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Despite removal of dollar peg, yuan still a currency under control

by Teruhiko Mano

On July 21, the People’s Bank of China announced it had ended the yuan’s effective peg to the U.S. dollar and that it would link it to a basket of currencies based on China’s main trading partners. The central bank also said that the yuan’s exchange rate as of that evening was 8.11 to the dollar.

The following day, newspapers worldwide reported that China had up-valued the yuan by a mere 2 percent. But we must not mistake the significance of this change, which differs from exchange-rate adjustments made by major industrialized nations.

The central bank’s decision to remove the yuan’s dollar peg has only given the currency a narrow range in which to fluctuate from the exchange rate announced by the Chinese monetary authority.

It does not give it the dynamic flexibility to soar up and down with the forces of the market.

One should note that except within China, there is no major foreign-exchange market in the world where the yuan’s exchange rate reflects supply and demand for the currency.

A list of currency rates at a Japanese foreign-exchange banks shows the yuan’s rate as “unquote.” In other words, the only yuan rate in the outside world is the one unilaterally announced by the People’s Bank of China.

Given the rapid expansion in China’s foreign trade and its trade surplus, it is indeed strange that the yuan is not freely traded on the market and that no exchange rates are quoted at banks worldwide. By simply looking at the exchange rate quotations, one may assume the yuan still lacks convertibility.

China’s foreign-exchange control regime is divided into the current account transactions on goods and services, and capital account transactions such as foreign investments.

In December 1996, China liberalized conversion of the yuan for payment and receipt of foreign currencies in current account transactions, on the condition that the required documents are prepared. Nevertheless, the yuan is not freely traded on overseas markets, and no quotations exist for the currency.

This is because the Chinese authorities, fearing a possible loss of control over the value of their own currency, are reluctant to let its exchange rate be established under market forces.

The July 21 announcement mentioned a transition in which the yuan would be linked to a basket of currencies. The main components of the basket were later announced as the dollar, euro, yen and South Korean won. The other components include the Singapore dollar, British pound, Malaysian ringgit, Australian dollar, Russian ruble, Thai baht and the Canadian dollar.

While the central bank did not release the weightings of the currencies, it is already emerging that the yuan’s rate under the new system will continue to be set arbitrarily by Chinese authorities.

Normally, when a country liberalizes current account transactions and starts accepting its obligations under Article VIII of the International Monetary Fund, its currency is traded on overseas markets and the exchange rate is determined by supply and demand.

But that has not been the case with China. In a bid to ease external pressures, China has introduced a new system that appears to add flexibility to its currency regime, but in fact gives the nation the ability to maintain unilateral control over the yuan’s rates.

In this sense, China has not effectively accepted its obligations under IMF Article VIII. It is strange that the IMF has left the matter untouched and that the U.S. — despite its large and well publicized trade deficit with China — isn’t trying to pursue the matter.

Some experts speculate that the United States, competing with Europe for aircraft sales to Chinese airlines, is trying to stay quiet about the yuan’s inability to be traded.

Given such a situation in the current account, one can expect much greater hurdles before China’s capital account transactions are liberalized. China’s foreign-exchange reserves have rapidly expanded, but the nation also has large external debts.

When Japan and China normalized diplomatic ties and the yen-yuan settlement system was introduced in the early 1970s, the yuan’s value was set at 140 yen. Over the past three decades, the value of the Chinese currency has declined to one-tenth that level, and Chinese residents haven’t been allowed to own foreign currencies.

Once the capital account is liberalized, there will be huge demand for foreign currencies, which may put downward pressure on the yuan.

One should not forget that China is facing a number of tough economic problems that might threaten its one-party rule, including the expanding gap between rich and poor regions of the country, bad debts at state-owned enterprises, joblessness, an uncompetitive farm sector, and relief measures for farmers who have lost their land.