I post an old article here, which is relevant to the thread. It gave a good overview of the issue.
Time has come for China to let yuan float
China is at a crossroads. After three decades of unprecedentedly rapid gross domestic product (GDP) growth, the country weathered the global economic crisis exceptionally well. However, it sustains considerable economic imbalances, which are undermining its ability to achieve high-income status.
The question is whether China’s leaders — preoccupied with challenges such as financial instability stemming from risky shadow-banking activities and a heavy burden of local-government debt — have the policy space to put the economy on a sounder footing.
In the aftermath of the global economic crisis, China appeared to be on track to complete such a rebalancing. Its current-account surplus fell from more than 10 per cent of GDP in 2007 to 2.6 per cent in 2012, and it ran a large capital-account deficit for the first time since 1998.
Moreover, China added only US$98.7 billion (S$125 billion) to its foreign-exchange reserves in 2012, compared with an average annual increase of more than US$435 billion from 2007 to 2011. That meant diminishing upward pressure on the yuan’s exchange rate.
However, over the past year, China’s imbalances have returned with a vengeance. Its trade surplus last year probably exceeded US$250 billion; its capital-account surplus exceeded US$200 billion in the first three quarters of the year; and its foreign-exchange reserves soared by US$510 billion.
Meanwhile, the lower current-account surplus (as a share of GDP) could be a result of its increased investment-income deficit. And, while recovery in the advanced economies boosted exports, persistent overcapacity, combined with slower household-consumption growth than in 2012, caused investment growth, though still rapid, to decline to its lowest rate in the past 11 years.
RESOURCES GROSSLY
MISALLOCATED
In principle, a country can run a current-account deficit or surplus continuously for decades. However, China’s chronic surpluses are problematic.
Given that China remains among the world’s poorest countries, with per capita income amounting to less than US$7,000, its position as the world’s largest exporter of capital signifies a gross misallocation of resources.
In fact, after running twin current- and capital-account surpluses persistently for two decades, China’s foreign-exchange reserves are poised to break the US$4 trillion threshold, with the marginal cost of every dollar accrued vastly surpassing its potential benefits.
In this context, the continued accumulation of foreign-exchange reserves is clearly counterproductive.
Of course, rebalancing China’s economy will take time and it will entail some risks and sacrifices. However, China’s leaders must recognise that the country faces massive welfare losses and thus should be willing to accept slower growth in the short term in exchange for a more stable long-term growth path.
In fact, with a well-designed policy package, the duration and impact of the growth slowdown could be minimised.
A critical first step is for the People’s Bank of China to stop intervening in the foreign-exchange market, which would halt the growth of the country’s foreign-exchange reserves. In other words, China should adopt a floating exchange-rate regime as soon as possible.
Although this transition would have a negative impact on China’s economic growth, it would not be nearly as dire as many seem to believe. For starters, while it would probably cause the yuan to strengthen, the consensus in China is that the current exchange rate is not far from the equilibrium level, meaning that the appreciation would probably be moderate.
Similarly, although yuan appreciation would diminish export growth, the slowdown would probably not be dramatic, given that China’s export sector is dominated by the processing trade (specifically, the assembly of intermediate inputs imported from countries such as Japan and South Korea).
The accompanying increase in imports will probably not damage China’s economic growth significantly; it is more likely to complement, rather than substitute, domestic demand. In short, China can afford the costs of rebalancing.
TACKLING ‘HOT MONEY’
Given that the liquidity flowing into China over the past several years was increasingly short-term capital aimed at exchange-rate and interest-rate arbitrage (so-called “hot money”), there may be a surge in capital outflows when appreciation expectations have disappeared.
To prevent large-scale capital flight from threatening China’s financial stability, cross-border flows must be managed carefully.
A flexible exchange rate dictated by market forces would eliminate the opportunities for currency speculators to make one-way bets on yuan appreciation, thereby diminishing the stock of hot money that currently accounts for the bulk of China’s capital-account surplus.
Even if China’s current account remained in surplus for some time, the shift from twin surpluses to a more normal external position would boost the efficiency of resource allocation considerably.
For too long, China has delayed the necessary adjustment of its balance-of-payments structure. It is time to make a change, even if it requires them to brace themselves for risks.
PROJECT SYNDICATE
ABOUT THE AUTHOR:
Yu Yongding is former President of the China Society of World Economics and Director of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences. He has also served on the Monetary Policy Committee of the People’s Bank of China.
Ref:
http://www.todayonline.com/chinaindia/ch...epage=true