China must rethink free float for the yuan, as US border tax looms

Weifeng Zhong and Zhimin Li say a market-led exchange rate regime is the best option for Beijing, with the proposed US import tax poised to deal a heavy blow to China’s monetary system and growth outlook

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US President Donald Trump hosts a meeting with the House and Senate leadership in the White House on March 1. Among the attendees are (from left) House Republican leader Kevin McCarthy, Senate Republican leader Mitch McConnell and House Speaker Paul Ryan. Photo: AP

Published: 3:46pm, 7 Mar 2017Updated: 8:09pm, 7 Mar 2017

The US Republicans’ border-adjusted tax plan – to tax imports and exempt exports – could deal a strong blow to the stability of China’s monetary system and its growth prospects. Beijing would be wise to move to a floating exchange rate regime.

The proposed tax plan would not improve America’s trade balance, as many claim, but would, instead, boost the value of the greenback against the currencies of its trade partners, including China.

The import tax would reduce US demand for Chinese products, trimming the supply of US dollars in foreign exchange markets. The export exemption would increase Chinese demand for American goods, pushing up the supply of the yuan in currency markets. In the end, a 20 per cent border adjustment would cause the yuan to depreciate by 20 per cent against the dollar – leaving the incentives of exporters and importers, as well as the balance of trade, unchanged.

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China’s exchange rate regime could then play out in three likely scenarios, none rosy. The best option would be to let the market determine the yuan’s value.

If China were to cling to its current, heavily managed regime – a crawling peg against the dollar – it would see its forex reserves dwindle even further. To prevent a rapid depreciation of the yuan, the government would need to pour its forex reserves into the market to prop up the currency.

China has already used up 20 per cent in the past two years as the yuan fell by 10 per cent. Its reserves are now just above US$3 trillion. If America’s border adjustment leads to a 20 per cent fall in the yuan, China’s forex reserves could easily fall to a level that the IMF would deem inadequate for a country’s financial stability.

China’s foreign exchange reserves are now just above US$3 trillion, amid a continued drive to prop up the yuan. Photo: Reuters

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If China were to peg its currency tightly against the greenback, it would potentially face daunting deflation pressures. Under the 20 per cent import tax, market forces would eventually make the border price of Chinese goods 20 per cent cheaper for US consumers. If the yuan’s exchange rate did not adjust downward by 20 per cent, the price of Chinese goods would instead have to fall by 20 per cent – a deflation for China. That would compromise the independence of China’s monetary policy and further weaken its frail economy.