from Follow the Money

The $1.3 billion question: What will happen to the renminbi

March 22, 2005

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A week in China certainly does not make me an expert. Like many, I see China through the filter of English-speaking Chinese economists, and, to more precise, through the filter of those economists and analysts that Nouriel Roubini and I spoke to during our visit.

Roubini’s basic views were pretty hard for any Chinese policy maker with a Bloomberg terminal (or subscription to the Herald Trib) to miss. That no doubt influenced the set of people willing who were willing to meet us.

Still, I came away thinking the odds of a major move in the renminbi -- say a revaluation of more than 10% -- are higher than I thought going in. Why? Because Chinese economists, including economists in research institutes with links to the People’s Bank of China, are very aware that the-oft discussed 3-5% revaluation in the renminbi would not do much. It is too small a move to have much of an impact on China’s (growing) global trade surplus. More importantly, such small move would leave investors expecting a further renminbi appreciation. Consequently, it would not significantly reduce the pace of China’s reserve accumulation.

I suspect that the People’s Bank of China is privately arguing for a significant revaluation. Of course, the People’s Bank of China is only one voice among many on exchange rate policy. The policy process in China remains opaque, at least to me -- but it seems that any change in exchange rate regime would require a decision from a committee of the state council. That is no real surprise: the choice of exchange rate regime is usually a political, not a technical, decision and the renminbi has been pegged to the dollar at its current value that any move will be big news. China’s state council no doubt worries about a lot of things other than the difficulties China’s rapid pace reserve accumulation is creating for the central bank. China’s export sector is a lobby just like Walmart is a lobby here in the US. Committee policy making lends itself toward compromise and small steps -- not bold moves. I certainly have no real idea how China’s internal debate will play out.

There clearly is a fair amount of concern in China about the dollar’s path. I guess that is only natural if you hold as many dollar reserves as China does. The Chinese are quite cognizant that the dollar’s value has slipped relative to the euro, and relative to oil. They certainly worry -- rather publicly -- that the US is not doing all that good of a job looking after the value of China’s existing investments in dollar-denominated securities. But they are also worry that Europe is perhaps not dynamic enough to be all that great an alternative; the Europeans have made it clear that they both don’t need and don’t want any more financing from China. The euro is quite strong enough already. All this is leading a decent of number of Chinese economists -- including economists with links to China’s central bank -- to conclude that China already may have as many (if not more) reserves than it really needs.

No doubt, there was a bit of selection bias in the voices Nouriel and I heard. We did not talk to any property developers enjoying the cheap financing made possible by rapid growth in bank credit fueled, in part, by rapid reserve growth, or to anyone with major investments in China’s export sector. We did hear a number of economists echo the themes Guo Shuqing, the outgoing head of China’s State Administration of Foreign Exchange, laid out in the China Daily last week -- namely, that fast export growth and large FDI inflows are not necessarily good for China -- and even that trade surpluses and large reserve increases are not always a sign of economic health.

There is growing concern about the impact rapid reserve growth is having on monetary policy. It is true that inflation subsided over the course of 2004, helped by a strong harvest that kept food prices tame and lots of steel and auto capacity. But there could well be a new round of inflationary pressure building: reserves grew rapidly in the fourth quarter, and fiscal policy may help control money growth less in 2005 than it did in most of 2004. China’s 2004 tax revenues wildly exceeded expectations in 04, and the surplus was kept on deposit until December, helping to limit overall money growth. It seems, tough, that there was a burst of spending at the very end of the year and reserves are likely still growing rapidly, even if they probably are not growing quite as fast as in q4.

This concern matches one of the points Nouriel and I made in our paper. However, Chinese critics of the current exchange rate policy also make some points that Nouriel and I missed.

First, they note that FDI comes to China in search of a return of 15% or more. But China doesn’t need the money per se. It has more than enough savings of its own to finance a very high level of investment, so foreign funds invested in China end up in the PBOC earning something like 4%, maybe a bit more, maybe a bit less. That is not a good trade for China. China of course likes the technology transfer that comes with foreign investment, but it seems a bit less interested in attracting foreign investment in standard labor-intensive manufacturing sectors. I expected to hear concerns about hot money flows and foreigners speculating on Chinese real estate. I did not expect to hear a critique of FDI flows: I don’t think it is an accident that Guo argued that China is giving foreign investors too good of a deal.

Second, Chinese economists note that foreign investment is concentrated on China’s coast, and tends to widen the economic divide between the coast and interior. An obvious point, but still news to me. This was linked to a broader critique that the current renminbi peg is generating an unbalanced Chinese economy -- one that exports perhaps too much for a large continental economy and is a bit too exposed to the global macroeconomic cycle. After all, it is not necessarily a good sign if one of your biggest customers can only afford to buy your products if you extend credit on generous terms. I heard more concern about China’s rapid export growth than concern about China’s amazing real estate boom.

Some in China worry that a revaluation would slow export growth. But some also worry that a revaluation would not slow export growth much, and therefore not eliminate the tensions that come with China’s large bilateral trade surplus with the US. Personally, I suspect that revaluation won’t have much of a short-term impact on the bilateral trade deficit between the US and China. Any increase in US exports to China is likely to more than offset by the higher price the US will pay on its existing Chinese imports. The impact on trade will come over time, as incentives to relocate production to China will be reduced. The more immediate impact could well come through the financial markets. If less capital flows into China, China will have less money to lend to the US ... and higher US interest rates will slow domestic demand, reducing the United States’ overall trade deficit.

All in all, I was surprised by the number of people arguing that the current exchange rate system was not working for China. No one strongly made the case that China’s rapid reserve accumulation and export-led growth were key components of a new Beijing consensus that would support rapid growth in any country that tried it.

That may just be a function of those people that Nouriel and I happened to talk to. Stephen Roach talked to people with real power, and got a different picture ... less concern, and more satisfaction that China was able to use "administrative steps" (limits on bank lending) to cool off the economy (a bit) and cut back (a bit) on credit growth without lowering overall growth too much.

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