Written by Laurence Brahm - Published by South China Morning Post on 05/24/2005

Premier Wen 1iabao warned an American Chamber Of Commerce delegation on May 16 that reform of the exchange rate system was "a matter of China's sovereignty, and any pressure and speculative exploitation of the issue or any attempt to turn an economic issue into a political one will not be conducive to resolving it".

He went on: "As long as conditions are right, the Chinese government will take steps to reform the exchange rate system without pressure from outside countries. If conditions are not right, the government will never hastily take any action, regardless of how great the pressure is from outside."

The next day, the US Treasury Department, in a report to Congress, demanded action by China within six months, and threatened punishment otherwise. Last month, the US Senate passed a bill to apply punitive tariffs on Chinese imports in an attempt to leverage some movement. passed a bill to apply punitive tariffs on Chinese imports in an attempt to leverage some movement.

As a result of US pressure, speculative hot money – estimated at between US$70 billion and US$100 billion – flowed into China from international financial institutions. US analysts predicted a yuan appreciation on either May 8 or last Wednesday, fuelling rumors and speculation.

But Mr Wen has explained clearly that "the reform of our exchange rate regime must consider the actual conditions in China, our macro-controlled economic environment and the ability of enterprises to undertake this". To understand his logic, it is necessary to examine some fundamentals of China’s monetary regime and policy.

First, Beijing's objective is to have a free-floating, fully convertible currency – something which c an be realized under the current administration. However, financial reforms remain incomplete, and the system is immature. Because o f the acute financial frag ility, China will not adopt any sudden measures – especially when another nation demands action for its own domestic political purposes.

Second, to achieve full currency convertibility, China must open its capital accounts. But at least 43 different kinds of currency services are normally required to achieve open capital accounts. Currently, China has only a dozen.

Third, under Wor1d Trade Organization requirements, the financial system must open to direct foreign participation by next year. C1ear1y, China’s domestic banking system is not ready. However, to fast- track the move towards a more international system, key institutions such as the Bank of China and the China Construction Bank are preparing international listings.

The problem is that, to qualify, the massive amount of non-performing assets must be written off. From this perspective, China’s huge foreign exchange reserves of US$659 billion seem like a mirage. This is why Beijing cannot move o n the exchange rate, despite ПS pressure.

As of last year, the total non-performing assets of banks and asset management companies stood at US$374 billion, or 26.5 per cent of gross domestic product. Ultimately, the cost of this bailout will require drawing from these reserves.

Last year, China's exports totaled IIS$593 billion, 55 per cent of which was by enterprises with foreign investment. Imports were US$561 billion, leaving a surplus of only US$32 billion. Moreover, a decade ago, China was self-sufficient in energy; now it imports most of its oil.

In China, when the economy is on a roll, everything seems great.

However, any crises will be on a massive scale, and foreign exchange reserves, which once seemed enormous, may pale beside what could become China's real import needs in the immediate future.

The battle lines have been drawn in the exchange rate issue over questions of whether nations in transition have the right to undertake their own financial reforms, independent of the Washington Consensus model. Is a stable monetary policy wrong?

Laurence Brahm is a global activist, international mediator, political columnist and author. He is the leading advocate of a fresh development paradigm - The Himalayan Consensus - an innovative approach to development.

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