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Commentary: Current renminbi exchange rate right for times
( 2003-11-10 09:00) (China Daily)

The current renminbi exchange rate is appropriate. In 1994, China carried out reform of its foreign exchange system and adopted a unified, managed floating exchange rate regime based on market supply and demand of foreign exchange.

The renminbi has experienced an appreciation against the currencies of China's major trading partners since that time.

By the end of 2002, the renminbi had appreciated against the US dollar, the euro and the Japanese yen by 5.1 per cent, 17.9 per cent and 17.0 per cent, respectively, in nominal terms.

The currency would have risen by 18.5 per cent, 39.4 per cent and 65.3 per cent, respectively, against the above three major currencies in real terms, if inflationary factors were accounted for.

IMF Estimate

Estimates of the International Monetary Fund showed that between January 1994 and September 2002, the nominal effective exchange rate of renminbi against the currencies of China's major trading partners appreciated by 14.3 per cent, and the real effective exchange rate appreciated by 18 per cent.

All these figures show that the renminbi exchange rate is determined mainly by market forces and thus is a floating rather than a fixed rate.

The current relatively narrow floating band of renminbi exchange rate is a result of the country's responding to the request that renminbi not be devalued during the 1997-99 Asian financial crisis, a request made by our neighbouring economies and the entire world.

Those who advocate a yuan revaluation quite often list the following four reasons to support their stance.

First, the theory of purchasing power parity. Some people cite the Big Mac Index calculated by the Economist as proof of renminbi's undervaluation by over 50 per cent, while others believe that the exchange rate of the yuan against the US dollar would stand at 2:1 if based on the purchasing power parity worked out by the World Bank for each country in the world.

Second, China records surpluses both on its current account and capital account.

Third, China is experiencing a rapid increase of foreign exchange reserves.

Fourth, China's economy is growing at a fast speed.

In our view, these four reasons do not warrant a revaluation of the renminbi, though they do produce some pressures.

First, the purchasing power parity should not be taken as a reliable measure for appropriate exchange rate levels.

The theory of purchasing power parity is based on the "law of one price," which means competitive markets will equalize the price of an identical good in two countries when the prices are expressed in the same currency.

In reality, however, the law of one price is not applicable to most goods since their prices are also affected by a combination of different factors including tariff and non-tariff barriers, transportation costs and the propensities of consumers.

It is for such reasons that most economists view the theory of purchasing power parity as inapplicable in the short term; this is because there are large and frequent deviations between the exchange rate and purchasing power parity in the short term.

At the same time, results of more and more empirical studies (eg, Charles Engel, 2002) show that the theory of purchasing power parity is unlikely to stand even in the longer term, and such a theory often tends to overvalue the exchange rate of currencies of the developing countries or economies in transition.

If purchasing power parity is used as a benchmark to determine the equilibrium of exchange rates or as the basis to fix a country's exchange rate, certain misperceptions are bound to arise.

For example, if based on purchasing power parity, the Russian ruble would have appreciated by over 50 per cent since 1997 instead of experiencing a persistent fall against the US dollar from 6:1 at the end of 1996 to the current level of 31:1.

Big Mac Index

Again, if calculated based on the Big Mac Index, the value of the currencies of the Philippines, Malaysia, Thailand and Argentina would all have risen by 20-50 per cent.

But in reality, all these currencies have been facing devaluation pressure in recent years and Argentina has even experienced a currency crisis.

Second, neither a trade surplus nor large foreign exchange reserves constitute a sufficient condition for currency appreciation.

If that is not the case, the currency that needs revaluation should be the Japanese yen, not the Chinese yuan, for Japan tops the whole world both in terms of its registered trade surplus and the stockpile of foreign exchange reserves.

Japan's trade surplus climbed to 11.7 trillion yen (US$98.2 billion) in 2002, which is more than three times that recorded by China.

Japan's foreign reserves totalled US$467.07 billion at the end of February this year, 1.5 times larger than China's.

During the first half of 2003, China recorded a trade surplus of merely US$4.5 billion, far less than the US$37 billion recorded by Japan.

Measured on this basis, the current renminbi exchange rate is basically neutral, and has not been artificially manipulated to boost China's exports.

