china's exc.rate policy

8/3/2019 China's Exc.rate Policy

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American Economic Association

China's Exchange Rate Policy DilemmaAuthor(s): Morris Goldstein and Nicholas LardySource: The American Economic Review, Vol. 96, No. 2 (May, 2006), pp. 422-426Published by: American Economic AssociationStable URL: http://www.jstor.org/stable/30034684Accessed: 12/12/2009 22:53

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ASIANCURRENCYMATTERSt

China'sExchangeRatePolicyDilemmaBy MORRISGOLDSTEINAND NICHOLASLARDY*

Thispapersummarizeskey aspectsof China'sexchangeratepolicy,outlines heproblemst cre-ates forbothChina and the global economy,andproposesa feasiblepolicy compromise.I. China'sCurrencyRegime

On July 21, 2005, China announced a 2.1-percent appreciationof the renminbi (RMB)against the U.S. dollar, a move to a managedfloat,and a numberof other"reforms."Most ofthese reforms simply reiteratedlong-standingarrangements; ince 1994, Chinahas identifiedits currencyregime as a managedfloat and hasset a 0.3-percent,per day, fluctuation imit (ineitherdirection)for the RMB againstthe dollar(vis-a-vis the centralparity).The July 2005 announcement,however, didpledge two potentially mportantalterations: a)the RMB was, henceforth, o be managed"withreferenceto a basket of currencies" ather hanbeing pegged to the dollar;and(b) the exchangerate was to become "more flexible," with itsvalue based more on "market supply anddemand."In practice, the July 2005 reformshave hadlittle visible effect. As of mid-December2005,the RMB-dollar rate was 8.07, a furtherappre-ciation of only 0.5 percent.There is also littleevidence of pegging to a basket; rather, theRMB continuesto trackthe U.S. dollarclosely.And the central bank's monthlyintervention ntheforeignexchangemarket n AugustandSep-tember remained huge, at $18 billion permonth-only slightly smallerthan the $19 bil-

lion permonth n the first half of 2005. In short,China'sexchangeratesystemremainsa heavilymanaged peg to the dollar-and at a dollarexchange ratevery close to the level prevailingbefore the July reform.II. Is the RMB Undervalued?

There are several approachesto evaluatingthe misalignmentof the RMB. The "underlyingbalance"approachasks what level of the real,effective (trade-weighted) xchangeratewouldproducean equilibrium n which the "underly-ing" current-account osition is approximatelyequal, and opposite in sign, to "normal"netcapital flows.During the 1999-2002 period, before therewas any expectationof a currencyappreciation,China ran an average capital-accountsurplusequal to 1.5 percentof GDP. Take this as ourmeasureof normalnet capital flows.Next, define the "underlying"urrentaccountas the actualcurrent-account osition, adjustedfor both cyclical movementsthat make the de-mandfor importsunusuallyhighor low, andthelagged trade-balance ffects of recentexchangerate changes.China's 2005 current-accountsurplus willprobablybe in the neighborhoodof 7 to 9 per-cent of GDP. The underlyingcurrent-accountsurplusshould be somewhatlower-say 5 to 7percent of GDP-because (buoyant GDPgrowthratenotwithstanding)domestic demand

t Discussants: Eswar Prasad, InternationalMonetaryFund;PeterKenen, PrincetonUniversity.* Goldstein:Institute or InternationalEconomics, 1750MassachusettsAvenue, NW, Washington,DC 20036-1903(e-mail: [email protected];Lardy:Institute for Interna-tionalEconomics, 1750MassachusettsAvenue,NW, Wash-ington, DC 20036-1903 (e-mail: [email protected]).

