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The appreciation of the yuan: A compromise solution

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In Brief

A compromise solution involving the appreciation of the yuan is possible. But the following basic points must be observed.

It is not possible for China to remove capital controls and expect a large outflow of private capital to offset its trade surplus (making a further buildup of official exchange reserves unnecessary) unless the yuan-dollar rate is expected to remain stable into the indefinite future. Otherwise, private Chinese investors would be loath to acquire dollar assets, as there would be a good chance that they would depreciate in terms of renminbi (yuan).


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Nor is it possible for the Chinese government to simply float the exchange rate after capital controls are removed. The reason for this is that China’s trade (net saving) surplus of about USD300 billion per year is too large and risky for China’s private sector to finance, even if the yuan-dollar rate just fluctuates randomly. Only if foreigners became willing to borrow in RMB (renminbi) from Chinese banks, or to sell RMB denominated bonds in Shanghai, would the currency risk perceived by Chinese financial firms abate sufficiently for the private sector to willingly finance China’s huge trade surplus.

The German experience provides an instructive contrast to China’s situation. German private financial institutions lend more than enough to cover Germany’s trade surplus, which is almost as large as China’s. Because all such lending is denominated in euros (an internationally accepted currency), German banks see no currency risk. Accordingly, the euro can easily float in international markets even though exchange rate fluctuations are substantial.

By contrast, China has a huge currency mismatch – its claims on foreigners are mainly in dollars while the liabilities of domestic financial institutions are in RMB.  This is a major source of the currency risk perceived by Chinese financial firms. And if floating was tried, without any willing private buyers of the huge dollar inflows, the RMB would spiral upward indefinitely.

Until the RMB becomes an internationally accepted currency like the euro, the best interim solution is first to fix the yuan to the dollar – and then loosen capital controls on both inflows and outflows. But a credible fix, say, at 6.5 yuan to the dollar, requires that the US stop bashing China to appreciate. It also requires that the Federal Reserve abandon its zero interest policy. This misguided policy is causing monetary havoc in many parts of the world, including contributing to China’s property bubble, while gumming up interbank markets in the United States itself.

So here we have the makings of a deal. China agrees to a one-off modest appreciation of the RMB while continuing to reduce its net saving surplus (trade) by increasing consumption. The US agrees to the People’s Bank of China stabilising the yuan-dollar rate indefinitely while working on reducing America’s huge net saving (trade) deficit. Both sides agree to stop the (incipient) trade war which has seen them imposing, or threatening to impose, tariffs or other restrictions on the other’s goods.

The rest of the world would breathe a great sigh of relief.

Ronald I. McKinnon is the William D. Eberle Professor of International Economics at
Stanford University.

2 responses to “The appreciation of the yuan: A compromise solution”

  1. Not a bad idea.

    There is an issue that the two sides also need to come to some sort of accommodation, that is, the Chinese official $US reserves and holding of US government bonds.

    I think for the Chinese government to be able to face its increasingly demanding and restless domestic audience, it has to have some way to say o them it has not sold out their interests in those assets.

    That is not an easy job, given that many Chinese are now aware that issue related to the exchange rate and the implications of currency appreciation.

  2. Maybe, a potential solution is for the US and the Chinese governments to sign an agreement that to change the denomination of Chinese official holdings of bonds from current $US alone into a mixed denomination of the two currencies, so there is little impact of the relative movement of the two currencies on the yuan value of those assets.

    This de-coupling between trade issues and assets holdings may make both sides more comfortable and leave them enough flexibility and rooms to make changes to the exchange rate.

    I am, however, not sure how they can handle the official reserves of $US, though. That is an issue that the Chinese central bank has to confront and consider how to handle it.

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