By Wang Tao, Bank of America economist
By closely linking the yuan with a sharply declining U.S. dollar, China is importing a highly accommodative U.S. monetary policy, which sits oddly with Chinese monetary policy considerations. On top of China’s already large, basic balance of payment surplus, speculative inflows likely have risen in recent months as yuan appreciation expectations have become entrenched. A combination of a one-off revaluation of the Chinese currency and tightened capital controls by government regulators may help break the expectation in the near term, although these steps would be highly controversial.
The speed of China’s foreign exchange reserves accumulation has been nothing short of astonishing. In a previous report (see “Country Alert China, Difficult 2008 Part I: The Speed of FX Accumulation,” March 17, 2008), we identified the influx of foreign exchange as one of the biggest challenges facing Chinese policymakers this year. Our estimate puts the actual increase of net foreign assets in 2007 at between US＄ 570 billion and US＄ 685 billion, and we are not surprised that FX reserves increased by more than US＄ 120 billion in the first two months of this year.
Most of the increases in FX come from easy-to-identify sources: trade surplus, services receipts, investment income (mostly from the large stock of FX reserves), net FDI inflows, and the valuation effect from the appreciation of non-U.S. dollar reserve currencies. The contribution from “unexplained” FX inflows is less certain, ranging anywhere from US＄ 37 billion to US＄ 150 billion (figures 1 and 2), depending on whether some of the FX transfers from the People’s Bank of China (the central bank) to China Investment Corp. was from FX inflows in 2007 or previous years. If indeed the “unexplained” FX increase was in the order of US＄ 150 billion in 2007, which is consistent with data for the first two months of 2008, then it means that unexplained inflows have become sizable since 2007. If that number was as low as US＄ 37 billion in 2007, but has been in the order of US＄ 150 billion a year in the first two months of 2008, then it implies a sudden surge in unexplained inflows in recent months. In either case, the data justifies current concerns about the increase in unexplained flows. Some also argue that speculative inflows may have been partly disguised as FDI and trade inflows as well.
Currently, there are strong economic incentives for FX inflows into China, “hot money” or not, and the U.S. subprime crisis may aggravate the situation in the near term. China’s financial sector has had little direct exposure to the subprime-tainted assets, and its economy is expected to grow strongly, by 9 to 10 percent in 2008, despite a global slowdown and probable U.S. recession. While the U.S. Federal Reserve is aggressively cutting interest rates, interest rates in China have been raised -- six times in 2007 -- and are biased upward (figure 3) . After a few months of steadily, more rapid yuan appreciation against the U.S. dollar, market expectations of 8 to 10 percent annual appreciation have become well established (figure 4) . Given such strong incentives, everyone, including foreign direct investors and domestic companies and banks, will try to bring in FX and hold yuan. Whether and to what extent these fund inflows constitute “hot money” is a rather technical issue that we will not discuss here.
Trying to maintain a relatively stable yuan exchange rate against a sharply declining U.S. dollar keeps the yuan weak in effective terms. A weak currency fuels external demand and transmits higher import prices to higher domestic prices. Moreover, even with existing capital controls, appreciation expectations and rising interest rate differentials likely have led to increased and speculative inflows, adding to the already large basic balance of payment surpluses. Liquidity generated from FX reduces the effectiveness of intended monetary tightening, compromising monetary independence.
Some might not see any big problems here. Hasn’t the central bank been able to sterilize most FX inflows while trying and succeeding in managing steady yuan appreciation? In addition, the government has used tight credit controls (including window guidance) to prevent excess liquidity from translating into excessive lending growth in recent months, resulting in the reasonable growth of monetary aggregates.
The fact that the central bank has been able to sterilize most inflows is an achievement and a testament to its creativity, but it does not mean that the challenge is small, or that this process should be sustained. Most, not all, inflows were sterilized, leading to a net injection of liquidity from FX flows, and resulting in low interest rates (figure 5) . Credit rationing can keep overall loan growth from rising too rapidly, but it increases the risk of misallocation. The low cost of capital serves to prolong the unbalanced growth pattern led by investment and industry. Moreover, the overhang of liquidity threatens to translate into rapid loan growth through administrative loopholes, undermining the effectiveness of credit management. While the current high inflation rate has so far been caused mainly by higher food prices rather than excess aggregate demand, continued generation of liquidity is like stockpiling gasoline beside a fire.
