By Century Weekly
) — Adjusting China’s foreign-exchange rate system — both the rate-setting mechanism and the rate itself — is more urgent than ever. Over the years, Chinese monetary authorities have stressed the need for a gradual, proactive and controllable approach to yuan policy. This is a prudent, rational approach.
But exchange-rate-system reform should be expedited whenever necessary. And with the yuan climbing to 6.5527 to the U.S. dollar April 1, its highest point since Beijing began exchange-rate adjustments in 2005, the time for action has arrived.
Some academics have recently suggested that China should move as soon as possible from its current exchange-rate system, based on a managed float, to a conditional free float. At the same time, they say, the yuan’s appreciation should accelerate. They say these moves would not only help rebalance the global economy, but benefit sustainable development in China as well.
This is sound analysis. Runaway inflation presents a persuasive argument for the need to let the yuan rise faster. Prices for food and some non-food items have risen significantly in China. Water, electricity, oil and gas costs remain subject to government controls, but the consumer price index is likely to hit a new peak by mid-year, when the index catches up with hikes from late last year and new pressures emerge.
Keeping a lid on consumer prices is a top priority for the government this year. But its measures so far — raising interest rates, hiking the required reserve ratio for bank deposits, and cooling the property market — have yet to work.
It’s clear that imported goods’ prices are having a direct impact on inflation. Gradual upward adjustments for the value of the yuan have so far failed to offset rapid price increases for major imports.
Between January and March, the yuan gained 1% against the greenback based on the inter-bank central parity rate. At the same time, the commodity price index rose 5.1%. Among key commodities, the price of crude oil, which exerts the biggest influence on all kinds of downstream products, has surged 24% this year.
Import data from the General Administration of Customs tells the same story. Crude oil rose 19.4%, iron-ore costs jumped 62.2%, and natural rubber prices increased 80.6%. These costs were passed on through market chains.
Clearly, there is room for a more rapid appreciation of the yuan. Its depreciation against the euro, pound and other currencies should be reversed, while its rise against the U.S. dollar should be accelerated. This move would go a long way toward easing inflation pain in China.
Of course, we cannot expect exchange-rate adjustments to restrain domestic prices immediately. And the impact of such a change would be limited. Besides, the effects of a rising yuan are complex. Hence, reforms should mainly target the exchange-rate mechanism.
Yet another pragmatic reason for exchange-rate reform is the dwindling value of China’s foreign-exchange reserves. The recent depreciation of the U.S. dollar is worrying and points to a long-term decline. According to the U.S. Treasury, China held $1.16 trillion worth of U.S. government bonds at the end of last year, accounting for about 60% of the 2010 increase in foreign official holdings of U.S. Treasurys.
The larger China’s dollar holdings, the higher the risk. To get to the root of this problem, China should stop accumulating these foreign-exchange reserves. The easiest way is for the People’s Bank of China to stop interfering in the foreign-exchange market through U.S. dollar purchases. Excess liquidity tied to this practice has been injected into the market and is a main source of inflation.
Without such direct intervention, the central bank will be moving away from a managed exchange-rate system and eventually toward a free float for the currency. This would help not only resolve short-term trouble in the economy, but rebalance China’s international trade as well. The move would strengthen the market and promote several long-term goals by boosting yuan-denominated cross-border trade. It would also help businesses sharpen their financial hedging tools and encourage mainland private businesses and citizens to invest overseas.
This strategy may seem radical, but we have an understanding of the risks. Since exchange-rate reforms began in 2005, the gap between the yuan’s real and optimal levels has narrowed. The value of the yuan has grown 57.9% since 1994, when China combined the official exchange rate and a market-based rate. But even this massive change did not bring about a dramatic shrinking of the export sector nor widespread unemployment, as many feared. Instead, in response, businesses raised productivity levels and improved product mixes.
Still, exchange-rate reform hurdles remain. For one, interest rates are seriously distorted, which in turn distorts exchange rates. Second, a free-floating yuan would require sound policy-making by an independent currency authority. Besides, how might financial authorities — and the domestic economy — deal with a freely convertible capital account?
To cope, some scholars suggest limiting short-term capital flow and allowing authorities to intervene in the market modestly and occasionally. Financial institutions would be advised to diversify currencies among their assets to hedge against risks.
These suggestions are worth considering. A gradual, proactive and controllable evolution of China’s currency exchange must be based on market principles and pragmatism. With proper planning, though, there is a good chance the yuan can achieve conditional, free convertibility in three to five years.
See this commentary at Caixin Online.