From Observer, page 41, issue no. 342, November 19th, 2007
Translated by Zuo Maohong
Original article: [Chinese]

Bubbles, surplus, loss of control, imbalance… these all have been popular keywords used to describe China’s economy over the past several years. And in observing China's transitions and high-speed economic growth, it's not surprising. But when imbalance in the economy is worsening everywhere-- bubbles in the stock market, uncontrolled housing prices, expanding foreign exchanges, a soaring trade surplus, and a real interest rate of -3%-- they merit serious concern. While appearing to be independently caused, in fact they all share one root: the yuan's slow appreciation. Many say that a slow appreciation is meant to keep China from following the economic recession that Japan experienced in the 1990s. But in my opinion, on the contrary, it’s actually contributing to this.

A crawling yuan has brought imbalances everywhere.

“Move gradually” has always been the basic strategy of China’s economic reform, which evidence shows has been successful. However, if the same strategy is applied to financial pricing policies, the result may be reversed. This is because compared to the commodity market and other factor markets, operations in the financial market, as well as the values of financial assets, are totally dependent on market expectations, and the deviation between prices and values of financial products can instantly affect market participants’ actions.

For example, pork prices on a certain day is basically decided by the supply and demand ratio at that time. There may be expectations of rising pork prices and therefore growing investment in hog raising, which may consequently ease future pork prices. But this can’t affect the market’s supply and demand and further the price of the day, because it needs time to expand production and wait for other alterations to be effective. Therefore, general economic policies have enough room for “gradual moves”, and the same is true of the commodity market reform and social reforms.

But the financial market works differently. Take the yuan as an example: thanks to its high fluidity as a financial asset, any change in its supply and demand due to market expectations immediately affects prices in the market. In this case, the yuan’s exchange rate against the US dollar is more directly influenced by expectations of appreciation or depreciation of the currency.

Everybody knows that the yuan should appreciate by 15 percent, yet the government only allows a 5 percent growth each year, which means it has to “move gradually” for three years. The outcome then is apparent: familiar imbalances and high economic risks.

First, a suppressed yuan appreciation means its value is far higher than its price, and the government’s plan of keeping it at a 5 percent growth rate each year indicates the least possibility of the yuan’s depreciation. Any investor will turn to yuan-valued assets when seeing nearly zero-risk returns. Hot money or speculative capital from out of China therefore flows in.