Exchange rate opportunity

China should not overreact to the recent decline of the yuan, as unnecessary interventions will hinder its internationalization

The yuan closed at 6.3606 against the US dollar on Tuesday, hitting the 0.5-percent lowest limit for 10 consecutive days, statistics from the China Foreign Exchange Trade System indicated.

Since China launched its exchange rate reforms, it has been rare for the yuan to experience such a decline against the US dollar, so this has sparked worry and speculation in the market. Some analysts believe it is the result of the accelerated outflow of international capital from China, which reflects a pessimistic outlook on the Chinese economy.

Considering the effects on local economies of the outflow of international capital from Southeast Asian countries and Brazil, China should be particularly vigilant against the possible retreat of international capital and take timely countermeasures if the international society does indeed hold a pessimistic view of its economic prospects.

However, the fact of the matter is, the basic backbone of China's economy and its foreign trade has not experienced any fundamental changes and the deceleration of the country's fast economic growth is expected to be a long-term and gradual process that should not ignite any market panic. Thus, the recent decline is a temporary market move instead of a substantial depreciation of the yuan against the greenback.

In the context of the deteriorating debt crisis in some eurozone countries and a lingering global economic recession, it is understandable that some capital-thirsty agencies should withdraw some of their funds from China and turn to the US dollar to hedge against possible risks. And due to the different yuan exchange rates against the US dollar inside and outside the Chinese mainland, some investors have also chosen to buy the dollar on the mainland to sell in other places to gain from the price differentials.

China's decreased trade surplus in recent months has also contributed to the yuan's declining exchange rate against the US dollar. Statistics from the General Administration of Customs indicate that the country's trade surplus in October was only $17.03 billion, a decrease of 36.5 percent from the same period last year.

At a time when the pace of yuan appreciation is expected to further slow, it is normal for some "hot money" to choose to retreat from China, contributing to a weaker yuan, but that does not mean the yuan is on the way to depreciation and that the Chinese government should intervene.

From a long-term perspective, the Chinese economy is still on a robust footing and thus the yuan will not face depreciation pressures in the future if the country's export-driven economic model remains unchanged. Given the slim possibility of any drastic worsening of China's economy within the next five years, the yuan is unlikely to become a sell-off target. And the country's $3 trillion-strong foreign reserves mean it has sufficient capability to intervene in the exchange rate market if necessary. Despite hitting its permitted lowest limit for 10 consecutive days, the rising parity prices of the yuan against the US dollar, set by China's central bank, is a crystal-clear indication that the Chinese government will not remain idle while witnessing a continuous depreciation of its currency. No hedge fund or hot money will bet on the depreciation of the currency of the world's largest foreign reserves holder.

China should not overreact to the recent decline of the yuan's spot exchange rate and the market's concerns. Any overreaction and unnecessary interventions will not only hamper the country's exchange rate reforms and internationalization of its currency, they will also cause other countries to brand it a "currency manipulator".

As a country holding more than $3 trillion foreign reserves, China should not take policy measures toward what is only a $40 billion decline in its funds outstanding foreign exchange. The outflow of some hot money will alleviate the pressures brought about by the accelerated inflow of international capital in previous months, and reduce the issuing volume of its base currency. That is beneficial to the country's efforts to rein in intractable inflation and regulate its real estate bubbles.

At the same time, the yuan's declining exchange rate offers China the opportunity to increase its elasticity and further improve its exchange rate formation mechanism.

The author is an economist with the Chinese Academy of Social Sciences.

(China Daily 12/15/2011 page8)