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Revaluation of the yuan is priority number one

Whether the Chinese yuan should appreciate has become a hot international issue. One of the reasons for this is that China is sitting on an enormous foreign exchange reserve worth more than US$400 billion, second only to Japan's US$600 billion forex reserve.

Foreign exchange usually comes from two sources: trade surplus and net foreign investment. China's trade surplus with the US reached US$103 billion last year and it is predicted to reach US$130 billion this year. Beijing's deliberate measures to keep the yuan weak are believed to be the main cause of the massive trade surplus.

We can understand something about the massive flow of foreign investment into China from an expression used in recent years to describe the appeal of the Chinese market: the "capital magnet" effect.

As foreign money flows into the Chinese market and has to be exchanged to yuan before circulating there, the demand for the yuan naturally increases. In a free market, the price of the yuan would see an increase based upon the simple principle of supply and demand. However, the Beijing authorities suppress the price. As a result, large amounts of yuan have accumulated in China. This currency circulates in the form of idle money, causing currency or asset inflation (that is, speculative bubbles in the real estate or stock markets).

This was painfully experienced in Taiwan in the 1980s. So, what really happened in Taiwan at that time?

As described by the late Academia Sinica member Hsing Mu-huan (邢慕寰), the value of the New Taiwan dollar was kept at NT$40 to US$1 until 1986. This serious undervaluation served

as an invisible export subsidy. Together with tax returns from raw materials exports, this led to an abnormal increase in the trade surplus and in foreign exchange. Two grave consequences followed from this.

First, technology ceased to grow. Second, the flood of idle money led to potential inflation, speculation in the real estate and the stock markets and gambling.

More serious, the West's industrialized nations were given a good excuse to force Taiwan to open its markets and revalue its currency. When the NT dollar suddenly appreciated considerably, most small and medium-sized enterprises (SME) were unable to sustain themselves and serious unemployment was the result.

The initial reason for not revaluing the NT dollar was to protect export-oriented SMEs. Nevertheless, revaluation -- and excessive revaluation at that -- eventually became inevitable, and many SMEs that could have survived a steady revaluation policy went bankrupt.

Beginning in 1985, Taiwan saw a sharp surge in foreign exchange assets, and speculation ran wild for a time until the stock market plunged and the bubble burst in 1990, the impact of which can still be felt in Taiwan today.

Will this happen to China too?

Today's China is very similar to Taiwan's situation in the early 1980s. What's worse, production volume and value growth rates in China are often inflated and

the money supply has doubled, while the accumulation of foreign exchange reserves is leading to an increasing demand for the yuan.

Combining these two factors, the problem with the flood of idle money is even worse than it was in Taiwan 20 years ago. Once the inflated demand collapses, the consequences will be grave, and the impact on the global economy unimaginable. Therefore, for the good of the world, the Chinese authorities need to liberalize their foreign exchange market soon.

Wu Hui-lin is a research fellow at the Chung Hua Institution for Economic Research.

Translated by Jennie Shih
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