China may allow appreciation of currency to reduce risk of inflation

China may soon allow the yuan to rise against the dollar, despite it being bad for Chinese producers.

China's existing portfolio contains some US$3 trillion worth of dollar bonds and other foreign securities. EPA

China's government may be about to let the yuan-dollar exchange rate rise more rapidly in the coming months than it did during the past year. The exchange rate was frozen during the financial crisis, but has been allowed to increase since the summer of last year. In the past 12 months, the yuan strengthened by 6 per cent against the dollar, its reference currency.

A more rapid increase of the exchange rate would shrink China's exports and increase its imports. It would also allow other Asian countries to let their currencies rise or expand their exports at the expense of Chinese producers. That might please China's neighbours, but it would not appeal to Chinese producers. Why then might the Chinese authorities deliberately allow the yuan to rise more rapidly?

There are two fundamental reasons: reducing the portfolio risk and containing domestic inflation.

Consider first the authorities' concern about the risks implied by its portfolio of foreign securities. China's existing portfolio of some US$3 trillion (Dh11.01tn) worth of dollar bonds and other foreign securities exposes it to two distinct risks: inflation in the US and Europe, and a rapid devaluation of the dollar relative to the euro and other currencies.

Inflation in the US or Europe would reduce the purchasing value of the dollar bonds or euro bonds. The Chinese would still have as many dollars or euros, but those dollars and euros would buy fewer goods on the world market.

Even if there were no increase in inflation rates, a sharp fall in the dollar's value relative to the euro and other foreign currencies would reduce its purchasing value in buying European and other products. The Chinese can reasonably worry about that after seeing the dollar fall 10 per cent relative to the euro in the past year - and substantially more against other currencies.

The only way for China to reduce those risks is to reduce the amount of foreign currency securities that it owns. But China cannot reduce the volume of such bonds while it is running a large current-account surplus. During the past 12 months, China had a current-account surplus of nearly $300 billion, which must be added to China's existing holdings of securities denominated in dollars, euros and other foreign currencies.

The second reason why China's political leaders might favour a stronger yuan is to reduce China's own domestic inflation rate. A stronger yuan lowers the cost to Chinese consumers and Chinese firms of imported products. A barrel of oil might still cost $90, but a 10 per cent increase in the yuan-dollar exchange rate reduces the yuan price by 10 per cent.

Reducing the cost of imports is significant because China imports a wide range of consumer goods, equipment and raw materials. China's total annual imports amount to about $1.4tn, or nearly 40 per cent of GDP.

A stronger yuan would also reduce demand pressure more broadly and more effectively than the current policy of raising interest rates. This will be even more important as China carries out its plan to increase domestic spending. A principal goal of the recently presented 12th five-year plan is to increase household incomes and consumer spending at a faster rate than that of GDP growth.

The combination of faster household spending growth and the existing level of exports would cause production bottlenecks and strain capacity, leading to faster increases in the prices of domestically produced goods. Making room for increased consumer spending requires reducing the level of exports by allowing the currency to appreciate.

The dollar is likely to continue falling relative to the euro and other currencies over the next several years. As a result, the Chinese will be able to allow the yuan to rise substantially in order to decrease China's portfolio risk and reduce inflationary pressures.

Martin Feldstein, professor of economics at Harvard, was chairman of President Ronald Reagan's council of economic advisers and is former president of the national bureau for economic research.

* Project Syndicate