Renminbi deserves depreciation
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The plunge in the euro and threat of persistent economic instability has caused the Chinese government to take a more cautious approach to adjusting its exchange rate. But ironically, the collapse of the euro presents a golden opportunity for China to introduce greater exchange rate flexibility.
China should do this now, rather than wait for the crisis to abate. And to the surprise of many, it should begin by depreciating rather than appreciating the value of the renminbi.
Chinese authorities have been reluctant in the past to appreciate the exchange rate in response to global pressure because when markets are convinced that the renminbi will rise even gradually - in value over the foreseeable future the rise will encourage speculative capital inflows. Over the past decade, estimates suggest that perhaps 20-40 percent of the annual capital inflows have been "hot money" pursuing the likelihood that the currency would appreciate either steadily or in measured steps. Such inflows intensify pressure for further appreciation and create negative results that China is already struggling to address.
Damaging consequences include excess liquidity and lower than desired interest rates that help push up investment - notably real estate - to unsustainable levels, and raise the prospect of a major collapse in asset values. Housing prices in Beijing and Shanghai are clearly inflated and demand continues to grow unabated. While unit values have doubled in many cases in the past year, rents are stagnant. Apartments remain empty as owners wait to "flip" their holdings. With these concerns, one-way bets on the exchange rate are not something China should encourage.
There are two problems with China's exchange rate: one, the value of the renminbi and, two, its flexibility. Despite conventional wisdom, it is actually more important to tackle the latter first, rather than fretting about the former. China and the rest of the world have more to gain from Beijing adopting a flexible exchange rate.
The renminbi has been pegged to the US dollar for nearly two years and since November the euro has fallen nearly 20 percent against the renminbi. Given the importance of the European market to China - and east Asia as a whole - the renminbi's sharp appreciation relative to the euro provides China with an opening to begin the process of allowing the renminbi to fluctuate within a wider band. Chinese officials have publicly indicated they would allow this. Initially, the renminbi - to the surprise of many - could depreciate a few percentage points relative to the dollar before going up, due to the temporary turbulence in the eurozone.
China's key objective should be to move to a more flexible exchange rate system that does not have any pre-ordained bias in moving up or down. When China broke the fixed peg to the dollar in 2005, it embarked on a steady but gradual appreciation of the renminbi until August 2008, when the renminbi was repegged to the dollar.
During this period, the unspoken rule was that the rate of appreciation would not exceed 6-7 percent a year. Anything more than 7 percent would encourage excessive capital inflows as investors would be guaranteed an attractive return after allowing for differentials in interest rates between financial centers and the costs of transactions for moving funds across markets. Even with an appreciation of about 20 percent over these three years, capital inflows continued and pressures to appreciate did not fade.
With pressures building over the past two years, market watchers are speculating that the needed adjustment is much larger than a gradual appreciation of 6 to 7 percent. Still, the government remains adamantly against any major or sudden adjustments and reluctant to embark once again on a gradual appreciation in one direction that would not necessarily solve the problem - and, in fact, could make it worse.
The question remains: if the market determined the value of the renminbi, would it be higher or lower in five years? It is widely believed that the currency would appreciate owing to persistent trade surpluses and China's abundant foreign reserves. But, even with the lack of movement in the renminbi's value, China's competitiveness is already eroding as inflation accelerates, pressures for significant increases in real wages mount, and property values continue to rise. Perhaps the most challenging aspect for the government is the pressure on labor markets as reflected in the highly publicized strikes in southern China, which reflect not so much a shortage of labor per se but more the unwillingness of the newer generation of migrants to relocate when equally attractive opportunities nearer to home are now emerging.
It is also worth noting that most Chinese households and companies find it difficult to move funds abroad given existing capital controls. Many have yet to consider the possibility that owning property in another country could be even more attractive. But with growing sophistication in considering investment alternatives and greater flexibility in transferring funds, the Chinese - like all others with significant assets - will diversify their holdings more quickly by shifting capital abroad. Prudently diversifying assets could mean the renminbi will get weaker rather than stronger over time on a "market basis". Its value in the next few years is anyone's guess - the way it should be.
The writer is a senior associate at the Carnegie Endowment for International Peace and former country director for the World Bank in China. The article first appeared in the Financial Times.
