To revalue renminbi, or not?
By Yi Xianrong (Business Weekly)
Updated: 2004-12-08 14:01

As the US dollar, and some other currencies, keep dropping, international voices rise again, calling for a revaluation of the renminbi.

At the Asia Pacific Economic Co-operation (APEC) meeting in Chile, and the G20 meeting of financial ministers and governors in Berlin, the yuan exchange rate became one of the hottest issues.

At a sideline meeting with US President George W. Bush during the APEC forum, President Hu Jintao reiterated that China will implement more flexible currency policies, but only if particularly necessary conditions are met, especially concerning the guarantee of China's economic stability.

Actually, concerns rose only because the renminbi interest rate was raised recently, while the US dollar is on a continuous dip against other currencies.

Given such pressure, many people, including my colleagues, have begun to exchange their foreign currencies into renminbi. Media reports on the issue only heighten the urgency.

Such widespread concern, both at home and abroad, about the value of renminbi indicates the significant influence such a revaluation would have on society and the economy.

To predict a change in the value of renminbi, we must understand whether there is a "best" exchange rates regime, in theory or in practice, and whether the current exchange rates for renminbi are proper. If the yuan is not reasonably valued against other currencies, which level is better? If it is, why are there always countries or groups calling for China to revalue the yuan? And what kind of influence would the currency revaluation bear on the economy of China and the world?

Academics around the world have worked out numerous theories about the exchange rate regime. Judging from research in recent years, it seems economists and observers have just reached a consensus that the intermediate regime of exchange rates, which stands between a fixed exchange rate and a free-floating one, is most likely to cause a financial crisis.

Research carried out by Columbia University and the International Monetary Fund shows that financial crises occur much more frequently in countries with intermediate exchange rate regimes, be they in developed or in developing countries, in emerging market economies, or otherwise.

To avoid a financial crisis caused by an exchange rate system, many countries resort to one extreme regime, a phenomenon called "polar solution" in international financial research.

However, according to the research of Jao Yu Ching, a professor at the University of Hong Kong, neither the fixed rate regime nor the free float rate regime is the "best" exchange-rate arrangement. The polar solution is unable to prevent all financial crises; this can be proved in the failure and setbacks that occurred in Hong Kong, during its free-floating regime between 1974 and 1982, and in Malaysia in 1998.

As Jeffrey Frankel, a professor at Harvard University, pointed out, there is no exchange rate regime which is proper for all countries or at any time. There could be many models or theories for currency policy, but it is impossible to find an omnipotent one suitable for every country.

Since there is no such "best" regime, the urge for China to take a more flexible, or free-floating, exchange rate regime is neither grounded in theory, nor proven reasonably in practice.

China is following a regulated, floating exchange rate system based on market supply and demand. The yuan is pegged to the US dollar.

With this currency policy, the Chinese Government can control the exchange rate by large-volume deals on currency markets. This year, the central government revised the conditions and regulations for foreign currency deals against the backdrop of hot speculation on renminbi. Such a revision aims at limiting capital inflow, facilitating capital outflow, and easing the pressure on appreciating the renminbi. As yet, the measures have not achieved their expected goals.

The foreign exchange reserve maintains high-speed growth in the first three quarters. By the end of September, the foreign exchange reserve of China was more than US$514.5 billion, 34 per cent higher than the same time last year, and US$111.3 billion more than at the end of 2003.

Those who call for appreciating the renminbi think it is far below its real value. It affects the employment, product competitiveness and trade balance of China's trade partners.

It also attracts a lot of hot money into China. They think the existence of hot money in China is the real culprit of the over-heated economy. Since hot money cannot find high-yielding and low-risk investment on the stock market, it flows into real estate, in turn increasing the growth of construction material industries.

The consideration is reasonable in some sense, but it is far from a decisive factor to justify appreciating the renminbi.

First, the yuan exchange rate does have some impact on the competitiveness of Chinese merchandise in the international market. Yet the real edge of Chinese exports is the ultra low cost of labour.

Currently, per capita labour cost in the United States is more than 10 times that in China. Even if the yuan appreciates by 10 per cent against the US dollar, the huge difference will only reduce the gap by 10 per cent. It would be impossible to eliminate the difference within a short time. Therefore, the competitiveness of Chinese goods on the international market is unlikely to be sliced away by yuan appreciation.

Second, the economy did not become over-heated just because of hot money. The more-than-normal growth in real estate investment is caused by the pursuit of local governments striving for higher GDP, the competition among real estate developers for sudden huge profits, and bank loans to encourage the purchase of houses by ordinary people. Even if hot money is invested into real estate, it does not make up a remarkable percentage of the market.

Therefore, it can only be deduced that the reasons used to urge China to appreciate the renminbi are not solid enough. The exchange rate of Chinese currency is better decided by the economic market.

As pointed out in an announcement by the State Administration of Foreign Exchange, improving the currency mechanism is a choice of China's own initiative. Dramatic fluctuations in the currency have to be avoided to ensure the stability of the economy and society.

The steep rise in foreign exchange reserves, and the trade surplus, is still putting more pressure on appreciating the yuan, but the pressure can be eased by several other means.

Concerns over uncertainties in the economy are bordering on obsessive: How effective the measures of economic control will be; how long the inflationary factors will persist; and how much the economy will suffer from the oil price hike.

It is necessary to be prudent and, at any time, refrain from introducing new uncertainties to the market. The exchange rate of renminbi must remain stable.

Authorities should also prepare for a more market-orientated reform to the currency regime. After all, the one-decade-old regime is not as adept at accommodating the economic progress after this period.

[The author is director of finance development division of the Institute of Finance and Banking under Chinese Academy of Social Sciences.]

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