One point worth mentioning here is that it is quite natural for a country with high savings like China to record a certain amount of trade surplus.

The rapid increase of China's foreign exchange reserves is less a result of the rise of the trade surplus than it is of two other factors which also do not have much to do with the exchange rate of renminbi.

One is the large inflow of foreign direct investment, which is mainly generated by China's extensive, high quality labour force and the huge domestic market.

The other factor is the partial convertibility of the renminbi.

With certain capital account transactions still under control, the foreign exchange demand of both enterprises and individuals has not been fully satisfied.

Moreover, under the managed floating exchange rate regime, foreign exchange requirements are still in place.

Given this case, there is a distinct difference between the central banks of China and Japan in terms of their practice in buying US dollars from the foreign exchange market.

Since Japan has adopted a free floating exchange rate regime, the Japanese Government, theoretically, need not and should not intervene in the foreign exchange market, and thus does not need to hold too much in foreign exchange reserves.

However, the Japanese Government has repeatedly intervened, and with increasing strength, in recent years.

For example, although the Japanese Government spent a total of 8 trillion yen in the market to control the exchange rate in the first half of this year, despite Japan having built up a trade surplus of 100.2 trillion yen (US$835 billion) and a net increase of foreign exchange reserves of US$404.1 billion since 1995, nonetheless, the exchange rate of the Japanese yen against the US dollar experienced a persistent fall.

When commenting on intervention by the Japanese Government in the market to control the yen exchange rate, a US Treasury official said the United States would not demand the stop of such a practice by the Japanese Government aimed at boosting the export competitiveness of Japanese products.

Such "dual standards" should be taken as a warning shot.

Third, rapid growth of the economy will produce pressures on but not necessarily result in revaluation of the currency.

Japan's Example

As is well known, the Japanese economy witnessed a fast growth in the 1960s, with the average growth rate reaching over 10 per cent between 1959 and 1969, which is much higher than the average growth rate of 7.7 per cent recorded by the Chinese economy over the past five years, but that the Japanese yen remained fixed at 360 against the US dollar through those years.

More and more Japanese experts and scholars have now realized that rapid appreciation of the Japanese yen after the "Plaza Accord" was the prime cause of the persistent weakness of the Japanese economy in the 1990s.

As an old Chinese saying has it, "Past experience, if not forgotten, should serve as a guide for the future." It is the lessons learned from Japan that have buttressed our resolve not to revalue the renminbi at a highly uncertain time.

Those who advocate an appreciation of the renminbi have also more or less neglected a myriad of depreciation pressures facing the Chinese currency. These pressures mainly come from the risks associated with non-performing loans in the banking system, contingent liabilities in the fiscal sector, incomplete reform of the State-owned enterprises, unemployment and other uncertainties arising in the process of economic restructuring.

On top of this, the current exchange rate actually does not fully reflect the relationship between demand and supply of foreign exchange under the existing foreign exchange administration system.

That is to say, demand for foreign exchange from enterprises and individuals is somewhat contained by the practice of capital control, which tends to overvalue the renminbi under the current policy framework.

The deepening of foreign exchange reform and gradual relaxing of capital control in the coming years will release the appreciation pressure on renminbi.

Kenneth Rogoff, chief economist of the International Monetary Fund, admits: "It is impossible to determine whether the pricing of renminbi is too high or too low, since capital accounts and interest rates are both under control in China."

Moreover, we should not turn a blind eye to historical lessons.

After the outbreak of the Asian financial crisis, Asian currencies, with the exception of the Chinese renminbi, all experienced sharp falls, and the renminbi also came under intense pressure.

Asian Crisis

However, China stuck to its policy of non-devaluation through the crisis and eventually paid a heavy price for honouring its commitment.

It would not be an exaggeration to say that China made a great contribution to the stability and early recovery of the economy in the region and in the entire world.

As a result, the Chinese currency actually appreciated amid speculation of depreciation. This also serves to justify the current renminbi exchange rate.

Based on above analysis and the fact that the renminbi has already appreciated in recent years, we deem the current renminbi exchange rate and its formation mechanisms are compatible with the current stage of China's economic development, and that this is a basically reasonable arrangement.

