The Hindu Business Line : When yuan plays mischief... Switch to the basket peg

While the free float of the yuan can wait, China should consider the option of switching over to a `basket peg' of key currencies of major trading partners. This is the second best solution to the one-dose medicine of revaluation. It is time China got out of the dollar peg. However, emerging markets have more to learn from China than to preach sermons to it, says D. Sambandhan.

THE Asian Countries' reluctance to allow their currencies to appreciate against the US dollar — more precisely their fear of floating is meriting more attention and criticism from the US and the IMF, including Bank For International Settlement (BIS). The world's seven largest holders of foreign exchange reserves are all in Asia; next to Japan, China is the second largest holder of forex reserves which crossed $400 billion mark recently.

In an age and environment of managed floating, huge accumulation of reserves is a sign of Central banks' resistance to allow their currencies rise against the dollar and hence the legitimate accusation. That is, by linking their currencies rigidly with the dollar, Asian Governments are causing global economic strains.

For quite some time, China's yuan, also called rinminbi, is on everybody's screen. But China is not yet very keen to be in the limelight. A respectable growth rate for a longish period, combined with an impressive macro economic picture, inclusive of an over all BoP surplus, suggest that Chinese currency needs to be revalued; it should be made stronger reflecting the changed economic fundamentals.

The London Economist's Big Mac Index (which incorporates Purchasing Power Parity criteria) says that yuan is the most undervalued currency in the world today. Various other independent estimates also put the percentage of revaluation somewhere around 20-25 per cent.

The misalignment of not just yuan, but many other currencies, has been obvious under floating. So what? A casual glance at the 20th century currency experience might show that the world economy has lived with a set of disequilibrium exchange rates. China alone cannot be singled out now.

There are times when the life of a currency becomes a `problem' rather than a solution; when the relevant economic fundamentals make a currency a certain candidate for revaluation and authorities resist it with all force, then it becomes a problem to others. There are many reasons, however, why China does not dread any revaluation dream now. It does not want to let loose the currency and make the market go crazy with the yuan, with all its attendant speculative frenzy. Before going for a defence of China's stand, a look at the truth behind `China bashing' which is popular in the US, Japan and Europe.

``Blame it all on yuan'' is certainly a good politics for the US President, especially on the election eve, when the annual bilateral trade deficit with China has exceeded $120 billion. It is cited as a proof of China stealing jobs in US industries "from clothing and toys to furniture and consumer electronics" by adhering to an unrealistic, sticky dollar peg of 8.28 for nine long years. It is argued that the grossly undervalued currency is a major irritant in the global payments adjustment process. Japan also complains that yuan's mischief deepens its deflation. In Europe too, the steep appreciation of the euro against dollar by more than 40 per cent in the face of reluctance of rinminbi to share the burden of depreciation of dollar is causing an enormous degree of discomfort.

The euro has completed the full circle and has arrived at the old initial rate of exchange with which it began its journey with a sense of diffidence four years ago. But, now, Europe trembles with the strong euro, as it hurts its exports. It is an irony that it is not comfortable with its initially tried rate, while China could manage with an unrealistic dollar peg for nearly a decade.

The US trade troubles are the manifestation of the basic deep-seated imbalance between saving and investment and the willingness of the rest of the world to finance its deficit. In this case too, the other side of China's trade surplus — its equivalent purchase of US treasury bills — has only helped the US finance its tax cut and keep the interest rate low. While the US goods market is hit, its financial market has become the major beneficiary of China's trade surplus.

Japan has no moral right to accuse China, as the latter is only following in its footsteps; operating with a disequilibrium rate (read here an undervalued rate) has been the Japanese way of growing in the early stages of high growth. China had seen Japan trimming its exchange rate and resisting the tendency towards appreciation to suit her growth and export prospects. At least China is more open to trade and investment than Japan was three decades ago.

