Fri, Aug 26, 2011 - Page 8 News List

Why China may let the yuan rise

By Martin Feldstein

China’s government may be about to let the yuan-US dollar exchange rate rise more rapidly in the coming months than it did during the past year. The exchange rate was actually frozen during the financial crisis, but has been allowed to increase since the summer of last year. In the past 12 months, the yuan strengthened by 6 percent against the US dollar.

A more rapid increase of the yuan-US dollar exchange rate would shrink China’s exports and increase its imports. It would also allow other Asian countries to let their currencies rise or expand their exports at the expense of Chinese producers. That might please China’s neighbors, but it would not appeal to Chinese producers. Why, then, might the Chinese authorities deliberately allow the yuan to rise more rapidly?

There are two fundamental reasons why Beijing might choose such a policy: reducing its portfolio risk and containing domestic inflation.

Consider, first, the authorities’ concern about the risks implied by its portfolio of foreign securities. China’s estimated US$3 trillion portfolio of US-dollar-denominated bonds and other foreign securities exposes it to two distinct risks: inflation in the US and Europe and a rapid devaluation of the greenback relative to the euro and other currencies.

Inflation in the US or Europe would reduce the purchasing value of the US dollar bonds or euro bonds. The Chinese would still have as many US dollars or euros, but those US dollars and euros would buy fewer goods on the world market.

Even if there were no increase in inflation rates, a sharp fall in the US dollar’s value relative to the euro and other foreign currencies would reduce its purchasing value in buying European and other products. The Chinese can reasonably worry about that after seeing the US dollar fall 10 percent relative to the euro in the past year — and substantially more against other currencies.

The only way for China to reduce those risks is to reduce the amount of foreign-currency securities that it owns. However, China cannot reduce the volume of such bonds while it is running a large current-account surplus. During the past 12 months, China had a current-account surplus of nearly US$300 billion, which must be added to its existing holdings of securities denominated in dollars, euros and other currencies.

The second reason why China’s leaders might favor a stronger yuan is to reduce domestic inflation. A stronger yuan lowers the cost to Chinese consumers and firms of imported products as expressed in yuan. A barrel of oil might still cost US$90, but a 10 percent rise in the yuan-US dollar exchange rate reduces the yuan price by 10 percent.

Reducing the cost of imports is significant because China imports a wide range of consumer goods, equipment and raw materials. China’s total annual imports amount to roughly US$1.4 trillion, or nearly 40 percent of GDP.

A stronger yuan would also reduce demand pressure more broadly and more effectively than the current policy of raising interest rates. This will be even more important in the future as China carries out its plan to increase domestic spending, especially spending by Chinese households. A principal goal of the recently presented 12th Five-Year Plan is to increase household incomes and consumer spending at a faster rate than that of GDP growth.

This story has been viewed 5677 times.

Comments will be moderated. Remarks containing abusive and obscene language, personal attacks of any kind or promotion will be removed and the user banned.

TOP top