1 Goldstein(2004) providesfuller discussion of this ap-proach. There could be cases where some increase in re-serves was desirable, or where only some share of theexternal mbalancewas to be eliminatedwithin a given timeperiod. Nevertheless,the basic premise is that a large dis-crepancybetween normalcapital flows and the underlyingcurrent-account ositionsignifiesa misalignmentof therealequilibriumexchangerate.422


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growth has slowed and in 2005 the RMB hasappreciated n real trade-weighted erms.If China'sunderlyingcurrent-accounturplusis now in the range of 5 to 7 percentof GDP,while what is requiredto offset normalcapitalflows is an underlying current-accountdeficitequal to 1.5 percentof GDP, then China's cur-rent account needs to deteriorateby a whopping6.5 to 8.5 percent of GDP to restore (strict)balance-of-payments quilibrium. f one does aset of simulations with a small trade model tocalculate what size real, effective appreciationof theRMBwould be necessaryto producesucha large turnaroundn the currentaccount-tak-ing into account the high import content ofChina's exports, using a plausible range forprice elasticities of demand and supply, andmaking alternativeassumptionsabout the sec-ond-round effects of income changes on thedemand or imports-the answerscongregate nthe upper part of the 20 to 40 percent range.This is somewhatlargerthan the estimatedun-dervaluation or 2003-2004.2We would not want to go to the stakefor theprecisionof our estimatesof RMB undervalua-tion: after all, there is uncertaintyabout theunderlying parameters, other methodologiesyield somewhat differentestimates, and Chinais in the midst of a nontrivial revision of itsGDP accounts.Still, withhuge reserve accumu-lation in each of the past three years; withpersistent surpluses on both the current andcapital accounts;with the real, trade-weightedRMB showing a cumulativedepreciationsincethe dollarpeakin February2002; with the Chi-nese economy runningat full steam,or close toit, for most of the past three years; and withAsian currencyappreciationneeded to reducethe excessively large U.S. current-account ef-icit, we submit that it is difficult to arriveat acredible estimatethat shows anythingbuta size-able undervaluationor the RMB.3

III. Problemswith the CurrentRegimeChina's current xchangerateregimehas cre-ated problems for China and the global

economy.First,the (de facto) fixed-dollarexchangeratelimits the independence of China's monetarypolicy and has contributed, hereby,to the pro-nounced macroeconomic fluctuationsof recentyears. In 2003-2004, when investment wasbooming and the rate of price inflation wasaccelerating,the centralbank was reluctanttoraise domestic lending rates, in partbecause itfearedthat,despitecontrols,higherrates wouldattractcapitalinflows. As a result, the real rateof interest to corporateborrowers(proxied bythe one-year bank-lending rate minus thechange in the corporategoods price index), fellfrom 8 percent in 2002-Q3 on the eve of theinvestmentboom to negative 4 percent duringApril through September 2004; that, in turn,contributed o an excess demandfor loans.Second, China's undervaluedcurrency hascontributedto growing tradesurplusesand, atleast in some years,to very large portfoliocap-ital inflows, which appearmotivatedby an ex-pectation of appreciation.Mammothexchangemarketintervention,amountingto 11, 12, and14 percentof GDP in 2003, 2004, andthe firsthalf of 2005, respectively,has beennecessarytoprevent currency appreciation.The centralbank sterilized much of this re-serveaccumulation hrough ncreases n reserverequirements ndopenmarketoperations.Sincemid-2004, the centralbank also used adminis-trative controls to limit bank credit creation.This approach is costly in several respects.There have been episodes when the barndoorwas locked only after the horses had left. In2003 and the firsthalf of 2004, therewas a bankcreditblowout, with the ratioof the increaseinbank credit to GDP hitting an all-time high.This led to an investmentboom, with long-termconsequences for excess capacity in a numberof sectors,for downwardpressureon operatingmargins in these sectors, and potentially fornonperformingoans in banks that lent heavilyto supportsuch projects.In 2005 we againwit-nessed a substantialbuildupof bank liquidity,reflected n growingexcess reserves anddeclin-ing money marketrates.Increased use of administrativecontrols on

2 Goldstein (2004) and Lardy (2005). To estimate theundervaluation f the RMB with respect to individualcur-rencies, one needs a multi-countrymodel. William R. Cline(2005) does such an exercise and estimates that as of No-vember2005, theRMB was undervaluedwithrespectto theU.S. dollarby 43 percent.3Taking a broad view of the evidence across severalmethodologies, it looks to us like the RMB is undervaluedin real, trade-weighted ermsby 20 to 35 percent.