Such an understanding is also widely shared by many international economists.

For example, Paul Volker, former US Fed Chairman, once warned that an appreciation of the renminbi would lead to rampant speculation which would result in a devastating blow to the Chinese economy, and that what China should do is to maintain the stability of the renminbi exchange rate against the US dollar.

Robert Mundell, the well-known "Father of the Euro," also voiced his support for China's resistance to foreign pressures for appreciation

The prevailing economic recession is the first of its kind since the initiation of economic globalization, and is a result of combined factors such as business cycles, the new economy and the bursting of financial bubbles.

Recovery is being held back by some uncertain factors including terrorism attacks, the war in Iraq and other geopolitical tensions.

In order to bring about a rapid recovery of global economy, it is crucial to address the following three issues.

First, remove all uncertain factors as soon as possible, particularly those non-economic factors, and rebuild the confidence of consumers and investors.

Second, address the imbalance in international economic development to pave the way for a steady recovery of the world economy.

Among these measures, it is also important to establish a new and fair order for international economics, trade and finance in order to remove all kinds of technological and trade barriers against developing countries, improve capital and technology flow to developing countries, and raise the purchasing power of developing countries to overcome the imbalance between demand and supply of world commodities and services.

Third, all nations in the world should strive to solve their own problems, accelerate structural reform and adjustment to reduce their reliance on the US economy.

Because it is an inconvertible currency, the renminbi's appreciation would not help solve any of the above problems, but would add new uncertain factors to the world economy.

Structural Imbalance

For the United States, the challenge it faces for the moment is the severe structural imbalance resulting from excessive investment during the period of economic bubbles.

The imbalance was witnessed domestically in the mismatch between demand and supply, with one quarter of capacity lying idle, investment continuously falling and unemployment rising, and externally in its record-high trade deficits.

The United States does run a trade deficit with China, but it only accounts for around 9 per cent of its total deficits.

The real intention of pushing for a revaluation of renminbi is to put the damper on China's exports.

However, the basic principles of economics tell us that exchange rates are not the only variable affecting trade conditions.

The US trade deficit with China is mainly attributable to the following factors.

First, China has an abundant, cheap, high quality labour force while the United States has advanced science and technology, making for a strong complementary trade relation between the two countries.

The different economic structures of the two countries and their different places in the international division of labour determine China's trade surplus with the United States.

On the one hand, China's quality and cheap commodities meet the needs of the US consumers.

According to World Bank estimates, US consumers on average pay US$15 billion less for products imported from China than they would have to if they imported from other countries.

On the other hand, the huge volume of foreign exchange reserves from China is used to pay off the US fiscal deficit.

Therefore, the US trade deficit with China does not in the least hurt the interests of the United States.

Historical Experience

Historical experience suggests that it is hard to change the current Sino-US trade situation merely through adjusting exchange rates.

It is known that since the 1970s, the United States has forced Japan to revaluate the yen based on the significant trade surplus of Japan with the United States.

However, in fact, with the appreciation of the yen, the trade imbalance between Japan and the United States continued to expand rather than diminish.

Similarly, an appreciation of the renminbi will not change the Sino-US trade situation either.

Second, traditionally, the US Government exercises strict control over exports to China.

And, clearly, lifting the discriminatory restrictions on exports to China is the most effective way to achieve a trade balance between the two countries.

Currently, China is implementing a strategy of "rejuvenating the Chinese economy through technological development" to accelerate the industrialization process and information modernization, which is likely to generate a massive demand for high-tech products from the United States.

And on top of all this, a high level of foreign exchange reserves ensures China's payment capability.

The Association of American Manufacturers recently admitted in its testimony to US Congress that since 1997, the United States has seen its largest increase in trade deficits coming not from China but from the European Union.

In the first quarter of 2003, US exports to China climbed by 37 per cent, exceeding the growth rate of exports to other countries in the same period.

It should be noted that the US economy has shown signs of accelerated improvement since the second quarter. The growth rate of the GDP rose to 3.3 per cent; expansion of both individual income and expenditures accelerated in July and August; corporate profit performance has improved and the stock market has rallied significantly.

All these factors suggest that the US economy is not likely to be affected by the renminbi exchange rate.

