The yuan dichotomy

September 19, 2006 at 2:20 am (China, Economics, Finance)

For the first time, Chinese central bank governor and the banking regulatory leader clearly signaled the appreciation of yuan. Zhou Xiaochuan, the central bank governor, said more flexibility will be introduced to yuan. Zhou made his comments in Singapore on Monday, the same day when he had a dinner with Henry Paulson, the newly-elected U.S. Treasury Secretary. After Zhou, Liu Mingkang, the banking regulatory leader, said Chinese banks must be prepared to hedge their currency risks.

 

American economists and businessmen have been predicting the appreciation of yuan for a long time, but they always missed one key point, that the yuan rate is not an economic problem, it’s political. Almost everyone in China, be them politicians or economists, will agree with an exchange rate reform. The only concern is how much social and political percussion will follow.

Economically, raising the yuan rate at least can save China from the monetary policy dilemma. China has been deliberately maintaining an interest rate gap with the US dollar in the hope of fending off short-term speculators who can’t afford the large opportunity cost of investing in yuan when its interest rates are much lower than US dollar’s. This failed to stop the inflow of hot money. China then has to counterbalance the monetary market by purchasing US dollars. By doing this China risks a round of inflation and an abnormal high volume of foreign exchange (almost $1 trillion). Stacking huge amount of foreign exchange is a tremendous waste of resources.

 

On the other hand, the economy, with the growth rate reaching a more than 15 years record in the second quarter, has increasingly seen an overheating. Exports, which accelerate the stock of foreign exchange, account too much to the economy. Risk of inflation is haunting.

 

The economic authorities have been fighting the awkward situation with few efficacy. Although they knew the root solution is the appreciation of the yuan, they constantly shied away from it.

The upsides of an appreciation are obvious. It will discourage exports, balance the monetary market, enable the central bank to raise interest rates, and silence those countries who have been disgruntled by China’s so-called exchange rate manipulation. But the drawbacks are what the authorities are more reluctant to see. It may slow the economy, increase unemployment, create social instability, and put its feeble financial system in a more dangerous situation.

 

It’s a dichotomy, but someday, someone has to do something.

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2 Comments

  1. A China-US Economic Team « Random Blog 乱 博 said,

    […] China’s central bank governor Zhou Xiaochuan showed his amity and sincerity when he had dinner with Paulson in Singapore. Chinese government responded to Paulson’s visit by allowing the yuan to strengthen to it’s highest since the government dissolve the peg policy and introduced a managed float rate last July. […]

  2. Big News on the yuan « Random Blog said,

    […] Also see The Yuan Dichotomy […]

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