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424 AEAPAPERSAND PROCEEDINGS MAY2006

lending is inconsistent with the government'slong-term policy of requiring state-ownedbanks to operate on commercial principles.Whenthecentralbankspecifies lendingceilingsandsectorallending priorities, he developmentof a credit culture is slowed. And when moneymarket interest rates are depressedby excessliquidity,bankprofitability uffers, since banksare net lenders in the money market.Third, a highly undervaluedRMB encour-ages excess investment n tradablegoods. Even-tually,the realexchangeratewill appreciateandwill lower profitability n tradablegoods indus-tries,againwith adverseimplications or banks.Fourth,China is accumulatinga large expo-sureto potential capital losses. China's foreignexchangereserveswill, at year-end2005, be inthe neighborhood of 40 percent of GDP. A20-percentrevaluation of the RMB against themajorreserve currencieswouldimposea capitalloss equivalentto 8 percentof GDP.Finally, China's prolonged,large scale, one-way intervention n the foreign exchange mar-ket-along with its large and growing globalcurrent account surplus-fuels protectionistpressure in the United States and elsewhere.One reflection is the Schumer-Graham ill inthe U.S. Senate, which could lead to a uniform27.5 percenttariff on all Chinese imports.An-other is the ill-consideredcongressionalactionsubjectinga potentialChina National OffshoreOil Corporation CNOOC)purchaseof Unocalto a special congressional review. Since overhalf of China'sexports go to the United States,Euroland, and Japan, and since China has along-term nterest n investingabroad, uchpro-tectionistthreatsought not be takenlightly.In sum, the costs to China of maintaininganundervalued currency are already significantand are likely to rise over time. Moreover,un-like some others (e.g., Michael Dooley et al.,2004), we do not see the growth and employ-ment benefits of an undervaluedRMB as ex-ceeding its costs (Goldstein, 2006; GoldsteinandLardy,2005).China's inflexible currency regime and itsundervaluedRMB also handicap he adjustmentof global imbalancesand increase the risk of ahardlandingfor the dollar and the U.S. econ-omy, with adverseglobal spillovers.The U.S. current-accountdeficit is now run-ning at about 6.5 percentof GDP-an all-time

high. If the U.S. current-accountdeficit is notreduced,U.S. net foreign debt relative to GDPwill rise to a worrisome level and U.S. assetswill eventuallylose their attractiveness elativeto alternative nvestmentopportunities-result-ing in some combination of a fall in capitalflows to the United States, higher interestrates on U.S. liabilities, and a decline in thedollar. If these adjustments were large anddisorderly, they would depress U.S. growthsignificantly, with adverse spillovers for U.S.trading partners.As Michael Mussa (2005) has emphasized,the inevitable correction of the U.S. externalimbalancewill necessarily involve a deprecia-tion of the dollar against most currencies,and domestic demand growing more slowly(faster) than domestic output in the UnitedStates (rest of the world). The first channel isthe expenditure-switchingchannel, while thesecond is the expenditure-changingchannel.Both are needed. That is why both a moreambitiousprogramof fiscal consolidationandatighteningof U.S. monetaryconditions are es-sential-along with policies that stimulatedo-mestic demand growth in major U.S. tradingpartners.The real, trade-weightedU.S. dollar needs tofall by an additional15 to 25 percentfrom itscurrent level to support external adjustment.The currenciesof Japan,China, and the rest ofemerging Asia have a combined weight ofroughly 40 percent in the Federal Reserve'sdollar index. If the Asian currencies do notparticipate, ithertheoveralldepreciationof thedollar will be too small or the appreciationburden will fall too heavily on economieswhere a further,large appreciationwould notbe warranted.In the wave of dollar depreci-ation startingin February2002, the euro, theCanadian dollar, and the Australian dollar,among other market-determinedcurrencies,experiencedstrong,real appreciation,whereasthe Asian currencies-with the notable ex-ceptions of the Korean won and Indonesianrupiah-did not.China remainsa primecandidatefor leadingwider Asian currency appreciationbecause ofits large external imbalance and because theRMB's behavior can influence -for better orworse-the attitude hat other Asian economieshave towardpressuresfor appreciation n their


