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Yuan Reform Takes Time

By David Cohen Despite some market expectations to the contrary, China unveiled no dramatic foreign-exchange news in conjunction with President George W. Bush's mid-November visit to Beijing. At a joint press conference, President Hu Jintao reiterated the Chinese commitment to currency reform, but disappointed those who looked for the announcement of further revaluation of the country's currency, the yuan, vs. the U.S. dollar.

Bush has praised the previous move, which led to a 2.1% increase in the Chinese currency's value vs. the greenback, as a good first step. Yet he has repeatedly urged China to allow further appreciation.

DAILY TRADING RANGE. But Beijing, as always, is keeping to its own timetable. The yuan has gained a modest 0.3% vs. the dollar since July, 2005, as China moves at its own pace in permitting more response to market forces. Traders expect gradual appreciation over upcoming quarters, with the one-year forward contract implying approximately 4% appreciation a year out. While that seems a far larger margin, it's hardly as dramatic as the last time an Asian trading partner agreed to let its currency adjust vs. the dollar: the 50%-plus jump in the Japanese yen after the 1985 Plaza Accord.

China in July took the long-awaited step of removing the yuan from its peg to the dollar, in place since 1994, and switching to what it describes as a managed, floating regime, based on supply and demand. The currency is targeted against a basket of currencies (a reference, not necessarily a fixed peg). Also under the new regime, the dollar-yuan rate is allowed to float within a band of 0.3% each trading day, compared to the previous closing rate announced daily by the People's Bank of China (PBoC).

Mind you, 0.3% per business day in itself is not overly limiting, as it would permit cumulative 20% appreciation or depreciation vs. the dollar over the course of a quarter. But some observers had thought Beijing might announce a widening of the daily limit as a symbolic goodwill gesture on the occasion of Bush's visit. In September the Chinese widened the daily trading range for nondollar currencies to 3% from 1.5%.

TOUCHY TOPIC. The PBoC, in its quarterly monetary report this month, reaffirmed its commitment to hold the forex rate stable. It said it would maintain tight control on foreign-exchange inflows because of the large balance of payments surplus but would continue to expand channels for capital to leave the country as part of broader reform efforts.

In the face of a widening current-account surplus and continued strong capital inflows, China's international reserves have risen to $769 billion in September, an increase of $58 billion during the third quarter ($159 billion during the first nine months of the year), suggesting ongoing forex market intervention by Beijing.

China remains under international pressure to move toward greater currency flexibility as a means to correct its bulging trade surplus, which hit $80.4 billion during the first 10 months of 2005. Most dramatic is the bilateral surplus with the U.S., whose total trade deficit widened to a record $66.1 billion in September alone, including a record $20.1 billion gap with China.

That's a touchy topic in Washington these days. U.S. Treasury Secretary John Snow has warned that "serious support" remains in Congress for the Schumer-Graham bill that threatens to impose a 27.5% tariff on Chinese imports unless there's a shift to greater currency flexibility. However, Snow acknowledged, "I don't think they respond very well to threats." Senators Charles Schumer (D-N.Y.) and Lindsey Graham (R-S.C.) announced recently that they would hold off -- perhaps until March -- on calling for a vote on their bill.

"HIGHLY DISTORTIONARY." Despite mounting protectionist pressure, The Wall Street Journal has quoted Administration sources as saying that the Treasury, in its semiannual briefing to Congress, will refrain from accusing China of forex manipulation; originally due in October, the report was delayed until after President Bush's trip and is expected early next week.

The previous Treasury report, released in May, called China's system "highly distortionary" and warned that unless there's a "substantial alteration in policy," it may soon meet the requirements for designation as a manipulator (formal grounds for U.S. tariff imposition).

The Administration reportedly will try to enlist the International Monetary Fund in its campaign to bring more pressure to bear on Beijing to further revalue its currency, though IMF Managing Director Rodrigo Rato said last Friday that his organization has not been asked to initiate a "special consultation" with China over its currency practices.

SMALL CHANGE. After regular consultation with China earlier this year, an IMF staff report dated July 8 urged greater exchange-rate flexibility, stating that it would be in China's best interest. An Aug. 1 supplement welcomed the change in the forex regime, encouraging authorities to fully utilize the leeway afforded by the new arrangement.

The IMF argued that direct effects upon the commercial banking sector should be small, with exposure to currency risk relatively low.

Although exporters may suffer, the net impact on the corporate sector would be balanced because the value of foreign-currency debt would decline, according to the IMF.

LACK OF URGENCY. The report argued that correcting global imbalances is a responsibility of all the major countries, and noted that a Chinese move toward greater flexibility should facilitate movement in the exchange rates in some other Asian currencies, thereby indirectly contributing to the orderly adjustment of imbalances.

The IMF report stressed that conditions are favorable for pursing greater flexibility, given that the Middle Kingdom's economy is currently quite strong. It also argued that the effects on growth and employment of a change in the forex rate were likely to be moderate. The consensus outlook is for annual gross domestic product growth of more than 9% in 2005 and in the 8% to 9% range in 2006.

On the other hand, China's lack of urgency in making further currency moves is bolstered by low inflation. The government is projecting consumer price index growth of around 2% (year-over-year) in 2005 and expects the CPI to remain benign in 2006. This represents moderation from 3.9% in 2004, primarily reflecting a supply-related swing in grain prices. Supply is keeping pace with demand growth, as capacity has been boosted by strong investment.

ECONOMIC BUFFER. Perhaps hinting at things to come, PBoC Governor Zhou Xiaochuan said on Nov. 4 that China's economy is flexible enough to withstand a more freely traded currency. He said that economists at other government departments have overstated the disruptive impact of a stronger yuan, and instead cited import and export elasticity, labor market flexibility, and the growing role of private companies. He argued that the central bank plans to keep interest rates low in order to spur consumer spending, which would help buffer the economy against any loss of export competitiveness.

Zhou's remarks appear consistent with prevailing expectations for gradual appreciation of the yuan. Since Beijing moves at its own measured pace, of course, a dramatic revaluation is not in the cards.

Cohen is director of Asian economic forecasting for Action Economics

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