China stands firm at G-7

It was a strategic decision on the part of China to stand firm against strong pressure from American and European leaders to untie the yuan from the U.S. dollar, arguing that it needed more time to reform its financial system.

Finance ministers and central bank governors from the Group of Seven Industrialized Countries (G7) who met in London over the weekend were expecting a commitment from China to float the yuan within a clearly-defined timeframe, a move market analysts see as a revaluation of the Chinese currency.

There had been widespread speculation that there might be a dramatic announcement by China at the London meeting, but the G7 statement essentially eliminated the possibility of an adjustment to the yuan exchange rate anytime in the near future.

The G7 finance ministers and central bankers by and large only repeated the statement they made a year ago in Florida. They acknowledged that they had held "productive dialogs" with the Chinese government. The only strong, if veiled, warning for China, can be inferred from their reaffirmation that exchange rates should reflect economic fundamentals, and that excess volatility and disorderly movements in exchange rates are undesirable for economic growth.

They said they will continue to monitor exchange markets closely and cooperate as appropriate, pointing out that more flexibility in exchange rates is desirable for major countries or economic areas that lack such flexibility to promote smooth and widespread adjustments in the international financial system, based on market mechanisms.

The right conditions do not exist at the moment for China to adjust its yuan exchange rate. First of all, its financial markets are still very immature, and its corporations do not yet know how to deal with daily exchange-rate fluctuations. Most importantly, China has yet to establish a system for appropriate currency hedging.

The tragic experiences of such countries as Indonesia, Thailand and South Korea, which prematurely liberalized their foreign exchange markets while their financial systems were still very weak, should serve as a lesson for China to move gradually on its foreign-exchange rate policy.

Many policy makers and economists argue that the Chinese yuan, pegged for a decade at 8.28 to the dollar, is grossly undervalued, and that a revaluation is necessary to reduce America's huge current account deficit. This point of argument, however, seems weak because China accounts for less than 10 percent of America's total trade. A steep revaluation could deal a double blow to the Chinese economy since China's exports have a high import content that limits the impact of exchange-rate movements on export prices.

The biggest problem for China's current exchange rate policy is not the yuan, but rather the performance of the dollar. A fixed exchange rate is supposed to provide stability.

Instead of pressuring China to revalue its currency, European countries, with support from major Asian economies, should have sternly warned the U.S. that the international community is running out of patience with its huge twin deficits (budget and trade). But there was little emphasis in the G7 statement on Saturday on international concerns about these massive U.S. deficits.

The deficits have been the source of the dollar's weakness and the euro's strength, which in turn has hurt European exports and growth.

Hopefully U.S. President George Bush, who is delivering a new budget on Tuesday (Indonesian time), will make a strong pledge to increase fiscal discipline.

If the U.S. continues to take no action to halt the dollar's decline, then it may become imperative for Asian nations to shift their central bank reserves in favor of the euro.