False yuan stability a threat to economy

SINCE China's managed floating currency system came into effect early this year, the yuan has been hovering comfortably at a level of 8.7-8.6 to the US dollar.

A stable currency allows easier and more accurate financial planning. Any financial controller must surely welcome that. Yet, financial controllers of foreign-funded companies can draw little comfort from the yuan's apparent stability.

Such is the confidence in the yuan's stability that the country's foreign exchange administrators have forbidden foreign-funded companies from using state-designated banks for their currency transactions when a new national interbank system comes into operation today.

Originally, the idea was to abolish all swap centres, and local and foreign companies could use state-designated banks for their currency transactions.

The reason for the U-turn? ''We are thinking about retaining swap centres only for adjusting the surpluses and deficits of foreign-funded firms to help them find a foreign exchange balance,'' said an official at the State Administration of Exchange Control.

Sounds reasonable. But the truth lies in the fear that banks would see a deluge of orders for hard currencies, leading to the collapse of the yuan.

Foreign companies are understandably upset. Swap centres are a cumbersome and inefficient way of buying and selling hard currency. Hedging exchange risks is an arduous task because of a severe shortage of foreign exchange.

It is no secret that the stability is more a result of intervention by the People's Bank of China (PBOC), the country's central bank, than of market forces. At a time of runaway inflation, the PBOC may have valid reasons for keeping the yuan stable.

But that raises the question of how long the PBOC should maintain the artificially induced stability? For a country experiencing worsening double-digit inflation, the currency at some point will have to make compensatory downward adjustment against hard currencies.

An artificially high currency distorts trade, making imports cheaper and exports more expensive than they should be. Worse, the fear of a depreciation fuels a much stronger demand for foreign exchange.

Until it is freely convertible, the PBOC will have to adjust the limits of yuan intervention to allow the currency to edge towards its true market value.

By holding it artificially high over a long period, the PBOC is only distorting the picture. The pent-up demand for hard currencies could explode any time, and there is a real danger that the currency could fall with a thud in the event of unforeseen political or economic circumstances.