Wolf on Renminbi Flexibility

[Michael Pollak <mpollak@xxxxxxxxx>]

[I thought this was a surprising good discussion that covered all the
bases.]

Financial Times, December 2, 2003

China must move to a flexible currency -- eventually

By Martin Wolf

To float or not to float, that is the question. To be more precise, it is
one of the questions. The Chinese authorities could also repeg the
renminbi at a higher rate. My recent visit has convinced me that the
leadership will not change what they see as a successful regime in the
near future. But it will also not last forever. When and how might it
change?

Since the Chinese seem willing to accumulate foreign currency reserves
without limit, the leverage of its partners is limited. This is a decision
China will make, on its own terms. Nevertheless, the starting point must
be whether the currency is undervalued. Many Americans assume it is,
pointing to their country's vast, and growing, bilateral trade deficits.
But these tell us nothing. What matters is the overall balance of
payments.

Over the past seven years, China has been running current account
surpluses of about $10bn to $40bn a year (see chart). The International
Monetary Fund forecasts the surplus this year at $25bn, a little under 2
per cent of gross domestic product.* But China also has a huge net inflow
of foreign direct investment. If one takes the sum of these two elements,
the surplus this year will be a good 5 per cent of GDP.

Until 2001, however, China also had a balancing outflow in the rest of its
capital account. Overall, therefore, the country did not accumulate
substantial foreign currency reserves. But this has changed. The balancing
capital outflow has become a huge inflow. Between the end of 2000 and
September 2003, foreign currency reserves rose by $218bn.

At least until 2001, surpluses on the current account and FDI were offset
by other capital outflows. The currency was not undervalued. Strong upward
pressure has emerged since then, but much of this may be speculative. On
balance, the IMF's board of directors has concluded "that there is no
clear evidence that the renminbi is substantially undervalued".

Nevertheless, two offsetting points must be made. The first is that global
payments are significantly out of balance, with a huge US current account
deficit offset by surpluses elsewhere. A real appreciation of the renminbi
must be a necessary element in global adjustment. The second point is that
the prices of China's exports are falling, in dollars. If many of the
world's currencies appreciate against the dollar (and so also the
renminbi), prices of a wide range of manufactures must fall in their
domestic currencies. That would strengthen the charge that China is
exporting deflation. It would be better if, instead, the dollar prices of
China's exports were rising.

My conclusion is that the case for an appreciation of the Chinese real
exchange rate has merit, from a global perspective. But the argument looks
very different to the Chinese themselves. For them, the dollar peg has
many advantages: it provides stability for both exporters and Hong Kong,
whose currency is also pegged to the dollar; and it has given a framework
in which the economy has performed excellently.

More important, the disadvantages of allowing the currency to appreciate
are significant. It would represent a concession to pressure from the US
authorities and speculators; it would lower domestic prices of tradeable
goods in a country that already has very low inflation, with particularly
severe effects on farmers; and it might reveal substantial weaknesses in
the balance sheets of Chinese businesses.

It is also unclear what the right alternative regime would be. If the
currency were repegged at a higher rate, speculators might well try again.
If it were floated, it might overshoot. In the presence of exchange
controls, it would also be difficult for companies to hedge foreign
currency risk. But lifting exchange controls would expose bankrupt and
ill-managed financial institutions to the temptations of the global
capital markets.

All these seem cogent reasons not to consider changing policy. But there
is also a reason to do so: the monetary consequences of current reserve
accumulation. Money and credit have been growing far faster than nominal
GDP this year. That means excessive investment now and still more
non-performing loans in the years to come. Yet even this is not an
overwhelming worry, at present. That is partly because the authorities
believe they are bringing credit growth under control, partly because the
government welcomes the high growth and partly because inflation is
non-existent. Somewhat higher inflation could even be a helpful way to
lower the mountain of bad debt in the financial system.

The conclusion is that the authorities will not change policy soon. In the
short term, the aim, instead, will be to lower the pressure. Policies can
-- indeed, already do -- include further liberalisation of capital outflow
and imports, along with special programmes to buy goods abroad. All this
makes practical sense.

In the medium term, the best and most likely policy would be a move to a
heavily managed float, rather than an upward adjustment of the peg. Such a
float is even compatible with exchange controls, as the Indian example has
shown. The float can be achieved by widening the bands or moving to an
unspecified currency basket. The important feature of such a system would
be greater exchange rate uncertainty. The authorities could increase that
uncertainty by driving the dollar back up against the renminbi from time
to time.

In the long term, however, China will want full liberalisation of exchange
controls, a freely floating currency and an inflation-targeting central
bank. But this would also require an efficient and well-regulated
financial system. A good guess is that this will not happen before the
beginning of the next decade, or even later.

Managing the transition of the renminbi to its prospective role as a world
currency is a huge challenge. Large changes in policy cannot be expected
right now. But the Chinese authorities should be liberalising imports and
capital outflow aggressively, while moving, in the reasonably near future,
to a more flexible exchange rate.  The sooner the Chinese escape from
their reserve-accumulation treadmill, the better off both they -- and the
world payments system -- will be.