An Analysis of the Chinese Yuan Exchange Rate Policy

ABSTRACT

Though China has achieved remarkable developments in its economy, the stronger competition has caused in recent months the Japanese and the US governments to intensify their demands for an appreciation in the Chinese Yuan exchange rate. An appreciation, it is expected, would raise the cost of China's production exports, and would thus somewhat mitigate the threat that China poses to its two major trading partners.

China's official position on the issue, however, is that a stable currency rate is not just desirable for China, but for the world economy as well. Yet, from the perspective of China's rapidly expanding market, maintaining a stable currency rate in relation to a single currency such as the dollar will lead, in the long run, to a gradual enlargement of the burden upon the real economy. A gradual appreciation of the currency, in other words, would be to China's benefit.

In terms of China's international revenue and expenditure, both its current balance and its capital balance have been pt in positive figures. While under normal circumstances, the influx of dollar-based investments would lead to a rise in the Yuan, because China has adopted a foreign currency intensive management system, the central bank is buying dollars and selling Yuan on a daily basis. As a result, while the Yuan is being kept at 8.28 to the dollar, the foreign currency reserves managed by the central bank are rapidly increasing ($401 billion at the end of October 2003).

Broadly speaking, the US government wants China to refrain from this intervention, maintaining that the exchange rate should be determined by the market; i.e. it prefers a natural market appreciation to a government controlled appreciation. American researchers propose, moreover, that, in conjunction with less intervention, the Yuan's margin of fluctuation be enlarged from below 1% where it currently stands to around 5%, and that the currency, instead of being based on the dollar, should be based on a euro-yen-dollar currency basket.

While the Chinese government has shown a positive attitude toward decreasing its intervention in the mid-term, allowing the currency to naturally appreciate, it remains very cautious about it in the short term. An immediate adjustment in the exchange rate, moreover, would not necessarily be beneficial for either companies or the economies of Japan and the US. It is possible, for instance, that an appreciation in the Yuan would in fact be a drawback for American and Japanese companies that have entered the Chinese market. One more reason for China's cautious attitude toward adjusting its currency is the uncertain direction of Hong Kong' economy, and the precarious status of the Hong Kong dollar.

Looking toward the next few years, China will continue to reform its financial systems, dispose of its nonperforming loans, and see overall progress in the liberation of its capital market. From this, it is likely that China will eventually decide to free up its currency market as well.