The currency war is now upon us, and the mainland and its currency are at the center of it. The Central Government has rejected the notion that the yuan exchange rate is the culprit behind global economic imbalances and is so far resisting the increasingly loud calls for a large yuan appreciation.

The US Congress is trying to force this through protectionist trade legislation, but most experts believe that is unlikely to take place and in any case would take a long time for it to be effective. However, as the US is worried about economic growth and is using quantitative easing (QE) to reduce the risk of deflation, it will be able to force real currency adjustments upon its trading partners by printing as much of its own currency as it desires. A few other advanced economies are able to follow suit, most notably Japan.

What will QE do? While it is not clear how effective QE may be in boosting economic growth in the US and other advanced economies, global interest rates will be kept low for a much longer period of time. It is all but certain that a flood of liquidity will be seeking lower risk and higher returns - emerging markets, including the mainland, will continue to be favored destinations. As emerging currencies face appreciation pressure, some countries, notably Brazil and Thailand, have stepped up capital controls.

So, what can the Central Government do in light of the challenges posed by QE? How might it win or lose this currency war? Martin Wolf, the renowned Financial Times columnist, has argued convincingly why he thinks the US will win the battle. Some in the Chinese community, however, believe that since the US cannot force currency appreciation on the mainland, China will win.

While China may be able to hold on to its current exchange rate policy, and gradually adjust it as it pleases, that in itself cannot be the sole criterion for losing or winning the currency war.

Can the mainland escape the unwanted consequences of QE, limit the damage of large liquidity inflows, asset bubbles, and potentially gross misallocation of resources while still tightly managing currency appreciation? That will be the real test.

Firstly, QE will make the mainland's monetary policy decisions even more difficult, increasing the risk of policy errors. To the extent that QE is seen as a reflection of the weakness in the US and global economy, some may be inclined to keep the mainland's monetary policy accommodative for longer, to further stimulate domestic growth to compensate for weak external demand. Moreover, interest rates may be kept low to avoid drawing in more capital flows. QE and the wall of money potentially headed for emerging markets will further weaken the stance of those who favor rate hikes and a quicker exit from the expansionary credit policy.

Maintaining a loose monetary policy and low interest rates for too long on the mainland will not only be misguided but also dangerous. The US and other advanced economies have a lot of economic slack and may need to keep monetary policy expansionary for a prolonged period of time to help smooth their adjustments in private sector deleveraging, or fiscal consolidation - or both.

However, on the mainland the cyclical position is very different: there is little or no slack. The mainland should be able to sustain relatively rapid economic growth of 8-9 percent even with weak growth in advanced economies in the next couple of years. There is no need for policy to be overly accommodative to keep growth at or close to double digits, especially as changing demographics have reduced the pressure to create new jobs. Indeed, in an economy with no slack, ample liquidity plus increasingly negative real interest rates could lead to misallocation of resources, inflation, and asset bubbles.

Secondly, the mainland's exchange rate policy will come under increasing pressure, both political and speculative. QE in the US has already led to a rapid depreciation of the US dollar against the euro and some other major and emerging currencies. In this environment, the Central Government's reluctance to allow faster yuan appreciation will draw even more criticism, even though some Asian countries may hide behind the yuan for their own mercantilist reasons. Increased political pressure will increase market expectations of yuan appreciation. As the mainland provides relatively high returns to investment and its currency is expected to appreciate, more capital inflows, real or speculative, are expected in the coming months and years, putting further upward pressure on the currency.

However, faster yuan appreciation now could invite more trouble if not managed well. Faster appreciation could help defuse some international pressure and reduce the threat of trade protectionism in the short run, and could help to reduce trade surpluses and economic restructuring in the long run. However, in the current environment, faster appreciation could also raise expectations for further appreciation and invite greater capital inflows, which may offset the liquidity tightening effect of the initial appreciation. Capital inflows have not been under the media spotlight, but this may change soon if the Central Government does not further tighten capital controls.

The author is managing director and head of China economic research, UBS Securities. The opinions expressed here are entirely her own.

(HK Edition 11/17/2010 page2)