When Will China Loosen Its Peg?

By David Cohen After being invited as a prominent guest to the previous two meetings of the Group of Seven industrial powers, China will be conspicuous in its absence at the G-7 gathering in Washington on the weekend of Apr. 16-17. Even so, you can bet that the Middle Kingdom's currency peg -- which ties the value of the yuan to that of the U.S. dollar -- will be a major topic of conversation.

Perhaps the G-7 is trying a more low-key approach in its efforts to encourage China to permit some appreciation of the yuan, in order to avoid public lectures directed at Beijing. China, now the world's fourth-largest exporting nation, is second only to Japan in holdings of foreign-exchange reserves. It has repeatedly pledged a "gradual move toward exchange rate flexibility," while refusing to give a timetable.

Some analysts think Beijing is waiting for the topic to fade from attention -- the forward market premium on the yuan has narrowed considerably from the end of last year, when speculation was more intense. Many analysts say changes might come by the end of this year, potentially in the form of permitting the yuan to trade within a band vs. the greenback or against a basket of currencies. As such, it might trigger a broader array of foreign-exchange rate adjustment across Asia, since many of China's neighbors are currently wary of permitting appreciation of their currencies vs. the dollar for fear their exports will be less competitive with China's.

SOURCE OF STABILITY. China has kept the yuan pegged at about 8.28 to the dollar since 1994, spending a total of $195 billion in official acquisition of foreign exchange reserves during 2004 to bring its total holdings to over $610 billion by the end of last year (second only to Japan's $845 billion). Like many other Asian central banks, the People's Bank of China (PBOC) is no doubt considering whether it's in its best interest to continue such rapid accumulation of U.S. dollar assets, which would leave China exposed to potential losses in the event of a collapse of the greenback's value.

However, China might be wary of discontinuing an arrangement that many analysts see as a source of stability in its recent achievement of impressive growth with limited inflation.

Nevertheless, a strategy of cutting back on intervention and allowing some appreciation of the yuan vs. the dollar offers some potential attractions to policymakers. For one thing, allowing appreciation would be another market-oriented restraint tool to keep the Chinese economy from overheating, similar to the decision in October, 2004, by the PBOC to raise interest rates for the first time in nine years.

APPRECIATION BONUS. Though year-over-year increases in the Chinese consumer price index have subsequently moderated on a swing in food costs, economic growth shows little sign of slowing from the robust 9.5% annual GDP increase posted in 2004, including a 35% year-over-year increase in exports. Some further macro restraint may well be useful to Chinese policymakers.

At the same time, currency appreciation wouldn't be all that painful. For one thing, it could help to contain the higher oil-import bill China faces. Finally, moves toward currency flexibility could help deflect potential imposition of trade barriers by customers, including the U.S., where the growing bilateral trade deficit with China has touched off protectionist criticism in Congress.

It should be emphasized that the bilateral U.S.-China trade imbalance -- $162 billion in 2004 -- overstates the overall Chinese trade surplus, which was considerably smaller, at $32 billion in 2004. Even the current account surplus, estimated by the PBOC at $70 billion (twice the September estimate by the IMF, and including $20 billion in "errors and omissions"), was more moderate. It shows that China registered a sizable trade deficit with nations other than the U.S. -- in particular the rest of Asia, including a substantial amount of intermediate components assembled in China for export to the U.S.

REGIONAL BENEFITS. In effect, the massive U.S. bilateral deficit with China is a proxy for the U.S. deficit with the entire region, and the yuan is merely the primary member of the list of undervalued currencies among regional exporters. Many Asian nations have intervened heavily to resist appreciation of their currencies vs. the dollar, in part because they are wary of losing competitiveness to China.

Indeed, while the Chinese total of $195 billion spent in official foreign-exchange acquisition in 2004 turned many heads, the eight biggest Asian central bank holders (Japan, China, Taiwan, Korea, India, Hong Kong, Singapore, and Malaysia) hold a combined $2.3 trillion in forex reserves. Aside from India, they have been running steady current account surpluses since the 1997-98 regional currency crisis, and might have regained the nerve to tolerate some currency appreciation.

Some relaxation of the Chinese peg is probably necessary in order to allow many of the other Asian economies to tolerate some further appreciation vs. the dollar. Malaysia, for example, which has seen reserves swell while maintaining its own currency peg to the dollar since 1998, might be attracted to flexibility for some of the same reasons as Beijing -- but it's wary of losing competitiveness to the Chinese in the key electronics sector. Even the Japanese, though they compete on a higher level of technological sophistication, presumably would be inclined to permit appreciation of the yen (which is also probably undervalued) if the Chinese were to relax their peg.

ASIAN BLOC. With South Korea's currency, the won, currently stronger against the yen than since since 1998, policymakers in Seoul will likely resist gains against the dollar until the yen firms. When the central bank governors of China, Japan, and South Korea meet at their first international conference on May 27, they might contemplate the advantages of mutual appreciation vs. the dollar. The situation offers a classic case for policy coordination, since the measures are less risky taken jointly.

While the latest general firming in the dollar has relieved the pressure on China for the moment, a move by Beijing to permit some appreciation vs. the U.S. currency would be a welcome step toward correcting the fundamental U.S. current account imbalance. It would allow other Asian currencies to move in sympathy, and no longer depend upon the euro to bear such a disproportionate share of the adjustment in the value of the U.S. currency.

Beijing is moving at its own pace, having loosened some capital controls, and is in talks with several foreign banks about opening up currency trading. It would seem just a matter of time before the changes come, and we at Action Economics think it will probably happen before the end of this year. Cohen is director of Asian economic forecasting for Action Economics

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