from Follow the Money

The intent is good …

January 26, 2006

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The Governor of the China's Central Bank said pretty much all the right things at Davos - at least from my point of view.    China does need to base its growth far more on domestic consumption.  And it is not in China's interest to continue to add $200 b (a bit more actually, once you factor in funds transferred to ICBC, the currency swap and valuation effects) to its reserves every year from now until eternity.  Chris Giles of the FT:

China is committed to slower foreign exchange reserve accumulation, Zhou Xiaochuan, the governor of the People's Bank of China told the World Economic Forum, in rare comments about China's exchange rate policy.

 Mr Zhou said that his country was committed to increasing domestic demand, rebalancing the economy gradually away from net exports, promoting consumption, particularly in rural areas, all of which would reduce the pressure on the country to keep increasing the rate of reserve accumulation at an annual rate of $200bn a year.

He said: "We need to make a change to stabilise the [foreign exchange reserve] situation".

"China has no intention of faster acceleration of foreign exchange reserves," he said, adding that he believed "the pace of foreign exchange reserves will be reduced".

But he damped hopes that China was on the verge of another, more substantial, currency revaluation. Speaking to Reuters, he said: "our foreign exchange policy is already in a good position".

Dooley, Folkerts-Landau and Garber should take note: China's central bank doesn't think continuing to add to its reserves at the current pace is in China's interest.  

I'll even excuse Zhou for not stating more forthrightly the need for additional RMB appreciation.  I think he still wants further appreciation - he argued for a bigger move in July.  But what you can say depends on where you sit - Zhou has to defend the existing parity until he changes it.

There are certainly plenty of rumblings that further changes could be in the works.   The Washington Post reported on January 10:

China has resolved to shift some of its foreign exchange reserves -- now in excess of $800 billion -- away from the U.S. dollar and into other world currencies in a move likely to push down the value of the greenback, a high-level state economist who advises the nation's economic policymakers said in an interview Monday.

Alas, China cannot push down the greenback without pushing down the RMB.  And a weaker RMB is not exactly the most obvious way to slow reserve growth.  That is why I suspect that China will need to modify its currency regime if it wants to significantly modify the composition of its reserves.

Yes, the PBoC has also denied any intent to change its reserve composition.  But there is enough smoke to think that there just may be a fire somewhere.  Yu Yongding certainly doesn't seem to be alone in arguing that China should not be adding to its stock of dollar reserves. 

Unfortunately, there also is a significant gap between the central bank's statements of intent and observed outcomes.   Last spring, it was not hard to find Chinese government officials and academic economists alike making the argument that China needed to base its growth more on domestic consumption and to reduce the pace of its reserve accumulation.

What actually happened in 2005?  Net exports contributed more to China's growth than in 2004 or 2003, China's current account surplus ballooned, China continued to peg to the dollar (for all intents and purposes) and total reserve accumulation rose - particularly if you adjust the 2004 and 2005 totals for valuation effects.

Good words.  But not (yet) good deeds.

One unsolicited suggestion: China's credibility would rise if Chinese officials stopped making statements that are rather difficult to square with reality.

Like arguing that the market sets China's exchange rate.  The Assistant Governor of the People's Bank (via Mark Thoma and Bloomberg):

People's Bank of China Assistant Governor Ma Delun said the market is determining the yuan's exchange rate

It doesn't.   The central bank determines China's exchange rate.  The market clears at the point where the central bank steps in to buy dollars, or at the point where private actors think the central bank will step in to provide dollars.

A couple of weeks ago China made some technical changes to the operation of its peg.   The reference band for one day's trading is still very small, but that band is no longer tied to the RMB's closing price the previous day. 

That in theory allows more RMB appreciation, since one day's opening price is no longer tied down by the RMB's closing price the night before.  

But there still will only be more appreciation if the central bank wants more appreciation.  It doesn't change the fundamental nature of China's regime.

Thomas Stolpher of Goldman gets this absolutely right:  

"In practice, the PBOC will remains the all-important player in the Chinese FX market and therefore any appreciation remains conditional on the implicit approval of the authorities ..  As before the actual spot rate will depend almost exclusively on the amount of appreciation acceptable to the PBoC.  The State Administration of Foreign Exchange is likely to remain the most important counterparty in the Chinese foreign exchange market, and, as the rapid pace of reserve accumulation illustrates, SAFE is by far the largest seller of CNY.  SAFE will therefore directly and indirectly control the quotes submitted to the new fixing process" 

Fixing here is the process for fixing the day's exchange rate. 

I suspect that there is consensus inside China that China has more reserves than it needs.  I am not sure that there is yet consensus that the RMB should be allowed to rise signficantly.   And I am not convinced that China has found a way to cut into its reserve growth while holding on to its current exchange rate, or something similar.  

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