These days, almost everyone seems to think that, in 2008, the Chinese currency will appreciate faster against the US dollar than in previous years. The arguments for a much stronger yuan seem compelling. China's foreign-exchange reserves - US$1.5 trillion and counting - have roughly doubled in less than three years. Inflation, too, is rising. A stronger currency would be a powerful tool to counter these trends, as it would lower both China's export earnings and import prices. And, in this year of the US presidential election, a faster yuan appreciation would provide China with some political cover from accusations that cheap Chinese exports are destroying American jobs. But the consensus view isn't always right.
Chinese policymakers never cease to be amazed by outsiders' growing criticism that China's forex reform has been 'too little, too slow'. The yuan, after all, has gained about 12.5 per cent since it was depegged from the US dollar in July 2005. But recently another, more worrying, trend has caught them by surprise. Amid mounting expectations of a faster appreciation, the People's Bank of China is having difficulty maintaining its policy of a gradual rise. The real problem, though, is that China's economic cycle is increasingly diverging from that of the global economy.
While Chinese authorities are forced to tighten their monetary stance amid concerns about economic overheating, central banks in most developed countries are worried about the ongoing US subprime mortgage crisis and are easing policy. When the global economy was booming, interest rates in the US were about 3 per cent higher than in mainland China. That meant the People's Bank could set the pace of yuan appreciation at 3 per cent to 5 per cent per year, because speculators' gains from the exchange rate would be offset by the interest rate differentials. But this blissful condition disappeared when, in the last quarter of 2007, the US Federal Reserve and the People's Bank found themselves moving in opposite directions. Now, if you bet on a stronger yuan, you could be doubly rewarded with higher exchange and interest rates. People who had been deterred by the interest rate gap are jumping on the speculation bandwagon. That is why the consensus is that the yuan will appreciate faster this year.
The popular view that 'trend is your friend' is often wrong, however. Otherwise, it would be too easy to speculate in currencies. Speculators should remember that Beijing can cool the economy by clamping down on bank lending, as well as by raising interest rates.
The People's Bank must do some soul-searching about forex reform. China's annual current-account surplus is between 8 per cent and 10 per cent of gross domestic product, or at least US$200 billion. Even foreign politicians demanding a 30 per cent rise of the yuan agree that China's high savings rate, not its undervalued currency, is more responsible for such immense imbalances. Meanwhile, the rapid build-up in China's forex reserves reflects the dearth of capital outflows. Because of draconian capital controls, the People's Bank is the main buyer and seller of foreign currency in the market. But Chinese central bankers are no better than Chinese firms or individuals at this. The People's Bank should allow the yuan's value to be more market determined, as a deficit in the capital account would offset the current-account surplus.
What about adopting a stronger-currency policy to fight rising inflation? Again, contrary to market consensus, the People's Bank should perhaps not do that. If the US economy slides into recession, that could help check inflation in China. To compensate for falling exports, Chinese firms would rather lower prices than cut production. And if export growth decelerates, the People's Bank will become more wary of a faster currency appreciation.