Saturday, January 26, 2008

Fed Rate Cuts Force China To Accelerate Yuan Appreciation

One of the reasons China have started to allow the yuan to rise faster, and will continue to allow it to rise faster, is the recent and likely future Fed interest rate cuts.

As Yu Yongding,former adviser to the People's Bank of China, notes, the widening interest rate gap between China and the U.S. could increase the inflow of "hot money" into China. That in turn will fuel higher money supply growth unless the exchange rate appreciates. That in turn implies that interest rate increases could prove useless in cooling down the economy.

Instead, other measures must be used, including higher reserve requirements and a higher value of the yuan versus the dollar. However, if the U.S. recession reduces exports enough, China may not need to tighten monetary policy much further, so higher reserve requirements doesn't seem necessary, appropriate or likely. A higher yuan is appropriate for other reasons and should therefore be the only measure undertaken at this point. Together, the higher yuan and the U.S. recession should reduce the current account surplus and accumulation of foreign exchange reserves enough to reduce money supply growth and price inflation to levels deemed more appropriate by the Chinese leaders.


Anonymous Jeremy said...

In my view, the "hot money" inflow issue is not just one of widening interest rate differentials, but also one of expectation of exchange rate appreciation.
Therefore a faster rate of appreciation would not deter inflows, but may further encourage them.
To me what is needed is some loosening of capital controls, allowing greater domestic holding of FX, and providing wider channels for that FX to be channeled out of China.

10:57 AM  

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