Untying The Yuan Would Get China Out Of A Bind

Again and again during a weekend of meetings in Washington on Oct. 1-3, People's Bank of China Deputy Governor Li Ruogu heard the same plea from world financial leaders. For the sake of the global financial system, implored officials from the U.S. Treasury Dept., the International Monetary Fund, European banks, and economic think tanks, China's central bank must loosen its grip on its currency. By keeping the undervalued yuan pegged at 8.28 to the U.S. dollar, China is making it impossible for the U.S. to cut its $600 billion balance-of-payments deficit and is forcing other nations to intervene in their currencies.

But everywhere he went, Li delivered the same message Beijing has given for years: "We are moving toward a more market-based, flexible exchange rate." And when? Don't hold your breath. Given China's shaky financial system and the disasters in Thailand, South Korea, and Russia after they dismantled capital controls, it's not surprising that China isn't about to let foreigners dictate its currency policies.

With each passing month, though, China's argument for maintaining its rigid link to the greenback grows weaker. The biggest reason is the financial pressure building in China's domestic economy. Every month China records a net inflow of some $10 billion from export earnings, foreign investment, and borrowings. As a result, China's foreign reserves have swelled from $212 billion to $471 billion in less than three years. The People's Bank invests most of these dollars in U.S. Treasury bills. But to prevent inflation and keep the peg, the central bank must also "sterilize" the inflows by selling an equal sum of yuan-denominated bonds to local banks. Experts say there's a limit to how much of this paper the central bank can unload without hiking rates.

The dollar peg also makes it hard to cool the overheated economy. The best way would be to raise lending rates, which have stayed at 5.3% for a decade. But the PBOC can't raise rates much higher than U.S. rates. Otherwise, even more dollars would gush in as Chinese companies boosted borrowings of cheaper money from abroad.

Indeed, the IMF worries, the low yuan already is fueling big inflows of hot money. Until 2002, almost all of the balance-of-payments surplus could be accounted for by foreign direct investment (FDI). But last year, FDI equaled just 40% of the surplus. The remainder, economists surmise, is from Chinese companies, foreign-owned factories, and individual investors bringing in dollars now, while Chinese assets are cheap, before the yuan rises. So although Beijing has forced banks to curb lending, overinvestment in everything from office towers to TV factories roars on, thanks in part to speculative funds from abroad. "The administrative controls aren't working, because everyone is finding ways to circumvent the banks," says Joyce Chang, head of emerging-market research at J. P. Morgan Securities Inc.

How does China get out of the jam? Letting the yuan appreciate by a good 15% and then fluctuate within a band would probably cool the speculation and move the currency close to a market rate, figures Nicholas R. Lardy of Washington's Institute for International Economics. Such a sudden jolt is unlikely. But at the least, China should start moving gradually in that direction while its economy remains strong -- and any pain can be absorbed.

By Pete Engardio in New York

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