Yuan focus must shift from dollar
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But many criticisms levelled by international leaders against China's exchange rate policy are unfair and often driven by the economic and political problems plaguing their own countries. One such example is American politicians' tendency to blame China's currency policy for the high unemployment rate in and large current account deficits of their country.
China, however, is a huge country with a huge population and the world's second largest economy. It is thus natural for its policy decisions to evoke strong reactions. So, we cannot rule out the possibility of the US resorting to trade protectionism against China, at least for now. Were this to happen, it would be detrimental to China's economic future. Therefore, it is in China's own economic interest to respond rationally to international criticisms.
China started its managed float exchange rate regime aimed at a basket of currencies in 1994. This has remained the general policy framework despite disruptions during the Asian and global financial crises. Therefore, the critical issue is not the policy regime but the level of exchange rate.
Developments over the past two decades show there exists a wide gap between China's policy preference for gradual change and the international community's expectation of rapid revaluation of the yuan. Thus, striking a compromise between these two factors has become crucial for China's economic future and its future role in the world economy.
There are many ways that China could improve its exchange rate policy. It is important to recognize that rigid exchange rate is no longer compatible with China's large and dynamic economy. A steady revaluation of the yuan is needed by China's own changing economic conditions, and not simply forced upon it by some other country.
For instance, a stronger currency is consistent with China's policy objective of shifting the economy away from exports and investment toward consumption. It would facilitate industries' shift from producing low value-added goods to high value-added products and, therefore, support sustainable economic growth. Although the policy objective should induce two-way exchange rate fluctuations, it seems reasonable to expect an average rise in the yuan of about 5 percent a year against a basket of currencies.
On a more practical level, PBOC should think of de-emphasizing the importance of the bilateral exchange rate against the US dollar. Despite the announcement of the basket regime, PBOC continues to quote the yuan's rate against the greenback as the most important reference. This is misleading, and at times provides excuses for global criticism. It is probably better for PBOC to focus more on an index against a basket of currencies. After all, China's policy objective is to maintain exchange rate stability against a basket of currencies, not the dollar.
Economics textbooks tell us that real exchange rate adjustment can occur either through nominal exchange rate or inflation. China's average consumer price index (CPI) has averaged only 1 percent during the past decade. But it is now entering a new phase of development with steady increase in the costs of labor, land, capital and resources. These imply greater inflation pressure going forward. It might be helpful if the central bank could tolerate a somewhat higher inflation rate in the coming years.
When they were at a development stage similar to what China is in today, Japan (in the 1960s) and South Korea (in the 1980s) experienced close to 6 percent average CPI. Tolerance of a somewhat higher inflation rate in China is not only necessary for overall price adjustment, but also useful for reducing pressure on nominal appreciation.
The author is professor of economics at Peking University's China Center for Economic Research.
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