Lessons to be Learned

5.1 Similarities and Differences Between the PRC and Japan

Japan’s economic situation during these periods somewhat resembles the PRC’s recent economic situation. From the PRC’s point of view, its most important trade partner, the US, is suffering from the war on terrorism, which consumes significant financial resources. This is similar to the US in the late 1960s with the Vietnam War. The US also suffered from the collapse of a new economy bubble from 2001 until recently. This aggravated the so-called twin trade and fiscal deficits in the US economy and put a downward pressure on the value of the dollar. Domestically, since the PRC joined the WTO in December 2001 and started to gradually liberalize its capital account transactions, the country has registered an increasing trade surplus and accumulated a large amount of foreign reserves, though some efforts have been made to ease the appreciation pressure on the renminbi.

Three aspects of the situations faced by Japan differ importantly from that faced now by the PRC. First, because the economies of the world are now extensively interlinked through trade, more FDI and international money flow now than when Japan faced the yen appreciations. Second, most major countries have now, in principle, completed liberalization on current and capital account transactions under a floating exchange regime and removed various external barriers. Third, unlike Japan during these periods, the PRC’s capital account balance continues to register a large surplus, reflecting the PRC’s traditional “one-way” regulation of encouraging capital inflow by attracting foreign-invested enterprises while strictly regulating capital outflow. Furthermore, a significant amount of hot money, most of which is deemed to be the recycling of capital flight in the past based on speculative motivation, and is reflected statistically in the errors and omissions in the PRC balance of payment account, reportedly comes back to the PRC. This further contributes to accumulating significant foreign reserves over a very short period of time. All these factors put a higher pressure of appreciation on the renminbi than that put on the yen in the early 1970s and mid- to late 1980s.

On the other hand, the PRC currently faces two serious factors that did not exist in Japan in the past. These may explain why the PRC government is very careful about or strongly resists renminbi appreciation. One factor is the serious unemployment problem in rural areas and the mounting pressure to create employment opportunities in urban areas. In the eyes of the PRC government, only rapid economic development can solve these problems. Naturally, the PRC is thus very sensitive to anything that might affect employment opportunities in rural as well as urban areas.¹ The other factor the PRC now faces relates to solving non-performing loans (NPL) in stateowned banks (SOB). In recent years, it seems that the PRC government and four asset management companies (AMC) have been trying to involve foreign investors in the liquidation and disposal of NPLs. However, a sharp appreciation of the renminbi would definitely discourage them from participating in the NPL disposal. Clearly, this is what the PRC does not wish to see happen.²

See Tables 1 and 2 of this document. [ PDF 38.8KB | 1 page ]

5.2 Impact on Macro Economy

Japan faced serious inflation both after the early 1970s and in the mid–late 1980s. One of the important underlying factors is loose monetary policy. Due to the strong allergy or serious concern about possible adverse impacts of the sharp appreciation of the yen on economic activities, in particular on the export-oriented manufacturing industries, perhaps the loose monetary policy was excessive. Also, policy change was not implemented in a timely fashion in either period. However, it seems the actual macro economic situation was not as seriously affected as anticipated and it started to recover earlier than predicted. In other words, the impact of the currency appreciation on the economy tended to be overemphasized. Thanks to the appreciation of the yen, prices of raw materials declined and terms of trade (export/import price indices) were improved significantly, even benefiting Japanese industries. The international competitiveness of Japanese commodities was also unexpectedly high in terms of quality management. Furthermore, many Japanese companies flexibly started to adjust to the new environment by such means as shifting their production lines to locations overseas. These unexpected benefits indicate the importance and difficulty of assessing the behavioral change and international competitiveness of enterprises and predicting the overall impact of currency fluctuation on the macro economy.

In the PRC context, theory and empirical evidence have shown that the renminbi was indeed undervalued on average by about 17 percent in past years. Thus, the 2.1 percent revaluation of the currency announced in July 2005 is not sufficient to weaken the competitive power of the PRC economy and reduce the trade surplus against the US. In the short run, the J-curve effect may cause the balance of trade to continue expanding. The revaluation has a limited impact on overall inflation. Considering the chain effects and accumulated effects of renminbi revaluation, the PRC economy could endure more extensive revaluations from the macro economic point of view. However, the PRC’s main problems are not in the aggregate level, which is maintaining 9 percent growth, but in the structural or sectoral levels. Different industries have different endurance to the shocks of revaluation.

The PRC government is worrying most about the agricultural and automobile sectors, which may be easily affected by renminbi revaluation, and the unemployment problem induced by revaluation.

