"You can't shut out the world without shutting yourself in"
-Arnold Glasow

THE CHINESE CURRENCY CONTROVERSY:
I thought I should put this up as part of my research into China, emerging markets and stabilization and growth.

INTRODUCTION
The Chinese currency is the RenMinBi (RMB), generally pronounced Yuan in written form, but spoken as Kuai. Chinese paper money is available in RMB1, RMB5, RMB10, RMB50 and RMB100.

The Chinese have kept a fixed exchange rate of 8.28 Yaun/renminbi to the US dollar since 1995. In July 2005, the Chinese revalued the Yuan by 2.1%. Earlier this summer, the Chinese authorities abandoned the Yuan peg with the dollar, and linked the currency to a basket of currencies. The move immediately resulted in a 2.1 pct appreciation in the value of the yuan, raising it from 8.28 Yuan to the dollar to 8.11 Yuan to the dollar. The step was widely seen as a political move by China aimed at appeasing trading partners like the US and was widely praised by governments and economists as the 'first step' toward greater flexibility in China's forex regime.
But the US government finds that 'China's fixed exchange rate is now an impediment to the transmission of price signals and international adjustment, and imposes a risk to its economy, China's trading partners, and global economic growth'. The revaluation was appreciated but the US has clearly stated that it was not enough.


The build up:
Will China be unable to avoid a crash? Since 2003 Chinese banks' reserve requirements have been raised three times, but to little effect. Banks still have more than enough reserves and tighter restrictions have been placed on property lending. The central bank has also tried to use persuasion, asking banks to curb their lending to overheating sectors—again with little apparent success.
In the year to the first quarter:
Bank credit surged by 21%
GDP grew by 9.7%
Fixed investment by 43%
Inflation has risen from just 0.9% a year ago
Many economists reckon that the Chinese economy is even hotter than the official figures suggest. Based on electricity usage, annual growth may really be as high as 12-13%; and the true inflation rate is probably above 5%, as a significant number of prices are still controlled in some way by the government. On the other hand, official figures overstate the growth in investment, because the investment survey now covers more firms than last year. Even so, investment is still growing too fast.

Rumours are rife that the People's Bank of China is about to raise interest rates (one-year bank-lending rates are currently 5.3%) for the first time in nine years. The fact that this is even being discussed shows how concerned the Chinese leadership is about the investment boom. Wen Jiabao, the prime minister has said that China will take “very forceful measures” to cool its economy. This was followed by reports of a temporary freeze on new lending by smaller banks, later played down by China's banking regulator. Later the government announced tighter controls on investment projects and some new price controls. It clearly is desperate to curb new lending and investment.
The State Council, China's highest executive body, has issued new guidelines requiring companies to use more of their own capital and less debt to fund steel, aluminium, cement and property projects, the sectors which show most signs of overheating. Provincial government leaders have also been told to be stricter about approving investment in these sectors

Chinese Currency Controversies – Barry Eichengreen – A synopsis
Eichengreen’s article must be understood in the context of the timeframe within which it was written, i.e. early 2005. The situation has changed since then, and will be discussed further in this paper.

According to Eichengreen, since summer 2003, Chinese currency peg has been an issue for the US and the complaints have been political (due to slowing US growth, the US has argued that the RMB is overvalued.

However, the level of exchange rate is one factor fueling Chinese export growth (in fact, Chinese imports are growing faster than exports, producing a trade balance deficit).

He points out there is no question that eventually China will need to have a more flexible exchange rate, to accommodate its own distinctive business cycle conditions. But the Chinese are worried that a more flexible exchange rate would disturb expectation, discourage adjustments and growth and undermine (further) stability of the banking sector. According to most estimates, the inconvertible assets on the Chinese banking sector constitute as much as 40-50% of the GDP. He goes on to state that, “In a sense Chinese economy is facing the familiar exit problem that follows any exchange rate based stabilization.”

Implications:
Eichengreen recommends that China should move to a more flexible exchange rate sooner rather than later – the easiest time to abandon a currency peg following an exchange-rate stabilization is when there are large capital inflows and exchange rate is strong.

