-of-whack exchange rate. For example, an overvalued currency dampens exports, fuels imports, and stokes foreign-currency borrowing. Beijing also is increasing wages at state companies and government offices in another effort to soften the blow of WTO entry.

So far, China's exchange-rate stability has won it kudos from Washington. At a time when Asia buckled under the weight of the 1997-98 crisis, China's firmness in maintaining its currency rate helped prevent a full-fledged regional collapse.

Now, China's surging exports point to the economy's renewed financial health and a stronger yuan--at least in the short term. Exports shot up 37% in the first five months of the year. Foreign investment contracts surged 26%, to $18 billion, in the same period. The economy is likely to grow by 7.8% for the year, up from 7.1% in 1999. Merrill, Lynch & Co. economist Guonan Ma expects China's trade surplus to hit $34 billion this year.

Although the central bank, the People's Bank of China, refuses to confirm any change, Zhu's comments are a signal to the market in an effort to soften the inevitable disruptions that will accompany any move toward a flexible exchange rate. Academics and government officials in Beijing have discussed a currency float for some time. But by raising the possibility to Hong Kong businessmen, Zhu is signaling them to be prepared. Disruptive though it may be initially, unshackling the yuan would be yet another step toward the freeing of the Chinese economy. But Zhu could be in for a rough ride along the way.

By Mark L. Clifford in Hong Kong

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