Currently one of the major sources for absorbing excess labor and mitigating the unemployment problem is FDI in the PRC. Assuming the current renminbi exchange rate and looking for cheap labor, many foreign companies have set up production lines and recruited a number of rural workers in China, in particular in special economic zones. If the renminbi is sharply appreciated, the PRC’s noncompetitive agriculture sector and SOEs will be affected and more excess labor will be created; FDI may somewhat decline due to the higher operating costs in the Mainland. These changes might make the unemployment problem even worse.

Overall, prices have remained stable in the PRC. However, inflationary pressure, especially in terms of real estate prices, has been increasing in recent years. However, this pressure comes not only from the undervaluation of the renminbi, but from some other factors. Economically, to stabilize the renminbi exchange rate under the surplus in the current account, the PRC has to absorb USD by issuing renminbi notes, which increases the money supply.³ Politically, the new PRC Administration differs from the old one in that it tends to (or cannot but) accommodate all requests for development assistance from regional governments under the policy agenda of addressing regional disparities. This additional funding to regional governments is also putting inflationary pressure on the economy as a whole.⁴

5.3 Independent Monetary Policy and Regulations on Capital Flow

The events of both the early 1970s and mid–late 1980s raised the traditional question of a trilemma among the three economic goals: ensuring free international capital transactions, maintaining independence of the monetary policy, and keeping a pegged exchange rate regime. In the early 1970s, Japan tried to maintain a pegged exchange regime while allowing adjusted inflation to achieve external balance (in other words, a somewhat loose independent monetary policy). In the mid–late 1980s, under the framework of international policy coordination put forward in the Plaza and Louvre Accords, readjusting or keeping exchange rates stable became a major goal of monetary policy. Differing views may exist about the goals of monetary policy, but in this case, when monetary policy lost its freedom, domestic equilibrium was sacrificed. We should keep in mind that all goals cannot be achieved simultaneously; we must think about relevant policy assignment.

In the PRC context, we need to take note that the trilemma argument that generally applies to small-sized economies is not necessarily able to explain the situation in the PRC. The trilemma argument states that a small country cannot carry out an independent monetary policy and a fixed exchange rate policy while keeping free capital flow. At the early stage of economic reform, PRC was economically a small country. Monetary policy was regarded as an indication of sovereignty and had to be maintained. If we apply the trilemma argument to the PRC under the early stage of economic reform, under the situation when its capital account transactions were not fully liberalized yet, to maintain and pursue a fixed exchange rate system and independent monetary policy could be justified especially if PRC achieved a trade surplus.

Recently, the PRC can no longer be regarded as a small country; if it was economically small, the US would not have needed to put pressure on the renminbi exchange rate. As a large economy, the PRC is capable of carrying out an independent monetary policy under a fixed exchange rate regime with regulated capital transactions. Thus, for the PRC internally, a fixed rate regime may not be a very serious problem, although it may result in external imbalance and incur foreign pressure. Such imbalances are certainly not caused only by the exchange rate, but also by other factors, for example, the US war on terror and the collapse of the US bubble economy.

In fact, many measures could be taken to deal with one problem. The current problem between the PRC and the US can be resolved through either external or domestic adjustment. Adjusting the renminbi exchange rate is only one of the options available. For example, the current imbalance could be resolved by cutting US public or military expenditures, which amount to more than 50 percent of the whole world’s spending in these categories.

Alternatively, it could be resolved by easing export restrictions on the PRC. Looking at Japan’s experience, inflationary pressure could be mitigated by taking a more timely monetary policy and leaving the external balance basically to the adjustment of the exchange rate. This is something that the PRC may learn from Japan’s experience.

Regarding regulations on capital transactions, the PRC is still in the process of change. In the course of liberalization, it is moving to lift regulations on capital outflow with the “Go Overseas” (Zou chuqu) policy.5 This policy is expected to mitigate appreciation pressure to some extent. However, at the same time, there would be an increasing risk if the PRC further deregulated capital outflow while keeping a rigid exchange rate regime. This is an issue of policy sequence. In the case of Japan, intentionally or unintentionally, the move toward a floating exchange regime took place in tandem with the deregulation of capital account transactions.

5.4 External Imbalance and Exchange Rate Adjustment

Japan’s experience also indicates that external balance cannot be achieved only through exchange rate adjustment. It is generally expected that currency appreciation raises export prices in terms of USD, which cuts down price competitiveness and decreases export volume. However, looking at Japan’s experience in the mid-1980s, export prices in USD terms were raised by only 50 percent in terms of the percentage change of yen appreciation and the overall export volume was not much affected. The remaining 50 percent was absorbed by the streamlining efforts by the enterprises and the decline of the prices of imported raw materials (Japan’s White Paper on International Trade and Industry). After all, looking at the I-S balance, the current imbalance reflects a domestic I-S imbalance among the countries concerned. Since under a free international capital flow regime, the exchange rate itself is deeply affected by capital flow and interest rates among countries, the adjustment role of exchange rates to current balance tends to be diminished (Japan’s Economic White Paper). We should therefore note that to solve external imbalance problems, it is essential to focus on the structural I-S imbalance of each country.

