Money and Finance

3.1 What the yuan can learn from the yen

The renminbi exchange rate has attracted significant attention from both market participants and government officials. Assessing how the renminbi’s sharp appreciation will impact the economy of the PRC remains a heated discussion point among experts. Here history may offer us some insights. Japan’s economy underwent two periods of sharp yen appreciation subsequent to World War II. The first period occurred when President Nixon suspended the convertibility of the US dollar to gold in 1971. This shock led major currencies, including the Japanese yen, to shift from fixed rate systems to floating rate systems. The yen then sharply appreciated from 360 to 260, which lasted for several years. The second big yen appreciation coincided with the “Plaza Accord” of 1985 that brought radical adjustments to major currencies vis-à-vis the US dollar. Between 1985 and 1987 the Japanese yen increased from 240 to 120.

Interestingly, both periods were marked by high economic growth in the United States coupled with a subsequent deterioration of US trade and fiscal balances. Concurrently, Japan was enjoying export-driven economic growth and a significant trade surplus. Political and geographical considerations were also important. During these two periods of yen appreciation, the US was involved in the Viet Nam War and an intensifying Cold War. These periods of increased US military expenditures aggravated the US fiscal balance, much as the current situation in Iraq now burdens the US economy.

What lessons can be drawn from the yen’s experiences then? Japan’s primary concern during sharp appreciations was the impact of the yen on the export-driven manufacturing industries and the consequent economic slowdown. To address these worries, Japan attempted to maintain a pegged rate system as well as minimize further appreciation by stimulating domestic demand. Excessive domestic adjustments were made to maintain the external equilibrium. Monetary policy appeared to lose its free hand. And notable, Japan’s economy suffered from hyperinflation or “economic bubbles” following both appreciations. Another point to remember is that the yen’s appreciation in both periods triggered large-scale and far- reaching changes in Japan’s industrial structure. In the 1970’s, assembly-type machinery industries such as automobile and electronic appliances became mainstream. They replaced traditional heavy steel and chemical industries. Following the yen’s sharp appreciation in the 1980’s more high value-added industries began growing domestically. Manufacturing companies started operations overseas by using FDI.

There is a trade-off between adhering to a fixed rate system and maintaining an independent monetary policy under free international capital transactions. While the liberalization of capital actions is not yet complete in the PRC, nuanced options other than a pure pegged system or a perfect floating system do exist. As the yen model has shown, the impacts of appreciation are long-range and far-reaching, which means the PRC need always keep in mind the eventual winners and losers from any currency fluctuation. (14 March 2005. Recapitulation from Policy Brief No. 14)

3.2 Reasons behind the PRC’s resistance to renminbi (RMB) appreciation

Two of the most serious, unsolved policy issues facing the PRC government have important connections to the issue of renminbi appreciation: unemployment and non-performing loans (NPLs) in state-owned banks (SOBs). Although official urban unemployment figures are well below other countries, showing 4.2 percent or 8 million unemployed, the larger picture is more serious. Restructuring of the state-owned sector generated at least 10 million laid-off workers “xiagang”) in urban areas, and when added to the excess 150 million workers in rural areas, the real unemployment rate climbs to 25–30 percent nationwide. The addition of 8–10 million workers flowing into urban areas per annum raises the total labor force by about 15 million, and puts mounting pressure on the PRC’s labor markets.

Foreign direct investment (FDI) is currently seen as one remedy that can absorb excess labor and mitigate immediate unemployment problems. Many foreign companies in search of cheap labor have set up production lines that utilize rural workers, particularly in the special economic zones. Sharp renminbi appreciation could not only cause a decline in FDI by effectively raising operation costs for companies, it could also damage the already uncompetitive agriculture sector and state-owned enterprise sector creating even more excess labor. Losing FDI would thus mean an even bleaker labor market.

