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Thursday March 17, 2005 - 14:27:38 GMT

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Time for yuan policy change

Underlying pressure for a yuan revaluation will persist over the next few months. The Chinese authorities still need to avoid a free float and a realistic compromise would be for a switch to a trade-weighted basket with a gradual widening of the yuan trading band.

There will be a strong temptation to avoid change given the potential capital-account volatility and perceived benefits of inertia, but there are growing domestic and regional risks from the build up of reserves and intervention to prevent regional currency gains.

Further delays would risk more serious regional inflationary pressure, the need for an aggressive monetary tightening and, eventually, an Asian recession. Overall, the dangers of delay now look greater than the risks of measured changes.

Chinese pressures continue

The flurry of remarks from Chinese central bank officials suggest that the authorities are moving closer to a yuan policy shift. So far, however, there is still resistance to a shift away from the effective currency peg and the overall impression given is that they would prefer not to alter the peg.

The latest balance of payments figures reported that China had a capital account surplus of over US$111bn in 2004 with a current account surplus of US$70bn. China, therefore, bought close to US$200bn during 2004 to stem upward pressure on the yuan. It will be increasingly difficult to mange these inflows and avoid a further destabilisation of the financial sector and domestic economy.

The Chinese authorities are aiming to alleviate capital account pressures by offering greater freedom to the capital account and promoting outflows. Insurance companies, for example, will be able to invest overseas There will be measures to boost overseas direct investment and a limited issue of yuan-denominated bonds will also be permitted. China will still find it difficult to curb capital inflows.

It will also be increasingly untenable to maintain a fixed yuan peg at the same time as allowing increased capital account freedom.

The strong investment inflows will also pose significant inflation risks. The evidence so far suggests that the pressures are manageable with headline consumer inflation below 4.0%, but there will be an increasing risk of hidden inflationary pressure. Investment levels also remain strong and there will be further pressure for an increase in interest rates. Higher rates would increase the risk of speculative inflows, although this risk will be offset by rising US interest rates.

Regional pressures liable to intensify

Regional economies remain extremely sensitive to China’s export competitiveness and there is a continuing resistance to significant currency appreciation throughout the region. South Korea, for example, has been intervening again over the past week to stem won gains. Trade surplus are continuing to create excess dollars in Asia and this is forcing central banks to increase dollar reserves.

Allied with strong investment inflows, there will be an increased risk of overheating in local economies. Eventually, this could force a sharp increase in interest rates and risk a regional recession. Although the situation is not critical, it will be increasingly dangerous to maintain an intervention policy. The build up of reserves will also increase the risk of currency-market volatility which could destabilise regional economies.

No sense in currency float

There will still be heavy opposition to a free float and this would certainly not be a sensible policy move in the foreseeable future. The Chinese economy would not be able to manage the financial pressures and economic stability would be a high risk. The authorities are, therefore, left with the possibilities of a new peg at a stronger rate against the dollar, a wider trading band or a switch to a trade-weighted basket. There would also be the potential for combining these policies.

There are clear dangers in a gradualist approach as there could be an increase in speculative inflows on expectations of a further widening and these fears will increase the attractiveness of resisting a policy change.

Yuan could weaken against the dollar

If China delays too long and there is a switch to a trade-weighted basket, there will be the intriguing prospect that the yuan could actually weaken against the dollar. If the Chinese authorities hold off from a revaluation until the dollar has weakened further on a trade-weighted basis, there would be the potential for a stronger US dollar after Chinese reform measures have been announced. Through the mechanism of a trade-weighted basket this would weaken the yuan against the dollar. This would be a particular risk if the Chinese economy started to show greater vulnerabilities. In this context, it would also be advisable for the Chinese authorities to take action sooner rather than later.


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