Since late 1990s, China's import growth has always exceeded export growth. In the first eight months of 2003, China accounted for 70 per cent of Japan's export growth. China has begun opening up more of its goods market partly to meet WTO obligations and also accelerate its growth. China can neither be blamed for exporting deflation to Japan nor causing deindustrialisation in the US.

For nine long years, the yuan was tied with the US dollar, dancing along with it, going up and down, and sharing its fortunes — both good and bad. The real economy has not suffered from it. Indeed, even at the height of South-East Asian currency crisis and the resulting contagion, the yuan withstood the devaluation threat/possibility which was always there.

In that mid-98 period, China could manage and handle the massively depreciated currencies in the neighbourhood, which cut into its exports prospects and slowed down the growth rate. China did not choose the path of competitive devaluation then, and did not become an engine to ever-widening Asian contagion of endemic recession. China did not complain about the undervaluation of Asian currencies then; it was praised for its sensible and responsible behaviour. China could manage because of the depressed real wage rate at home. Now, it is blamed for its refusal to revalue, by mistakenly focussing on a massive bilateral trade surplus with the US alone. But China's aggregate trade surplus with the rest of the world is small and many economists forecast that it may turn into deficit in the near future.

Economist Paul Krugman has recently pointed out that the balanced view of China's trade must take into account Hong Kong's trade deficit also, as it is a part of Greater China. Looked at this way, "China-sans-Hong Kong" shows trade surplus but "China-plus-Hong Kong" does not run big trade surpluses.

Giving the trade figures available he observed: "China ran a trade surplus of almost $ 24 billion — but Hong Kong, as one would expect for a mainly service producing city state, ran an offsetting deficit of $19 billion, reducing the total to a fairly unimpressive $4.6 billion.

China's trade surpluses, in other words, are largely a statistical illusion produced by the fact that so much of management and ownership of the country's industry is located on the other side of an essentially arbitrary line". The allegation of the US, therefore, is not only misleading but also mischievous.

China's fear of floating — its refusal to allow the yuan to appreciate — mainly stems from its weak and fragile banking system and outmodel central banking practices. China's institutional structure, the players in forex and money market, the restrictions on the number of currencies traded, the manner and method of foreign exchange settlement and so on are still primitive by any international standard. China needs time to clean up its messy banking and financial system and its bad loans and also learn the art of managing speculative capital flows.

Lessons from South-East Asian currency meltdown, abundantly, make it clear that flexible exchange rate cannot mix with the fragile banking system and free capital mobility will eventually invite disaster, in underdeveloped financial markets.

This is precisely the reason why China's exchange rate policy judiciously combines the virtues of pegged rate (the dollar hug) and selective capital controls. Nearly a decade old dollar peg has helped to spur growth, stimulate exports and take care of massive unemployment.

They want to direct both exchange rate and monetary policy towards the goal of providing maximum support to employment and growth. China wants the transition from socialism to market economy somewhat less painful. Emerging markets have more to learn from China than to preach sermons to it.

China cannot go on forever like this in a world of floating exchange rates, dominated and frustrated by the US hegemonial power and WTO rules. By resisting revaluation, it risks inflaming global protectionism.

In its own long-term self-interest, China should grasp the consequences of building up of huge reserves and the resultant BoP shifts on money supply and asset inflation. There is an inherent risk of financial bubble emerging. In the short run, it can ride on exchange rate protectionism as every one does but, in the medium run, it must face the ground level reality.

The best way to dampen the outcry of revaluation is to liberalise the outflow of dollars and accumulate assets overseas. While the free float of the yuan can wait, China should consider the option of switching over to a `basket peg' of key currencies of major trading partners.

This is the second best solution to a single, straight-forward one dose medicine of revaluation. That will ensure the much-needed flexibility in managing the monetary policy and acquiring control over the plausible asset inflationary bubble. It is time China got out of the dollar peg.

(The author is on the faculty of School of International Studies, Pondicherry University.)

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