Buttonwood RESEARCH TOOLS Economist.comsuRveYs Oriental mercantilists Sep 18th 2003 From The Economist print edition Asia's addiction to cheap currencies must end. But not overnight THE average homeowner in Peoria has probably never heard of Toshihiko Fukui, Zhou men, respectively bosses of the central banks of Japan, China, Hong Kong, Taiwan and souts o Xiachuan, Joseph Yam Perng Fai-nan or Park Seung. But he has a lot to thank them for. The Korea, have become the world's most enthusiastic purchasers of American government debt and Fannie's bonds keeps the dollar relatively strong and mortgage rates in Peoria down adie's including that of the mortgage giants, Freddie Mac and Fannie Mae. Their appetite for fre Between them these five Asian central banks hold around $1. 3 trillion in official reserves (or over half of the global total, most of them in dollar assets. Since Piling December 2001, Japans reserves have shot up by 36%, Foreign-exchange reserves*, latest, sbr China's by 65% and Taiwan's by 49%(see chart 10) 0100200300400500600 The Asians passion for American bonds is explained by their desire to stop their currencies appreciating against the dollar. China and Hong Kong fix their currencies against the dollar, in Hong Kong s case through a South Korea currency board. That means a current-account surplus orHong Kong big capital inflows automatically translate into higher Singapo reserves. The other countries ostensibly let their currencies float, but heavy intervention by central banks Source: National statistis Excluding gold, except Singapore has ensured that Japan's yen and South Korea's won have risen by over 13% against the dollar since the beginning of 2002, compared with a 25% increase for the euro another floating currency(see chart 11) For the man from Peoria(and for Americas economy) this has brought a short-term benefit. The dollar's fall over the past 18 months has been smaller and more gradual than it would have been without the Asians ntervention. The trouble is that the asian dollar binge is utting off the inevitable adjustment to Americas current-account deficit America continues to accumulate foreign debt at an ever faster rate so the eventual adjustment will be correspondingly bigger. At the same time a disproportionate share of whatever decline in the dollar does materialise falls on those countries that let heir currencies float, especially the euro
Oriental mercantilists Sep 18th 2003 From The Economist print edition Asia's addiction to cheap currencies must end. But not overnight THE average homeowner in Peoria has probably never heard of Toshihiko Fukui, Zhou Xiachuan, Joseph Yam, Perng Fai-nan or Park Seung. But he has a lot to thank them for. These men, respectively bosses of the central banks of Japan, China, Hong Kong, Taiwan and South Korea, have become the world's most enthusiastic purchasers of American government debt, including that of the mortgage giants, Freddie Mac and Fannie Mae. Their appetite for Freddie's and Fannie's bonds keeps the dollar relatively strong, and mortgage rates in Peoria down. Between them, these five Asian central banks hold around $1.3 trillion in official reserves (or over half of the global total), most of them in dollar assets. Since December 2001, Japan's reserves have shot up by 36%, China's by 65% and Taiwan's by 49% (see chart 10). The Asians' passion for American bonds is explained by their desire to stop their currencies appreciating against the dollar. China and Hong Kong fix their currencies against the dollar, in Hong Kong's case through a currency board. That means a current-account surplus or big capital inflows automatically translate into higher reserves. The other countries ostensibly let their currencies float, but heavy intervention by central banks has ensured that Japan's yen and South Korea's won have risen by over 13% against the dollar since the beginning of 2002, compared with a 25% increase for the euro, another floating currency (see chart 11). For the man from Peoria (and for America's economy), this has brought a short-term benefit. The dollar's fall over the past 18 months has been smaller and more gradual than it would have been without the Asians' intervention. The trouble is that the Asian dollar binge is putting off the inevitable adjustment to America's current-account deficit. America continues to accumulate foreign debt at an ever faster rate, so the eventual adjustment will be correspondingly bigger. At the same time a disproportionate share of whatever decline in the dollar does materialise falls on those countries that let their currencies float, especially the euro
