China's rising trade surplus and rivers of foreign direct investment flowing into the country have led calls for the Central Government to revalue the renminbi. Governor of the People's Bank of China Zhou Xiaochuan has reiterated that the value of the renminbi will remain unchanged, as has Chinese Premier Wen Jiabao, who said in early August that there was no need to do so.

Their comments have not stopped calls for the yuan to appreciate, nor have they stopped the flood of "hot money" pouring into China in anticipation of the yuan appreciating.

To maintain the renminbi's stability, China has increased the supply of money by more than 20 percent in the past few months at the risk of overheating the economy. Concurrently, the shadow of inflation appeared in the latest CPI and M2 figures.

Alarmed by such developments, the Central Government is looking into possible solutions with the least side effects. One possibility would be to liberalize the flow of foreign exchange, including opening up of the renminbi capital account and allowing domestic investors to invest overseas. China's immature banking system and a high ratio of bad debts, however, could lead to a flood of illegal capital out of the country, which would destablise the banking sector.

That said, Chinese citizens can now take money out of the country with the newly implemented outbound tourism measure, streamlining of foreign investment procedures, as well as the QDII plan, which is now under negotiation. Even so, these initiatives alone would do little to help reverse the rising tide of the foreign exchange reserves.

The suggestion of suppressing exports to reduce its trade surplus and boost imports has aroused widespread concern. News from the Ministry of Commerce and Finance hints that this would be done through the macro control measure of cutting the export tax rebate rate by 4 percentage points, although no plans have yet been put in place.

China set up its export tax rebate mechanism in 1985. At the time, export rebates for coal and agricultural products subject to a 5 to 7 percent value-added tax (VAT) were fixed at 3 percent. For industrial products paying 13 percent VAT, the rate was 10 percent, while the rebate was 14 percent for all other kinds of export goods in the 17 percent VAT category.

In 1996, rebates were halved, due to the government's huge fiscal burden. To stimulate export growth that had dropped to almost zero in 1998 after the Asian Financial Crisis, VAT rates were adjusted to 13 or 17 percent in July 1999, while export rebates were raised to 5, 13, 15 or 17 percent. In sum, the average rebate rate is 15 percent and major industrial products exported enjoy almost 100 percent VAT refund.

Since 1999, China's exports have been growing rapidly as a result of its tax rebate policy. This is in line with the common international practice of not imposing indirect taxes on domestic exports to secure their competitiveness.

The underlying problem, however, is that the government is far behind in its rebate payments. According to statistics compiled by the State Council's Development and Research Centre, the Central Government is expected to owe 300 billion yuan in rebates by the end of this year, up from 247.7 billion yuan today. This hidden deficit plus the visible deficit of more than 300 billion yuan per year means that China is actually suffering from a total deficit exceeding 5 percent of its GDP.

One reason for the delay is that China's tax management fits badly with the implementation of the rebate policy. The central and local governments share value-added tax receipts to a ratio of 3:1, but the Central Government bears the full burden of refunding export tax.

The proposed rebate cut might be seen as a way to kill two birds with one stone: it would ease pressure to revalue the RMB, and reduce fiscal pressure on the Central Government. Such a move would, however, hurt exports and reduce employment, two issues which the government does not want to create, especially higher unemployment.

A moderate cut in export tax rebates of 2 percent would probably not cause exports to contract, but a 4 percent cut would have serious consequences. Given that most business only manage to earn small profits annually, such a big cut might send them into the red. Consequently, the impact of a 4 percent cut on the export sector should not be under-estimated.

With many grey areas exisiting in its tax system, China needs to perfect the mechanism to increase tax revenues, establish a fair responsibility-sharing mechanism between the central and local governments and minimize the impact of taxes on the national economy.