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Stable exchange rate crucial
By Dai Genyou (China Daily)
Updated: 2004-03-10 10:58

For the time being, it is wise to keep the renminbi exchange rate at its current level to ward off any potential external shocks.

Foreign exchange control that aims to track international short-term "hot money" serves as an important anchor of the country's financial stability.

After joining the World Trade Organization (WTO), China's economic integration with the rest of the world has been accelerating. In this condition, it is in the country's best economic interest to properly address the issue of renminbi exchange rate.

Experiences since 1994 show China's foreign exchange management and exchange rate regime fits the nation's economic basics. In the past decade, for example, foreign direct investment has been increasing and renminbi has served as a creditable stabilizer for the regional and international economy.

A woman and her son get a close up view of a Chinese 100-yuan note at an exhibition in Beijing. China's currency peg is a hot-button issue for President George W. Bush as he heads to an Asia-Pacific summit pressing for freer exchange rates in a bid to ease the crushing US trade deficit and revive the sagging US labor market. [AFP/file]
The balance of trade is the key to examining whether the exchange rate is rational.

The basis of a country's balance of international payments is the trade balance. No country can shoulder the prolonged impact of unfavourable balance of trade.

Seen from the perspective of trade balance, it is advisable to maintain the renminbi exchange rate at a relatively stable level.

Since 1998, China's foreign trade surplus has seen an overall downward trend, registering US$43.5 billion, US$30.4 billion and US$25.5 billion in 1998, 2002 and 2003 respectively.

In the coming years, as China's WTO transitional grace period ends, the country could suffer from continual trade deficit.

Over the first half of last year, China has seen unfavourable trade balances with Japan, the Association of Southeast Asian Nations, the Republic of Korea, Russia, Australia and Canada. Although it has a US$25.6 billion trade surplus with the United States, the balance is more the result of fallout from restrictive US trade policies towards China than an accurate barometer of Sino-US trade relations.

The judgement of whether the renminbi exchange rate is at a proper level should also take into account the middle- and long-term trend of the rate.

From such a perspective, renminbi will face great devaluation pressure.

China's current account balance of payment, especially the trade balance, may suffer from prolonged deficit, which has surfaced right now.

The inflation pressure as a result of accumulated high-rate money supply and loan growth is set to have serious impact on the renminbi exchange rate.

During the 1998-2002 period, the broad measurement of money supply, which includes cash circulation and deposits, increased by an annual average of 15 per cent. In 2003, the rate was 20 per cent.

If the money supply grows at an annual average of 15 per cent over the following decade, the M2 will reach 75 trillion yuan (US$9 trillion) while China's gross domestic product (GDP) would register at 20 trillion yuan (US$2.4 trillion) if it grows at an average year-on-year 8 per cent.

The money supply growth in the past two years shows that it may accelerate in the coming years. If that happens, the M2/GDP ratio may reach an astonishing 400 per cent, which is unprecedented in the world's financial history.

The high-rate growth of money supply and loan extension will lead to accumulated inflational pressure, which means the price of renminbi in international transactions will inevitably be driven down.

World economic history shows most new market economies have seen the value of their currency first rise and then fall due to failure to resist the "attack" of international speculative capital.

China should draw valuable lessons from that.

While keeping renminbi stable, China needs to continually improve the formation mechanism of the renminbi exchange rate.

Its exchange rate policy must be made independent and able to promote its balance of international payments.

Since it is the basis of the international payment balance, the current account balance must be achieved. It is crucial for a developing country like China to manage its capital accounts and maintain independent monetary and exchange rate policies.

The real effective exchange rate, which is calculated by taking into account the multi-lateral interaction of renminbi exchange rates with different foreign currencies, is the most important factor concerning the current account balance. Therefore, the formation mechanism of the renminbi exchange rate should be made conducive to the stability of the real effective exchange rate of renminbi.

Stressing that the formation mechanism of the renminbi exchange rate should contribute to stabilizing the renminbi real effective exchange rate does not mean the rate should remain unchanged for good. The goal is to make the nominal renminbi exchange rate, through the People's Bank's operation in the foreign exchange open market, dance to the tune of its real effective exchange rate in the long term.

The task of the People's Bank is to closely watch the change in the real effective exchange rate of the renminbi and practise a managed floating exchange rate regime based on market supply and demand conditions. Such a regime fits China's concrete conditions and should be continued in the coming years.

The goal of managing the renminbi exchange rate is to ensure the relative balance of the current accounts, which will facilitate policy-makers to take initiative to adopt an independent monetary policy to serve the domestic economic objectives.

It should be pointed out that given the fierce international competition, maintaining the ability to manage the exchange rate helps safeguard a country's "monetary sovereignty" and ease its macro-economic regulation.

Currently no country (including the United States) gives up the power to manage its capital accounts, nor does any nation spare efforts to swing the exchange rate of their home currency when it is deemed necessary.

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