He argues that what is needed is not reevaluation (as argued by most experts of around 25%) but a new regime, in which China would be better able to tailor local financial conditions to local needs.

His recommendation for the best flexible exchange rate: a form of open-economy inflation targeting in which the authorities formulate monetary policy to limit deviations of inflation and growth from their respective targets. This implies intervening to limit currency fluctuations since exchange rate affects inflation and economic growth. In order to do that, he says China needs an increase in flexibility and limits on the extent of possible volatility.

Eichengreen clarifies that a more flexible exchange rate does not mean capital account liberalization. While controlled capital account rules out the possibility of a free-float, a managed float is possible.

The costs and benefits of the peg according to Eichengreen

Exports are the biggest factor in Chinese rapid growth; rising by 20% per yr, which also attracts FDI.

Is exchange rate peg important for this process? According to econometric studies there is little impact of exchange rate variability on trade and investment (I). It is more likely that economic reform and China’s entrance into the WTO, as well as, increase in global outsourcing fueled the growth. A modest change in level of exchange rate and/or shift to a higher level of variability would have only a moderate (if any) impact on growth in the short term.
- Multinationals are unlikely to be liquidity constrained as they could borrow. In China, foreign investment enterprises and joint ventures account for bulk of the exports.
- Main worry: impact of exchange rate variability on private domestic firms, as in case of difficulties, they would have to obtain financing from banks. But these firms contribute only to 10% of exports.
- Benefits: greater flexibility for People’s Bank of China (PBC) to be able to limit pro-cyclicality of money and credit. The peg results in misallocation of resources

Under a peg: positive shocks to A and Y -> positive shock to money and credit supply; increase in interest rates (which would damp the economic activity) is offset by increase in K inflows/ decrease in K outflows.
Pegging the currency prevents a) a move to a market-based monetary policy, because it reduces the extent to which monetary conditions are independent of the peg; b) use of interest rates to allocate credit, which leads to property lending and property market heating.
Peg leads to massive allocation of sR*, instead of private investment.



Alternatives
Step Revaluation – one-time revaluation on the order of between 10-40% to relieve pressure from the US, because of temporary slowdown in growth of China’s exports and cooling off of the economy, fighting off of the inflationary pressure.
This does not address the problems experienced under original peg, the problems are likely to reoccur and magnify because of expectations of future reevaluation and subsequent speculative capital flows. As K account grows more porous the problems will worsen.

If revaluation is too small would prompt expectations of future revaluation and more speculatory pressure on the peg. A revaluation that is too large would unnecessarily slow the growth of the economy.

Step Revaluation with a Shift to a Basket Peg – monetary conditions more stable because the currency would then not be tied to US economy. But this also doesn’t address the peg problems.

Step Revaluation with a Later Shift to a Float - the exact magnitude proposed (15-25%) may be a bit much and highlight drawbacks of the peg being in place before the float is introduced.

Arguments for delaying float: rapid K account liberalization threatens financial stability b/c of banking sector problems. However, this problem would not be compounded by a more flexible exchange rate system, which would allow slow K account liberalization while strengthening the banks. Another argument for delaying transition until K acc liberalization is that K controls prevent firms from using financial instruments to insulate themselves from crises.

Managed Float – Since K account is increasingly porous, China should move towards a more flexible exchange rate system. An initial adjustment of about 5% can be attempted to see if this slows accumulation of reserves and causes heating. If not, this doesn’t challenge credibility and authorities can further allow the exchange rate to go up. Since the currency can appreciate and depreciate the speculators would be deterred. If economic conditions change and market causes the exchange rate to move, the authorities could move the currency more or less so depending on the changes.

The underlying reason for a particular exchange rate regime is the monetary policy. When exports are the only dynamic sector, it makes sense to have a peg. Eichengreen recommends the PBC should weight the exchange rate and its range for fluctuation depending on how responsive the inflation and economic growth are to shocks. This is rudimentary form of inflation targeting. The band should be dome away with because if too small it may induce a shift and if too large it would not serve as a guide for monetary policy.

