WITH the rapid depreciation of yuan in the foreign exchange market in China, will the Chinese Government devalue the official exchange rate according to the expectations of the market? The question has perplexed China traders, local officials, bankers, state enterprise managers and ordinary citizens. The central government has repeatedly indicated its commitment to merge the two exchange rate systems (the official and swap market ones)and introduce convertibility of yuan as a way to prepare China for its membership of GATT. This means China will, sooner or later, devalue its currency to eliminate the widening gap between the official and swap market rates. For those who hold or have access to foreign currency, this represents a government-guaranteed business opportunity. If they hold on to their foreign currency or increase its stock, they are guaranteed a higher yuan income than present official and market exchange rates. This strong profit incentive has led foreign trade firms, local branches of state banks, other enterprises, officials and people in the street to join in a widespread scramble for foreign currency, and has resulted in a massive withdrawal of foreign currency from the Chinese national network of swap markets. One may say the Chinese Government's eagerness in expressing its determination to rejoin GATT and to pursue a market economy constitutes the driving force behind the deterioration of the swap market rate of yuan from about US$1 to seven yuan in November to as low as US$1 to 8.8 yuan in early February. The reform in the foreign trade system and foreign exchange retention system in 1991 has put 80 per cent of China's foreign currency earnings distributed outside the central government (40 per cent of the total) in the hands of a small number of foreign trade firms. Since foreign currency distributed to local governments and enterprises constitutes the major source of supply in the swap markets, these foreign trade firms are able to manipulate market prices. The easy availability of yuan loans from the state banks has also provided the financial means for speculative hoarding. Meanwhile most industrial and commercial firms have been deprived of any foreign currency retention and local governments are left with only 10 per cent of the total exports and other foreign currency earnings China gets. The demand for imported raw materials, machinery and consumer goods forces local governments to bid for the limited supply of foreign currency in the swap markets. The demand for import and thus for foreign currency from the rising economic acceleration in 1992 (with December gross industrial growth reached a year-on-year real growth of 32.2 per cent) has led to a large trade deficit and rapid depreciation in yuan. Any economic player would predict a rapid yuan depreciation if they knew the December trade deficit to be a huge US$2 billion, the first monthly trade deficit in China since 1989. China has relied on imported raw materials and consumer goods to keep downcost-pushed inflation and boost retail sales in the second half of last year. Without any sign of deflation in the economy but with the central government's open efforts to get into GATT in 1993, the trade deficit will not be transitory phenomenon. But out-of-control trade deficits will handicap China's ability to repay the huge amount of debts it has borrowed in the 1980s. Depreciation of yuan will introduce imported inflation to the existing strong inflationary pressure in the economy. It will also widen the gap in economic growth between the coastal and interior provinces, as the coastal provinces will benefit from devaluation while their interior counterparts will suffer from the high costs in imports. If unchecked, the rapid depreciation in the swap market or black market rates of yuan will generate a general loss of purchasing power. The result may be a financial crisis that will exacerbate the present inflation problems and bring in a general economic crisis. At a time China is facing a generational change in its leadership and the growing hostility from the West under American leadership, it is hard to see the Chinese leadership will allow the market to restore its equilibrium through adjustments in prices and demand. Examples of government intervention in foreign exchange market in Western market economies are plentiful, and the Chinese Government still has many administrative and political means to manipulate the behaviour of its state enterprises, including the leading speculators of state foreign trade firms and local branches of state banks, and control the prices in the swap and black markets. However, if China does not slow down its excessive economic growth and investment, and find a way to reduce imports and capital flight, the resort to non-economic measures may not be sufficient and would inflict unnecessarily high costs to its economy and population. Thomas Chan is reader and co-ordinator of the China Business Centre, Hongkong Polytechnic.