Crying foul Holding steady Exchange rates against the dollar January 1st 2002-100 Small wonder, therefore, that complaints about the Asians behaviour are getting louder. When Europe's finance ministers met their Asian counterparts at a 三w。三 summit in Bali in July, they made a fuss about those weak currencies. America's Treasury secretary, John Snow, went to China earlier this month specifically to lobby for a change in the exchange-rate regime. And tensions are rising within Asia itself. The Japanese ar unhappy about the undervaluation of China's currency, and the south Korean government recently suggested that China should allow the yuan to appreciate. broadly speaking those complaints are justified. Asia's J FMAMJJASONDJEMAMJJAS currencies must play a part if the world is to stop relying 2002 2003 on the single American engine. But too many of Asia's Source: Thomson Datastream critics oversimplify both the dilemma facing the world economy and the difficulties facing individual Asian countries In the short term, Asia's central banks are right to claim that they are supporting the world economy not undermining it. Were Mr Fukui and his friends to give up on American bonds overnight, the dollar would plummet and bond prices would soar. To help the world economy. the adjustment needs to be gradual-a point that is often lost on the shrillest foreign critics Second, Europeans, especially, tend to exaggerate how much they are suffering. True, the euro has borne a disproportionate share of the dollar's adjustment so far, but without the Asians interventions the fall in the dollar would have been steeper, so in the short term the europeans may not be much worse off. The point is not that the Asians are harming the Europeans in particular, but that they are preventing the adjustment of America's imbalances, making the long-term problem worse hird, although Asia's central banks are all doing the same thing(buying dollars), their economies are by no means all in the same boat. This suggests that no single solution will suit everyone Too much of a good thing Rising foreign-exchange reserves are not necessarily a bad thing Countries need reserves to guard against sudden shocks; say a big drop in exports or an unexpected drying-up of foreign lending. As economies grow, so the level of reserves tends to rise. In general, more open economies need more reserves than those where foreign trade is less important and those with a fixed currency, such as China, need more reserves than those with a floating one Reserves are particularly important for emerging economies. As these countries open up to foreign capital, they need relatively more res hat was one painful lesson of the 1997-98 Asian financial crises, when several emerging economies turned out to have insufficient reserves given their level of short-term foreign debt
Crying foul Small wonder, therefore, that complaints about the Asians' behaviour are getting louder. When Europe's finance ministers met their Asian counterparts at a summit in Bali in July, they made a fuss about those weak currencies. America's Treasury secretary, John Snow, went to China earlier this month specifically to lobby for a change in the exchange-rate regime. And tensions are rising within Asia itself. The Japanese are unhappy about the undervaluation of China's currency, and the South Korean government recently suggested that China should allow the yuan to appreciate. Broadly speaking, those complaints are justified. Asia's currencies must play a part if the world is to stop relying on the single American engine. But too many of Asia's critics oversimplify both the dilemma facing the world economy and the difficulties facing individual Asian countries. In the short term, Asia's central banks are right to claim that they are supporting the world economy, not undermining it. Were Mr Fukui and his friends to give up on American bonds overnight, the dollar would plummet and bond prices would soar. To help the world economy, the adjustment needs to be gradual—a point that is often lost on the shrillest foreign critics. Second, Europeans, especially, tend to exaggerate how much they are suffering. True, the euro has borne a disproportionate share of the dollar's adjustment so far, but without the Asians' interventions the fall in the dollar would have been steeper, so in the short term the Europeans may not be much worse off. The point is not that the Asians are harming the Europeans in particular, but that they are preventing the adjustment of America's imbalances, making the long-term problem worse. Third, although Asia's central banks are all doing the same thing (buying dollars), their economies are by no means all in the same boat. This suggests that no single solution will suit everyone. Too much of a good thing Rising foreign-exchange reserves are not necessarily a bad thing. Countries need reserves to guard against sudden shocks; say, a big drop in exports or an unexpected drying-up of foreign lending. As economies grow, so the level of reserves tends to rise. In general, more open economies need more reserves than those where foreign trade is less important; and those with a fixed currency, such as China, need more reserves than those with a floating one. Reserves are particularly important for emerging economies. As these countries open up to foreign capital, they need relatively more reserves. That was one painful lesson of the 1997-98 Asian financial crises, when several emerging Asian economies turned out to have insufficient reserves given their level of short-term foreign debt