In addition to sterilization, China has tried to reduce FX accumulation. The measures have included:
-- Allowing faster yuan-U.S. dollar appreciation (although appreciation against a trade-weighted basket of currencies have been very small);
-- Reducing import duties and export tax rebates, and restricting certain processed exports;
-- Tightening foreign borrowing by domestic banks and corporations;
-- Encouraging outward FDI and portfolio investment;
-- Abolishing the FX surrender requirements for companies, and relaxing limits on individual purchases of foreign currency.
Some would argue that tighter regulation and supervision on the stock and property markets have also been aimed at slowing speculative inflows. However, the above measures are unlikely to adequately stem continued and rapid FX accumulation and, especially, the recent surge in speculative inflows amid rising pressure for appreciation of the yuan.
More drastic measures may be necessary to reduce liquidity-generating FX inflows and loosen the close link with the accommodative U.S. monetary policy. The answer may be a combination of a one-off revaluation and tightened capital controls, accompanied by structural measures. As the U.S. dollar continues to slide, the yuan needs to appreciate more vis-à-vis other major currencies to achieve the effective appreciation needed to reduce China’s large trade surplus, which has been the most important source of FX reserves accumulation so far. However, the current and steady appreciation of the yuan has entrenched expectations and helped fuel speculative inflows. A one-off revaluation could help break the expectation in the near term if it is combined with tightened capital controls.
Two issues would immediately arise from the above approach: the difficulties in determining the appropriate size of the revaluation, and the questionable effectiveness of capital controls. On the first, we doubt anyone would be able to make an accurate estimate of the yuan’s fair value or degree of undervaluation. However, that may not be necessary. A sizable revaluation that is significant enough to have an impact on the trade surplus yet deemed acceptable by the government over a one-year period (say 10 percent) could be picked. An unexpected revaluation, combined with the right statement and other policies, could send a clear signal to the market that this round of yuan appreciation has ended, thus staving off speculative inflows.
On the second issue, international experience has shown that capital controls are never water-tight, and their effectiveness erodes with time. However, the point of capital controls is not to completely shut down monetary flows, but to increase risks and transaction costs to deter excessive (usually short-term) flows. This could in turn help shield the domestic economy from importing the “wrong” monetary policy and from the volatile international financial market conditions, long enough so that domestic policy priorities could be better pursued. One frequently cited example is Chile in the 1990s. Chile used, among other steps, an unremunerated reserve requirement on capital inflows to prevent a wave of capital flowing into emerging markets at that time from disturbing its domestic policy agenda.
Both revaluation and tighter capital controls are likely to be highly controversial. Some would argue that a one-off revaluation would have a serious negative impact on China’s export sector amid slowing global demand. However, despite the global economic slowdown, China is still expected to record a large trade surplus. The impact of a revaluation on exports may be more manageable (through hedging) and less ad hoc than changes in tax or industrial policies, and would be less distorted. A stronger yuan also would have the benefit of lowering import prices. Tightening capital controls may invite skepticism that China is reversing its intention to gradually open its capital account. However, international experiences (see IMF Occasional Paper No. 220, “Effects on Financial Globalization on Developing Countries: Some Empirical Evidence,” Prasad Eswar et al., 2003) show that developing economies would be wise not to open their capital accounts too quickly and prematurely, as it can expose their economies to excessive fluctuations of international capital flows and volatility in the global financial market.
China indeed faces a difficult year in 2008. Amid increasing external and internal uncertainties, we think one overriding issue facing China remains excess liquidity and its consequences. Reducing the speed of FX accumulation and ties to U.S. monetary policy are critically important. Something has to give, and we think it should be external surplus, not domestic economic stability.