While NPLs are now officially reported as 15–20 percent of GDP, some experts estimate the real rate to be around 35 percent. Furthermore, the recent decline in the NPL ratio seems to be mostly due to the increase in lending volume, which means that new NPLs could surface in the next few years. PRC authorities acknowledge the need to invite foreign investors in to solve this problem. In fact, the Ministry of Finance issued a circular in 2004 on administration of foreign debts relating to external transfer of NPLs by asset management corporations (AMCs), which aims to streamline the procedure and attract foreign investors to invest in NPLs.

In late 2004, Huarong AMC reportedly targeted foreign investors in an attempt to sell a package worth 150 billion RMB, the largest deal so far. Silver Grant International Industries Ltd., which is a Hong Kong, China listed company controlled by China Xinda AMC, was established to dispose of NPLs. Silver reportedly unveiled a plan to sell more than US$200 million worth of new shares and convertible instruments to Citigroup Global Investment Management. In January 2005, Silver and Citigroup signed a memorandum of understanding to establish a joint venture that will invest in NPLs in the PRC. If the renminbi appreciates, foreign investors may grow hesitant to buy NPL’s. These underlying factors are important to remember when trying to understand why the PRC sticks with its dollar-pegged renminbi. (10 June 2005)

3.3 A dangerous cycle: Foreign reserves, price determinants, and renminbi appreciation

PRC foreign reserve holdings have been accumulating rapidly. At the end of the first quarter of 2005 the figure stood at about US$660 billion, almost 50 percent more than the corresponding month in 2004. Both current and capital accounts in the PRC have registered surpluses, and swelling the foreign reserves is an inflow of speculative “hot money” ( “reqian”). This inflow, which has been attributed to repatriating capital flight, has grown significantly over the past three years, a period coinciding with the intensified appreciation pressure on the renminbi. Some estimates show levels of errors and omissions in the balance of payments that reflect the inflow of hot money in amounts of US$7.8, 18.4, and 20 billion for the years from 2002–2004, respectively.

A cyclical effect seems to be occurring. The current account surplus, as well as the surplus in capital and financial accounts, drives a huge and rapid accumulation of foreign reserves that causes mounting pressure for renminbi appreciation. The heightened expectation of renminbi appreciation brings even more speculative hot money flowing in, further contributing to the accumulated reserves. Such growing expectations of renminbi revaluation, and the consequent speculative and volatile rush of hot money, adversely impact the PRC’s economy by causing “leads and lags” that distort the rational behavior of local enterprises engaged in foreign trade as well as foreign investor behavior.

Many government authorities and market participants are paying keen attention to the smallest decision about renmenbi revaluation, trying to make predictions based on the slightest utterance of PRC policymakers or local newspapers. This expectation of renminbi appreciation leads to unnecessary volatility in the international foreign exchange market. An example was how in late April to early May 2005, the Japanese yen appreciated sharply against the US dollar following a local PRC newspaper report about revaluation. Although no one can control how market participants interpret messages from the PRC, it is important to recognize that PRC authorities do not welcome the growing expectation of renminbi appreciation since it ultimately damages the economy.

The PRC’s trade imbalance with other countries is seen as the main force behind growing international pressure to appreciate the renminbi. Many argue that the PRC’s export prices are too low because of the undervalued renminbi. But the exchange rate is not the only factor determining export prices. Production factor costs such as labor, water, power, and natural resources also determine the prices of exports. The real question is whether market supply and demand conditions in the PRC determine these factor costs at the optimal level: for instance, they may well be undervalued due to the legacy of the centrally-planned economy. Moreover, these factor costs do not properly reflect so-called “external diseconomies,” (negative externalities) such as environmental degradation. We may need to think more closely about the adequacy of the price structure in the PRC first before gradually addressing the exchange rate. (16 June 2005)

3.4 A closer look at the recent renminbi revaluation

On the evening of 20 July 2005, the People’s Bank of China (PBOC) unexpectedly announced the 2.1 percent revaluation of the renminbi. What observations can we make about this announcement? The first relates to timing. While many experts and media sources saw the announcement as abrupt and surprising, careful examination indicates that this was not necessarily the case. In looking at the various indicators such as balance of payment, foreign reserves, and short- term capital inflow, PRC officials actually pursued the earliest possible timing for revaluation. And to avoid the impression that external pressure had led to the revaluation move, the PRC authorities waited until such pressure was mitigated somewhat by a moment of US dollar appreciation. Moreover, given the political and economic importance of its relationship with the US, it was also predictable that the PRC would take revaluation measures prior to the scheduled meeting of each country’s leaders in the autumn of 2005.

