A difficult balancing act

Author(s): Zhang Ming

Source: China Daily

External and domestic factors mean yuan's exchange rate against the US dollar is likely to remain around the current level

During their campaigning for the US presidential election, both candidates have made verbal attacks on China and the issue of the yuan's exchange rate. Republican candidate Mitt Romney has even said he will brand China an exchange rate manipulator his first day in office if he is elected.

Yet at the end of China's National Day holidays, the yuan was 6.2486 to 1 against the US dollar in terms of its on shore spot exchange rate, a new high since China launched the reform of the yuan's exchange rate regime in July 2005.

The US dollar's depreciation has to some degree eased appreciation pressures on the yuan's effective exchange rate, thus expanding the space for the rise of the yuan's nominal exchange rate against the dollar. The third round of quantitative easing embraced by the US Federal Reserve directly increased dollar supplies in the foreign exchange market and reduced investment demand for US national debt, resulting in the US dollar having a lower value against other major currencies, including the yuan.

Improved foreign trade conditions have also helped boost the yuan's value against the dollar. In September, China's exports grew by 9.8 percent year-on-year, much higher than the 1 percent in July and the 2.7 percent in August. China's trade surplus reached $22.7 billion in September, the second highest this year. From January to September, the total value of the country's trade surplus was $149.5 billion, considerably higher than the $109.8 billion during the same period last year.

The slowed outflow of short-term capital has also helped ease imbalances between the yuan's supply and demand in the foreign exchange market. China's funds outstanding for foreign exchange declined for the six months from October 2011 to August 2012, with a decline of 3.8 billion yuan ($608 million) and 17.4 billion yuan in July and August. But the funds are expected to have shown positive growth in September although no figure has yet been unveiled. With the introduction of the latest round of quantitative easing by developed countries and with the European debt crisis subsiding, it is expected that the flow of short-term capital out of China will slow. There is even the possibility of their influx again in the future.

Besides, the lower market expectations for more interest rate cuts by China's central bank have also fueled the yuan's appreciation against the dollar. The two interest rate cuts made by the country's monetary authorities in June and July fueled expectations for similar actions in the coming months. Expectations for a narrowed interest rate gap with the dollar consequently caused a weak yuan. However, the reverse repurchasing adopted by China's central bank to pump liquidity into the market in recent months has dispelled market expectations for further cuts in interest rates. The increased possibility of China's gross domestic product bottoming out in the third quarter and a possible rebound in the Consumer Price Index in the coming months also mean there is less possibility of the central bank further loosening established monetary policy, which will continue to bolster a strong yuan against the dollar.

But despite the September rise in exports, external demand remains weak and the possibility of increased trade frictions with other countries and ongoing adjustments in the prices of domestic factors of production mean that its exports still face a gloomy prospect and the profit-making capability of its enterprises will not fundamentally improve. These, together with the deleveraging efforts of domestic enterprises and the likelihood of the European debt crisis continuing will undercut the yuan's future appreciation against the US dollar.

The increased, instead of decreased expectations for yuan's depreciation in the mainland's swap market and overseas non-deliverable forwards market are forcible evidence that there is a lack of market confidence in the yuan's exchange rate. However, the Chinese government has sufficient policy room to tackle a potential crisis.

Therefore, it is likely that the yuan's future exchange rate against the US dollar will maintain its current level and any further appreciation will only be moderate.

(The author is a researcher with the Institute of World Economics and Politics under the Chinese Academy of Social Sciences.)