The free conversion of the Chinese currency (RMB) is controversial and debatable in China's financial circles, despite the great interest abroad aroused by the Chinese government's recent announcement that the free conversion would be introduced by the year of 2000 or earlier.

China will take two steps towards the free conversion of RMB: first, a free conversion for current account items, as required by the IMF Agreement for member countries, and second, an overall free conversion including capital account items. The second step, without a timetable yet, will be taken in some time m the future

Affirmative Views

Although every one in the financial sector agrees to the convertibility, views differ as to when and how fast.

Advocates mostly governmental officials in charge of the issue, believe that China is ready for the free conversion while other people, mostly scholars, call for more agreeable conditions.

For advocates, the success of the exchange reform in past decades has provided solid ground:

• China in 1994, abolished its dual exchange rate system by merging the official and market exchange rates into one unified, managed floating exchange rate; introduced the foreign exchange surrender and settlement system, and set up the interbank exchange market;\
• Trade surpluses rose from US$ 5.3 billion in 1994 to US$ 16.69 billion in 1995;
• The soaring trade surpluses and booming foreign investment quickly expanded foreign exchange reserves – from US$ 10 billion at the end of 1993 to more than US$ 73 billion at the end of 1995; and
• On July 21 2005, RMB was appreciated by 2.1% against the dollar and ended 10 years of fixed rate of RMB with the US dollars. The People's Bank of China announced on the same day that RMB will be valued against a basket of currencies and will be allowed a 0.3% floatation daily.

In fact, as they argue, a pseudo free conversion – free conversion for trade items only -- has virtually taken place smoothly in the past two years. They take this as strong evidence to support their position.

Moreover, they believe that the fundamental basis of a free currency system lies in tile country's economy. China's GDP grew 13.5%, 11.8% and 9.8% in 1993, 1994 and 1995 respectively. Sustained high economic growth has yielded a strong impetus to export growth. The amount of exports rose from US$ 91.76 billion in 1993 to US$ 148.77 billion in 1995. China's vigorous export growth provides the key condition for the free conversion of RMB.

Conservative Views

However, some scholars harbor doubts about the timing for the free conversion and caution the down-side risks. They remark that as there are still some deep-rooted economic problems to be solved, a period of transition is imperative.

Although trade surpluses in China were impressive, they were mainly the result from the existing import permit and control system, instead of a free imports system. If China relaxes its import restrictions together with incessant reductions of tariffs, export growth will lag behind import growth with eventual deficits in trade. It is, therefore, realistic to free the import system gradually before RMB becomes freely exchangeable. Controls on excessive amounts of imports can be more easily imposed under the existing exchange system than under the would-be free currency system.

Hikes in consumer prices in recently years were much greater than the inflation rates in developed countries. The inflation is certainly pushing up the export costs in RMB for foreign exchange, detrimental to the growth of exports as well as to the stability of the exchange rate after the free conversion.

Evidence shows that diminished from January to the trade surplus in 1995 November in proportion to the growth of the export costs in RMB for foreign exchange. The RMB will probably depreciate against the dollar in 1996, as a result of the restraint of trade surplus and foreign investment. Besides, the government's ability to control economic development on macro level needs to undergo more tests. Currently, the pricing for a few major commodities is still controlled by the government and price subsidies by the government for many commodities are still in effect. This is advisable to maintain economic stability under the condition of relaxing price controls completely, so as to lay a solid foundation for RMB exchange rate stability after the free conversion.

Furthermore, these scholars believe that the introduction of the currency free conversion, together with free imports and overall price control relaxation, may bring shocks to the economy. Free imports will enhance the volume of imports and provoke disasters to infant industries.

They can envision a scenario like this: imports exceed exports, exchange supply falls short of demand, and RMB depreciates accordingly. As a result, the more expensive imports in RMB boost prices of commodities for export. The joint price hikes of exports and imports then give rise to a general hike in domestic prices.

The reciprocal causation of RMB depreciation and domestic inflation will form a vicious circle, jeopardizing the stability of the economy and impeding the advance of economic growth. They suggest that when introducing the free conversion, it will be necessary to guard against shocks of free imports, excessive exports, RMB sharp depreciation and domestic inflation.

A freer RMB in vision

The basic difference between these views stems from judgments on the country's situation with regard to economic reforms, resulting in different priorities of reform measures -- free conversion, relaxation of import permits, or price controls. Since more government officials are in favor of the affirmative side, and in view of the ponderous weight of the opinions of the said officials, I may presume that the process for the free conversion of RMB is likely to go on. This measure will certainly be conducive to currency transfers, freer trade and freer business operation for foreign and domestic merchants, and hence further increase foreign investment in China.

Since July 21, 2005 when the first devaluation of Chinese currency RMB against US dollars and major currencies after 10 years of fixed rate with the US dollars, the convertibility of RMB is on its track to the free convertibility.