After these crises Asia's emerging markets rapidly built up their arsenal of foreign exchange According to an analysis in the IMF's latest World Economic Outlook, this build-up was justified by economic fundamentals until about 2001. since early 2002, however, reserves have rocketed and are now unnecessarily high The suspicion, therefore, is that Messrs Fukui, Zhou, Fai-nan and company have been buying dollars for nefarious reasons: to keep their exports artificially cheap and hold on to their traditional export-led growth. Exports now make up 64% of the region s gDP, up from 55% in the early 1990s. Asians seem to like it that way. Yusuke Horiguchi, chief economist of the Institute of International Finance and former top Asia expert at the IMf, talks of a deeply rooted mercantilist instinct in Asia with an almost religious attachment to trade and current account surpluses But this passion for trade surpluses is not without its problems Not only does it prevent Asians from playing their part in rebalancing demand away from America, it also contravenes the rules of world trade. The charter of the IMF prohibits a country from manipulating its currency to gain an unfair competitive advantage"over its trading partners The definition of manipulation includes protracted large-scale intervention in one direction in the exchange markets. That sounds suspiciously like what the Asians have been doing Unfortunately there is no simple answer, because all the countries' problems are different. Japan is by far the region's biggest economy. Unlike the others, it is a rich industrial country which has been running a current-account surplus since 1981. It already has the largest dollar reserves in the world and is accumulating more at a rapid clip all this suggests that Japan should take the biggest share of any dollar adjustment in Asia. Yet, as the previous section explained the country suffers from chronic deflation. A sharp appreciation in its currency right now could undermine any hope of boosting growth in the short term. On balance, therefore, most analysts have concluded that a boost to Japanese demand will be more helpful to the world economy than a stronger yen on economic grounds that is the right choice, but politically it will make it harder to persuade other Asian countries to let their currencies appreciate Collectively the other dollar-buyers in Asia pack an even bigger economic punch than Japan 20% of world trade, compared with Japans 5%. Their combined current-account surplus in China, South Korea, Taiwan and the region 's other emerging economies together account 2002 was $133 billion, larger than Japan' s($113 billion or the euro zone ' s($72 billion ). That is why they must play a big part in any global economic adjustment China, in particular, is crucial. Leaving aside Japan, it is the region's giant, with by far the fastest-growing economy and the biggest stash of reserves. Most Asian countries are terrified that China will beat them on every product, so no country will allow its exchange rate to rise unless china 's does too China's currency, the yuan, has been fixed at 8.3 to the dollar since 1994. In the late 1990s Chinas fixed currency won it many plaudits. as other currencies in Asia succumbed to financia crises, the yuan remained stable(appreciating sharply against the rest of Asia ). China was credited with preventing a round of dangerous competitive devaluations Now, however, China's attachment to its fixed rate generates hostility. After years of fast growth and huge inflows of foreign investment, claim the critics, the yuan should be stronger
After these crises, Asia's emerging markets rapidly built up their arsenal of foreign exchange. According to an analysis in the IMF's latest World Economic Outlook, this build-up was justified by economic fundamentals until about 2001. Since early 2002, however, reserves have rocketed and are now unnecessarily high. The suspicion, therefore, is that Messrs Fukui, Zhou, Fai-nan and company have been buying dollars for nefarious reasons: to keep their exports artificially cheap and hold on to their traditional export-led growth. Exports now make up 64% of the region's GDP, up from 55% in the early 1990s. Asians seem to like it that way. Yusuke Horiguchi, chief economist of the Institute of International Finance and former top Asia expert at the IMF, talks of a “deeply rooted mercantilist instinct” in Asia “with an almost religious attachment to trade and currentaccount surpluses”. But this passion for trade surpluses is not without its problems. Not only does it prevent Asians from playing their part in rebalancing demand away from America, it also contravenes the rules of world trade. The charter of the IMF prohibits a country from manipulating its currency to “gain an unfair competitive advantage” over its trading partners. The definition of manipulation includes protracted large-scale intervention in one direction in the exchange markets. That sounds suspiciously like what the Asians have been doing. Unfortunately there is no simple answer, because all the countries' problems are different. Japan is by far the region's biggest economy. Unlike the others, it is a rich industrial country which has been running a current-account surplus since 1981. It already has the largest dollar reserves in the world, and is accumulating more at a rapid clip. All this suggests that Japan should take the biggest share of any dollar adjustment in Asia. Yet, as the previous section explained, the country suffers from chronic deflation. A sharp appreciation in its currency right now could undermine any hope of boosting growth in the short term. On balance, therefore, most analysts have concluded that a boost to Japanese demand will be more helpful