A world banking organization warned that an abrupt decision by China to allow its currency to float freely could destabilize that nation’s economy. Some observers have complained the fixed exchange rate gives Chinese manufacturers an unfair...

GENEVA — A major international banking organization last week cautioned that China should resist demands to allow its currency to float freely, warning such a move could have destabilizing consequences.<br><br>The recommendations, which came in a...

GENEVA — A major international banking organization last week cautioned that China should resist demands to allow its currency to float freely, warning such a move could have destabilizing consequences.

This story first appeared in the July 6, 2004 issue of WWD. Subscribe Today.

The recommendations, which came in a report from the Bank for International Settlements, are in opposition to calls from manufacturer groups in many nations that compete with China. Also last week, the Fair Currency Alliance, a Washington-based group of U.S. exporters, reiterated its call for China to allow the yuan to rise in value.

The FCA report asserted that by maintaining a fixed exchange rate of 8.28 yuan to the U.S. dollar, China undervalues its currency, sometimes also called the renminbi, by as much as 40 percent. Keeping down the value of the yuan in turn makes Chinese exports to the U.S. seem lower in price than they would otherwise be.

In its report for 2003-’04, the Bank for International Settlements cautioned China may not be ready to allow its currency to float freely. It said China faces some domestic constraints effectively limiting its options.

“Chinese financial markets are still at an early stage of development, the banking system still has huge problems and the apparatus for effective supervisory is not yet in place,” the BIS report said.

As a result, the report continued, freeing up the Chinese exchange rate without adequate control over capital flows “would have highly unpredictable, and probably highly undesirable, consequences.”

The BIS suggested a more reasonable possibility might be “to revalue and peg against a basket of currencies.” In a basket approach, the yuan’s value would be based on an average of several other currencies. In theory, as the currencies in the basket changed relative to one another, that would allow the exchange rate for the yuan to shift slightly.

Yet even allowing the yuan more wiggle room, this should not be seen as a panacea, either for China’s problems of economic overheating or for global trade imbalances, the report noted.

It said China is now a heavy importer of machinery, raw materials and other supplies required for the assembly and export of finished products “and is rapidly becoming the world’s manufacturing center.”

In the last year, among the larger economies, the report said, “China provided the clearest evidence of an increase in inflation.”

Concerned about the possibility their economy will overheat, Chinese authorities have taken a series of steps to “slow down both lending and spending,” the report said.

However, according to the report, data for the first quarter of 2004 suggest growth is still accelerating.

“Bank credit growth and inflation have also remained high,” the report said. “Investment demand continues, partly reflecting already planned projects, as well as a reduction in real interest rates.”

To prevent the economy from overheating, the report said, “further tightening might, therefore, be required.”

Property prices have risen in double-digit rates in Shanghai for three years in a row and were up 18 percent in 2003 over the year before, while the surge in Chinese demand has spurred the rise in commodity prices globally, the report noted.

In March 2004, China’s foreign exchange reserves totaled $439.8 billion, compared with $286.4 billion in 2002. This is a critical figure because China is able to manage the exchange rate for its currency by buying up foreign currencies, thereby reducing the supply of foreign currency in circulation while increasing the supply of its own. Some observers have warned that China’s growing foreign reserves also give it considerable power on the international stage because it could throw the value of other currencies into a tailspin by releasing its reserves quickly.

Nout Wellink, BIS president, told representatives from more than 100 central banks and international institutions at a meeting in Basel, Switzerland, that while China’s economic prospects were currently excellent, “global imbalances were too large.”

He?added that China’s macroeconomic policies cannot remain as aggressively bent on expansion if the economy is to be kept stable.