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How Should the Revaluation of the Yuan be Interpreted?

July 27, 2005

Key Points of the Report

1. Outlook for the Yuan/Dollar Exchange Rate

Although much of the practical detail of the new exchange rate system has yet to be revealed, in the short term, it is likely to be operated in such a way as to minimize the fluctuation of the yuan/dollar exchange rate, which will be virtually fixed at around 8.11 yuan/dollar, and will not bring any great changes as compared with the system operated until now, under which the yuan was effectively pegged to the dollar. The "currency basket" will be used for little more than reference purposes, and it may be concluded that the systemic reforms implemented on this occasion, at any rate, do not constitute the introduction of a "currency basket system" in the strict sense.

However, the reforms are in part a response to the problem that intervention aimed at stabilizing the yuan/dollar exchange rate was giving rise to excessive liquidity. As long as market expectations of a rise in the value of the yuan remain strong, the curbing of this excessive liquidity suggests that the Chinese monetary authorities are likely to allow the yuan to appreciate against the dollar in the medium term, albeit progressively and with attention to timing.

2. Outlook for the Yen/Dollar Exchange Rate

The US government and Congress have provisionally indicated their approval of the revaluation of the yuan, and it is likely that the upward pressure on the value of the Japanese yen fueled by the revaluation of the yuan will be relieved in the short term.

However, it is thought highly likely that the yuan will see further revaluations against the dollar and over the next 6-12 months or so, it is possible that expectations of a revaluation of the yuan will once again accelerate the strengthening of the yen against the dollar. In this event, it is likely that the appreciation of the yen will precede the revaluation of the yuan and that the yen will also strengthen against the yuan.

In the medium term (3-4 years ahead and onwards), it is likely that the yuan will strengthen against the yen, too. This is because, in the long term, continued rapid economic growth will boost China's economic strength relative to Japan.

3. Impact on the Chinese Economy

The recent revaluation of the yuan (2.1%) was extremely small, and its macro impact on the Chinese economy is likely to be limited. However, if the yuan continues to strengthen at a gentle pace in the medium term, it is likely that this will have the effect of setting the Chinese economy on a more stable and desirable growth path. A stronger yuan would have the effect of curbing exports and a fall in import costs, through the "improved trade conditions effect", would tend to stimulate consumer spending.

4. Impact on the Japanese Economy

The short-term impact (over the next 12 months) and medium-term impact (over the next 3-4 years) of the fluctuation of the yuan exchange rate on the Japanese economy must be considered separately as the movements of the exchange rate will differ in the short and medium term.

The "Short Term": 12 Months Ahead

In the short term, the effects of the revaluation of the yuan by the two routes of the strengthening of the yuan against the dollar and the strengthening of the Japanese yen against the dollar must be considered separately. Although the former will exert downward pressure on China's economic growth rate by reducing its trade surplus, this will, to some extent, be canceled out by the boost provided to the economies of China's trading partners, including the United States. The effects of the latter, although basically detrimental, are unlikely to be particularly severe. However, it should be remembered that a continued strengthening of the yen due to expectations of further revaluations of the yuan against the dollar, etc. could be a setback to the Japanese economy, which has only just begun to escape from its "growth plateau".

The "Medium Term": 3-4 Years Ahead

Looking 3-4 years ahead, it is likely that the yuan will have seen further revaluations against both the dollar and the yen. If the yuan/yen exchange rate at this time is 15% higher than at present, then, although preceded by negative effects in the form of a rise in the prices of products imported from China, in the medium term, the increased price competitiveness of Japanese products will boost the growth of the Japanese economy. On the other hand, by curbing exports, the revaluation of the yuan will exert downward pressure on the Chinese economy and the resulting fall in Japan's exports to China will tend to curb Japan's economic growth. By contrast, by reducing import costs - equivalent to boosting real incomes - the revaluation of the yuan will encourage domestic demand-led growth of the Chinese economy and, eventually, is likely to offset the export-curbing effect of the strengthening of the yuan. In summary, a gentle revaluation of the yuan, by 15% over the next 3-4 years, is likely to boost Japan's economic growth by around 0.4%.

5. Impact by Sector of Industry

If, in 3-4 years' time, the yuan has strengthened to some extent against the Japanese yen, then, depending on the balance of imports and exports and the importance of China to the sector in question, the impact on Japanese industry by major sector, is likely to be as follows:

International division of labor/production base-oriented sectors

In the electronics sector and part of the general machinery sector, the international division of labor in production processes is advanced and the volume of trade is largely determined by world final demand, so that the impact of the revaluation of the yuan in itself will be limited. However, in 3-4 years' time, the level of wages paid to Chinese workers will also have risen and, if the yuan is revalued, it may be necessary to reconsider the strategy of production in China, which is based on the assumption of low wage costs.

Import-oriented sectors

In clothing, food and beverages, Japan has a trade deficit with China and a revaluation of the yuan would have a severe negative impact on distributors and developmental importers of clothing and food in the form of a rise in import costs. A rise in the yen-based cost of wages paid to Chinese workers could make it necessary to reconsider the desirability of production in China.

Local production/marketing-oriented sectors

In the transportation machinery sector, local production accounts for a greater proportion of business than exports and although a rise in the value of the yuan would boost exports, Japan's exports center on products with higher added value that are not in competition with Chinese products and the boost to export volume would be limited.

Export/local demand-oriented sectors

For sectors exporting products with high added value that are not in competition with Chinese products or sectors that manufacture and market their products locally, such as chemicals, steel, some parts of the general machinery industry, which are less vulnerable to the effects of exchange rate fluctuation in the first place, the positive impact will be limited. However, for products with less added value that are in competition with Chinese products, the stronger yuan will have a positive impact in the form of increased price competitiveness.

6. The Long-Term Outlook

In the longer term, it is likely that China's continued rapid economic growth will gradually resolve its labor surplus and that conditions for a full-scale revaluation of the yuan against the Japanese yen will be put in place. Incidentally, if wages were to continue to rise at their present rate for the next seven years, and if the yuan were to strengthen by 30% against the yen, the average cost of labor for foreign companies operating in China would be likely to rise to a level almost equal to the current minimum wage in Japan. The changes made to the yuan system are only the beginning of the coming "age of violent currency fluctuation surrounding the yuan". Japanese companies need to undertake an urgent strategic review of their visions for the international division of labor in the wider Asian region and repositioning of their bases in China, based on their assessment of the future of the Chinese market.

For more information on the content of this report, please contact: Yamada, Miyamori the Japan Research Institute, Limited.

Tel: 03-3288-4524
E-mail:yamada.hisashi@jri.co.jp, miyamori@rsc.jri.co.jp

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