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Economists: Chinese Currency Adjustment Could Take Time - 2004-10-12

The United States and other Western nations complain China has an artificial trade advantage against them because of its fixed exchange rate system. Beijing promises that it eventually will make some adjustments. China faces a dilemma over how to deal with its currency.

The Chinese currency has been pegged at 8.27 yuan to $1 (US) for nearly one decade.

China's trading partners, particularly the United States, argue the peg is too low. They say it gives Beijing an unfair trade advantage, because it makes Chinese exports cheaper and hurts manufacturers in their own countries. The U.S. trade deficit with China, for instance, rose 20 percent to $124 billion last year.

Economists say China faces a dilemma over the yuan. If China allows it to appreciate, exports become more expensive and imported goods cheaper. This could hurt economic growth and put millions of jobs at risk.

Some economists argue an exchange rate adjustment rests largely on China's ability to reform its weak financial system. If China abandons the peg, it also may need to end controls on the flow of capital in and out of the country.

Some say this presents the risk of millions of Chinese moving their money overseas to more lucrative or safer investments. That could destabilize weak banks, causing a crisis. Leong Liew heads the international business department at Griffith University in Australia.

"If you let the currency float and lift capital controls there is danger that some exogenous shock or event can lead to massive capital flight and destabilize China's financial system," said Mr. Liew. "China's exchange rate is very much driven by capital inflows and a fair amount of that is speculative."

Others also argue that China still lacks a system of hedging investments to protect them from exchange rate fluctuations. Economists say developing the necessary complex hedging practices will take considerable time.

At the same time, they must improve the banking system. Chinese officials are grappling with an overheating economy and rising inflation, fueled in part by foreign capital. Economists say a currency adjustment could help slow the economy by making investing in China more expensive.

In the Group of Seven finance meeting in Washington earlier this month, China pledged to "firmly and steadily" work toward a more flexible exchange rate, but gave no timetable. The United States and other Western countries are pressuring China to do it soon.

When it does happen, economists say China has several options: There can be a one-time revaluation, the yuan can be re-pegged to a basket of currencies, managed exchange rate could be created, or the yuan could trade without restrictions, the way most Western currencies do.

Jean Pierre Verbiest, an economist at the Asian Development Bank, says China would have to find the least disruptive option.

"What is harmful in exchange rate changes is mainly if you have very rapid shifts in rates. So I guess the (ideal) system would be a system where you keep your exchange rate relatively stable with some scope of appreciating or depreciating depending on the circumstances," said Mr. Verbiest.

The latest pressure on China comes as the United States prepares for presidential elections next month. Some analysts say Washington's demand is largely political rhetoric at a time when candidates want to portray themselves as defending local industries.

But economists say the situation is far more complex. China has accumulated large reserves of U.S. dollars. It also holds a significant amount of U.S. government debt. That helps keep the dollar strong and U.S. interest rates low, effectively putting China in a position of subsidizing the American economy, which struggles with a heavy national budget deficit.

Mr. Verbiest say the U.S. trade and budget deficits cannot be solved by a China solution alone.

"Historically large deficits in the U.S. were not really resolved in a major way until domestic demand is actually coming down," he noted. "As long as consumption remains very strong, even if imports are more expensive, they [Chinese products] would still be imported to the U.S."

Many economists say a yuan adjustment may not come any time soon and the United States and other Western nations still must find ways to deal with their trade deficits.