The plunge in the euro and threat of persistent economic instability has caused the Chinese government to take a more cautious approach to adjusting its exchange rate. But ironically, the collapse of the euro presents a golden opportunity for China to introduce greater exchange rate flexibility. China should do this now, rather than wait for the crisis to abate. And to the surprise of many, it should begin by depreciating rather than appreciating the value of the renminbi.
Chinese authorities have been reluctant in the past to appreciate the exchange rate in response to global pressure because when markets are convinced that the renminbi will rise – even gradually – in value over the foreseeable future the rise will encourage speculative capital inflows. Over the past decade, estimates suggest that perhaps 20-40 per cent of the annual capital inflows have been “hot money” pursuing the likelihood that the currency would appreciate either steadily or in measured steps. Such inflows intensify pressure for further appreciation and create negative results that China is already struggling to address.
Damaging consequences include excess liquidity and lower than desired interest rates that help push up investment – notably real estate – to unsustainable levels, and raise the prospect of a major collapse in asset values. Housing prices in Beijing and Shanghai are clearly inflated and demand continues to grow unabated. While unit values have doubled in many cases in the past year, rents are stagnant. Apartments remain empty as owners wait to “flip” their holdings. With these concerns, one-way bets on the exchange rate are not something China should encourage.