It was the unstoppable force meeting the immoveable object. During his recent visit to Beijing, U.S. Treasury Secretary John Snow stated that his objective was to get China to commit to moving to a "free-floating" currency, while senior Chinese officials stressed the contribution that a "stable" yuan had made to economic stability and development in China, Asia and the world. How then to square the circle that seems to call for three objectives: a near-term revaluation of the yuan, greater stability of the yuan in the medium term and greater flexibility and market determination of the yuan a little later down the road?
Most proposals for Chinese currency reform fall prey to one of two problems. If revaluation of the yuan has to wait until China is willing to undertake full capital-account liberalization, then the rest of the world has to live for too long with a misaligned yuan. Alternatively, if China is asked to free float the yuan and adopt capital-account convertibility before it puts its domestic financial sector on a firmer footing, it would be casting aside one of the main lessons of the Asian financial crisis.
Our answer to this dilemma is that China should view reform of its currency regime as a two-step process. The first step should be a medium-size (15% to 25%) revaluation of the yuan, a widening of the currency band (to between 5% and 7%, from less than 1%), and a switch from a unitary peg with the dollar to a three-currency basket peg, with weightings of roughly a third each for the dollar, euro and yen. Step two should be adoption of a managed float, after China strengthens its domestic financial system enough to permit a significant liberalization of capital outflows.
The Chinese leadership implicitly recognizes the yuan is undervalued. But they apparently believe the disequilibrium in the foreign-exchange market can be ameliorated by selective liberalization of current- and capital-account transactions while leaving unchanged the current fixed parity with the dollar.
The authorities recently increased the amount of yuan that Chinese tourists can convert to foreign currency and began to allow Chinese firms with certain types of foreign-exchange earnings to retain them rather than surrender them to the central bank. They have given the green light for a state-owned bank to issue its first dollar-denominated bond on the domestic market and have already signaled that requests for outward foreign direct investment are now more likely to be approved.
They are also discussing a reduction in the value-added tax export rebate rate to 11%, down from its current level of 15%. And they may allow mainland residents and certain financial institutions to purchase limited amounts of foreign securities. The authorities hope that these steps will either increase demand for, or reduce supply of foreign exchange, thus relieving the upward pressure on the currency.
While the go-slow approach presumably appeals to the leadership because of its limited short-run effect on China's exports, incoming FDI, and trade-related jobs, it is likely to do little to remove the misalignment of the yuan that has pushed China's overall balance of payments into a larger surplus, fed a huge reserve accumulation over the past 18 months, and increasingly concerned many of China's trading partners, including the United States, Euroland, Japan and South Korea. Very small adjustments could simply stoke further capital inflows by persuading market participants that speculation on the yuan is a one-way bet. Although the low interest rates paid on domestic central bank bonds has meant that sterilization of international reserves has so far been less onerous in China than in many other emerging economies, experience shows that sterilization becomes more costly and less effective the larger it is and the longer it goes on.
With its mountain of bad loans, China cannot afford to let capital inflows exacerbate the already excessive expansion in bank lending, money-supply growth and investment. The recently announced increase in reserve requirements for banks indicates that overextension of the financial system is now clearly visible on the central bank's radar screen.
In contrast, consider the advantages of our proposal for a medium-size revaluation. This would immediately deal with the existing undervaluation of the yuan and remove the incentive for further speculative capital inflows and reserve accumulation. No longer would the foreign component of the money supply be working at cross-purposes with the needs of domestic stabilization. It would show trading partners that China is not attempting to manipulate its exchange rate, thereby lessening the threat of protectionist measures against China's exports. It would make the yuan part of the solution to the global pattern of payment imbalances-not part of the problem.
In doing so, it would add to the plaudits that China received during the Asian financial crisis for conducting a responsible exchange rate policy and for taking the wider interest of the region into account. It would also increase the odds that Japan and emerging economies elsewhere in Asia would be willing to allow their exchange rates to appreciate, reducing the burden on the euro contributing to the needed downward adjustment of the dollar and limiting the deterioration in China's competitiveness. By adopting a wider band, China would gain valuable experience in allowing the exchange rate to be more responsive to market forces.
Just as important, by moving to a three-currency basket peg, China would increase the stability of its overall trade-weighted exchange rate. In a context where the dollar needs to depreciate further to help reduce the unsustainable U.S. current-account deficit, a basket peg would permit the dollar to depreciate against the yuan without a series of yuan parity changes. That could not happen if China retains its present unitary peg to the dollar.
The key to reconciling China's desire for exchange-rate stability with the need for the yuan to play its proper role in global balance of payments adjustment is to recognize that a fixed rate for the yuan need not be at the present parity. Stability of China's exchange rate should be interpreted against a wider set of reserve currencies than the dollar alone. The transition from "fix" to "flex" need not occur in one fell swoop, since liberalization of the capital account will proceed in stages.
Looking farther down the road, China will find it in its interest to move to a regime of managed floating because capital mobility in and out of China will increase and because it will want to exercise greater monetary-policy independence for stabilization purposes. It would be unwise to float now because the domestic financial system is still far too fragile to rule out large-scale capital flight in response to bad news. In addition, the government still dominates foreign-exchange transactions to a degree that precludes the market functioning properly. But these obstacles to floating the exchange rate should lessen as China reduces its large stock of nonperforming loans in the banking system, government involvement in the credit-allocation process declines in favor of market forces, and the progressive dismantling of restrictions on international capital flows widens and deepens the scope and liquidity of foreign-exchange trading.
As a host of emerging-market crises of the past decade have demonstrated so dramatically, high capital mobility vastly increases the vulnerability of a publicly announced target for the exchange rate. With China's public debt burden rising under the weight of bank recapitalization and assumption of pension liabilities, fiscal pump priming will be more constrained and monetary policy is likely to take on an increased share of stabilization duties. Thus China will want to increase the flexibility of its exchange rate regime.
But this need not mean slavish adherence to a pure float. If and when market forces push the yuan beyond the levels consistent with its economic fundamentals, China, like other countries, should retain the option to manage the float by intervening in the exchange market-so long as that intervention is not prolonged and not just in one direction. In short, a managed float should be the preferred regime choice for the second stage of reform.
The currency regime that has served China well in the past is not the currency regime that will serve China best today or in the future. Likewise, if the U.S. wants to persuade China to reduce the serious undervaluation of the yuan and to play a larger role in the global adjustment process within the next year or so, it too will have to alter its opening negotiating position by dropping the suggestion that China move in one great leap forward to a free float and completely open its capital markets. With some compromise by all parties and with the right sequencing of China's currency reform, a workable solution is in sight.