The Hindu Business Line : Pegged yuan: Five cheers to China

It may be unfashionable to defend pegged exchange rates. But it is also necessary to showcase what China has managed to accomplish through a somewhat indefensible policy. China will let the yuan float freely, some day. But it would be foolish to disregard the enormous gains reaped from pegged rates, says G. Ramachandran.

CHINA faces too much flak for its pegged exchange rate policy. Some economic experts are alarmed at the precarious peg on which the yuan (CNY) is perched. The yuan has remained pegged at 8.28 CNY to the United States dollar for over five years now. There is pressure on China to set a higher value for the yuan, say, at 7.87 CNY to the dollar. Others have advised it to give up pegged rates. They want it to float the yuan and let the market set the right price for the yuan.

Trade analysts in Europe and the US have aligned their voices with that of the economic experts. Theirs is the stronger of the two forces that have been driving China's critics and rivals into a frothy frenzy.

Their principal complaint is that the weak yuan has artificially strengthened China's external competitiveness.

They argue that freely floating rates would lead to a surge in the yuan and a decline in its formidable trade competitiveness. They are eager to see the yuan at 7.87 CNY to the dollar or stronger at 7 CNY before the yuan is set to float freely.

In this rather intimidating din and sabre rattling, China's monetary authority has kept its cool. But there are signs it may be beginning to wear out. It has begun to assert that the exchange rate policy is wholly its prerogative and right. It has not been as assertive as it should have been in telling the world that the pegged rate has worked well for China.

It is unfashionable to defend pegged exchange rates. But it has become necessary to showcase what China has managed to accomplish through a somewhat indefensible policy. China will let the yuan float freely, some day. But it would be foolish to disregard the enormous gains reaped from pegged rates.

Two-headed trouble

Currency experts who have suggested that the yuan should be freely floated are of the view that pegging is anachronistic. They regard it with justifiable suspicion and dread. They regard China's pegged rates as a threat to the international financial architecture. Why?

China is the world's third largest economy. Pegged rates require its monetary authority to manage both monetary and exchange rate policy. By contrast, freely floating rates require the setting of monetary policy. Exchange rate then moves on autopilot. Pegged rates may also be contrasted with fixed rates. With a fixed rate, exchange rate policy is set. Monetary policy then moves on autopilot.

With pegged rates, nothing is on autopilot. What this means is that there can be fatal conflicts between monetary and exchange rate policies. Moreover, the monetary base will have to reckon with the domestic and foreign components. Therefore, balance of payments crises can occur.

Monetary policy experts think that China is inviting serious monetary trouble by working with a weak yuan. The weak yuan has led to the ballooning of the foreign component of the monetary base.

This has necessitated a compression of the domestic component of the monetary base. This, they say, may derail its economy sooner than later.

Pegged exchange rates can indeed cause balance of payments crises. They can derail the domestic economy. But they have not hammered China into a position of weakness.

They have not hammered it into a humiliating economic surrender. By contrast, China has shown how to make its pegged rate work wonders as much for its economy as for the global economy.

Productivity

China's severest critics are in the US. They believe that the US economy has ceded economic advantage to its manufacturers. It is their beef that the artificially weak yuan has put US manufacturers at a relative disadvantage.

Their principal line of attack is that imports from China are cheap and very affordable to US households and businesses because the yuan is artificially weak. That is, prices of imports in dollars are very low since the yuan is artificially weak.

If the yuan is priced right, prices of imports in dollars will not be as low. US manufacturers would, as a result, regain their economic advantage from China's manufacturers.

Critics in Europe have joined their peers in the US with significant enthusiasm. This is not surprising. However, all critics overlook China's enormous gains in productivity. This is an egregious lapse.

Almost all exports from China are made of imported materials, metals and energy that have globally-traded dollar prices. Almost all exports emanate from factories and facilities that have significant long-term investments from European and American businesses.

Barring the price of domestic credit and human resource, the fixed and variable costs of exports from China are driven by global forces.

These costs can be measured in dollars. They have to be measured in dollars. Regardless of the value of the yuan, these costs in dollars will be the same anywhere in the world. So, the principal source of China's competitiveness is not the weak yuan.

The principal source of its competitiveness is the rising productivity of its workforce. As productivity keeps rising, China will remain competitive, even if the yuan is set at 5 CNY to the dollar.

Monetary economy, for all

In `Nothing macho about forex reserves', the principal assertion was that foreign exchange reserves are not earned by a country .

China has to augment its foreign exchange reserves to keep the yuan weak. It has no choice but to expand its reserves to keep the yuan pegged at 8.27 CNY to the dollar.

It augments its foreign exchange reserves by expanding its monetary base. The risk from such action is that the surge in the monetary base could fuel inflation. However, inflation in China is not a big worry. It was benignly low at 1.8 per cent, year-on-year in April 2005.

What this means is that China has found the right reasons and the right uses for raising its monetary base. More and more economic activity has been monetised in China.

Its monetary economy has drawn in more and more households and businesses into its fold. By contrast, India continues to flog its food-for-work programme.

Capacity to absorb capital

China's capacity to absorb capital is at the centre of its phenomenal economic success. It would be daft to believe that capital flows are autonomous occurrences. Capital flows and investments are the results of its policy mix and earnestness.

The handsome rise in productivity and the unceasing monetisation of the domestic factors of production have made China's assets very attractive to both domestic and global investors.

The crux of the play lies in capital absorption. If China's capacity to absorb capital had been impaired, its pegged rate policy would have broken down a long time ago.

What needs emphasis is that China has found the right policy mix aimed at absorbing global capital and domestic savings.

Growth for all

Rising productivity, rapid monetisation of the factors of production and the enthusiastic absorption of capital have fuelled growth in China. Rising employment and incomes have followed.

Its per capita income of nearly $1,000 can be explained as the result of its conscious efforts aimed at opening up more and more of its core economic activities to more and more households and businesses.

It is not an accident that its economy has been growing at about 10 per cent annually for almost 15 years. The handsome growth may not be wholly the result of its pegged rate policy.

China may have performed as well with a fixed rate policy or a floating rate policy. But what is clear is that the pegged rate policy has not halted China in its progress.

Global benefactor

China's pegged rate policy has bestowed significant benefits on the regional and the global economy. This may be an aggressive defence of its policy.

But the facts support this assessment. Many of its Asian neighbours had collapsed in 1997 after the Asian currency and economic crisis. Japan had been in deflationary slumber then. China has hauled its neighbours out of a deep hole. It is now a lucrative market for exports from the regional neighbourhood. It is a competitive source for value-added inputs. Its stability and growth have been vital to many Asian economies.

Japan too has benefited from China's robustness. But its pegged rate policy has not imposed any costs on the global economy. How? Most globally traded inputs used by China's producers are priced in dollars. Crude oil and metals are prime examples.

The artificially weak yuan raises the landed prices of these inputs. But they have not complained. They could have benefited from a strong yuan. Landed prices would have been lower.

But a strong yuan would have also pushed demand from China's producers. This would have in turn pushed up global prices to new highs.

This would have pushed some big economies into trouble. It is a relief that the weak, pegged yuan has been a balm to the big global economy.

It has hoisted China's economy to new highs without pushing other economies into new lows. The pegged rate deserves a vigorous pat on its back.

(The author is a financial analyst. Feedback may be sent to indiagrow@yahoo.com and pari@thehindu.co.in)

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