from Follow the Money

What, if anything, has China decided to do differently?

May 20, 2007

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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China widened the band around the RMB and raised (slightly) interest rates, with the rate on deposits going up more than the rate on lending.     It hardly seemed like a major policy shift to me – but it attracted a lot of attention.


Widening the band in particular didn't strike me (or some others) as much of change.   After all, China hasn’t made much use of its existing band.   An anonymous Shanghai trader in the Wall Street Journal:


“It "means nothing" for yuan appreciation, said a Shanghai-based trader with foreign bank. "We don't even use half of the current band. This is just to impress [U.S. Treasury Secretary] Henry Paulson."


If a wider band doesn't lead to faster appreciation, I doubt Paulson -- and more importantly the Congress -- will be all that impressed.   I liked the way Keith Bradsher of the New York Times reported the limited scale of RMB appreciation over the past two years:  an initial 2.1%, and then another 5% over nearly two years. 


That works out to about 2.5% a year.   In other words, not much.   Not when the dollar has slid against other currencies.  Not when Chinese inflation has generally been lower than US inflation.  Not when China’s trade and current account surplus is growing so fast.  


I was, though, struck by another bit of data that came out: the 167.4b yuan fall in Chinese bank deposits in April.    Deposits are expected to fall further in May.   (Big hat tip, David Altig of Macroblog).  That presumably is why China hiked deposit rates more than the lending rate (see Morgan Stanley's Denise Yam)


Chinese citizens haven’t exactly jumped at the prospect of pulling their funds out of the domestic banks and buying dollar and euro-denominated bonds.   But they do seem to be jumping at the chance to buy into China's own market -- and perhaps into China's own version of a "bubble economy."


The fall in deposits matters.   The core underlying reason why China has been able to sterilize its massive reserve increase at a fairly low cost is that China’s own citizens have been willing to hold their savings in the banking system even though the banks pay a low interest rate.    The government then effectively forced the banks to lend some of their cheap deposits to the central bank – typically by buying sterilization paper – at a low interest rate.   In return, the banks got a fat margin on their lending, and lots of help taking their old NPLs off their balance sheets.  


So long as the banks lent a rising share of their growing deposits to the central bank, a big chunk of China’s household savings was effectively locked up and sequestered abroad. That helped hold inflation down.   If it now takes higher rates to draw savings into the banking system – or perhaps just to keep deposits from running out of the banks and into stocks -- the government will likely have to pay the banks a bit more on its sterilization bills.    That may change the government's own evaluation of the costs and benefits of its current policy.  Fewer of the costs can be passed to China's households (in the form of low deposit rates).


And if the rising stock market generates a bit of a wealth effect, spurs consumption and starts generating a bit more inflation, that too could generate pressure to change.


I do hope, though, that Keith Bradsher of the New York Times isn’t accurately reporting the thinking of China’s officials when he notes that higher Chinese rates – and a smaller gap between Chinese rates and US rates – imply a smaller rate of yuan appreciation: 


But raising domestic lending rates could make it harder for China to allow further appreciation of the yuan.  That is because the central bank is itself a borrower. It borrows yuan, by issuing bonds, to pay for its extensive interventions in currency markets, where it has accumulated $1.2 trillion in foreign exchange reserves, mainly dollars.


The central bank earns a higher interest rate on American Treasury securities than it pays on yuan-denominated bonds at home. The authorities use this profit from the difference in interest rates to cover losses on the foreign exchange reserves, which are worth less and less in yuan as the yuan appreciates.


I sort of see the logic.   The central bank thinks it can cover the capital losses associated with borrowing in yuan to buy depreciating dollars out of the interest rate spread (the “carry”).

But in a deeper sense, I don’t see the logic.   The central bank has been intentionally buying overvalued dollars with undervalued yuan for a long time – that is how it has kept the yuan undervalued.   It will eventually take a loss on those dollars.    And the more dollars it buys to keep the yuan undervalued, the bigger the loss.   In this case, I am fairly confident that the “carry” is too small to cover the expected exchange rate loss.


Slowing the pace of appreciation even more because of less carry means that the yuan’s undervaluation will last longer – and in all probability that the central bank will end up having to buy even more dollars.   The central bank avoids reporting a loss today – but it adds to its future loss.

Tell me again what China’s exit strategy is?     

Stephen Green of Standard Chartered thinks China will run a $400b current account surplus this year, and an even larger surplus in 2008 and 2009.  $500b isn’t out of the question.   Others have a slightly smaller estimate, but nearly everyone thinks China is set to run large ongoing current account surpluses so long as it maintains its current policy constellation.


If China's government is unwilling to allow the yuan to appreciate by more than the interest rate differential,  isn't it just locking itself on a path where the government will need to continue to borrow a ton of yuan from Chinese citizens to buy (and hold) massive amounts of (depreciating) dollars in the foreign exchange market?  

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