Case for stronger yuan not clear-cut
Apart from cloudy outlook for global growth, labour costs are rising fast
23 March 2010
China accumulated currency reserves last year at the rate of more than US$50 million an hour. That alone seals the case for a stronger yuan.
Its trade surplus fell 34 per cent last year and its commerce minister reckons a deficit is on the cards this month. That alone seals the case for keeping the yuan steady for now.
Both proponents and opponents of scrapping the yuan’s 20-month-old peg against the dollar have no shortage of statistical ammunition.
While the vast majority of economists favour de-pegging because it would give the central bank greater monetary policy leeway, they concede that the purely economic case for a stronger exchange rate is not as clear-cut as it was in the run-up to China’s landmark currency reform in 2005.
‘Arguably in 2005 you had a stronger world economy and the outlook for export growth at that point looked a lot healthier than it does right now,’ said Mark Williams, an economist who follows China for Capital Economics in London. He favours a rise in the exchange rate, but he added: ‘In a sense, this is the worst time to do it.’
China re-valued the yuan by 2.1 per cent against the dollar in July 2005 and then let it climb nearly another 19 per cent before calling a halt in 2008 to help its exporters ride out the global financial crisis.
The administration of US President Barack Obama is threatening to label China a currency manipulator next month, and US lawmakers are warning of trade sanctions, unless China lets the yuan resume its ascent.
But Chinese officials and economists are extremely wary. ‘A country’s currency appreciation is very limited in helping to rebalance global trade,’ Commerce Minister Chen Deming said on Sunday.
Apart from the uncertain outlook for global growth and exports, Lian Ping, chief economist at Bank of Communications in Shanghai, listed other fundamental reasons for standing pat.
One difference is that labour costs are now rising much faster than in 2005, eroding exporters’ thin margins; another lesson from the past is that putting the yuan on a one-way rising track attracted huge volumes of capital into China, complicating monetary policymaking.
What’s more, Mr. Lian added, China’s trade surplus peaked in 2008 and was likely to shrink further this year. ‘If the trade surplus continues to narrow in the next few months, I doubt China will need a significant rise in the yuan. Doing so will be very risky,’ he said, noting 150-200 million Chinese are in export-related jobs. ‘That’s not a small number.’
Tim Condon with ING in Singapore also has doubts about the economic case for appreciation.
After joining the World Trade Organization in 2001, China’s terms of trade improved as it became more attractive for overseas business. This triggered a foreign direct investment surge that increased China’s productivity and swelled its trade surplus from about US$25 billion a year pre-WTO to US$102 billion in 2005.
A stronger exchange rate was thus required to avoid inflation. However, the terms of trade shock has dissipated since the trade surplus peaked at US$296 billion in 2008, removing a key argument for a firmer yuan, Mr. Condon says.
He still expects China to let the yuan rise next quarter, by widening its trading band to plus or minus 3 per cent a day from 0.5 per cent now, but the reasons will be different than in 2005. ‘It won’t be a monetary policy measure. It’s a structural reform measure,’ he said.
Mr. Williams at Capital Economics said the imperative for structural reforms to tilt the economy away from exports had only grown in the past five years, especially since the financial crisis had dimmed the long-run outlook for China’s exports.
‘The need to try and boost domestic incomes has strengthened, and a stronger currency is one way to do that,’ Mr. Williams said. ‘So there’s a pretty strong case for taking steps now that you don’t necessarily have to take to get through the next year or two, but that will help bring about the longer-term rebalancing that will be good for the Chinese economy.’
Mr. Williams acknowledged that a rising yuan was likely to be a magnet for speculative capital but said the People’s Bank of China had demonstrated in 2007 and 2008 that it was perfectly capable of mopping up hefty inflows of foreign exchange.
‘It’s important to keep the magnitudes in perspective,’ he said. ‘Over the last 12 months we have seen massive monetary expansion against which the sort of expansion you would get from capital inflows pales pretty much into insignificance.’ Ultimately, the yuan’s fate lies in the hands of China’s political leaders, not its technocrats.