China’s exchange rate policy should, however, focus more on a basket of currencies, de-emphasising the bilateral exchange rate against the US dollar.

Having said this, expectations of a sharp rise in the yuan by international investors and foreign policymakers were unrealistic. Although the central government is determined to make the exchange rate more flexible, it has never given the impression of a drastic revaluation of the yuan.

In fact, the policy statements of PBOC, the country’s central bank, during the past few years have repeatedly emphasised the need ‘to improve the exchange rate formation mechanism’ and ‘keep the exchange rate at the rational and balanced level basically stable’.

What is driving the government’s conservatism?

The government’s stance on the yuan’s revaluation is best understood by its concern over GDP growth and job creation. Traditionally, China’s policymakers have been reluctant to implement any policy with negative short-term growth implications. But this is changing gradually. There is increasing agreement among policymakers that overemphasising short-term growth may result in serious structural problems such as large current account surpluses which, in turn, could damage long-term growth potential.

And like any other country, China’s exchange rate policy is also subject to domestic politics. A large number of exporters and foreign direct investment entities strongly oppose the revaluation of the yuan, often citing potential job losses as the main fallout. For instance, one government department conducted a stress test a few months ago, which showed that a 3 per cent rise in the value of the yuan was the maximum change that the export sector could possibly cope with. It is worth mentioning that this ‘test’ was flawed, because the yuan rose more than 5 per cent a year between 2005 and 2008, at a time when the export sector and the job market both were at their strongest.

In addition, recent developments in the world economy have probably made Chinese policymakers more cautious. The deteriorating sovereign debt crisis in the European Union increased the risk of a ‘double dip’ recession in the world economy. China’s economic growth slowed down too, though modestly, in the second quarter and the trend is likely to continue next year.

And more importantly, China’s current account surplus has shrunk sharply – from a peak of 10.8 per cent of GDP in 2007 to 3.5 per cent during the first quarter of this year. This has certainly weakened foreign politicians’ argument that reevaluating the yuan is the key to adjusting external imbalances.

But despite all of these factors, most Chinese policymakers agree that the yuan should rise in the long run, because of structural imbalances and rapid productivity growth. PBOC officials, too, have complained about losing monetary policy independence because of a very rigid exchange rate policy.

In addition, most China’s undervalued currency has already resulted in huge amounts of foreign exchange reserves. It has also contributed to excessive liquidity in the markets, evident in rapid growth of asset bubbles and sharp increases in prices of certain products, such as garlic and cotton.

Many criticisms levelled by international leaders against China’s exchange rate policy are unfair and often driven by the economic and political problems plaguing their own countries. One such example is American politicians’ tendency to blame China’s currency policy for the high unemployment rate in and large current account deficits of their country.

China is a country with a huge population and the world’s second largest economy. It is natural for its policy decisions to evoke strong reactions. So, we cannot rule out the possibility of the US resorting to trade protectionism against China, at least for now. Were this to happen, it would be detrimental to China’s economic future.  It is in China’s own economic interest to respond rationally to international criticisms.

Indeed, China started its managed float exchange rate regime aimed at a basket of currencies in 1994. This has remained the general policy framework despite disruptions during the Asian and global financial crises. Therefore, the critical issue is not the policy regime but the level of the exchange rate.

In sum, developments over the past two decades show there exists a wide gap between China’s policy preference for gradual change and the international community’s expectation of rapid revaluation of the yuan.

Striking a compromise between these two factors has become crucial for China’s economic future and its future role in the world economy.

How can China improve its exchange rate policy?

Primarily, it is important that policymakers recognise that rigid exchange rate is no longer compatible with China’s large and dynamic economy. A steady revaluation of the yuan is needed as a result of China’s own changing economic conditions.  It is not something simply forced upon it by another country.

For instance, a stronger currency is consistent with China’s policy objective of shifting the economy away from exports and investment toward consumption. It would facilitate industries’ shift from producing low value-added goods to high value-added products and, therefore, support sustainable economic growth. Although the policy objective should induce two-way exchange rate fluctuations, it seems reasonable to expect an average rise in the yuan of about 5 per cent a year against a basket of currencies.

On a more practical level, PBOC should also think of de-emphasising the importance of the bilateral exchange rate against the US dollar. Despite the announcement of the basket regime, PBOC continues to quote the yuan’s rate against the greenback as the most important reference. This is misleading, and at times provides excuses for global criticism. It is probably better for PBOC to focus more on an index against a basket of currencies. After all, China’s policy objective is to maintain exchange rate stability against a basket of currencies, not the dollar.

Finally, economics textbooks tell us that real exchange rate adjustment can occur either through nominal exchange rate or inflation. China’s average consumer price index (CPI) has averaged only 1 per cent during the past decade. But it is now entering a new phase of development with steady increase in the costs of labor, land, capital and resources. These imply greater inflation pressure going forward. It might be helpful if the central bank could tolerate a somewhat higher inflation rate in the coming years.

Tolerance of a somewhat higher inflation rate in China is not only necessary for overall price adjustment, but also useful for reducing pressure on nominal appreciation.

Yiping Huang is professor of economics at Peking University’s China Center for Economic Research and Professor of Economics at the ANU.

 

This article was first published here in the China Daily on August 10.