As for Japan, the long implementation of an export-orientated development strategy has resulted in a distortion of economic structure.

On the one hand, the export sector is highly efficient and competitive with large trade surpluses and the accumulation of foreign exchange reserves.

On the other hand, however, the domestic sector is trapped in an increasing number of non-performing loans, weak domestic demand and persistent deflation.

An appreciation of the renminbi will not help Japan's structural reform and stimulate its domestic demand; if anything it would contribute to the worsening of Japan's current economic structure.

Furthermore, appreciation of the renminbi would exacerbate Japan's deflation, with China exporting deflation to Japan - at least, some Japanese officials see things that way.

In the same vein, a revaluation of the renminbi is unlikely to defuse deflationary pressures in other economies. On the contrary, it would strengthen their dependence on exports, particularly on the US economy, leading to a slowdown or a deviation from the right direction of their economic structural adjustment.

Goldman Sachs Paper

According to a research paper by Goldman Sachs, a 10 per cent revaluation of the renminbi would only increase exports in emerging Asian industrialized economies by 1.6 per cent, their GDP by 0.4 per cent, ASEAN (Association of Southeast Asian Nations) GDP by 0.2 per cent, and Japan's GDP by less than 0.1 per cent.

And such a move is also unlikely to have any positive effect on the economies of the United States and Europe.

In light of the prevailing clamour for an appreciation of the renminbi, Stephen Roach, chief economist of Morgan Stanley, wrote: "I fear there's a deeper meaning to the pressures now being put on China: Unwilling to accept responsibility for their own shortcomings, the wealthy economies of the industrial world are making China a scapegoat for their weak recoveries."

The World Bank pointed out in a report published at the beginning of this year that China's economic rise would bring opportunity to world development and become a driving force for global economic and trade growth, much like the United States and Japan used to be.

The Economist, a conservative magazine in Britain, also published an article, saying that China's economic success means more of an opportunity than a threat to the world.

First, China's steady economic development constitutes a persistent stimulant for the growth of world trade.

In 2002, China accounted for 29 per cent of world trade growth.

A change destined to take place in the future is that China will become not only a big production base but also a vast consumption market, which means China will have a strong demand for foreign capital goods and consumer products, and will import large quantities of foreign goods at a faster speed, while exporting its cheap but high-quality products to overseas markets.

In the second half of this year, China's imports grew by 44.5 per cent over those for the same period of 2002, while exports were up 34 per cent, with the former being 10.5 percentage points higher than the latter.

These figures show that it is groundless to accuse China of controlling the exchange rate to boost exports.

A study by the Asian Development Bank concluded that China's growth has provided an unprecedented opportunity for East Asia and that China will become the largest export destination for the region by 2005.

Second, China constitutes a huge market for multinational capital investment.

By the end of June this year, 443,073 foreign-funded enterprises had been approved to be set up in China, with contractual value of foreign direct investment reaching US$879 billion and a realized foreign direct investment totalling US$478.2 billion.

Between 1994 and 2002, the share of foreign capital in China's fixed asset investment declined from 17.1 to 10.1 per cent, but the proportion of industrial production value created by foreign funded enterprises in the total jumped from 11.26 per cent to 33.4 per cent, and the share taken by foreign funded enterprises in total exports soared from 28.7 per cent to 52.2 per cent and further to 54 per cent in the first half of this year.

Between 1995 and 2002, foreign investors altogether repatriated about US$156 billion in investment returns from China.

In a word, most foreign investors have capitalized on China's rapid economic development.

For example, China's information technology market continues to grow at a two-digit pace while the global information technology industry is experiencing an overall downturn.

In the meantime, China has quickened its steps to "go abroad," guiding and encouraging the more competitive domestic enterprises to invest overseas and conduct a variety of economic and technological co-operative ventures with their foreign counterparts, based on the principle of mutual benefit.

At the end of 2002, there were 6,960 overseas Chinese enterprises, with investment value amounting to nearly US$10 billion.

Chinese enterprises' expansion abroad not only carves out space for their own development, but also benefits the local economies of foreign countries by creating more jobs and tax revenues.

(The author is a senior expert with the International Department of the People's Bank of China)

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