Western pressure on China to revalue its currency upward, by adopting "a more flexible exchange rate policy", has been intense. Last month's G20 meeting in Beijing reiterated the call, and so have US officials ahead of President Bush's visit for the Asia Pacific summit later this week.
While China faces obvious risks in too rapid a change in the exchange rate, there are dangers in too slow a response, too -- most importantly, the US threat to impose a 27.5 per cent duty on all imports from China.
While the Chinese authorities have made a small change in the exchange rate a few months ago, this is unlikely to satisfy the US: by itself, this change is more symbolic than substantive.
Perhaps, a change of 10 per cent or so alone may lead to the lifting of the import duty threat. (The non-deliverable forwards market in Hongkong/Singapore is factoring a 7 per cent change from the current level over the next 12 months.)
The arguments in favour of a revaluation of the currency are well-known. China's surplus on current account is expected to triple this year to around$100 billion, even after the recent agreements to restrict textile exports to both the European Union and the US, in effect, bringing back the era of quotas that was supposed to have ended! Under the recent bilateral agreements, full quota removal will come in stages by 2008.
There are serious limitations to the argument that it is the "manipulation" of the exchange rate by the Chinese authorities that is the root cause of the "global imbalances", a euphemism for the huge and galloping deficit on current account of the US.
It is not so much an under-valuation of the Chinese currency as the extremely low rate of savings in the US that is the culprit.
The US also gains from Chinese imports that help keep inflation low, despite the high commodity prices. And, the mirror image of China's trade surplus is the huge investments in US treasury securities. The result: long-term bond yields in the US have not gone up anywhere near the rise in the Fed funds rate engineered by the Federal Reserve.
The Chinese have another argument why the currency regime is not to be blamed for the US deficit: they point out that while the bilateral US deficit with China has gone up by about $ 40 billion last year, it was accompanied by a fall of $ 65 billion in the US deficit with Japan and other east Asian countries.
There is substance in the argument that the bilateral number has gone up because a lot of final assembly and manufacture has shifted from other east Asian countries to China.
In other words, the surplus of Asia as a whole vis-à-vis the US hasn't really gone up. Again, for many Chinese exporters, pricing has become so cut-throat that margins are razor thin and any significant change in the exchange rate may well bankrupt a large number of exporters, leading to unemployment and social unrest.
The Chinese have another major problem in making the exchange rate more flexible. Hitherto, only seven banks were allowed to operate in the forward market in Shanghai.
(Lately, 36 more have been authorised.) Neither the banks nor the corporate sector have adequate trained personnel to cope with a flexible exchange rate, or using and trading derivatives. (Bond futures had been introduced in the 1990s but the exchanges were closed after a major scandal.) The losses sustained by China Aviation Oil also evidence the lack of properly trained personnel.
The authorities seem to expect that the current account surplus may come down next year: they point to the increasing growth rate in imports in support of their view. It is an open economy with low import duties.
The authorities are also liberalising portfolio flows abroad, and maintenance of the dollar accounts by exporters. The policy focus will increasingly shift to meeting environmental and social challenges, and improving rural incomes.
To quote from a recent World Bank report, "This could be achieved by rebalancing growth in the direction of sectors that require less capital, energy and resources but which generate more employment and use capital more efficiently."
One is puzzled by the argument: if the efficiency of capital does go up for a given rate of GDP growth, domestic investments as a percentage of GDP will fall, and lead to an even larger surplus on the current account!
Be that as it may, the People's Bank of China Monetary Policy Report for Q2 2005 argues that, after the revaluation, "foreign travel will become more affordable ... (and) the general welfare of domestic consumers will be improved".
A refreshing contrast to our policy announcements, which rarely talk of the welfare of the consumer.