China's foreign exchange reserves have grown rapidly since the beginning of this year.

The central bank has to buy hard currency on the foreign exchange market to keep the yuan, or renminbi, stable, raising money supply and fueling fears of inflation.

If the People's Bank of China takes measures to ease the inflationary pressure, it will increase the pressure for renminbi appreciation.

Foreign countries including Japan and the United States have repeatedly demanded that China appreciate the renminbi.

But if the government appreciates the renminbi, the country's exports will be harmed.

China's monetary policy and foreign exchange policy are caught in a dilemma.

China has had a controlled floating exchange rate since 1994.

From January 1 of 1994 to June 30 of this year, the value of renminbi compared with the US dollar appreciated about 5 per cent.

But the appreciation occurred mostly between January 1994 and May 1995.

At that time, the band of movement for the exchange rate began to narrow.

The band further narrowed to less than 0.05 per cent in 1998, when the government wanted to avoid financial risks after the Asian financial crisis broke out.

The controlled floating exchange rate system looks more like a fixed exchange rate system.

When countries suffering economic recession hope to shift domestic problems on to other countries, they usually target countries with a fixed exchange rate system or similar system, and demand that they appreciate their currencies.

China's controlled exchange rate system has become such a target.

Trade deficit

In 1997, when the Asian financial crisis occurred, many countries chose to devalue their currencies.

But China decided not to devalue the renminbi.

China's sacrifice contributed greatly to the stability of the world economy.

The decision won high appraises not only from developing countries, but also from developed countries.

With the aim of digesting and absorbing the losses brought about by the decision, the Chinese Government has carried out a pro-active fiscal policy and a sound monetary policy aimed at expanding domestic demand for more than 5 years.

If the government decides to appreciate the yuan, it will once again give economic development a tremendous setback.

Japan, which fanatically preaches for yuan appreciation, has already become a big winner from the trade surplus with China.

China's trade deficit with Japan ranked fourth in 2002 and ranked third in the first five months of this year.

If the yuan appreciates, China's trade deficit with Japan will further deepen.

This would be unfair to China.

It is also improper for the government to appreciate the yuan at a time when discussions on the issue are "hot,'' because the appreciation will result in a vicious circle of "appreciation leading to more appreciation.''

Now, China is gradually opening its capital account.

The strong appreciation expectation will result in a fast inflow of hot money.

If the hot money flows out again because of economic fluctuations, China's economy will be greatly hurt.

The ensuing unrest in the Chinese economy would increase the instability of the world economy.

Domestic situation

Domestically, there is no need to worry about a possible overheating economy resulting from the large money supply due to the purchase of foreign exchange.

The government set a target of a 0 to 1 per cent rise in its inflation rate at the beginning of this year.

During the first six months, the consumer price index (CPI), the key inflation gauge, was 0.6 per cent, a sign of early inflation.

During that period, the broader money supply grew more than 18.5 per cent.

But the June CPI was only 0.3 per cent.

With the world economy still suffering from deflation, it is still unknown whether the CPI in China will continue to pick up in the second half of this year.

Appreciation of the yuan would be detrimental to keeping down inflation.

During the first half of this year, China was hit seriously by the SARS (severe acute respiratory syndrome) epidemic.

Industries such as tourism and catering suffered great losses.

But this helped cool down a possible economic overheating.

During the period, the country's exports rose 34 per cent and imports increased 44.5 per cent.

The import growth was much faster than the export growth.

Meanwhile, the SARS outbreak resulted in less trade orders from foreign countries.

This will have a negative impact on exports for the second half of this year and next year.

China's trade surplus is expected to fall.

Foreign direct investment will continue to be stable.

As a result, the fast increase in foreign exchange reserves will slow down.

The easing of economic overheating and the slowdown in foreign exchange reserves will help ease the pressure for renminbi appreciation.

China's current trade surplus is closely related to the country's tariff policy and the quota system.

As the country has entered the World Trade Organization, trade protection will be reduced.

In the coming years, it will be impossible for China to keep the trade surplus of about US$30 billion witnessed in 2002.

This will help ease the internal pressure for appreciation of the yuan.

Now, the impact of SARS on the Chinese economy is weakening and economic development is returning to the normal.

Fire wall

If the government continues to face appreciation pressures and the CPI reaches or surpasses the target of 1 per cent, it should consider taking advantage of the fiscal policy, exchange rate policy and monetary policy to build a fire wall to ease the pressure.

Presently, the average tax rebate rate in China stands at 15 per cent.

The country's finances cannot bear that heavy burden.

By the end of last year, the unpaid tax rebates to export companies reached about 247 billion yuan (US$29.8 billion).

It will be difficult for the government to continue the high tax rebate rate for a long time.

It has become urgent that tax rebates be reduced.

A reduction in tax rebates will result in a slow growth in exports and a drop in the current account surplus.

This will help ease the pressure for appreciation of the yuan and reduce the burden on the nation's finances.

In addition to pressure from the current account surplus, the yuan appreciation pressure is also a result of the large capital inflow.

As a result, the government could consider encouraging domestic capital to "go abroad.''

Since the beginning of this year, the government started the qualified foreign institutional investors (QFII) programme in China, which allows foreign investors to invest in the domestic securities market.

The financial authorities should consider kicking off the qualified domestic institutional investors (QDII) programme to encourage domestic investors to invest in foreign countries.

The government should also consider seeking investment areas in foreign countries for the country's huge personal savings deposits.

In recent years, personal savings deposits have grown rapidly and cannot find suitable investment channels.

If the money flows to some particular sectors such as the real estate industry, the country's economy will easily get overheated.

The government could also take advantage of the monetary policy to ease the pressure for appreciation of the yuan.

The central bank could lower the interest rate of deposits as required and keep the interest rate of loans unchanged.

This would increase the gains from holding US dollars and ease the pressure on the yuan.

The central bank also could raise the interest rate for loans while keeping the rate of deposits unchanged.

This would result in a declining competitiveness in exports.

The appreciation pressure stemming from the rapid increase of foreign exchange reserves would then ease.

The author is a researcher with the Development Research Centre under the State Council.

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