Another observation regards the prevailing misunderstanding about the PRC decision to abandon the US-pegged monetary regime and replace it with a currency basket approach. Though the PBOC announcement carefully stated that the renminbi exchange rate would adjust based on market supply and demand with reference to a basket of currencies, it does not make clear whether “reference” means the same thing as “pegged” to a basket of currencies. In either case, the PBOC did not announce the composition of the basket of currencies (see Note page 27), and since 21 July has allowed the actual renminbi exchange rate to fluctuate within a very narrow range centered on the new 8.11 RMB to 1 US dollar rate. Although the announcement allows the fluctuation range of 0.3 percent, the PBOC seems to be intervening significantly in foreign exchange, and doing its best to contain the fluctuation. Recently the PBOC firmly denied the possibility of another revaluation for the moment, which is certainly strange if the PBOC has truly moved to a currency basket regime.

Other countries and experts mostly welcomed the announcement of a change in the currency regime as a first step, but remain concerned that the new system is less transparent than the previous dollar-pegged regime. The statement, “with reference to a basket of currencies,” is vague and many fear that the PRC might more freely manipulate the RMB exchange rate by foreign exchange intervention. The 21 July revaluation is a good example of the PRC’s traditional gradualist approach: starting with a limited scope on an experimental basis and then carefully examining the impact of the move before expanding the scope. At face value, the core announcement seems to offer nothing more than a one-time, nominal revaluation that raises no expectations for any significant change in the nominal exchange rate or in the exchange rate regime. However, this is more likely a first step that needs to be watched carefully for indications on when a next step might follow. (8 August 2005)

3.5 Direction of public finance in the PRC

Since the Asian financial crisis the PRC has taken a proactive fiscal policy by issuing national construction bonds to avoid a slow-down in the economy. The central government deficits and its proportion to GDP in 1997 was 56 billion RMB and 0.8 percent, while these figures went up to 319.8 billion RMB and 2.7 percent respectively in 2003. Following the 2003 Central Economic Conference, PRC authorities have shown signs of shifting fiscal policy from “proactive” to “prudent” in order to respond to overheating in the economy. New government bond issues were cut to 110 billion RMB in 2004 and 80 billion RMB in 2005, down from the annual 140–150 billion RMB during the years between 2000 and 2003. Central government deficit in 2004 remained at the same level, 319.8 billion RMB, but its ratio to GDP declined 2.5 percent from its peak of 3.0 percent in 2002.

Individual income tax is becoming an important tax source as revenues have increased from 41 billion RMB in 1999 to 173.7 RMB in 2004. Its ratio to total tax revenue also increased dramatically from 1.4 in 1994 to 6.8 percent in 2004. But the system for the individual PRC taxpayer remains extremely complex. Currently, individual income can be divided into eleven categories, each one subject to different rates and cost calculations. To achieve more efficient tax collection, the PRC Ministry of Finance is trying to shift towards a more unifying individual tax scheme. Already major tax reforms in 2002 introduced a new system that shares income tax between central and local governments as a means of addressing regional equity. In 2005, against the backdrop of growing per capita income and intensified sentiments of unfairness towards the tax code, the State Council proposed to raise the personal income tax exemption from 800 RMB to 1,600 RMB as a way to reduce the tax burden on the poor.

