China Signals Yuan May Be Inflation Tool

APRIL 21, 2011   THE WALL STREET JOURNAL

By JASON DEAN And TOM ORLIK

BEIJING—In official comments that have fueled speculation about faster appreciation of the yuan, senior Chinese leaders seem to be acknowledging an argument long made by Washington and others that a stronger yuan may be helpful in taming the country's rising inflation.

U.S. officials, and many economists, have argued that an artificially cheap Chinese currency, while boosting China's exports, is ultimately self-defeating because it adds to inflation, in part because export earnings flood the economy.

In recent days, as inflation readings have accelerated, Chinese officials have made comments that some analysts believe signal greater acceptance of that argument. Premier Wen Jiabao, at a meeting last week of the State Council, China's equivalent of a cabinet, listed "strengthening the flexibility" of the yuan's exchange rate as one of several tools the government should better use to control prices. Less senior officials have made that argument before, but Mr. Wen's remarks were unusual for a top leader.

View Full Image

European Pressphoto Agency

Chinese Premier Wen Jiabao, shown here in 2010, last week listed more flexibility for the yuan's exchange rate as a tool to control inflation.

Still, economists say Beijing's change in language, while significant, is unlikely to result in a sharp jump in the yuan.

"China appears to be on the verge of allowing faster currency appreciation in response to inflation," Mark Williams, senior China economist for Capital Economics in London, wrote this week, citing official comments. But Mr. Williams predicts the yuan will end this year around 6.20 per dollar, a gain of about 5.25% from current levels—meaning only a slight pickup in the pace of appreciation.

The yuan ended trading Wednesday in Shanghai at a record high against the U.S. currency. But at 6.5255 per dollar, the yuan has gained only 4.6% since June, when Beijing ended a nearly two-year peg to the dollar. That is a pace of about 0.5% a month, much slower than some economists and foreign critics have urged.

Economists generally agree that faster appreciation could help cool prices, at least somewhat. A stronger yuan would reduce the costs in local currency of crude oil, iron ore, soybeans and other commodities that China imports in enormous quantities—soaring prices for which have been passed on to consumers in higher costs of food and transport.

Mr. Wen has said fighting inflation is China's top economic priority this year, and the government has raised interest rates four times since October, ordered companies to halt price increases, and cranked back the supply of bank credit. But consumer prices still rose in March at their fastest pace in 32 months.

On Monday, People's Bank of China Governor Zhou Xiaochuan said the government is working to reduce the accumulation of foreign-exchange reserves. They have soared to more than $3 trillion largely as a consequence of China's currency policy, which forces the central bank to buy dollars from exporters and foreign investors. Mr. Zhou said the reserves pump excess cash into the economy and "exceed our reasonable requirements."

China's currency policy has long been a source of friction with trading partners, especially the U.S., which argue that an undervalued yuan unfairly benefits Chinese exporters.

On Monday, a group of 10 U.S. senators arrived in Beijing—the largest such delegation ever, including Democrat Charles Schumer, perhaps China's biggest critic on the currency issue—for meetings with Chinese officials including Mr. Zhou at which they raised the exchange-rate issue

But the Obama administration also has stressed to Beijing the importance of a stronger yuan in fighting inflation, recognizing that China's leaders place far more importance on domestic considerations than on foreign pressure. U.S. criticism of the pace of yuan appreciation has been muted recently, a sign that the Administration believes China is on the right path.

Top political leaders in China like Mr. Wen—the ones who ultimately decide key issues like exchange-rate policy—in the past didn't typically view the currency as a monetary-policy tool, analysts say. But that may be changing.

"There may be a shift under way from thinking about the exchange rate mainly as a variable that affects the competitiveness of exporters to a macroeconomic variable that is part of the management of growth and inflation," said Louis Kuijs, economist at the World Bank in Beijing.

Still, estimating the impact of a stronger yuan on inflation with any precision is difficult.

And there are limits to the relationship between the two. Higher costs for imported fertilizer and diesel affect the agricultural sector, but most of China's food—which accounts for nearly a third of the basket used to calculate the consumer-price index—is grown domestically, not imported.

Even for goods that are imported, the government's other tools, like price controls, help mitigate the impact of imported inflation on consumers: State-set prices for gasoline and diesel in China have risen about 10% this year, as global prices for crude oil have soared more than 20%.

A stronger yuan would do little to affect one key structural component of China's inflation: rising wages. Economists believe that China has hit a point in its development at which demand for labor starts to grow faster than supply, pushing up salaries. A survey conducted by Standard Chartered in the first quarter of 2011 showed average wages in a sample of 87 manufacturing firms rising by 9% to 15% from the previous year.

Balanced against the benefits of a stronger yuan are concerns about the potential impact on exporters, who employ a huge share of China's work force. Many of them operate on thin profit margins. Concern about exporters is one reason top officials have long insisted that any change in the yuan must be measured.

"We will further increase the [yuan's] flexibility according to the market," Mr. Wen said last month. "But we must also keep in mind that this kind of reform is gradual, because it affects companies and employment."

A hazard of the steady, gradual approach to appreciation is that it invites speculators to pump capital into China to profit on what they see as a one-way bet. Authorities revile such "hot money," in part because it can further fuel inflation.

As a result, some economists have argued that Beijing should opt for a sizable one-time revaluation of the yuan. But even academic advocates of this approach conceded that it is politically untenable.

Xia Bin, one of three academic advisers on the central bank's largely powerless monetary-policy committee, argued in an Internet post Tuesday that a one-time jump in the yuan "shouldn't be excluded." But he also said this was a "long-term" prescription. "In the current situation, excessive fast appreciation isn't good for the Chinese economy or social stability," he wrote.

Write to Jason Dean at jason.dean@wsj.com