Op-Ed Contributors

Renminbi deserves depreciation

By Yukon Huang (China Daily)
Updated: 2010-06-22 07:51

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.

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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.