The rate should be managed to limit the currency’s movement, with the extent of permissible fluctuations as a function of shocks rather than being predetermined by the width of fluctuating band.

Eichengreen’s Arguments to keep the peg:
The peg served China well during 1997-8 Asian crisis – but was that really the K controls?
The unemployment rate is still high, therefore China needs rapid export growth to absorb unemployed workers
Allowing exchange rate to appreciate would cause K losses on sR* - this really deals more with any sort of appreciation rather than flexibility
A peg is good for the neighbors

Eichengreen’s Implications for Asian neighbors

The impact would be uneven:
-In low-income countries that compete with China in the unskilled labor-intensive production, would be beneficial because China’s labor cost would go up comparatively.
-In the next tier the effect would be less beneficial. Positive impact on unskilled labor-intensive production and negative impact on skilled labor-intensive production would cancel out. (China would move towards production in the former latter sector).
- In the most advanced countries the effects would be largely negative, b/c deceleration in China’s growth would decrease it’s demands for their exports.


Today’s danger:
The biggest fear that economists have today is the Chinese economy overheating. The hotter the economy gets, the greater the risk of a hard landing, and a repeat of 1994-95 when a previous investment bubble popped, leaving a hangover of excess capacity and deflation that lasted for several years.
However, Hong Liang, an economist at Goldman Sachs in Hong Kong, thinks that talk of a hard landing is premature, because there are several differences between today and the early 1990s. Policy has been tightened sooner this time. In 1993 inflation was already 15% (it rose to 28% at its peak) before the central bank tightened, while money-supply growth then was twice as rapid as today's. In the early 1990s, real interest rates were negative, falling at one point to minus 13%. Today, bank lending rates are positive (see chart). Even so, the level of 5.3% is far too low for an economy where nominal GDP is growing at around 15%.
A second difference is that unlike a decade ago, there has not been a consumer-spending binge. Private consumption grew by only 6% last year, compared with average growth of 14% in 1992 and 1993. That is one reason why last year China had a current-account surplus; in 1993 it had a deficit of 2% of GDP.

The debate:
The term “overheating” is normally used when an economy is suffering from excess demand, which then causes inflation to rise. But China's boom has been led by investment, which means that supply is booming as well as demand. As a result, the biggest risk to the economy is not inflation, but overinvestment. A glut of property or industrial capacity could depress profitability, bankrupt firms and swell banks' non-performing loans.
China's banking system, which is virtually all state-owned, does not allocate credit efficiently, and the misallocation of funds gets worse as growth speeds up. Bad debts may already be 40-50% of loans. In the long run, to improve this China needs to commercialize its financial system. That will require financial reform, as well as a transformation in corporate governance. But that will take years. Right now, the government needs to slow the economy to avoid another wave of bad loans.
Some economists draw analogies between China and Thailand before its financial crisis in 1997-98. Investment in Thailand also surged to more than 40% of GDP. The big difference is that Thailand had a current-account deficit of 8% of GDP in 1996. In contrast, China had a surplus of 2% of GDP last year, because its saving is even larger than investment. If China were running a large deficit, its currency would now be under severe downward pressure given all the concerns about its economy. Instead its foreign-exchange reserves are building up because of strong capital inflows, driven by speculation that it will have to revalue its currency.
Indeed, the undervalued yuan is one important cause of China's credit boom and rising inflation. China's capital controls are porous, and investors all over Asia are betting on a currency revaluation by buying property in Shanghai or Beijing or putting their money into Yuan deposits to take advantage of interest rates higher than the paltry level available in America. The yuan has been more or less pegged against the dollar since 1995. If, as a result of capital inflows, there is an excess supply of foreign currency, the central bank must buy it and sell Yuan to keep the exchange rate stable. This injects new liquidity into the banking system, thereby feeding the credit boom. The central bank has been issuing bonds to mop up the liquidity, but this “sterilisation” is getting harder as the amounts swell. The bank has had trouble selling enough bonds in recent months, so the money supply continues to surge.

