Rumors about the Chinese yuan's appreciation have once again bubbled to the top of the business agenda. Since the end of last year, the Chinese media have revealed many times that Beijing hopes to change the yuan's exchange rate system from one in which the currency is pegged to the US dollar, to one where it is pegged to a basket of currencies.
If we take the basket to be the currencies of China's top 10 trade partners, the yuan's nominal exchange rate will rise by around 5 percent. In addition, there may also be some adjustment to the yuan's fluctuation band -- to a margin of plus or minus 2.5 percent, for example. Overall, the Chinese government has the room to appreciate the yuan's nominal exchange rate by 7 to 8 percent this year.
Such a major change in the Chinese government's attitude is not a matter of yielding to pressure from international powers, but of following strong market forces, both domestic and foreign. After 25 years of reforms, the Chinese government's intervention in the financial system is gradually failing. Besides, large loopholes have emerged in capital account controls. Market forces will determine policy on the yuan's future appreciation. On Feb. 10, Chinese Premier Wen Jiabao (溫家寶) stressed during an internal meeting that China will maintain the "basic stability" of the yuan's exchange rate while at the same time steadily promoting reforms in the hope of having market forces determine the exchange rate.
"Market forces" primarily mean the supply-demand balance of foreign exchange. Foreign exchange reserves and international hot money play crucial roles in this, but the increasing imbalance in the domestic economy puts more direct pressure on exchange rate policy.
The steep rise in foreign exchange reserves creates a steep rise in monetary supply and credit, which in turn causes the imbalance in China's internal economy to increase gradually. From May to November last year, both credit and the broad money surplus increased by amounts exceeding 20 percent. By the end of December, the broad money surplus rose by 19.6 percent compared to the end of the previous year. Loans grew by 21.4 percent. Following the rapid increase in credit, commodity prices, which had fallen by 1.3 percent in April 2002, rose gradually, posting a 3.2 percent increase last December. In less than two years, China has moved from worrying about worsening deflation to worrying about whether the economy is overheated.
The problems are more complex, however. China's inflation is driven by raw materials and foodstuff prices, but 90 percent of industrial products are still in a state of oversupply. Today, the steep rise in credit is accelerating the overheating and overproduction in some industries, especially in the steel, cement, automobile, electrolyzed aluminum and other raw-material sectors, pushing China to the brink of an economic bubble and then giving rise to serious financial and deflation problems.
Eager to avoid affecting the speed of economic growth, the Chinese government does not want to raise interest rates. It is trying to reduce investment in overheated sectors by executive orders and exhortation to prevent an expansion of the imbalance in its economic structure and to reduce the risk of overheating. To this day, however, such administrative approaches have not been effective. Market forces have the upper hand.
China's Minister of Commerce Lu Fuyuan (呂福源) was quite right when he said at the Fifth Asia-Europe High-Level Economic Forum last July, "China's economic situation is the most important consideration in its decision on the exchange rate. The suggestions and concern from other countries are only of secondary importance."
China certainly has enough political prowess to resist international political pressure, but the continued expansion of internal and external economic imbalances is an important factor in why China may have no other choice than to consider raising the yuan's value appropriately.
Tung Chen-yuan is an associate research fellow at the Institute of International Relations at National Chengchi University.
TRANSLATED BY FRANCIS HUANG
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