It was almost a year ago that Beijing announced a new exchange-rate regime for the yuan, which included a 2.1 per cent revaluation against the US dollar. Since then, the People's Bank of China has tried to foster a more robust foreign-exchange market by enlarging the foreign-exchange dealers' system and increasing the product range of yuan-based derivatives and hedging instruments.
Meanwhile, the State Administration of Foreign Exchange, a division of the PBOC, has significantly relaxed capital-outflow restrictions in an effort to promote a more flexible currency. The net result has been a gradual increase in the yuan's value since the one-shot revaluation, at a rate equivalent to about 1.5 per cent per year.
Yet, the perception gap has widened between mainland policymakers and their western counterparts, on the desirable exchange rate. From China's standpoint, even a 3 to 4 per cent appreciation against the US dollar would entail a huge sacrifice, considering the fragility of the country's financial system, the immense pressure on policymakers to create jobs and the lack of experience among domestic firms in managing currency risks. But from the west's standpoint, the yuan remains severely undervalued.
China's trading partners are also uneasily watching the rapid build-up of the country's foreign reserves, which has fuelled suspicion that China is manipulating the exchange rate and has fanned protectionism abroad.
There are only two ways to reduce China's massive reserves. One is to substantially relax restrictions on capital-account transactions. The other is to adopt a much stronger currency. But, from China's perspective, allowing a large, one-off adjustment of the yuan would be a flawed decision.
First, it would be seen as something imposed by the west, so there would be little political will behind it. Second, there are better ways to correct an exchange-rate misalignment. These include continued liberalisation in the trade sector, such as lowering import tariffs and export subsidies, to raise the prices of mainland goods abroad.