Instead of fixing its currency against the US dollar, China would achieve better exchange rate stability by pegging the yuan to a basket of currencies - and so would Hong Kong - according to a research paper* published this month.
The exchange rate against the US dollar would vary, but by adopting a basket peg, China could cut the overall volatility of the yuan against all its trading partners' currencies, argues the paper's author, former World Bank chief economist for South Asia John Williamson. That would be highly advantageous for Chinese importers and exporters and would lend extra comfort to both inward and outward investors.
China has defended the yuan's US dollar peg by arguing that it ensures exchange rate stability. But by fixing the peg to the dollar, China has actually ensured it suffers from major exchange rate volatility against the currencies of its other major trading partners.
Most important are Japan and the eurozone, which together account for 27 per cent of all of China's foreign trade. While the yuan has been kept steady against the greenback, in recent years the Chinese currency has fluctuated by more than 30 per cent against the yen, and by more than 60 per cent against the euro (see chart).
Much of that volatility could be eliminated if China were to peg the yuan against a basket of currencies.
One option would be a basket comprising the currencies of countries that account for more than 5 per cent of China's total foreign trade. This would consist of the yen, the euro, the US dollar, the Hong Kong dollar and the South Korean won (see chart).
If China had adopted this strategy between 2000 and 2004, the yuan's overall volatility against its trading partners' currencies could have been cut by nearly half, says Mr Williamson.