One might wonder what all the excitement is about. In the first five months of 2005, the dollar rebounded slightly from its December 2004 lows against the euro, pound, and yen. President Bush continued to state his support of a strong dollar, but always followed with the caveat that a weaker dollar makes U.S. goods cheaper overseas and helps drive down the troubling trade deficit. Although the trade deficit between the U.S. and Europe and the U.S. and Japan has been fairly stable, the trade deficit with China has continued to grow and now accounts for approximately 25 percent of the current record trade deficit. Why hasn’t the weakening dollar helped diminish this deficit? The value of the yuan is unofficially pegged to the dollar, and despite the general loss in the value of the dollar, the exchange rate has stayed constant at 8.277 yuan to the dollar—until the notorious 20 minutes on April 29, 2005.
As the dollar weakened, the Chinese government purchased record amounts of U.S. government securities—mainly Treasury Bills—to prop up the U.S. currency. Some experts suggest that if the yuan were allowed to float against the dollar, the yuan would increase in value by as much as 30 percent. A stronger yuan would result in a sharp increase in the price of Chinese goods exported to the U.S. and a sharp drop in the price of U.S. goods imported into China. U.S. imports should decrease while exports increase, and the trade deficit should narrow—or so economic theory suggests.
The Bush administration has pressured the Chinese government repeatedly to allow for some appreciation of the yuan. Rob Portman, the new U.S. trade representative, promised the Senate during his confirmation hearings that he would “get tough with the Chinese” over their currency policies. This article will examine the impact of current Chinese policy and the reasons for their reluctance to change.
Impact on the Chinese Economy
Actions and events that impact the Chinese economy are carefully scrutinized because of the growing importance of China in the global financial system and China’s integration into the world economy.
Weighing the Impact of a Fixed Yuan:
The decision by Beijing to peg the yuan to the dollar has both positive and negative implications. Following is a summary of both.
The cons include:
1. The fixed yuan has created excess liquidity in China that fuels asset-price bubbles (as in the real estate market). According to Standard & Poor’s, China last year received $500 billion in export earnings, $60 billion from foreign direct investment, and approximately $129 billion in additional capital inflows—including massive bets on a rise in the value of the yuan. Furthermore, this capital inflow shows signs of intensifying.
The Chinese government is taking steps to slow the money flow into certain markets. For example, the government hopes to restrict funds flowing into the housing market—thereby slowing the increase in housing prices—by raising the five-year mortgage rate by 20 basis points to 5.51 percent and the required mortgage down payment to 30 percent from 20 percent.
2. The growth in the Chinese economy is considered by many to be unsustainable. However, the government has had limited ability to use monetary policy to cool the overheated economy. Monetary policy suggests that the cost of borrowing should be increased to slow down economic growth. Instead, the interest rate stayed at 5.3 percent for nine years, thus encouraging lending by banks and fueling the overheated economy. Recently, China’s central bank caused a stir in the financial market by announcing an increase to 5.6 percent. However, rates cannot be raised much higher unless U.S. rates match the increase. Otherwise, even more dollars would flow in as Chinese companies increase their borrowing of cheaper money from abroad.
3. By keeping the value of its currency artificially low, China risks inflaming global protectionism. Protectionist sentiment has been rising with the trade deficit on both sides of the Atlantic. In Washington, Senator Charles E. Schumer and Senator Lindsey O. Graham introduced a bill that would allow tariffs up to 27.5 percent on Chinese goods if they fail to change their currency policies. Schumer withdrew the measure when the Senate voted against attaching it to a spending bill, but Senate Republican leaders have promised to allow a vote on the bill by the end of July. 
As the dollar (and, therefore, the yuan) lost 50 percent of its value against the euro, Europe’s trade deficit with China began to grow. In response, officials are citing exchange rate manipulation as an excuse for protectionist measures. On April 24, European Union Trade Commissioner Peter Mandelson declared that Europe is facing “a ruinous surge” of Chinese imports. Two days later, French President Jacques Chirac called for more regulation of trade with China.
Protectionism is causing some to question China’s admittance to the World Trade Organization. In a thinly veiled reference to China, the finance ministers attending the January 2005 meeting of the G-20 stated, “More flexibility in exchange rates is desirable for major countries or economic areas that lack such flexibility.”
4. Although the prices of commodities such as oil and steel have increased, Chinese manufacturers have absorbed the increase in the cost of production in order to maintain or increase their market share. The weaker yuan has increased the cost of materials, but manufacturers have not passed the increase along. They have instead decreased their profit margins. This decrease has caused problems for other Asian countries that have not been able to appreciate their currencies due to competitive pressures from China.
5. China could face a loss in the value of its foreign currency reserves. China’s stockpile of foreign currency reserves, held mainly in U.S. Treasury Bills, is expected to reach $800 billion this year, or almost 40 percent of GDP. If the yuan is allowed to appreciate significantly against the dollar, the value of China’s reserves would be negatively impacted. A study by Nouriel Roubini and Brad Setser calculated that given the current pace of China’s accumulation of reserves, a 33 percent appreciation of the yuan at the end of 2006 might inflict a capital loss of almost 15 percent of China’s GDP.
The pros include:
1. As previously mentioned, the fixed yuan has been good for Chinese manufacturers because it has increased exports to markets not only in the U.S., but also in Europe. As the value of the dollar fell against the euro, the price of Chinese goods exported to Europe also fell, thereby increasing European demand for Chinese products.
