Yuan move is vital to banking reform
Widening the currency's trading band will quieten critics and allow Beijing to focus on ailing lenders, Tom Holland writes
Observers can only guess why senior mainland officials declined to attend last weekend's meeting of finance ministers from the Group of Seven developed nations.
Whatever the reason Finance Minister Jin Renqing and central bank governor Zhou Xiaochuan decided to stay home, they certainly saved themselves an admonishment on the value of the yuan.
Robbed of the opportunity to collar the Chinese for a few quiet words on the sidelines of the Washington meeting, the assembled finance ministers resorted to megaphone diplomacy.
Although the final G7 communique called only for 'more flexibility in exchange rates', individual ministers made far more aggressive comments.
Leading the charge was United States Treasury Secretary John Snow, who demanded immediate action on revaluing the yuan.
While the mainland has been preparing gradually to allow some fluctuation in its currency's value against the US dollar, Beijing has other economic priorities. Top of the list is to press ahead with reforming the banking system, a process that has slowed recently.
Mainland economists have consistently stressed the importance of restructuring the country's big banks before tinkering with the exchange-rate regime.
This makes sense, up to a point. Certainly, Beijing is not about to relax its capital controls before fixing the banks. Burdened by a legacy of policy lending to inefficient state-owned enterprises, the banks are handicapped by poor credit controls and high levels of bad loans.
Their strength is that the mainland's vast army of savers has few other places to park money, guaranteeing the banks a near-inexhaustible source of cheap depositors' funds. If those savers were suddenly allowed to seek higher returns abroad, the banking system could collapse virtually overnight.
Allowing the yuan's exchange rate against the US dollar to vary a little is another matter. Over the past few years, as speculation that the mainland would revalue mounted, the risk has been that any move on the exchange rate would encourage more destabilising hot-money inflows. Until now, the safer path has been to hang tough in the face of foreign critics and quell the overheating effect of capital inflows through administrative steps.
So far, the policy has worked reasonably well. But as mainland exports rise, the dangers are growing of a protectionist backlash from western governments, which charge that Beijing is artificially undervaluing its currency to gain an unfair trade advantage.
Just a few days before the G7 meeting, the US senate voted by 67 to 33 to consider a bill that would allow Washington to slap a 27.5 per cent tariff on all mainland imports if Beijing failed to agree to revalue the yuan within six months.
It is debatable whether a moderate appreciation of the yuan would significantly affect the mainland's huge trade surplus with the US.
Still, a largely symbolic gesture from the mainland - say, widening the yuan's permitted trading band slightly to 3 per cent either side of a reference rate - could be highly beneficial. There would be some risk of hot-money inflows, but the move would quieten the international revaluation clamour for a year or two.
That would open an important window of opportunity. With the exchange rate off the agenda for the time being, Beijing's financial and economic leaders would be able to invest more time and political capital in reforming its Big Four state-owned commercial banks.
Although the banks have made strides in setting up credit policies and risk-management systems, more energy needs to be devoted to ensuring they are adhered to.
In another year, it is likely that loans made during the lending spree of 2003 will begin to turn bad. According to bank ratings agency Capital Intelligence, the non-performing loan ratio at the Big Four could climb as high as 30 per cent.
Rigorous implementation of reform would do much to ameliorate any emergency and smooth the way for further state recapitalisation of the sector. But if significant progress has not been made on changing the banks' business culture, the mainland will be left with a sorely weakened financial system just as pressure to reform the exchange-rate regime returns.