to the world economy than a stronger yen. On economic grounds that is the right choice, but politically it will make it harder to persuade other Asian countries to let their currencies appreciate. Collectively, the other dollar-buyers in Asia pack an even bigger economic punch than Japan. China, South Korea, Taiwan and the region's other emerging economies together account for 20% of world trade, compared with Japan's 5%. Their combined current-account surplus in 2002 was $133 billion, larger than Japan's ($113 billion) or the euro zone's ($72 billion). That is why they must play a big part in any global economic adjustment. China, in particular, is crucial. Leaving aside Japan, it is the region's giant, with by far the fastest-growing economy and the biggest stash of reserves. Most Asian countries are terrified that China will beat them on every product, so no country will allow its exchange rate to rise unless China's does too. China's currency, the yuan, has been fixed at 8.3 to the dollar since 1994. In the late 1990s China's fixed currency won it many plaudits. As other currencies in Asia succumbed to financial crises, the yuan remained stable (appreciating sharply against the rest of Asia). China was credited with preventing a round of dangerous competitive devaluations. Now, however, China's attachment to its fixed rate generates hostility. After years of fast growth and huge inflows of foreign investment, claim the critics, the yuan should be stronger
Instead, as the dollar has fallen over the past 18 months, the Chinese currency in effect, has fallen with it. Clearly, they say the yuan is undervalued In evidence, they point out that according to economic theory exchange rates in countries with rapid productivity growth should be appreciating. China's economy has been growing much faster than the rest of the world and its current account has been in surplus since 1994. For a fast-growing emerging economy with high levels of investment, a current-account deficit would be more normal. Moreover, capital is pouring into China. Last year it was the world's largest recipient of foreign direct investment with inflows totalling $53 billion. Like trade surpluses large capital inflows should push up the currency. Lastly, the huge and accelerating build-up of reserves suggests that, left to its own devices, the yuan would appreciate Estimates of the degree of undervaluation differ wildly. According to The Economist's informal Preeg, an economist at America's Manufacturers Alliance argues that if normal market force at applied, the yuan would rise by 40%. a recent study by UBS, a bank, put the figure aroung oo measure of currencies, the Big Mac index the yuan is undervalued by a whopping 56%. Erne 20%. Others reckon it might be only 10-15% he problem is that traditional gauges of undervaluation do not work well in an economy with tight capital controls and in the midst of colossal structural changes. Nobody can be sure that China's currency really is grossly undervalued. And if it is, it may not remain so for long For a start, the scale of China s current-account surplus is frequently exaggerated. Many Americans think it has a Up from behind huge overall surplus when in fact it has a large and rising bilateral trade surplus with America, which is now Trade surplus with America, sbn bigger than Japan's bilateral surplus(see chart 12) China s overall current-account surplus, on the othe hand, is much smaller than Japan 's, and is shrinking fast. In the first few months of 2003, China's trade Japan balance was actually in deficit This may reflect temporary factors: higher oil prices in advance of the iraq war, and a one-off surge in imports delayed to take advantage of tariff cuts introduced on January 1st. But it may also reflect a longer-term trend towards higher imports of capital and consumer goods 1986889092949698200002 China's imports have been growing at an annual rate of Source: US Bureau of Economic Analysis over 40%a year recently, even faster than its exports (30% plus). Many of those imports are inputs for exports, but not all. According to Nicholas Lardy, a China expert at the institute for International Economics, there are signs that imports are being fuelled by rising domestic demand. Car imports, for instance are up more than 60% on last year. The big tariff cuts associated with China's entry into the Wto may push up import growth even further. If Mr Lardy is right, and China's imports are set to grow rapidly even at the current exchange rate the case for a large appreciation looks weaker. Evidence from the capital account must also be treated with caution. Yes, China has recently been the worlds biggest recipient of direct investment, but according to Mr Lardy, many capital inflows have been speculative and might easily reverse themselves. Chinese companies expecting a revaluation of the yuan, are bringing home money that they had illegally stashed abroad. Mr Lardy reckons that these"unrecorded inflows"make up a big share of the recent
