Rousing round of appreciation for Chinese currency must continue

The yuan has remained strong over the past decade, so it's not news that the strength of the Chinese currency is continuing to rise this year - unless we look at the pace of that rise.

The currency has appreciated about 1.7 percent against the US dollar from January to hit about 6.16 yuan a dollar, far outshining the 1.03 percent rise for the whole of 2012. This year so far it has risen 2.6 percent against the euro and almost 20 percent against the Japanese yen.

The most dramatic appreciation has occurred since April with the yuan rising a remarkable 0.77 percent that month and 0.66 percent in May against the US dollar.

This was mainly fueled by a massive inflow of capital, with investors, both home and overseas, tending to hold yuan as asset and the US dollar as debt.

In the first four months of this year, Chinese banks' foreign-exchange purchases skyrocketed to a record 1.5 trillion yuan ($250 billion; 187.5 billion euros), more than double last year's total. China's trade surplus came to $61 billion, while foreign investments amounted to $38.34 billion during the same period.

Clearly, the global wave of rate cuts and programs to boost liquidity have created a greater rate difference between the yuan and other major currencies, and between the yuan's onshore and offshore markets. Arbitragers buy yuan and sell other currencies, making the yuan market a seller's one. Trading companies are desperate to increase yuan holdings to hedge foreign exchange risks.

The robust rise of the yuan was also a result of the central bank's loose control over the foreign exchange rate this year.

It was obvious that the People's Bank of China reduced its intervention by setting the daily benchmark rate basically in accordance with trading prices quoted by buyers and sellers.

The correlations between the benchmark rates and the real trading rates, after adjustment from weighing offshore and onshore yuan market sizes, is astonishingly high since March, coming to nearly 94 percent, 8 percentage points higher than last year. This shows the central bank remained hands-off in setting the rate since the new leadership took office in March, and it has facilitated the rise of the yuan since.

Many have argued that the yuan is rising too fast and called for a "soft landing" for its value. I would argue the opposite.

The pace of the yuan's rise does not go beyond any limits, and there is no need to worry if a similar growth pace is maintained throughout the year.

Whether or not the yuan is undervalued against the US dollar is not the issue. Also, whether there is an equilibrium point between the Chinese and US currencies is open for discussion.

Generally speaking, as long as China's economy grows relatively fast, its production costs continue to grow and production efficiency keeps improving, the yuan has room to increase in value.

Although China's economic growth is slowing down, it is still much better than any other major economy. The rise of production costs and efficiency in China also outpaces that of most of other countries.

Given these factors, the yuan's rise against other major currencies simply reflects China's growing economic strength, and the currency's appreciation is just a matter of course.

So at what pace should the yuan be growing?

My sense is that an annual growth rate of 3 to 5 percent will not shake the economic fundamentals of China, as long as GDP growth stands at above 7.5 percent, China maintains trade growth and surplus, and massive layoffs do not happen.

Historically, yuan appreciation does not determine the broad picture of China's economic growth. There were times when the yuan rose by nearly 5 percent a year but the economy grew more than 10 percent. And there were times when the yuan was, in practice, pegged to the greenback but the economy slowed down to less than 8 percent.

Similarly, that a low yuan will always help exporters is a myth, as seen in the industrial overcapacity that China is grappling with now.

Overcapacity in sectors such as steel, manufacturing and infrastructure construction, is a legacy of the cheap-yuan policy during most of the first decade of this century.

Export and manufacturing sectors, encouraged by the foreign exchange advantages, upped their capacity to full-scale to grab the global trade market, and labor-intensive and high-polluting businesses thrived. Innovation and brand building were put on the back burner. Since the foreign exchange advantage ensured easy money, who would bother to invest in research and development, or the environment?

The Beijing smog is just one downside of a cheap-currency policy.

A rising yuan is good for China's ambitious goal of transforming its economic structure. A high yuan forces exporters to compete with better technology and branding and will help reduce retrograde labor-intensive production.

It will also help Chinese companies to invest abroad, encouraging them to move part of production overseas and help reduce environmental and resources pressure in home markets.

Of course, this transition will be painful, with some exporters and workforces hit hard. But the resilience of Chinese manufacturing and export sectors must be trusted, as experience has shown how good industrial players are at adapting to market changes.

In this sense, the old habit of halting yuan growth when the economy is not doing well must be thrown out. Top policymakers pegged the yuan to the US dollar during the vortex of the 2008-09 financial crisis, and they intentionally slowed the pace of yuan appreciation last year as the economy slowed down markedly.

Those practices helped buoy the economy, particularly the export sector, in the short term. But the side effect was terrible in the long run. They resulted in overcapacity, excessive credit growth and, most importantly, a delay in economic reforms.

The appreciation of the yuan is also needed in the global use of the currency.

As China pushes for the internationalization of the yuan, maintaining the strength of the currency seems to be an inevitable choice.

Going on experience, an international or a regional currency in the making usually remains strong in value to ensure that it is attractive among users outside its home economy. The US dollar, the yen and the euro all experienced that period before they became widely used regionally or globally.

The yuan has now reached that period, too. To become a global currency, the first step is to have people outside China hold it, and better, use it.

Given that the yuan is not freely convertible and not accepted as a trading currency in most of the world, the easiest way to boost its popularity is to make it a good tool to maintain and appreciate value.

This has proved to be effective, as can be seen by the shifting popularity between the yuan and the Hong Kong dollar.

The yuan has seen explosive growth in this regional financial hub since 2007, the year when it traded alongside the Hong Kong dollar. Since then, the Hong Kong dollar has nose-dived to the point that in neighboring Shenzhen no street vendor or taxi driver will accept it, while the yuan has quickly become a vital part of the portfolio of Hong Kong investors, both individual and institutional.

Chinese leaders' determination to turn the yuan into an international settlement and reserve unit is nothing but resolute. Since the 2008-09 global financial crisis, they have agreed that China must keep its distance from the greenback-dominated financial system to remain immune to any world financial meltdown.

In this sense, the drive to globalize the yuan will continue - and so must appreciation of the yuan.

The author is a financial analyst in Shanghai. He can be reached at michaelzhoufeng@gmail.com

(China Daily European Weekly 06/21/2013 page10)