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Standard & Poor’s Ratings Services has stated that any flotation of China’s currency would be dangerous and could damage the sovereign’s creditworthiness, as well as that of local banks. Comments are contained in a Standard & Poor’s commentary article published in the run-up to the IMF/World Bank meeting recently in Dubai.

Ping Chew, Standard & Poor’s sovereign credit analyst for China (foreign currency BBB/Positive/A-3) says: “Despite increasing pressure on China by its trade partners, including the US and Japan, to revalue its currency, preferably by allowing the Chinese renminbi to float, Standard & Poor’s considers that lifting of exchange controls at the moment could be risky because Chinese banks are ill-equipped to handle volatility in the exchange rate.”

More broadly Standard & Poor’s concludes in its commentary that:

Efforts to have China lift exchange controls are unlikely to be successful

China’s trade imbalances are not as large as widely assumed as imports of goods and services have been accelerating broadly in line with exports

In the medium term, Beijing might choose to peg its currency to a trade-weighted basket of currencies rather than the US dollar

Expanding on the risks of a currency float, Paul Coughlin, managing director of Standard & Poor’s Asia-Pacific Corporate & Government Ratings, says: “We learned from the Asian currency crisis in the 1990s that the combination of a weak banking system, floating exchange rates and free flows of capital can be a very dangerous combination. China’s banking system is insolvent, with problem loans estimated by Standard & Poor’s at 45% of total loans, and its risk control systems are ill-prepared to deal a rapid liberalisation of the exchange rate and capital controls.”

As with previous challenges, China can be expected to respond to its trade surpluses and pressure for revaluation in piecemeal fashion. It might remove export tax subsidies, encourage overseas tourism, overseas investment, and more generally will allow the liberalisation under the WTO to enhance import growth.

It is the capital account that has driven the rapid accumulation of foreign exchange reserves. The capital flows came into China in search of its low manufacturing cost and huge domestic market potential. Foreign direct investment in China has been much more important for the accumulation of China’s massive foreign exchange reserves than has the trade surplus.

Chinese banks are dependent on the high savings (domestic savings rate of 40%) and liquidity to deal with its nonperforming loans problems, a fact that has only recently come under the spotlight. External assets also provide liquidity for the banks. The volatility from a currency revaluation (or even devaluation), coupled with capital flight, could crystallise the banks’ insolvency. The banks’ credit risk is also substantial, given many of its borrowers, especially public enterprises, are hardly profitable.

Chinese authorities are unlikely to view the exchange rate policy as a panacea to its problems, and will view suggestions to the contrary with suspicion. U.S. politicians are not alone in responding to populist and nationalist sentiment. The local Chinese media, including the official media such as the People’s Daily, have speculated about the “imperialistic” motives of the US and Japan. “Even if China accedes to a revaluation, the next correct level is debatable and its effectiveness questionable. It has to be large enough to have any effect, but the suggested level of 20%-50% is probably too much to stomach,” adds Chew.

If China loosens its exchange control regime in future, it is likely via a peg to a trade-weighted basket of currencies in place of the US dollar. This could also follow expanding its trading band. This reflects the gradualist and pragmatic nature of Chinese policy – essentially adopting cautious steps to address each problem. Such a policy change would have the attraction of not substantively changing the current system, but would provide the banking system a gradual and muted introduction to fluctuations in currency valuation.