Instead, as the dollar has fallen over the past 18 months, the Chinese currency, in effect, has fallen with it. Clearly, they say, the yuan is undervalued. In evidence, they point out that, according to economic theory, exchange rates in countries with rapid productivity growth should be appreciating. China's economy has been growing much faster than the rest of the world, and its current account has been in surplus since 1994. For a fast-growing emerging economy with high levels of investment, a current-account deficit would be more normal. Moreover, capital is pouring into China. Last year it was the world's largest recipient of foreign direct investment, with inflows totalling $53 billion. Like trade surpluses, large capital inflows should push up the currency. Lastly, the huge and accelerating build-up of reserves suggests that, left to its own devices, the yuan would appreciate. Estimates of the degree of undervaluation differ wildly. According to The Economist's informal measure of currencies, the Big Mac index, the yuan is undervalued by a whopping 56%. Ernest Preeg, an economist at America's Manufacturers Alliance, argues that if normal market forces applied, the yuan would rise by 40%. A recent study by UBS, a bank, put the figure around 20%. Others reckon it might be only 10-15%. The problem is that traditional gauges of undervaluation do not work well in an economy with tight capital controls and in the midst of colossal structural changes. Nobody can be sure that China's currency really is grossly undervalued. And if it is, it may not remain so for long. For a start, the scale of China's current-account surplus is frequently exaggerated. Many Americans think it has a huge overall surplus when in fact it has a large, and rising, bilateral trade surplus with America, which is now bigger than Japan's bilateral surplus (see chart 12). China's overall current-account surplus, on the other hand, is much smaller than Japan's, and is shrinking fast. In the first few months of 2003, China's trade balance was actually in deficit. This may reflect temporary factors: higher oil prices in advance of the Iraq war, and a one-off surge in imports delayed to take advantage of tariff cuts introduced on January 1st. But it may also reflect a longer-term trend towards higher imports of capital and consumer goods. China's imports have been growing at an annual rate of over 40% a year recently, even faster than its exports (30% plus). Many of those imports are inputs for exports, but not all. According to Nicholas Lardy, a China expert at the Institute for International Economics, there are signs that imports are being fuelled by rising domestic demand. Car imports, for instance, are up more than 60% on last year. The big tariff cuts associated with China's entry into the WTO may push up import growth even further. If Mr Lardy is right, and China's imports are set to grow rapidly even at the current exchange rate, the case for a large appreciation looks weaker. Evidence from the capital account must also be treated with caution. Yes, China has recently been the world's biggest recipient of direct investment, but according to Mr Lardy, many capital inflows have been speculative, and might easily reverse themselves. Chinese companies, expecting a revaluation of the yuan, are bringing home money that they had illegally stashed abroad. Mr Lardy reckons that these “unrecorded inflows” make up a big share of the recent
rise in reserves. Those who call upon China to revalue also point to its highly controlled capital account and its distorted financial markets. a good dose of deregulation, they say, would break China's mercantilist plot. But they may be overstating their case. One result of China's capital controls is that its citizens and firms cannot legally keep their money abroad but must entrust it to the country's troubled banking system. According to many China watchers, this means there is a huge pent-up demand for foreign assets Andy Xie, an economist at Morgan Stanley, points out that Hong Kong residents hold an average of $30, 000 each in foreign currency, whereas in mainland China the figure is a mere $100. If Chinese residents could hold more dollars, he argues, they would Mr Lardy says that the distribution of deposits in Chinese banks is highly skewed. A small number of rich people account for a huge share of total deposits. These richer, more sophisticated Chinese he argues, would quickly shift to dollars if they could, so that whenever China gets round to loosening its capital controls, it could see big capital outflows. The yuan might even fall, not rise In short, it is hard to determine whether the yuan is undervalued today. It is even harder to determine how far and in what direction it should move in future as china becomes more integrated into the world economy. There is a much clearer argument for making Chinas currency more flexible. A flexible exchange rate would allow the yuan to move as capital and trade conditions shifted and would give the government the monetary autonomy to deal with economic shocks And indeed, China says it is gradually moving towards a more flexible exchange-rate regime. But there are few signs that this is really happening. The government is deeply worried about the instability that might result. For some years it has derived its legitimacy such as it is, from the country's continuing economic boom. It fears that meddling with the currency could raise unemployment aggravate deflationary pressures and cause a meltdown in the banking system Many of these fears are overblown, especially those about deflation True, prices in