The Yuan in Ten Years

Basic Direction of the Yuan Increase and Factors of Uncertainty

According to Goldman Sachs predictions, China's GDP will overtake Japan's in 2016 to become the world's second largest behind the US. In the long-term, high growth of the Chinese economy will undoubtedly bring about an increase in the yuan and an expansion of the nominal GDP. However, when considering whether or not the yuan's value will continue to increase, close scrutiny of the content of the Chinese economy should precede judgment.

In the short-term, the growing trade surplus and the inflow of foreign direct investment have brought about an increase in foreign reserves and over-fluidity, while investment primarily in the real-estate market is overheating. The Hu Jintao and Wen Jiabao administration has been implementing austere economic policies since 2003, but they have had nominal effect.

To correct the unequal international balance of payments, a reform in the exchange regime of the yuan and a change to a more flexible system are necessary. However, a sharp appreciation in the yuan could deal a significant blow to industries weak in international competitiveness, such as agriculture. In addition, labor-intensive industries such as textiles and spinning are being exposed to fierce international competition, and profit margins are shrinking. Currently there are 19.6 million workers in the textiles and spinning industry, and according to Chinese government estimates that number would decrease by 670,000 with a 5% appreciation of the yuan.

While it is therefore true that an appreciation in the yuan is essential, it must be carried out gently, and it is necessary that it is accompanied by an upgrade in the industry structure.

With this in mind, how far can the yuan be expected to appreciate against the dollar within the next 10 years?

Considering the outlook for China's GDP and the US economy, it is predicted that rate of the yuan against the dollar will significantly appreciate from US$1 = 7.88 yuan (current as of November 2006) to US$1 = 4-5 yuan. In particular, a free trade agreement (FTA) within Asia is expected to be concluded around 2010, and a portion of exports into the US will be shifted to trade somewhere else within Asia. When this happens, there is a strong possibility that status of the dollar, the currency cornerstone, will experience a relative drop. The importance of the yuan, with a look to the emergence of an Asian currency unit, will follow its economic expansion and appreciate even more.

The Emergence of an Asian Currency Unit and Reform of China's Financial System

One lesson of the 1997 Asian financial crisis is that excessive reliance on the US brings about unstable economic growth. It is important to replace exports to the US with the establishment of a common market within Asia, and shift a portion of exports to the US to intraregional trade. To begin with, the conclusion of a free trade agreement within the region is critical. It is also expected that an Asia currency unit will emerge from the region’s major currencies, and the yuan should play an important role in this process.

As an overarching trend, the yuan will gradually appreciate in step with economic growth. At the same time, the range of fluctuation in currency exchange should amplify while flexibility is established. In addition, the yuan will become more trusted and gradually become a hard currency. In the future, the presence of the yuan on the global currency map will be solidified along with the dollar, yen and euro. As the currency anchors of the Asia region, the yuan and yen in particular will contribute greatly to the emergence of an Asia currency unit.

That being said, it is difficult to believe that the yuan will replace the US dollar or euro. Even if the US economy enters an adjustment period, the chances are slim that it will suffer a large break down. The strong presence of the euro should also be on display in line with the trend of increased solidarity within the EU. Therefore, the future of the global currency makeup will see the yuan added to the previous tri-currency system, ushering in a new four-currency era.

Once again, what is important here is the movement of the yuan. Easy conversion is already possible in the countries neighboring China. The yuan is obtainable at Japan's major international airports, while duty-free stores in Hawaii and Singapore accept payment in yuan.

The People's Bank of China knows that reform of the currency exchange regime does not simply involve the appreciation of the yuan – it is also aware of the emergence of an Asian currency unit and is calling for the strengthening of currency cooperation within the region. To realize this, the exchange rate is currently being determined on a daily basis by China, which references the basket of currencies. If the basket of currencies is introduced in earnest in the future it will increase the weight of the Asian currencies, and this could contribute to currency cooperation within Asia.

The delay of financial system reform within China is impeding financial internationalization and freedom – this is the problem. Reform of the four major state-owned banks is still a work in progress. The current economic growth has been realized with the background of a savings rate that has reached 48%. However, because the People's Bank of China is relied upon for household-to-investment financial brokering for businesses, the inefficiency of resource allocation leads to the deterioration of the banking sector's own assets.

Again, a major portion of national savings are brokered by state-owned enterprises. A structure is emerging where state-owned enterprises have an inclination to invest in unprofitable projects while the loans of state-owned banks go bad.

The direct financial market remains weak and undeveloped. Currently, the share of the stock market in the entire financial market stops at 17% (2005). As a result, financial policies have fallen into dysfunction. In other words, because market mechanisms are not functioning with regards to financial intermediation, financial polices are rendered lifeless.

In conclusion, without realizing efficiency in the financial system and financial market, hastily promoting financial liberalization and internationalization is to perhaps invite a financial crisis.