In the PRC context, the current surplus is basically matched by huge over-saving in the household sector. Promoting household consumption is an important policy agenda not only for addressing external imbalance but also for making economic growth sustainable.⁶ Regarding the direct impact of the appreciation of renminbi on the PRC’s exports, it should be noted that exports by foreign-invested companies account for more than half of the country’s total exports, so they may not be seriously affected. Companies that import raw materials and intermediate goods from other countries could offset the impact of the increase in export prices by a decline in import prices. Companies that operate in coastal areas where labor costs are already high could mobilize more labor from inland areas. In the case of Japanese companies, which dispatch many Japanese expatriates, they could replace those staff members with cheaper local staff.

5.5 Impact on Different Interest Groups

Japan’s experience also gives us a lesson to keep in mind: different interest groups are affected differently by currency fluctuation and some groups have a bigger voice than others. For Japan, doubtless the manufacturing industry sectors such as steel and machineries suffered from the appreciation of the yen, and since these sectors traditionally had bigger political voices, they had more ability to influence policymaking. Meanwhile, non-manufacturing industries and consumers who must have benefited were not so politically influential compared to the manufacturing industry, and their views were not necessarily reflected in the policy decision-making dealing with the currency appreciation. This indicates the importance and difficulty of ensuring fairness and balancing the interests of various groups.

Who in the PRC benefits and who loses due to the appreciation of the renminbi? State-owned enterprises (SOEs) and state-owned banks (SOBs), having no international competitiveness, and other export industries including agriculture will definitely suffer. Foreign-invested companies in general will also suffer. This may affect FDI as a whole, but the effect should not be expected to be too much because many foreign-invested companies are no longer looking only for cheap labor in the PRC, but are looking at the huge potential of the domestic market. Perhaps the consumers stand to benefit from renminbi appreciation.

As for the political influence of each group, the SOEs and SOBs may still have big voices. However, as the market economy matures and people become richer, private enterprises and individual households are gaining influence.

5.6 Long-term Impact of Currency Appreciation

Japan’s example shows that we need to pay attention not only to the immediate impact of currency appreciation, but also its long-term effect on the economy, in particular on the nation’s industrial structure. The sharp appreciation of the yen triggered upgrading or conversion of the industrial structure in both the 1970s and 1980s and made Japan a more advanced or high-value added economy. In the 1970s, traditional leading industries such as textile, steel, non-ferrous metal, and chemical were replaced by assemblytype industries like automobile, electric appliance, and machinery. In the 1980s, many Japanese companies started to shift their production lines overseas while trying to focus domestic production on more high-value added commodities.

In the PRC context, the appreciation of the renminbi or moving to a more flexible exchange rate regime should provide a good opportunity to move toward a more market-oriented economy. As estimated, the renminbi is severely undervalued under a fixed exchange rate regime, which distorts resource allocations across countries. Appreciation of the renminbi will help to correct the distortion. However, different estimates show differing views on how much the currency should be adjusted. We estimate that the currency is undervalued by 17 percent in terms of the nominal exchange rate (see our ADBI research paper series on renminbi revaluation). The variation of estimates, however, indicates how difficult it is for a planned economy to reach consensus on the appropriate equilibrium level. The best answer is to pursue marketization, adopting a more flexible exchange rate regime and letting the market determine the equilibrium level.

However, the exchange rate is much more volatile than goods prices, and its sometimes explosive behavior may bring some economic and political chaos. For example, some thought that the ten years of loss in Japan related to the sharp appreciation of the yen. The radical price reform in 1988 in the PRC directly resulted in high inflation economically and the political storm in 1989 forced the general secretary of the Central Communist Party to step down. In view of the negative experiences of Japan and the PRC and the successful experiences of gradual reform in PRC, we think that the PRC should stay firmly on the road toward a more flexible exchange rate regime with a gradualist principle and let the foreign exchange market explore its equilibrium level in two or three years so as not to cause too many shocks to the economy and to give market participants more time to adjust their behavior and gradually adapt to the new exchange rate. From this viewpoint, the principles of controllability, gradualism, and balance, which were announced by the PBOC, could be deemed to be relevant ones.

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