China until recently were falling slightly but much of that has to do with huge productivity improvements and excess capacity in state-owned firms, not with overall economic stagnation. It is hard to see how an economy growing at more than 7% a year can face a Japan-style deflation problem The price of stability ed currency may bring stability but at a price-to China as well as to the world Part of that price is the returns forgone when the chinese authorities pile up mountains of reserves: they are holding low-yielding American government debt rather than investing the money more profitably at home. There is also the risk of financial distortion. As Alan Greenspan recently pointed out, Chinas accumulation of reserves will eventually distort its monetary system. As the central bank builds up reserves by buying dollars, it must pay out yuan. Either which could overheat the economy and cause financial bubbles. Domestic credit has already this growth in the money supply is sterilised -which means selling domestic bonds to mop ul the excess liquidity, an increasingly expensive process-or domestic liquidity will rise rapic been soaring(relative to GDP, it was up 38% in the first half of 2003), leading to isolated property bubbles and a string of financial scandals. The longer this continues, the higher the risk of large-scale financial bubbles
rise in reserves. Those who call upon China to revalue also point to its highly controlled capital account and its distorted financial markets. A good dose of deregulation, they say, would break China's mercantilist plot. But they may be overstating their case. One result of China's capital controls is that its citizens and firms cannot legally keep their money abroad, but must entrust it to the country's troubled banking system. According to many China watchers, this means there is a huge pent-up demand for foreign assets. Andy Xie, an economist at Morgan Stanley, points out that Hong Kong residents hold an average of $30,000 each in foreign currency, whereas in mainland China the figure is a mere $100. If Chinese residents could hold more dollars, he argues, they would. Mr Lardy says that the distribution of deposits in Chinese banks is highly skewed. A small number of rich people account for a huge share of total deposits. These richer, more sophisticated Chinese, he argues, would quickly shift to dollars if they could, so that whenever China gets round to loosening its capital controls, it could see big capital outflows. The yuan might even fall, not rise. In short, it is hard to determine whether the yuan is undervalued today. It is even harder to determine how far, and in what direction, it should move in future as China becomes more integrated into the world economy. There is a much clearer argument for making China's currency more flexible. A flexible exchange rate would allow the yuan to move as capital and trade conditions shifted, and would give the government the monetary autonomy to deal with economic shocks. And indeed, China says it is gradually moving towards a more flexible exchange-rate regime. But there are few signs that this is really happening. The government is deeply worried about the instability that might result. For some years it has derived its legitimacy, such as it is, from the country's continuing economic boom. It fears that meddling with the currency could raise unemployment, aggravate deflationary pressures and cause a meltdown in the banking system. Many of these fears are overblown, especially those about deflation. True, prices in China until recently were falling slightly, but much of that has to do with huge productivity improvements and excess capacity in state-owned firms, not with overall economic stagnation. It is hard to see how an economy growing at more than 7% a year can face a Japan-style deflation problem. The price of stability A fixed currency may bring stability, but at a price—to China as well as to the world economy. Part of that price is the returns forgone when the Chinese authorities pile up mountains of reserves: they are holding low-yielding American government debt rather than investing the money more profitably at home. There is also the risk of financial distortion. As Alan Greenspan recently pointed out, China's accumulation of reserves will eventually distort its monetary system. As the central bank builds up reserves by buying dollars, it must pay out yuan. Either this growth in the money supply is sterilised—which means selling domestic bonds to mop up the excess liquidity, an increasingly expensive process—or domestic liquidity will rise rapidly, which could overheat the economy and cause financial bubbles. Domestic credit has already been soaring (relative to GDP, it was up 38% in the first half of 2003), leading to isolated property bubbles and a string of financial scandals. The longer this continues, the higher the risk of large-scale financial bubbles
