China's yuan decision: the economic costs of the inflexible exchange rate now outweigh its benefits.

AuthorLo, Chi

A revaluation of the yuan, as some have been pushing for, will not work to correct the global saving-investment imbalance, as I argued in the spring 2007 issue of TIE. A recent Bank of England research paper has added a new angle to this view. However, China has likely come to a point where bolder changes are needed to move the development process forward. This is because the distortions resulting from the current policy approach are likely to worsen, raising welfare costs and generating systemic instability down the road. The yuan policy is a case in point. Signs are emerging that the economic costs of the inflexible exchange rate are outweighing the benefits.

China may risk drawing the wrong lesson from the Asian crisis by fixing its exchange rate for too long and focusing on building up foreign reserves. China was least affected by the regional crisis, thanks to its strict capital controls. And by refusing to devalue at that time, it prevented aggravating financial contagion in Asia.

By the same token, the yuan's crawling peg and the consequent rapid build-up of foreign reserves have led to excessive liquidity growth and created serious economic distortions, notably in the asset markets where asset price inflation has been rampant. These economic imbalances could lead to vulnerabilities like the massive capital inflows, credit boom, excessive investment, and economic bubbles in the run-up to the Asian crisis. All this is not to say that China should change its yuan regime at once, but it does suggest that Beijing should seriously think about an exit strategy for the current yuan policy.

The Chinese authorities have long argued that a stable currency is in the best interest of the country. The argument has evolved into curbing the yuan exchange rate from rising on the back of a massive balance of payments surplus in recent years. However, the Chinese authorities' fears about a sharp yuan revaluation destabilizing the banking system and the economy, leading to capital outflow and depleting the foreign reserves, are becoming outdated. China's foreign reserves are getting too big, and they are creating excess liquidity and causing economic imbalances under the rigid exchange rate policy.

China's banking system is also much stronger today. Years of banking reforms, including recapitalization of the Big Four state commercial banks, bad loans carve-outs to the four asset management companies and, most recently, flotation of the state-owned...

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