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SCMP Reporter

SHOULD China have wished for a strong yuan against the US dollar, then its wish has been granted. But the yuan's appreciation in the past two weeks suggests to many China watchers that the People's Bank of China's (PBOC) task of maintaining the yuan's stability is losing out to its priority of controlling inflation.

  The yuan has gained more than 1.1 per cent since April 27, when the currency began its spiral against the dollar, and ended on Tuesday at 8.3247.

  The yuan has risen more than 4.3 per cent since January 1 last year, when China adopted a single-tier, managed floated foreign exchange system to replace a dual-rate system.

  As an indication of less intervention by the central bank, the yuan shot up 251 basis points in a single day, May 2, at the Shanghai-based National Foreign Exchange Centre.

  The fluctuation was wild, considering the normal tight trading band of less than 10 basis points in the first quarter of this year.

  'If you look at the first quarter money supply figures, the growth rate is higher than that by the end of 1994,' said Baring Securities (Hong Kong) economist Joan Zheng.

  From January to March, China's broad money supply rose 35.9 per cent, higher than 34.4 per cent in the last quarter of 1994, and a far cry from the state's target of a 25 per cent rise this year.

  'It means that the central bank is concerned about the expansionary effect of its purchase of foreign currency which is, in effect, injecting money into the market,' she said.

  Foreign reserves, which amounted to US$58 billion in the first quarter, have stoked the fire of growing money supply.

  Xiao Zhuoji, economics professor at Beijing University, was quoted by the semi-official Hong Kong China News Agency as saying that 300 billion yuan (about HK$274.8 billion) were pumped into the market last year as a result of foreign-currency purchases. 'Last year, inflation, to a larger extent, was due to the growth of money supply that was a result of rising foreign reserves,' Pan Ming, a senior economist at DBS Securities Hong Kong, said.

  This was evident in the ratio of foreign reserves to the PBOC's total assets, which soared to 75 per cent last year from 1993's meagre seven per cent. The ratio is a yardstick to see how much comes from foreign reserves for the monetary base.

  Under the austerity programme, inflation has slowed from its peak in October, with the retail price index rising at 19.9 per cent in the first quarter. But it is still higher than the state's target of 15 per cent this year.

  In an attempt to rein in inflation, one of the solutions lies with successful control of money supply, which can be done by buying less foreign currency in the market. This, in turn, means a stronger yuan.

  But Hongkong Bank China Service research manager Benny Chiu thought it was too early yet to say there had been a change in policy. 'It will take a few more weeks to see whether China has changed its policy.' The yuan has reasons to be strong. Strong export growth, which churns out a huge trade surplus, coupled with the tight monetary policy and the continued inflow of foreign investment, has fuelled the rise of the currency.

  Interest rate differentials between the yuan and the dollar have also encouraged hot money, estimated to be at least $10 billion last year, to flow into the mainland.

 Mr Pan was confident the yuan would trade at 7.8 to the dollar at the year's end - the same value as the Hong Kong dollar to the greenback.

  The advantage was inflation control as a result of a contraction of dollar-yuan credit expansion, he said.

  This was due to a decrease in the amount of yuan attached to the dollar inflow, as well as to yuan supply from the dollar swap, arising because of a slower inflow of foreign direct investment.

  Mr Pan said a strong currency would also be beneficial to the yuan's full convertibility and to servicing China's foreign debt, which amounted to $100 billion last year. This year China will pay about $12 billion to $14 billion for principal and interest.

  But the overriding concern is whether the yuan appreciation will affect exports which soared 62 per cent in the first quarter and brought China a trade surplus of $7.08 billion.

  Last year, China reversed its trade deficit in the first five months, as a result of robust exports due to the yuan's 33 per cent effective depreciation under the single-tier system.

  'The yuan's rise will negatively affect exports, but it will be balanced by the positive effect on inflation control. If the positive impact on inflation control is dominant, the exchange rate is still appropriate,' said Ms Zheng of Baring Securities.

   She said that the impact on China's exports would be limited, because 80 per cent of them were manufactured goods that were already low-priced, even allowing for foreign demand price sensitivity. 'If the price rises a little bit, foreign demand will not drop substantially,' she said.

  In addition, Chinese exports were competing with goods from Southeast Asia countries that had similar of currency appreciation. 'By comparison, China's exports will not be affected,' she said.

  On the other hand, the mainland would benefit by lower prices for finished goods, which would be translated into a lower consumer price index, due to cheaper imports of raw materials, machineries and capital goods, Ms Zheng added.

   But Mr Chiu of Hongkong Bank said that a weaker currency, which curbed imports and thereby helped development of domestic industries, would be more appropriate for China's situation as a developing country.

  'The yuan's appreciation is a way to solve the inflation problem, but that is not a good way,' he said. He suggested that China reduce foreign investment promotion to stall the growth of foreign reserves, and thereby the rise of money supply.

  In China, foreign currencies' demand and supply seems to be distorted. Under the prevailing system, domestic enterprises have to sell foreign exchange earnings to designated foreign exchange banks, but they have limited access for foreign currencies.

  'I will be surprised if, in the second half of the year, the currency still remains strong,' said J P Morgan's senior economist Huan Guocang, who expected the yuan to be 8.9 at the year's end.

  He said the PBOC was under pressure to buy foreign exchange, making it hard to manage the monetary policy.

  But he expected the policy, which restricted domestic enterprises ability to buy foreign currency, to be changed.

  In the short term, the market consensus is that the yuan will continue to head upward. But there is some division over its long-term direction, depending on assumptions of when China will loosen its monetary policy in light of the mounting bad debts among state enterprises.

   Ms Zheng expected the yuan to be about 8.2 and 8.3 to the dollar over the next five months, but to depreciate to 8.6 at the year's end as the government relaxes its tight grip on credit control.

  She expected the yuan to be down to nine at the end of next year.



Yuan strength points to inflation priority