China’s exchange rate policy

1. China’s exchange rate policy Pierre Jacquet French Development Agency (AFD) Panel discussion organized by Citigroup Dubai, September 21, 2003

2. Outline • Context of the debate • Is the yuan undervalued ? • Short term and longer term prospects

5. Context of the debate • Combination of China ’s WTO accession and of an impressive economic dynamism and export growth : China is feard as a disruptive competitor worldwide and in Asia. • Increasing concern, notably in the United States, but also echoed in Europe, about a surge in imports from China and about the reluctance of the Chinese authorities to let the yuan appreciate • Pressures from the manufacturing sector in the US especially, but also in Japan and Europe.

6. Local currency price (2) USD price (3) USD PPP (4) Actual exchange rate (5) Over (+) or under (-) evaluation (%) United States $ 2.71 2.71 UK £ 1.99 3.14 1.36* 1.58 + 16 Eurozone € 2.71 2.97 1.00* 1.10 + 10 Argentina Peso 4.10 1.43 1.51 2.88 - 47 Poland Zl 6.3 1.62 2.32 3.89 - 40 Thailand Baht 59.0 1.38 21.8 42.7 - 49 China Yuan 9.9 1.20 3.65 8.28 - 56 Japan Yen 262 2.19 96.7 120 - 19 Big Mac PPP (Source : The Economist, 24/04/2003) Nota : except for the £ et the euro (€) whose exchange rate represents their value in dollars (indicated by a star *), column 5 gives the dollar value of the local currency. Column 3 results from dividing (2) by (5). Column 4 (dollar PPP) results from dividing (2) (local curreny price of the Big Mac) by 2,54 (US price of the Big Mac) (except for the UK and the euro zone, where the reverse ratio is taken). Source : http://www.economist.com

12. Summary : Is the Yuan overvalued ? • The reasoning based on trade is misleading, hypocritical, and too short-term : in the long term, a growing, liberalizing China will absorb a fast increasing volume of imports, and is therefore more an opportunity than a threat, especially on a regional basis. Besides, Chinese current account surplus has declined, not increased, recently. • Purchasing power parity calculations suggest significant undervaluation : 3,7 Yuan per dollar instead of 8,3. But it is hard to find what the equilibrium exchange rate is in a fast reforming economy • Strong reserve accumulation also suggest a real exchange rate undervaluation (on the basis of the FEER) : If large FDI inflows are considered as « structural » (given the investment needs in a booming, reforming emergent country), then the FEER of the yuan would sustain a current account deficit instead of a surplus.

14. Reasons for not moving now • No fundamental domestic disequilibrium linked to exchange rate undervaluation; in particular, no inflation • Reserve accumulation provides a cushion against future risks and has been sterilized, with little impact on domestic monetary policy • Growth is high, but has slowed down, and high growth is necessary. A cyclical argument does not point toward appreciation of the yuan. Unemployment has been increasing recently. • Poor banking system, huge need for reform, with severe displacement of workers : real undervaluation can help domestic reform. • Companies and financial markets are not in a position to manage exchange rate risk. Financial reform and the development of market based risk instrument is a prerequisite for more exchange rate flexibility.

15. Prospects ahead • Economic reasons to move overtime • Large country, need to rely on autonomous macroeconomic (monetary) policy • Gradually, and only gradually, need to reform and liberalize capital markets, which will necessitate some exchange rate flexibility • Political reasons to move shortly : trade disputes, multilateral framework • Political economy reasons to move over time : China should aim at appearing as a benevolent regional leader. As we know well from recent history, the exchange rate of a big power is a problem for the others.