The exchange rate issue has never been a simple one. Instead, it poses complicated political and economic questions. In 2004, the need to alleviate the appreciative pressure on renminbi, or the yuan, remains.

Pressure builds

International pressure still needs to be acknowledged. First, in a US presidential election year, the renminbi exchange rate issue, which has been a "target" for various US political groups, will continue to be so. As the campaigns escalate, the pressure is likely to grow.

Second, although the world's major economic forecasting agencies have made relatively optimistic predictions for world economic growth in 2004, the prospects are still quite uncertain.

The effects of earlier economic bubbles are still being felt, rises in unemployment rates are constraining spending, and deflationary risk is growing.

Certain nations with sluggish economic growth, on the one hand, are likely to exert greater pressure on the renminbi to appreciate. On the other hand, they are likely to take protective measures in their trade with China.

Third, since the latter half of 2002, the US Government has allowed the US dollar to weaken to reduce the trade deficit and stem the continuous decline in inflation rates by pushing up the prices of imports.

As the renminbi is pegged to the US dollar, the dollar's sharp depreciation has caused the yuan to weaken against the euro and the Japanese yen, which has prompted strong complaints from Japan and Europe.

Although the room for the dollar to slide further against other major currencies is limited in 2004, a sharp rebound is also improbable, which means the pressure from Japan and Europe will remain.

Trade trends

In terms of international balance of payments, the pressure will hopefully lessen, as there is no sustained internal momentum for the yuan's appreciation.

Export growth will possibly tumble in 2004. This year's export growth rate is one of highest seen in recent years.

Second, the Chinese Government has decided to cut export rebate rates by an average of 3 percentage points starting in January next year, which will, to some extent, curb export growth in 2004.

Third, the number of anti-dumping cases against Chinese export commodities has risen this year. Chinese exporters are likely to face even tougher trade barriers next year.

Imports will also increase next year. The Chinese economy will keep growing at around 8.5 per cent in 2004, which will draw in more imports. And further cuts in import tariffs and the implementation of trade agreements under China's World Trade Organization commitments will also push up imports.

Our preliminary estimate is that China's trade surplus will decrease to some US$6 billion in 2004 from a projected US$12 billion this year.

Under the capital and financial account, with the world economy recovering further in 2004, capital flows into developed countries will accelerate gradually. Foreign direct investments in China will remain high, but the growth rate is unlikely to rise substantially.

As China gradually opens up its capital market, securities investments by foreign investors will continue in 2004, but are likely to be relatively small.

Therefore, the surplus on the capital and financial account will not rise sharply in 2004. The growth in foreign exchange reserves will slow down.

With slower growth in foreign exchange reserves, the growth in the central bank's purchases of excess dollars will hopefully subside, alleviating the pressure on monetary policy.

With interest rates on renminbi at a historic low, the persistent rapid growth of the economy and money supply, a steady rebound in prices as well as the limited choice of policy tools for the central bank, there is speculation that interest rates will rise. Should that happen, the difference in interest rates between foreign currencies and renminbi will broaden further, which is detrimental to the yuan's stability.

Stability preferred

The stability of the yuan's exchange rate not only supports China's 7-8 per cent annual economic growth, but is a major driver of China's foreign trade, foreign direct investment inflows, settlement of international balance of payment surpluses and rapid rises in foreign exchange reserves.

The fact that the Chinese economy has been growing in a sustained, fast and healthy fashion demonstrates that the exchange rate regime works. It matches the levels of economic development, financial supervision and Chinese firms' risk tolerance capacity, and therefore suits China's economy at present.

China's exchange rate policy is not a source of global deflation, nor is the yuan's appreciation a cure for deflationary pressures.

The reason behind the international industrial shift into China lies in the potential of the vast domestic market and the prospect for rapid economic growth, rather than an undervalued currency.

The reason China's trade surplus with the United States is growing is not because the yuan is undervalued, but because international industries are relocating here. Asian exports to the United States were formerly produced in Japan, South Korea and Taiwan. Now many of them are manufactured on the Chinese mainland before export to the United States, adding to China's surplus with the United States but expanding its deficits with Japan, South Korea and Taiwan at the same time.

China's robust economic growth in recent years has played an important role in supporting the recovery of East Asian and world economies. Should the renminbi firm and slow down China's economic growth, it will not alleviate deflationary pressure in East Asia, and may destabilize the region.

At present, China is still at an early stage of industrialization. Despite sustained rapid economic growth, it lacks products and enterprises with unique selling points, relying mainly on a price advantage thanks to low labour costs.

And then there is the grave problem of unemployment, let alone strong deflationary pressure. Therefore, in terms of China's economic strength, we cannot afford a sharp appreciation of the renminbi.

But maintaining the stability of yuan's exchange rate under upward pressure has its drawbacks. It may encourage excessive exports and utilization of foreign capital. A massive accumulation of US dollar-denominated assets is destabilizing to the domestic foreign currency markets and may prompt inflows of "hot money."

Besides, exchange rate stability adds to the difficulty of controlling domestic supplies of the currency, making it difficult to use interest rate as a monetary instrument.

But, weighing up the pros and cons, we think the renminbi's exchange rate should not appreciate at present, but should remain basically stable.

The author is a senior researcher with the State Information Centre, a think tank under the National Development and Reform Commission

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