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Debating the Chinese Yuan Exchange Rate

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The exchange rate of the Chinese yuan continues as a major topic of discussion on economics in the United States. While economists all agree on the need for China to adjust its exchange rate, they differ on what specific measures China should take.

Morris Goldstein, a senior research fellow from the U.S. Institute for International Economics, suggests that a rise in the yuan’s value would be good for China, provided the outflow of capital was controlled. Increasing the yuan’s value would facilitate reform of its banking system, stabilize prices, guard against protective measures on its exports, and promote the sound and sustained development of the overall economy, Goldstein said.

Goldstein and Nicholas Lardy, another expert on China’s economy, suggest that China should start adjusting its exchange rates using a two-phased approach. “The first phase should consist of three parts. First, allow the value of the Chinese yuan to rise immediately; secondly, instead of tying the yuan to the U.S. dollar use a package of currencies; and thirdly, widen the floating range of the Chinese yuan,” Goldstein said.

Based on Goldstein and Lardy’s suggestions, the yuan should rise in value by 20 to 25 percent right away and its fluctuating exchange rate should expand to 5 to 7 percent. In the meantime, capital outflow should be controlled. The second phase of adjusting the exchange rates should start after China has achieved certain banking reforms and is able to ease its control over the outflow of capital. By then, China could adopt a managed floating system.

Eswar Prasad, chief of China Division of International Monetary Fund, offers a different view. Many scholars have attempted to figure out the exact extent of the yuan’s undervaluation using various calculations. However, since China’s economy is undergoing a complicated institutional reform, it’s impossible to find the true number, he concludes. Under such circumstances, IMF believes, it’s not advisable to let the yuan’s value rise at a fixed percentage; rather, the reform should start by fluctuating the range of the yuan’s exchange rate.

Prasad said: “Other factors may appear in the future, such as the liberalization of capital accounts, which may change the pressure the yuan has to bear. So a large revaluation may lead to significant deviation from the true value of the yuan in the future. To avoid that, it would be better to increase the yuan’s flexibility by raising its fluctuating range, as we cannot ascertain the yuan’s shadow rate.”

Prasad said, in the view of the IMF, given China’s weak banking system, it should first increase its currency’s flexibility and further liberalize its capital accounts. But he warned that China must act at once on its exchange rates. He said the IMF had suggested a year and a half ago that China increase the fluctuation of its currency from 3 to 5 percent, a suggestion that was rejected by China. Right now, 3 to 5 percent is far from enough.

He said: “I believe that under the present circumstances, this will cause disastrous consequences, because the market will regard it as inadequate and only the first step in China’s adjustment of its exchange rates. So China should take bolder measures now, since it didn’t act earlier.”

Prasad suggested using a fluctuating range of 10 to 15 percent, and allow the market no higher expectations, so that the yuan would not be under excessive pressure. He also pointed out, it’s generally believed that the yuan is undervalued by at least 25 percent, and if China is able to maintain the current rate, it shouldn’t have any problem widening the fluctuation to 15 percent.

On the other hand, Zhang Liqing, a professor from the College of Finance, at the University of Central Finance and Economics in China, is not in favor of immediately adjusting the yuan’s exchange rate. Zhang, currently a visiting scholar at the U.S. Institute of International Economics, pointed out that China indeed needs to increase the flexibility of its currency rate, but this is not the optimal time to do it.

He said: “An increase in the rate fluctuation range will immediately cause a rise in the currency’s value, thus attracting more speculating capital. Also, widening the fluctuation range would hurt China’s already weak banking system, because at present China’s foreign exchange market has not developed fully and therefore has inadequate risk management.”

Professor Zhang believes that China should rely on macroeconomic measures rather than exchange rate adjustments, such as continuing to cut export subsidies, speed up liberalization of imports, maintain control of capital inflow, and selectively lift regulations on capital outflow.

However, China is under increasing pressure to reform the exchange rate of the yuan. In a message this month to China’s president Hu Jintao, President Bush indicated concern about the exchange rate of the Chinese yuan. Hu reiterated China’s official stance, and reassured Bush that China will steadily change toward a more flexible and market-based rate system.

Meanwhile, members of the U.S. Congress have endorsed 19 bills concerning China’s currency rate. Ernest H. Preeg of the Manufacturers’ Alliance, a U.S. policy research group, said that these bills could be consolidated into one bill that accuses China of manipulating its currency, and resubmitted to Congress for discussion in the next session.

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