Why a Booming China May Let the Yuan Climb

With China's GDP again expanding at a blistering 10.7% pace, Chinese officials have been scrambling to curb record bank lending in a bid to stave off overheating. Now, with the worst of the global financial crisis in the rearview mirror, but the specter of inflation an increasing possibility, Beijing may finally make a move that governments around the world have long been pushing for: letting the yuan appreciate in value.By keeping the yuan pegged to the dollar -- most recently at an exchange rate of about 6.83 -- and therefore artificially depressed, foreign commentators have often argued that China has benefited unfairly by making its exports cheaper than those of competing nations. The big difference this time around, however, is that a rising yuan may be in China's interest as well since it would help slow expansion and boost domestic consumption in an economy seen overly reliant on investment for growth.

As China's exports markets sagged under a globally synchronized recession, China injected record amounts of liquidity into its domestic economy by extending about $1.4 trillion in bank loans during 2009. But even as authorities now race to tighten the money supply by raising bank reserve requirements, fears of a bubble are mounting, and high-profile investors are pointing to skyrocketing property prices in the country.

Letting the yuan appreciate in value would benefit China by tamping down growth in the manufacturing sector and helping cool the economy. Domestic consumption, which accounts for a strikingly small 35% of the Chinese economy (compared to around 70% in both the U.S. and the developing region of Latin America) would also get a boost if the yuan's purchasing power increased.

China's trading partners, too, would welcome a rise in the yuan. Given his country's exposure to price-sensitive exports, French President Nicholas Sarkozy has been among the fiercest critics of China's currency policy. And the International Monetary Fund estimated that a 20% rise in the yuan would contribute an additional 1% to U.S. GDP growth.

While a 20% move is unlikely, a 5% appreciation may well already be in the works, according to Goldman Sachs Chief Economist Jim O'Neill. "They need to do something to slow the economy down and deal with the inflation consequences," O'Neill told Bloomberg News last week.

A Long-Term Benefit, at the Cost of Short-Term Pain

Despite the upside, Beijing also faces some major domestic political obstacles in letting its currency appreciate, some China experts point out.

"The problem is that the benefits of this kind of revaluation will be spread across the population and would occur over the longer term, whereas the costs would be concentrated in the short term among the export sectors," Michael Pettis, a professor at Peking University's Guanghua School of Management and senior associate at the Carnegie Endowment for International Peace told DailyFinance via email. "This kind of distribution of costs and benefits is always politically difficult."

Pettis says there's a "growing but still low probability that the government would choose a 10% one-off revaluation." One of the major advantages of a swift one-time adjustment over a gradual increase would be to prevent hot speculative capital from flooding the country in anticipation of a rise in the currency. "If we do see a major increase in hot money inflows, this could also help move policymakers in that direction," Pettis says.

Investors who want to bet on a rise in the yuan, meanwhile, can purchases shares of an exchange-traded fund such as the WisdomTree Dreyfus Chinese Yuan Fund (CYB).

With the Chinese economy looking increasingly like a runaway train while the rest of the world limps along, a rise in the yuan seems ever more likely.
Read Full Story
  • DJI27657.42-244.58-0.88%
  • NIKKEI 22523360.3040.900.18%
    Hang Seng24069.54-385.87-1.58%
  • USD (PER EUR)1.190.00250.21%
    USD (PER CHF)1.100.00070.06%
    JPY (PER USD)104.35-0.1820-0.17%
    GBP (PER USD)1.290.00190.15%

From Our Partners