bodyType

customContents

entityId

entityUuid

articlePageQuery

filter

article

articleBaseAdvertisingInfoArticle

articleListArticle

articleSeoArticle

hooksArticleAcknowledgementGateOverlayArticle

hooksTrackPageViewArticle

hooksContentInterestArticle

articleLinkingDataContent

hooksAmpRedirectArticle

articleSchemaContent

liveArticle

advertZone

sentiment

contentLock

topics

types

sections

paywallTypes

createdDate

publishedDate

urlAlias

moreOnThisArticles

sponsorType

commentCount

authorLocations

authors

corrections

displaySlideShow

multimediaEmbed

printHeadline

seriesContainer

articleSpeeches

socialHeadline

headline

images

flag

firstTopic

glossary

flattenTypeIds

image

relatedLinks

relatedNewsletters

__typename

sponsor

pdfFiles

seriesReverseOrder

series

disableOffPlatformContent

published

updatedDate

summary

subHeadline

body

keywords

readingTime

customTimezone

liveContents

SCMP Reporter

The halfway proposal may cost Beijing control of mainland economic levers

China's conciliatory call for exchange rate flexibility in the face of US Secretary Treasury John Snow's visit has raised  a debate  on how successful a new  regime would be.

Central Bank Governor Zhou Xiaochuan said there was room for discussion about a move to tie the yuan to a basket of currencies rather than to the dollar alone.

His comments followed  a meeting with Mr Snow  and other top leaders. Mr Snow said  he was 'encouraged' by China's reaffirmation of a policy to gradually de-peg the yuan.

A new exchange rate policy would be welcome news to American businesses who fear they are losing jobs to low-priced imports from China.

But economists say there are technical issues to be resolved with China's plan to establish an exchange rate policy that falls halfway between a fixed and floating regime and one linked more solidly to a number of currencies.

'In a world of freely flowing capital there is shrinking scope for countries to occupy the middle ground of fixed but adjustable pegs,' noted Lawrence Summers, former Treasury Secretary during the Clinton administration.

In a paper about exchange rate policy, Harvard University economist Jeffrey Frankel noted: 'The currently fashionable view is that countries are being pushed to the 'corners', the extremes of either free floating or firm fixing.  The intermediate regimes are said to be no longer viable.'

In reality, China  presently does not  have an actual peg. The yuan  floats within a narrow range against the US dollar, the Hong Kong dollar and the yen - although mostly against the US dollar.

Under  terms established in 1994, the yuan is limited to 0.3 per cent movement on either side of the dollar and  1 per cent around the Hong Kong dollar and yen.

Theoretically, the proposed intermediate regime can take a variety of forms, including the crawling peg (whose target moves according to set government policy), adjustable pegs and lastly, the basket peg (pegged to a basket of currencies) - the approach China appears to be leaning towards.

The problems cited with the intermediate regime are that no country can maintain control over all three of the key levers of the economy: exchange rates, monetary policy and capital mobility.

Fix one or two, and the third must be left to adjust. Given that most  economies - including China - are gradually allowing capital mobility, the choice is between  abandoning exchange rate flexibility or monetary policy.

In China's case, for example, it can control interest rates through the central bank and it can fix the exchange rate. However, to do so it must prevent the free flow of capital across its borders. Otherwise both the exchange rate and interest rates would fluctuate, as occurred during the Asian crisis. The halfway measures proposed by China do not resolve the question of which of these levers China's leaders are prepared to abandon.

'As capital mobility increases and interest rates are liberalised, preserving the peg will ultimately mean abandoning any remaining monetary policy independence,' write Ivan Roberts of the Reserve Bank of Australia and Rod Tyers of the Australian National University.

One of the more intriguing arguments about the difficulty of intermediate regimes comes from  Mr Frankel who argues that wide trading bands are awkward because they are hard for outsiders to verify. Lack of verifiability means a lack of trust, which is key to supporting an exchange rate band.

'Our point is that a simple regime such as a clear dollar peg, or even a free float, may be more verifiable by market participants than a complicated intermediate regime,' Mr Frankel said.

That is not to say economists defend China's peg.

Most agree that as its economy gradually opens, it  will require eventual abandonment of the peg. One potential problem is that as interest rates and capital are liberalised, maintaining a US dollar peg will bind Chinese monetary policy to the US Federal Reserve due to the need to keep interest rates in line.

That's a non-workable policy because China and the US face entirely different domestic and international economic requirements.

Second, as China gradually opens its economy to foreign capital, it would be prey to the kinds of speculative attacks on the currency seen during the financial crisis.

Finally, a fixed peg with capital mobility means there is no way to use the exchange rate to insulate the country from external shocks - such as capital flight.

Linda Yueh, an economist at the London School of Economics and Oxford University, agrees that the fixed exchange rate is  unsustainable.

But she points out the reasons at this stage have nothing to do with China's economy, but rather with the expectations that China will revalue or de-peg.

'There's a lot of pressure, not from fundamentals, but from the expectation of revaluation,' which is causing yuan hoarding, she said.

Until certain fundamental questions regarding China's economy are resolved, there will be hot money flows into China and continued yuan hoarding, increasing pressure on the currency.

She believes that a move to a halfway solution, such as pegging to a basket of currencies, would be a positive move. In her view, the likeliest outcome in the near term is a wider trading band or an adjustable peg.



Yuan pegs expected to land in basket