What to do about the Yuan

First published in The Asian Wall Street Journal, 17 July.

It's noteworthy that U.S. Federal Reserve Chairman Alan Greenspan expressed concern Tuesday about China's accumulation of U.S. dollar reserves, but we'd be careful not to read into his remarks what was purposely left out. It's certainly true that China's monetary policy is allowing pressures to build in the world's economic system and action needs to be taken to address this. However, Mr. Greenspan wisely stopped short of encouraging China to revalue the yuan. Other commentators may reflexively reach for the quick fix of adjusting the exchange rate, but the Fed chief is right that some reflection is in order.

First the basic facts. China's stock of reserves as of the end of June stands at $346.5 billion, a staggering figure second only to Japan's. But the flow is even more astounding. The cash pile grew by $60.1 billion in the first six months of the year, compared to growth of $30.6 billion in the same period last year. Something significant is going on.

China continues to run both trade and investment surpluses with the rest of the world, and the government buys the incoming dollars with yuan. This intervention creates the rising reserves, and also keeps the exchange rate fixed at 8.28 yuan to the dollar. Normally that would cause inflation, as the yuan used in these forex transactions drive up the money supply. But most of the yuan used by China's government, in the past about 80%, are then taken out of circulation, or sterilized, through the sale of central bank notes, government bonds and open market operations. For a long time, this arrangement allowed China to seemingly have it all -- trade and investment surpluses, low inflation, and a stable exchange rate.

But as the amount of capital inflows grew, fuelled by investors' optimism about the country's prospects after its entry into the World Trade Organization, foreign governments started to accuse China of free-riding on the world economy. Japanese officials, worried about the inroads Chinese products were making into their home market, had long been scathing about the yuan's peg to the dollar. Since Japan was playing the same game with the yen, this initially carried little weight. But once the U.S. dollar started falling against the euro, Europeans realized they faced a surge of cheap Chinese goods, and began to put similar pressure on Beijing to revalue. For instance, at the July 5-6 meeting of Asian and European finance ministers in Bali, the joint communique contained a veiled reference to China in its call for "fairly shared adjustment of international imbalances." And U.S. Treasury Secretary John Snow, father of the weak dollar, last month caused ripples when with obvious impatience he predicted that China would move toward a more flexible exchange-rate policy.

Moreover, China has evidently found it more difficult to sterilize its ever huger purchases of dollars. In recent months, the M2 measure of money supply has been growing at a rate of 20.8% year on year, well ahead of the official target and the needs of the economy. If this trend goes unchecked, the resulting inflation would ultimately have much the same effect on the country's international competitiveness as revaluing the yuan. But reining in money supply will mean convincing the banks to hold yet more bonds, which then reduces the funds available for credit creation, the engine of the economy.

Conventional wisdom has it that the way out of this conundrum is for China to widen the yuan's trading bands so that it can appreciate in value. That is a possible response, but before accepting it as the best one and pressuring the authorities in Beijing to break their unofficial peg to the dollar, let's consider other options.

First of all, the question of whether a currency is under or overvalued is very difficult to settle definitively in the absence of a free market. Since China maintains capital controls, nobody really knows how much of the vast pool of savings held by households would flow abroad if given an easy opportunity. The fact that foreigners are eagerly exchanging dollars for yuan in order to buy goods and build factories is significant but still only one half of the true picture. If considerable demand for dollars is being stifled, the yuan could still be overvalued.

That thought leads to one partial solution to the present imbalance. Lawrence Lau, an economist at Stanford who is well-regarded in Beijing, recently suggested that China might reduce pressure on the yuan by taking a two-pronged approach. On the current account, it could accelerate the implementation of its WTO commitments to reduce trade barriers, thus encouraging more imports. And on the capital account, it could press ahead with schemes like the proposed Qualified Domestic Institution Investor program, which would provide a regulated avenue for Chinese savers to invest abroad.

No one believes these would take care of the problem completely, but they would help. And there would be one additional benefit, according to Mr. Lau. They would provide Beijing with information about just how much pent-up domestic demand there is for dollars. This could help accelerate the process toward full convertibility of the yuan.

Full freedom to buy and sell the yuan is the ultimate solution to the current imbalances, and it is a goal that Chinese leaders have repeatedly affirmed. Ideally, convertibility would come at a point when the forces of supply and demand are in equilibrium at the exchange rate of the time, so that the transition to the market would be smooth. Gradually introducing more market forces and gauging the strength of those forces would allow Beijing to find that opportune moment to switch more quickly.

The problem, of course, is time. The QDII program has stalled in the bureaucracy and once restarted could take a year to implement. The temptation to take the easy way out and revalue the yuan will surely increase. That temptation is worth resisting, because it might lead China further away from convertibility, and because exchange rate stability is a valuable accomplishment which supports the country's competitiveness.

If the flow of dollars into China continues at the current pace, it may be time to think about more innovative ways to accelerate the shift to convertibility. Deng Xiaoping once described China's process of economic reform as crossing the river by feeling for the stones. But at this point China's economy looks more and more like a high-powered vehicle that could lose momentum if it hesitates too long at the bank of this particular stream.