Traditional economics posit that public finance “caizheng”) has three primary functions: reallocation of resources, adjustment of business cycles, and redistribution of income. Under the previous centrally planned economy, PRC public finance served to consolidate then allocate all resources and build up infrastructure. Lengthy budget statements made by Party and government officials tended to stress how budget resources allocated in various provinces and sectors would contribute to the nation’s overall development. More recent developments indicate that the PRC authorities now realize the effectiveness of using fiscal policy as a tool to smooth out business fluctuation and they are reviewing the tax system as a way of achieving social equity in light of growing income disparities. Although these trends are the logical consequence of economic reform and marketization, the role of public finance under a “socialist market economy with PRC characteristics,” deserves further observation. (19 December 2005)

3.6 Implications for PRC’s foreign reserve accumulation

Foreign reserves began flowing rapidly into the PRC in early 2002, reaching nearly US$8.2 billion by the end of 2005 (see Table 1 page 32). This was mainly attributed to three factors: current account surplus, influx of capital via foreign direct investment (FDI), and repatriation of PRC capital in anticipation of renminbi appreciation, reflecting errors and omissions in the balance of payments account.

There is no clear theoretical process for determining the optimum level of foreign reserves. The current ratio of foreign reserves to monthly imports is approximately 16:1 and that of foreign reserves to short-term foreign debt is about 10:1, both higher than the widely accepted figures of three months and one year, respectively. Compared to other countries, the PRC ratios rank number one for foreign reserves to foreign debt, and number 5 for foreign reserves to imports and foreign reserves to GDP. Moreover, FDI is the source of nearly 50 percent of recent foreign reserves.

The PRC is presently working to deregulate capital account transactions and encourage Chinese enterprises to move operations overseas “zou chuqu”). Under these circumstances, the rapid influx of foreign capital could end suddenly or even be reversed. Accordingly, to prepare for a sudden or unexpected capital outflow, particularly on the heels of the Asian economic crisis, the PRC and other Asian economies tend to accumulate foreign reserves beyond the presumed optimal level.

In terms of economic theory, the greatest concern is the monetary implications. Under normal circumstances, as foreign reserves flow into a country the central bank releases an equal amount of local currency into the domestic economy. Where there is a rapid influx of foreign capital, there is a risk of overheating the economy if too much money is injected into the market. Over the past few years, the People’s Bank of China (PBOC) has successfully used a “sterilization policy” to manage the money supply (see Table 2 page 32). For the time being there is no foreseeable need to worry about the influx of foreign reserves to the PRC, neither in terms of amount nor speed. However PRC authorities need to carefully consider the following issues:

1. The rapid accumulation of foreign reserves reflects the macro I- S imbalance of the domestic economy, external balance in particular. The government introduced a reform plan for the renminbi exchange rate system, but is trying to use foreign exchange rate intervention to mitigate large-scale exchange rate adjustments; the result has been further appreciation pressure.
2. A vicious cycle has been created, namely that the accumulation of foreign reserves gives rise to further anticipation of renminbi appreciation, resulting in an influx of foreign capital, which in turn triggers foreign exchange intervention.
3. The sterilization policy has certain cost implications. To date, the interest rate of PBOC bills has remained lower than that of US treasury bills, which is where a large part of the reserves are invested. However, depending on future developments related to domestic and foreign interest rates, this may not be able to be maintained.
4. The PRC has achieved strong economic growth of 9–10% in recent years, and this has required the money supply to grow at a relatively high rate. However, a modest economic growth rate of 6–7% is envisioned during the 11^th five-year plan. In order to prevent the economy from overheating, the money supply must grow at a more moderate rate as well.

How to utilize the massive foreign reserves accumulated for the PRC economy is the most important issue of all, and is not simply a matter for the PRC since other countries face the same dilemma. However the current PRC domestic economy doesn’t appear to be enjoying any specific benefits from the influx of foreign reserves.

In the latter part of 2005, the government injected a total of $60 billion from foreign reserves into the state commercial banks to strengthen their capital base, possibly giving a sign that the PRC is considering the appropriations of foreign reserves. If this is the case, there needs to be a planned appropriations effort such as setting aside reserves to create funds for projects like addressing environmental problems, promoting energy conservation, and enhancing technological innovation. In order to avoid risks and maximize returns, a review of the current composition of the foreign reserves portfolio— roughly 60% US dollar bonds and treasury bills, 20–25% euro and 15–20% yen—may also be required. (22 March 2006)

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