The over appreciation of the renminbi will cause turbulence in the Chinese economy, said Chen Deming, Vice Minister of Commerce, during the Third China-U.S. Strategic Economic Dialogue held in the middle of last December. However, directly after his remarks, the Chinese currency took a sudden rise. On January 14, the average value of the yuan, a denomination of China's currency also known as the renminbi, against U.S. dollar was 7.2566, a record high since the reform of the yuan exchange rate regime in 2005, and the yuan has appreciated about 12 percent since then.

Although the value of the yuan fluctuated in the following days, over appreciation pressure had drawn the attention of many economists. They feared that, if the trend continued, the Chinese economy would be seriously affected.

Statistics from the Chinese Academy of International Trade and Economic Cooperation under the Ministry of Commerce show that when the yuan appreciated 7 percent against the U.S. dollar, China's export-oriented companies had lost about 10 percent in profit. Because of renminbi appreciation, many companies will be forced to upgrade or transfer to other production. Moreover, as their product prices are not competitive in the international market, some previously profitable companies will suffer losses.

China agrees that the yuan should appreciate, but opposes rapid and irrational appreciation that does not fit with the country's national development situation. Because of this, the government is concerned that the yuan could continue to appreciate rapidly throughout the year.

Reason for sharp appreciation

Central Bank Governor Zhou Xiaochuan pointed out the recent yuan appreciation was mainly driven by surging international oil prices, domestic inflation and mounting trade surplus.

Zhou said the supply and demand in foreign exchange market was also part of the reason for renminbi appreciation. Some financial institutions have sold foreign exchange in large amounts, which propped up the renminbi's value.

But many people tend to believe a more important reason is that the Chinese Government hopes to cope with inflationary pressure through appreciating its currency.

In 2007, inflationary pressure has become a serious problem. The Chinese central bank raised its reserve requirement ratio 10 times during 2007, raised interest rates six times and issued large amounts of central bank bills and special treasury bonds. However, these measures did not seem to help. Inflationary pressure continued and the government hoped to ease the pressure by appreciating the currency.

The central bank stated in its third quarter monetary policy report that appreciation of the currency would be helpful to suppress domestic inflation, because fast renminbi appreciation would help reduce import costs, and relieve transferred inflation caused by the price surge of international food, oil and raw materials.

Ba Shusong, a financial expert with the Development Research Center of the State Council, supports the idea of relieving inflation pressure by appreciating the currency. Ba argued that if the renminbi appreciates 10 percent, the prices of imported oil, soybean and pork could quickly drop by around 10 percent.

A report conducted by the China International Capital Corp. showed that if other conditions remain the same and if the yuan appreciates by 10 percent, the CPI growth rate will fall 0.8 percentage points in the short term, and 3.2 percentage points in the long term.

Another reason for allowing the renminbi to appreciate is that many exporters have survived the previous round of renminbi appreciation. Gao Huiqing, a financial expert with the State Information Center, said the Chinese economy has been growing well with better risk control ability, and the government is more confident in handling risks.

Many research institutions have raised their renminbi appreciation expectations. JP Morgan Chase said in its research report that the renminbi will appreciate 10 percent amid sharp fluctuations.

Standard Chartered estimated that the Chinese currency will appreciate 9 percent and the renminbi exchange rate against U.S. dollar is expected to rise to 6.94 by the end of the second quarter this year.

The research department of China Merchants Bank estimated the yuan exchange rate against U.S. dollar will rise to 6.8 by the end of the year.

Impact on the economy

Renminbi appreciation is a two-edged sword. Some analysts believe continued yuan appreciation will continue to encourage a large inflow of international hot money.

The anti-money laundering department of the central bank said in the first half of 2007, over $121.9 billion of international hot money flowed into China. If the investors behind this money were sure the yuan would appreciate, more money would rush into China, which will lead to increased risks of inflation and an asset bubble.

Hua Min, a professor with Fudan University, said, if the pace of renminbi appreciation quickens, the value of the current national foreign reserves will depreciate. This means that short-term renminbi appreciation will cause future depreciation. If the renminbi value against U.S. dollar rises 10 percent, the value of Chinese foreign reserves will shrink 10 percent.

At present, the biggest problems concerning people's lives are employment and salary growth for people in lower-income groups. Fast yuan appreciation will have serious impacts on exporting companies, especially labor-intensive companies. The rise in costs will make Chinese exporting companies less competitive in the international market. "If the renminbi appreciates in a gradual manner, the companies can take it one day at a time. But sudden appreciation is fatal," said Li Ming, an officer of Beijing Import and Export Enterprise Association.

In addition, renminbi appreciation will make China less attractive to foreign investment, and is harmful to domestic tourism development. The financial deficit will increase with currency appreciation, which will make monetary policy unstable.

The United States has urged faster appreciation, but this demand might hurt U.S. interests in the end, because if the Chinese economy is hurt, the most direct victim will be the United States.

No hurry to appreciate

Renminbi is at present not convertible under the capital account, which means the renminbi exchange rate is not decided by the market. Therefore, since the renminbi exchange rate reform in 2005, people have wondered how far the Chinese currency can appreciate.

The purpose of the renminbi exchange rate reform is not to "appreciate," but to build up a new exchange mechanism in which the exchange rate is decided by the market. Guo Tianyong, a financial professor with the Central University of Finance and Economics, contended that before the mechanism is built up, the Chinese currency should not appreciate too rapidly.

Guo said in the current economic situation, renminbi appreciation could adjust the enormous trade surplus and relieve inflation pressure. But he argued as there is a lack of demand in the domestic market, the country cannot absorb the excessive commodities which would be caused by the reduction in exports. Therefore, the economy would suffer and inflation could become deflation.

Guo said the renminbi should appreciate in a slow and controllable manner. China will lose control over its own currency if the renminbi suddenly appreciates sharply. Meanwhile, Guo suggested the government make full use of other policy tools including interest rates and the reserve requirement ratio.