China to Let Yuan Move More Freely

China will let the yuan move more freely next year, but a stronger exchange rate does not hold the key to reducing the country's trade surplus, central bank governor Zhou Xiaochuan said on Tuesday.

Eugene Hoshiko

Zhou's pledge to allow greater flexibility in the yuan is not new, but it will be welcome news to U.S. Treasury Secretary Henry Paulson, who is likely to press China to keep pushing up the currency's value during talks in Beijing this week.

The central bank, which keeps the yuan on a tight leash, set a daily trading midpoint on Tuesday of 7.3797 per dollar, the highest level since it revalued the currency by 2.1 percent in July 2005 and unpegged it from the dollar to float in managed bands. The yuan has since risen a further 9.9 percent.

"From the beginning, we have said that we would continue to deepen exchange rate reform and increase the flexibility of the yuan's exchange rate. That still holds true for 2008," Zhou told a forum organized by Caijing magazine.

While it has risen against the dollar, the yuan has fallen some 7.5 percent against the euro since mid-2005, to the anger of European Union politicians dismayed by the bloc's swelling trade deficit with China.

Indeed, the yuan's trade-weighted exchange rate, measuring its value against a basket of currencies of China's main trading partners, has barely risen.

Zhou brushed aside criticism that Beijing has not done enough on the yuan. But, in an important acknowledgement, he said China should look at the currency's trade-weighted value, adjusted for inflation, rather than its rate against the dollar.

This has been a key recommendation of the Group of Seven rich nations, which argue that an undervalued trade-weighted exchange rate is contributing to China's mammoth trade surplus.

"If we just look at how much the yuan has appreciated against the dollar alone to gauge the value of the currency, there will be errors -- errors in analysis and in calculation," Zhou said.

Structural Change First

Still, Zhou said deep-seated policies to lower China's savings rate and boost domestic demand -- not exchange rate adjustments -- held the key to trimming China's trade surplus.

The government on Tuesday reported a slight dip in November's surplus to $26.3 billion, but the rolling 12-month total increased to $260.3 billion from $255.9 billion in October.

China also has a big surplus on its capital account, leaving the economy awash in cash that the central bank struggles to mop up to prevent a credit-led investment binge.

Zhou said the twin surpluses had grown beyond Beijing's imagination. "We are quite frank about it," he said.

The relocation of factories to China by multinational companies and the outsourcing of production to Chinese manufacturers also meant the trade surplus could not be tackled simply by adjusting the exchange rate, Zhou said.

Still, Beijing recognizes that it needs to wean the economy off exports and investment.

To that end, Zhou advocated a greater role for the service sector, more welfare spending and policies to develop the countryside and so promote a "harmonious society" -- the ruling Communist Party's slogan for reducing the rural-urban wealth gap.

Turning to monetary policy, Zhou said a decision last week by China's top leadership to shift to a "tight" setting from a decade-old "prudent" stance did not mean the central bank would be abruptly changing gears. "Any such operation is a gradual process," he said.

Beijing is tightening policy to control inflation and prevent the world's fourth-largest economy from overheating. The statistics bureau on Tuesday reported that annual consumer inflation spurted to an 11-year high of 6.9 percent in November.

Zhou said one of his concerns is that a five-yearly reshuffle of government and party officials now under way would boost bank lending for investment in 2008 as new appointees tried to make their mark by boosting growth and jobs.

During the last reshuffle in 2003 there had been a tidal wave of new loans, the central bank chief noted. "On this, we must be particularly careful at the end of this year and the
start of the next year," he said.