The Hindu Business Line : Rich China's poor yuan

China's rising external reserves should have caused the yuan to appreciate considerably. But the trend shows otherwise. There is a reasonably robust constituency in the US and East Asian countries for the continuation of the prevailing exchange rate regime, says Bhanoji Rao.

BY ITS nature, a fast moving developing country has insatiable demand for imports — raw materials, capital equipment, technological know-how, expertise, and so on. It is expected that such a nation would have, at least for some time, a current account deficit and a depreciating currency; the latter, according to economics texts, working to help export growth and promote care and attention with regard to imports. That stage has long passed in the Peoples Republic of China.

By 1990, current account deficits were a thing of the past. Between 1990 and 2002, the only year that China ran a current account deficit was in 1993. That was a transitory episode that actually helped the devaluation of the yuan. During the 13 years, China's total current account surplus was $188 billion. External reserves rose from $30 billion, in 1990, to $295 billion, a lot more than what the current account could add.

The reserves, thus, were also augmented by net capital inflows.

Such a performance, ceteris paribus, should have caused the yuan to appreciate a lot. Relative to the exchange rate of 8.7 yuan per dollar in early 1994, the rate should have moved up every year in line with the accumulating current account surpluses and reserves. The rate should have reached, say, a level of 5-6 yuan per dollar by the turn of the century.

What does a 5-6 yuan per dollar imply? First, rise in the imports into China. In case they did not rise, the world would have suspected non-tariff barriers to be in place and international action would have followed. Second, given that exports out of China would be expensive, an automatic drive for innovation and productivity growth among the Chinese business enterprises.

To a small extent, at least, China's top brass would have understood that creativity needs free space and thus a constituency for freedom, democracy and political reform would have begun to take root. Finally, the likes of Payless and Wal-Mart sourcing/making garments, shoes, and what have you, from China.

Time for a reality check (Table). Examine what the yuan trend has in fact been. While reserves accumulated all along, the yuan depreciated. How does one explain the unchanging yuan in the face of accumulating reserves?

Economist, Dr Paul Krugman, professor at the Massachusetts Institute of Technology, in his recent (May 20) column in The New York Times explains that the Chinese are able to keep the yuan down simply by sending the dollars back to the US. In 2004, for instance, the outflow from China to US was an estimated $200 billion. The purchase of dollar assets such as US government securities has helped the American government and people by keeping domestic interest rates down.

The China-assisted low interest rates helped the US government and the people by keeping costs of borrowing low. The government borrowed for plugging budget deficits, while people borrowed not only in keeping with the culture of the credit card society, but also to fuel a housing boom, which in turn has been accelerating the demand for many goods and services. The US economy has been doing better for all these reasons. This implies that there must be a reasonably strong constituency for the continuation of the prevailing exchange rate regime in China.

In June 2003, when the US Treasury Secretary, Mr John Snow, suggested that "the Chinese government is interested in moving toward market-based, flexible exchange rates", he was promptly given a tutorial by Dr Ronald McKinnon, professor at Stanford University.

Dr McKinnon wrote in the Asian Wall Street Journal (June 27, 2003) that a flexible yuan would lead to its `repetitive appreciation' and would be deflationary for the Chinese economy. "While many observers ask what the right level for the yuan/dollar exchange rate should be, that's really missing the point. What's far more important than the precise exchange rate — whether it be seven, eight or nine yuan to the dollar — is that it remains stable, eliminating foreign-exchange risk and so making Chinese savers more willing to continue to accumulate an indefinite future stream of dollar assets," he said.

Dr McKinnon concluded by calling for allowing the market value of the yuan to fluctuate within a narrow soft band around 8.28 yuan to the dollar. Almost to the dot, yuan stayed at the level of 8.28. One might wonder if US has been extending silent support for China's continued adherence to the under-valued yuan policy of enlightened self-interest.

It is good that the Chinese are getting support from some of the American intellectuals, which gives them the much needed confidence and space to carry on business as usual.

Whenever someone in the US establishment speaks about the yuan being undervalued by as much as 40 per cent, Chinese officials respond by saying that their fledgling economy would not be able to take any sudden changes or that they would need a lot more time to move towards a bit more flexibility, notwithstanding the fact that the yuan stayed around 8.28 for a decade so far.

What about the East Asian developing countries? Are they not hurt by the weak yuan? One must not forget how the leaders of the East Asian developing countries, with sizeable populations of Chinese dissent, thanked China for not allowing the yuan to `depreciate' during the financial meltdown of 1997-98.

How come they were unconcerned earlier, when the yuan actually lost a lot during 1993-94? That is because the business interests of the Diaspora and the leaders of the countries of their domicile have benefited from growing exports from China. Like the internal, the external constituency for a weak yuan is quite strong. Despite this, China economy watchers believe that the country has begun to put in place systems and institutions, which will help to eventually put the yuan on a flexible track. For instance, it has been reported that a currency-trading platform was launched a few days ago in Shanghai. It is expected that small- and medium-sized domestic financial institutions will be able to access the international currency market. Some think that China's strong foreign exchange reserves, currently in excess of $600 billion, will make it easy for the yuan to become freely convertible — eventually, of course.

(The author, formerly with the National University of Singapore and the World Bank, is professor emeritus, GITAM Institute of Foreign Trade, Visakhapatnam. He can be reached at bhanoji@gmail.com)

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