China's pegged exchange rate is not only causing problems at home. America accuses China of stealing jobs by keeping the Yuan artificially low. In fact, it is not so clear that the Yuan is undervalued. On the basis of purchasing-power parity (ie, relative prices) it does look undervalued. But almost all poorer countries look cheap by this gauge, and over the past decade China's real exchange rate has risen. Andy Xie, an economist at Morgan Stanley, calculates that, in real terms, the yuan has risen by 40-50% against both the Dollar and the Euro since 1993.

But what about another apparently telling piece of evidence: China's huge trade surplus with America? This, argue American politicians, proves that the Yuan is undervalued. In fact it does not. China's overall trade balance was in deficit in the first three months of this year, thanks to strong import growth.

Another argument is that China's large surplus on its basic balance (the sum of the current-account and net foreign direct investment) and its huge build-up of foreign reserves are both symptoms of currency undervaluation. Mr Xie again disagrees. The increase in reserves, he argues, partly reflects speculative capital inflows. Moreover, if the capital account was opened (which is unlikely over the next four or five years), allowing firms and households to hold foreign assets, the Yuan would probably fall, not rise, as the Chinese diversified their savings.
These arguments help to explain why the Chinese have so far ignored American demands to revalue their currency. It is not just crude mercantilism; there is much uncertainty about the Yuan's correct value. The Chinese government says it will move towards a more flexible exchange rate in the medium term, but for the moment it wants to keep the Yuan stable in order to support broader economic stability. Yet in fact, a flexible exchange rate can offer more stability, partly by providing a safety valve which helps to protect the real economy.

The strongest argument for a revaluation now is not that the Yuan is undervalued, but that an adjustment would halt speculative capital inflows and so mop up the excess liquidity. It would be unwise for China to float the Yuan until it has cleaned up its banking system, but it could re-peg against the dollar at a higher rate and shift to a currency basket, which is what the government has said it would like to do. The snag, however, is that a small revaluation of only 5% might encourage expectations of a further appreciation and attract more capital inflows. Analysts claim that any revaluation would need to be large enough, say 10-20%, to head off such speculation. But a rise of such proportions would be unacceptable to the government, so the Yuan is likely to remain fixed for the moment.


The latest:
This month (November, 2005) Zhou Xiaochuan, governor of the People's Bank of China: Zhou reiterated the need for a stable, balanced exchange rate for the country's currency, the Yuan. 'China will continue to improve the managed floating exchange rate system and maintain a stable Yuan at a reasonable and balanced level,' Zhou said, repeating the standard phrasing of senior government officials used both before and after July's 2.1 pct revaluation. As expected, the revaluation of the Yuan in July raised the value of Asian currencies against the dollar, and there was ongoing speculation that China may revalue its currency as part of President George Bush's visit to the country this month, has not happened. The trip has inevitably set the markets talking of another possible revaluation of the Chinese Yuan, which prompted the People's Bank of China to deny rumors an emergency meeting to discuss the exchange rate. Most analysts think an imminent revaluation is unlikely

China’s July revaluation, loosening the currency's peg to the dollar and allowing it to trade within tightly managed bands. But since then the Yuan has barely moved and risen only a further 0.33 percent against the dollar, prompting further cries from Washington and increased pressure on the IMF to lean on Beijing over its currency practices. The IMF has stated that it is understandable that the Chinese economy needed time to adjust after the July 21 revaluation. But, the IMF also stated that it does see scope now for greater flexibility. According to the IMF, "Fixed-asset investment (growth) was running in the high 20's (percent) in recent months , which is probably too fast ... it certainly means that investment is perhaps still growing as a share of GDP."
David Burton, director of the IMF's Asia and Pacific Department has said that the rebalancing of growth from investment towards consumption would help China sustain its high economic growth rates and distribute the wealth across the population.
Rebalancing growth required a combination of policy measures and reforms -- and more flexibility in the yuan would help. A greater exchange rate flexibility would contribute to rebalancing the composition of economic growth by reducing distortionary influence in investment decisions and potentially raising consumption by boosting households' real income.

© All Rights Reserved Maithreyi Seetharaman 2005