December 8, 2009 Tuesday

Strong arguments for a stronger yuan
Costs of an undervalued yuan may be too high for China in the long run

Grace Ng, China Correspondent

IF BEIJING'S current policy-making goals could be summed up in one word, that word would be 'stability'. And its policy on the yuan, which has been effectively pegged to the US dollar since October last year, has been motivated by that goal.

With China's - and the world's - economic recovery still 'unstable, unbalanced, uncoordinated and unsustainable', in the words of Chinese Premier Wen Jiabao, Beijing has been obsessed with maintaining stability, seemingly at all costs. This ranges from throwing 4 trillion yuan (S $800billion) into state-driven investments to support jobs and keep a lid on social unrest, to drowning out foreign entreaties to let the yuan appreciate.

A stable yuan exchange rate is vital for global economic recovery, and it is the instability of the US dollar that the world should worry about instead, argued Commerce Minister Chen Deming last week. His argument was?echoed by numerous commentators in local media.

China is right to cling on to a predictable yuan via a dollar-peg - if its only concern were the immediate interests of its own economy. But exchange rate policies always involve more than one party.

China, in its quest for stability at all costs, risks bearing too high a cost in the long-run if it resists yuan reform for long, especially if this comes at the expense of its trading partners.

But as China showed in its frosty reaction to calls for yuan appreciation by US President Barack Obama and EU leaders, it will not let external pressure dictate the timing of its yuan reforms. And the right time, as far as Beijing is concerned, is when Chinese economic recovery - particularly exports - stabilises.

The annual Central Economic Work Meeting, which charts the economic plan for the next year and lays the groundwork for the next five-year plan starting in 2011, ended yesterday with a statement highlighting the urgency of pushing the recovery of its exports.

Exports have fallen over 14 per cent over the past year and some local economists forecast export growth of just 10-15 per cent in the first half of next year - half the average 26 per cent rate of previous years.

Beijing will likely maintain a stable yuan at least until February, say Standard Chartered economists, to ease the worries of 50 to 100 million migrant workers about whether their jobs in the export sector will still be there after they return from the Spring Festival break.

Another reason for Beijing's insistence on maintaining a stable yuan is to quash expectations that the currency will appreciate sooner rather than later - as Shanghai traders assumed it would last week, betting on the Work Meeting announcing a greater flexibility in its yuan policy. But the meeting disappointed the market by not mentioning the yuan.

Yuan appreciation expectations have triggered rapid capital inflows into China. These have stoked fears of destabilising property and stock market bubbles.

China is effectively importing a loose money policy from the US due to the yuan's peg to the greenback. The policy is making it harder to control hot money inflows and asset price inflation.

The longer China clings on to a stable dollar, the stronger the yuan appreciation pressures will be. Ironically, insisting on the peg in the interest of stability has in fact amounted to Beijing giving up control of financial stability.

What may prove even more costly to China's economic recovery are the trade tensions triggered by its stable yuan.

Last week, Vietnam announced a 5 per cent devaluation of its currency, in part to protect itself from the undervalued yuan, sparking concerns in Thailand and other Asian export-oriented economies.

This suggests that 'the move towards global trade conflict may already be unstoppable', warned Peking University finance professor Michael Pettis, in a recent commentary in the Financial Times.

'As one group of countries seeks to gain or maintain trade advantage by manipulating its currencies, the historical precedent suggests that countries that are not able to devalue will respond with trade protection, especially tariffs and other barriers, and global trade will suffer,' he said.

China's response to such criticism has been to blame the depreciating US dollar for the yuan's own weakness. It also says its cheap goods have actually helped foreign consumers hit by hard times.

Indeed, the Work Meeting's pledge to 'tap new markets' and maintain the 'continuity and stability' of foreign demand for its goods may hint at its determination to keep exports price-competitive.

Keeping the yuan stable has reinforced China's reliance on exports and state-led investment. But capital is being trapped in increasingly inefficient investments, when it could be put to better use elsewhere to support its future growth. Recognising this, the Work Meeting paid special attention to rebalancing the economy and boosting consumption.

Beijing is now signalling the importance of 'improving the quality and efficiency of economic growth' - rather than just quantitative targets like the annual 8per cent gross domestic product rate, say analysts.

This offers hope that China may now be more willing to allow a gradual appreciation of the yuan in the second half of next year to boost consumers' purchasing power and allow Beijing to liberalise interest rates so that capital will be allocated more efficiently.

The Work Meeting's pledge to adjust its growth model and improve its trade balance may offer some positive signs that it may start to reconsider its view that a weak yuan is necessary to maintain economic stability. With trade tensions and asset bubbles brewing, China needs to take a longer term view on the costs of an undervalued yuan.

graceng@sph.com.sg