Commentary: A flexible yuan matters more than a convertible one
By Andy Mukherjee Bloomberg News Friday, January 28, 2005
Without announcing any time frames, China has vowed to make the yuan flexible and fully convertible. The order in which the authorities keep the two promises will decide how long the wait will be before predictions of a stronger Chinese currency come true.
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"The currency should be gradually moved toward full convertibility," China's central bank chief, Zhou Xiaochuan, said this month. "This year there will be further steps in this aspect, but generally speaking the progress will be steady." In a separate statement, also released this month, People's Bank of China said it would make changes to the exchange rate "actively and steadily."
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Full convertibility means the yuan can be freely exchanged into foreign currencies and vice versa for investments. Flexibility refers to the degree to which the yuan can fluctuate before the central bank intervenes. They are two distinct goals.
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"They don't have to be implemented simultaneously, and neither one implies the other," says a study by the International Monetary Fund researchers Eswar Prasad, Thomas Rumbaugh and Qing Wang. Yet, the Chinese authorities and several observers "have conflated the issue of exchange rate flexibility with that of capital account liberalization," the economists say.
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Policy makers in Beijing seem to be indicating that they want convertibility, which is at least a few years away, to be the basis for flexibility. That is making analysts pessimistic about the likelihood of a big jump in the yuan's exchange rate this year from about 8.3 to the U.S. dollar, a level at which it has been pegged for the past decade.
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At a November meeting of finance ministers and central bank governors from the Group of 20 nations in Berlin, Zhou said that China was "going to reform our exchange-rate regime and to try to set our exchange rate at an equilibrium, and also we are going to gradually reach capital-account convertibility."
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If that looks like an attempt to link two moves that do not need to be bundled together, consider statements by those who are pushing China to change its currency regime. Even they have made confusing demands. Donald Evans, until recently the U.S. commerce secretary, said in June that for China to qualify as a market economy, the yuan "needs to be convertible, not revalued."
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According to Evans, "the lack of free flow of capital leads to an un-level playing field." That view seems to clash with statements by the U.S. Treasury secretary, John Snow. Last month Snow said that the Bush administration was engaged in "tough-minded diplomacy" with China to "achieve the desired result, which is a flexible currency."
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China is much safer opting for flexibility before convertibility. The country's banking system, ridden with bad debt, is still too weak to sustain the removal of super-cheap local deposits that, in the absence of full convertibility, have nowhere else to go.
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Besides, the Asian currency contagion of 1997-8 has clearly demonstrated that a "fixed exchange rate regime with an open capital account provides a fertile ground for crises," the IMF researchers say.
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There is a reason Chinese policy makers frequently mention flexibility and convertibility in the same breath. And that reason is the "impossible trinity" theorem, which postulates that a country cannot pursue an independent monetary policy if it simultaneously keeps its currency pegged and its capital market open to the world.
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The trinity is China's main challenge. As the $1.4 trillion economy, Asia's second biggest after Japan, integrates with the rest of the world, its capital controls are proving to be much less effective than they appear on paper.
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China's foreign-exchange reserves rose by about $207 billion last year. About $96 billion or 46 percent of that increase was because of speculative inflows, according to an estimate by Credit Suisse First Boston.
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Since China obviously wants control over its domestic money supply in order to end what the authorities call "blind investments" in overheated industries like steel, cement and property, it has to adopt a more flexible exchange-rate policy.
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Over the past three years, China has indeed eased its capital controls, making the yuan progressively more convertible. The maximum amount of foreign currency that residents can import without declaration has been raised to $5,000 from $2,000. Local units of multinational firms can now lend money to affiliates in other countries. The state-sponsored social security fund and local insurers can invest a small part of their corpus in overseas assets.
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Yet, unless speculative fervor takes a 180-degree turn, a more liberal capital account could aggravate speculative inflows into China, not reduce them. Meanwhile, economic growth remains unsustainably high. China's gross domestic product expanded 9.5 percent from a year earlier in the fourth quarter of 2004, according to official statistics released this week.
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Currency flexibility should, therefore, be the top priority for policy makers. Convertibility is neither a prerequisite for flexibility, nor a solution to the problem of economic overheating. It'll be good if China has convertibility, but that can wait.
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