The power of yuan
At some point in the future, possibly soon, China is going to change the way it manages its currency, the yuan.
In all probability, the change, when it happens, will be small. It certainly will not be the 25 per cent upward revaluation China's critics in the US Congress are demanding. Much more likely is that Beijing will permit the yuan to rise in value against the US dollar by only a few percentage points, while allowing a little more day-to-day movement in the exchange rate.
Even so, it will be an important event. China is now a major trading nation. How its exchange-rate policy evolves in the long run will have a big impact, not just on its domestic economy, but on trading partners and competitors around the world.
Ever since the Asian crisis of 1998, the People's Bank of China (PBOC) has kept the exchange rate against the US dollar rock steady in a band between 8.276 and 8.28 yuan to the US dollar. That stability has served China well.
During the Asian crisis, China earned international credibility for resisting pressure to devalue the yuan, which could easily have set off another round of regional currency falls. In the years since, confidence in the exchange rate encouraged companies to invest in building up China's export industries.
But as China has developed and opened up to the world, the fixed-exchange rate has begun to cause stresses that risk distorting the economy and threaten to sour relations abroad.
Those stresses make change inevitable, and although a policy shift is not as urgent as some economists argue, some loosening is looking increasingly likely over the coming months.
Exactly what form the policy change will take, or when it will happen remain unclear, but a series of comments from senior officials give some pretty good clues on what to expect.
In March, Premier Wen Jiabao promised to keep the value of the yuan 'basically stable', while a week later he warned that reform of China's exchange-rate regime could happen 'unexpectedly'. Late last month, PBOC governor Zhou Xiaochuan said China was sensitive to foreign pressure and might need to speed up reform, while a front-page commentary in the China Securities Journal said preparations for a change of exchange-rate policy were now in place.
Mr Wen's pledge to maintain the yuan's basic stability clearly rules out a one-off upward revaluation of the yuan. Arbitrarily raising the value of the yuan, say by 10 per cent, and re-pegging it at about 7.5 yuan to the US dollar may temporarily silence China's critics in the US Congress, who charge that by maintaining the current exchange rate, China is artificially under-valuing the currency to give its exporters an unfair advantage in world markets.
In reality, however, a 10 per cent revaluation would do little to dampen US consumer demand for goods made in China, and it could prove highly destabilising at home.
Because much of China's export industry relies on using low-cost labour to process imported materials and components, raising the value of the yuan by 10 per cent would only increase the dollar price of exports by about half as much. According to research by Jonathan Anderson, chief regional economist at Swiss bank UBS, that would only knock about US$6 billion a year off US imports from China. That is a negligible reduction compared with the US economy's US$645 billion current account deficit, essentially its overdraft with the rest of the world.
On the other hand, a 10 per cent revaluation would decrease the yuan cost of imported goods by a full 10 per cent. That would have a devastating impact on China's farmers, who are already struggling to compete with cheap foreign imports of grain, oils and other staples. Significantly raising the value of the yuan at this point could exacerbate rural poverty and unemployment, causing the sort of social disruption in the countryside that China's leaders are desperate to avoid.
Although a straightforward revaluation is unlikely, China could still benefit from allowing a little more fluctuation in its exchange rate.
Over the past few years, Beijing has slowly relaxed its grip on capital flows in and out of the country. Chinese companies are now allowed to invest abroad, while exporters can hold on to most of their foreign exchange earnings. Soon, domestic financial institutions such as insurance companies will get permission to invest a small portion of their portfolios in foreign assets.
But freeing capital flows without allowing your currency to float is a risky proposition. When economic conditions are good, money flows in, posing the danger of asset bubbles. Then, if the economy takes a turn for the worse, capital can begin to flood out again. That can leave the central bank struggling to defend a fixed-exchange rate with fast dwindling reserves of foreign exchange, until devaluation becomes inevitable, as Thailand, South Korea and Indonesia discovered to their cost in 1997.
At the moment, China is enjoying capital inflows of more than US$10 billion a month. With the supply of foreign exchange far outweighing demand, to maintain its fixed-exchange rate the PBOC has been forced to buy up the surplus, selling yuan in return. The foreign exchange it buys goes into the central bank's foreign reserves, which rose to hit US$659 billion at the end of March. The yuan it sells go straight into the banking system. Having so much money sloshing around is potentially inflationary, so to take it out of circulation the central bank borrows it back again. So far, this has worked reasonably well, but it cannot go on for ever. Sooner or later, either inflation will rear its head, or all that government borrowing will push interest rates higher, harming the economy.
The alternative would be to allow the yuan to rise and fall in value, in line with demand.
With inflation subdued and interest rates low, these problems are still a long way in the future. But it makes good sense for China to move slowly towards exchange-rate flexibility now, to give the country's banks and corporations plenty of time to adapt to managing currency risks.
One way favoured by many economists would be to allow the yuan to move in a wider trading band, say of about 3 per cent either side of a reference rate. For extra flexibility, the central bank could fix the reference rate not against the dollar alone, but against a basket comprising the currencies of its trading partners and competitors.
The greenback would still be the single most important component, but the bilateral exchange rate would have more leeway to adjust over time in line with trends in international markets.
This is not all going to happen overnight. The Chinese authorities are keen to establish working derivatives markets to allow companies to hedge their foreign-exchange exposure before allowing any significant movements in the dollar-yuan exchange rate.
They are also anxious to discourage destabilising inflows of hot money from investors speculating on a big yuan appreciation.
However, changes in exchange-rate policies are political decisions. And the recent comments from senior officials such as Mr Wen and Mr Zhou indicate that the political debate over whether to allow more currency flexibility has already been settled. From now on, it is only a matter of timing.