To avoid this, China's government has been trying to reduce pressure from the reserve build should be accompanied by a move towards greater flexibility of the currencysrsiein ogo up, but without touching the yuan. It has slightly relaxed restrictions on residents' purchases of foreign currency: allowed firms to keep a bigger share of their foreign-exchange earnings; and announced plans to allow some Chinese firms to buy foreign bonds and stocks from later this year. These tentative steps towards a more open financial system are worth taking. But they This need not mean an immediate floating of the yuan the currency could float freely only if capital controls were substantially lifted. Given the parlous state of China's banks, such a big bang would be far too risky a main lesson of the asian crisis, after all, was that financia opening needs to be handled carefully Nor does re-pegging the yuan at a higher fixed rate seem a sensible option For a start, nobod really knows how much the yuan should rise if at all. Besides, a new peg would do nothing to prepare the exchange-rate regime for dealing with future economic shocks The best thing China can do-both for its own economy and to help global economic adjustment-is to tie the yuan to a broader basket of currencies, including the euro, and widen he band within which it can move. Increasing the wiggle room would allow the yuan to appreciate, making the global adjustment a bit easier. And by broadening the basket currencies, China would ensure that it did not simply follow the dollar when, as this survey predicts, the greenback heads down further. Drag the others along If China were to move to a more flexible currency regime, the chances are that other emerging economies in Asia too would let their currencies move within wider margins. These countries do not face the risk of sudden capital flight or financial-sector collapse. Unlike China, they have China is impossible. China is not just perceived as a competitive threat by many Asian out relatively sophisticated financial systems and freer capital flows, which suggests that they ar better placed to cope with stronger currencies. Politically however, any movement witl economies; it is also their biggest export market In sum, the safest outcome in the next couple of years for emerging Asia, as well as for the global economy, is not a huge jump in exchange rates but a gradual strengthening. The world economy will still be relying on Messrs Fukui, Zhou, Yam, Fai-nan and Seung to buy dollar assets, but not quite so many of them. If, on the other hand, China's leadership does nothing about the yuan, protectionist pressures may become irresistible particularly in America. That would be a disastrous outcome for China as much as for everyone else Copyright c 2004 The Economist Newspaper and The Economist Group. All rights reserved
To avoid this, China's government has been trying to reduce pressure from the reserve buildup, but without touching the yuan. It has slightly relaxed restrictions on residents' purchases of foreign currency; allowed firms to keep a bigger share of their foreign-exchange earnings; and announced plans to allow some Chinese firms to buy foreign bonds and stocks from later this year. These tentative steps towards a more open financial system are worth taking. But they should be accompanied by a move towards greater flexibility of the currency system. This need not mean an immediate floating of the yuan. The currency could float freely only if capital controls were substantially lifted. Given the parlous state of China's banks, such a big bang would be far too risky. A main lesson of the Asian crisis, after all, was that financial opening needs to be handled carefully. Nor does re-pegging the yuan at a higher fixed rate seem a sensible option. For a start, nobody really knows how much the yuan should rise, if at all. Besides, a new peg would do nothing to prepare the exchange-rate regime for dealing with future economic shocks. The best thing China can do—both for its own economy, and to help global economic adjustment—is to tie the yuan to a broader basket of currencies, including the euro, and widen the band within which it can move. Increasing the wiggle room would allow the yuan to appreciate, making the global adjustment a bit easier. And by broadening the basket of currencies, China would ensure that it did not simply follow the dollar when, as this survey predicts, the greenback heads down further. Drag the others along If China were to move to a more flexible currency regime, the chances are that other emerging economies in Asia too would let their currencies move within wider margins. These countries do not face the risk of sudden capital flight or financial-sector collapse. Unlike China, they have relatively sophisticated financial systems and freer capital flows, which suggests that they are better placed to cope with stronger currencies. Politically, however, any movement without China is impossible. China is not just perceived as a competitive threat by many Asian economies; it is also their biggest export market. In sum, the safest outcome in the next couple of years for emerging Asia, as well as for the global economy, is not a huge jump in exchange rates, but a gradual strengthening. The world economy will still be relying on Messrs Fukui, Zhou, Yam, Fai-nan and Seung to buy dollar assets, but not quite so many of them. If, on the other hand, China's leadership does nothing about the yuan, protectionist pressures may become irresistible, particularly in America. That would be a disastrous outcome, for China as much as for everyone else. Copyright © 2004 The Economist Newspaper and The Economist Group. All rights reserved