2. The fixed yuan has kept the Chinese export machines humming and its population working—at the expense of other countries with floating currencies. China’s exports to the rest of the world have become even more competitive with a low yuan.
3. The weak yuan and low labor costs have enticed more foreign direct investment (FDI) into China. While this development has caused problems in some markets, it has also helped to modernize and expand the Chinese manufacturing sector.
China’s Reluctance to Float the Yuan
As China weighs the pros and cons of a convertible currency, the country remains reluctant to float the yuan. China observed the problems experienced by Thailand, South Korea, and Russia after these countries dismantled capital controls. The Chinese government is aware that economic security is essential for political stability. However, the growth has not solved fundamental problems such as unemployment and the fragile banking system.
The Chinese economy is undergoing a painful transition as Beijing continues to restructure agriculture and privatize state owned enterprises (SOEs). Privatization has led to massive unemployment, currently running at about 20 percent. The government has to ensure that this surplus labor is absorbed into the Chinese economy. Given the government’s export-led growth strategy, the manufacturing sector must employ hundreds of millions of Chinese to produce goods for export to the rest of the world.
The 1997 Asian financial crisis and years of deflation in China led its government to pursue an easy monetary strategy. Growth was sustained through subsidies to money-losing SOEs. Such subsidies led to $1.8 trillion in outstanding bank loans, which is equal to 140 percent of China’s GDP. Four major banks hold 70 percent of China’s total savings of $3 trillion. However, these banks are all technically insolvent, given their huge portfolios of non-performing loans. Beijing is tidying up the banks’ balance sheets to meet global banking standards and to support possible initial public offerings (IPOs).
The Chinese government has taken several incremental steps to reform its fragile banking system. Since 1998, Beijing has recapitalized the banks and taken over some of the bad loans. The central bank recently eliminated the ceiling on banks’ lending rates, thereby allowing banks to charge more from riskier borrowers. In addition, China’s banking regulatory commission has promised to perform more audits and to carefully scrutinize the four largest banks.
At the same time, the Chinese government is slowing the building of its infrastructure and is gaining experience. It is allowing companies and individuals to exchange their yuan for foreign currency, a move that may help offset the effects of speculative inflows of funds. The government has said that during the summer of 2005, it will allow seven international banks to join two domestic banks to trade and quote prices in eight currency pairs, including dollar-sterling and euro-yen, through the Interbank China Foreign Exchange Trade System (CFETS). This will give Chinese banks training and experience in trading volatile currencies.
The People’s Bank of China’s (PBOC) Vice-Governor, Li Ruogu, said that Beijing “…had already made a host of fundamental preparations” for moving toward a more market-based, flexible exchange rate. This policy will slowly liberalize the exchange rate. He added that the PBOC intends to keep the yuan “basically stable.” In short, China will introduce more flexibility into its currency system on its own terms. Furthermore, the changes will be incremental, within Beijing’s time frame, and designed to keep China competitive.
As international political pressures increase, China is expected to gradually make the yuan convertible. China is likely to link the yuan to a trade-weighted basket of currencies rather than solely to the U.S. dollar. Such a tactic would allow for some appreciation of the yuan. Letting the yuan appreciate by 15 percent and then fluctuate within a band would probably cool the speculation and move the currency closer to a market rate, suggests Nicholas R. Lardy of Washington’s Institute for International Economics. Although these steps are not great leaps forward, they will move China towards a more flexible currency policy. At this stage, China’s competitiveness and strong economy should be able to withstand these changes.
China is facing increasing political pressure to allow some flexibility in its currency policies. While showing some inclination towards flexibility, China’s policy makers appear determined to formulate policy on their own terms and seem likely to move towards an exchange rate pegged to a basket of currencies. Changes will probably be made on an incremental basis for economic and political reasons. China’s shaky financial system and massive unemployment make quick economic change impossible. Political change is normally slow because of consensus decision-making and the fear of any social and political unrest that might be caused by widening income inequalities and unemployment.
However, the time is ripe for China to move towards a more flexible exchange rate given its strong economic growth and current account surplus. The question is not if, but how and when the yuan will float.
China took the long expected step and on July 21, 2005, relaxed its currency policy—at least somewhat. The People’s Bank of China announced that the value of the yuan would increase 2.1 percent, from 8.277 to the dollar to 8.11. In addition, the yuan will no longer be pegged to the dollar, as it has been since 1994, but to a basket of currencies. The announcement also stated that the yuan might not be expressed in terms of dollars in the future. The new policy is that each evening a new trading range within which the yuan will move during the next trading day will be determined based on the movement the previous day of an unspecified group of currencies. The only limitation set by the central bank is that the value will not change more than 0.3 percent in either direction from the center of the previous day’s range.
While this was a small step given that some believe that the yuan is overvalued by as much as 30 percent, this new valuation was an interesting step. Prior to the change, China had one of the clearest and most stable currency policies in the world. They now have one of the least transparent. That is, the currencies in the basket or their weights were not specified, the trading range will be reset each day, and the yuan may be expressed in terms of some unspecified currency. The results are that China maintains enormous discretion and can move the yuan up or down as they see necessary.
The impact of this step on the dollar, the U.S. trade deficit, the Chinese economy, and the global trade imbalance should be minimal. However, the door is open and market participants expect that this is only the first step in a slow, incremental loosening process.
 For a discussion of the U.S. Trade Deficit, see Crawford and Young, “The Twin Deficits – A Looming Crisis,” The Graziadio Business Review, Volume 7, Number 2.
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