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VOL.96 NO. 2 ASIAN CURRENCYMATTERS 425own currencies.4In this sense, it is importantthat Chinabe partof the international olutionto the adjustment of large external imbal-ances-and not partof the problem.

IV. PolicyConstraints nd a CompromiseSolutionChina's willingness and ability to deal withthe shortcomingsin the currentexchange rateregime areheavily constrainedby at least threeimportant actors.First, China's bankingsystem, althoughim-proving, remains fragile. Households, whichhave bank deposits equivalent to almost 100

percentof GDP, have had little opportunity odiversify the currencycomposition of their fi-nancial assets and could be susceptibleto cap-ital flightif they thoughtrisksof repaymenthadworsened.Thus, any adjustmentof China'sex-change rateregime will have to maintain mostexisting capital controls until the domesticbanks are furtherstrengthened.Second, the degree of undervaluationof theRMB is now so large thatit would take a longtime to correct if it were done in a series ofsmall steps. But this is apt to exhaust the pa-tience of the international ommunity.Also, thegreater he expectationthat each RMB appreci-ation will be followed by another,the largeristhe scale of capital inflows and the largerthesterilizationproblem.And third, China's currentleadership,evenmore thanits predecessor, appearsto preferanincrementalapproachto dealing with the cur-rentexchangerate dilemma.They highly valuegrowthandstability.They worry hat ettingmar-ket forces freely determinethe exchange ratecould result n too muchRMBappreciation,low-ing exports, employment, and growth and,thereby,contributeo increased ocialinstability.How then to square the circle? Absent theaforementionedconstraints, he policy solutionwould be straightforward: hinacould simulta-neously and immediately remove the restric-tions on capital flows and let the marketdetermine the value of the RMB. The con-

straintsmean the searchis for second-bestpol-icy options.All things considered, we believe the pre-ferredcourse of action is a compromise alongthe following lines.5 China would make a cred-ible down paymenton removing the large un-dervaluation of the RMB by immediatelyrevaluingit by 10 to 15 percent,relative to thecurrencybasket; t would widen thebandto 5 to7 percent on each side of the new parity; itwould simultaneouslyimplementfiscal expan-sion; and it would leave in place most capitalcontrols.The 10- to 15-percentevaluation f theRMB would help to reduceChina'svery largecurrent-accounturplusand shouldpersuadehosein theU.S. Congress,and n otherG-7legislatures,thatChinawas finallygettingseriousabout con-trolling ts growingexternal mbalance.A 10- to15-percentrevaluationwould be a much moretangible sign of progressthan the meager 2.5-percentrevaluationegisteredhus far.A significant widening of the band wouldgive China some increased independence formonetarypolicy, would allow scope for somefurtherappreciationof the RMB, and wouldgive China some practical experience in man-aged increased flexibility. It would also givesome substance to China's repeatedclaim that"marketsupply and demand" would increas-ingly determinethe RMB's value.Fiscal expansionis needed to offset some ofthe contractionary ffects of the RMB revalua-tion. The fiscal expansionneeds to be expendi-ture-based, because direct tax receipts inChina-like the agriculturalax and the incometax-are currentlyfar too small to provide ameaningful boost from a tax reduction. In-creased government expenditures shouldstrengthen he social safety net because one ofthe main factors behind China's very highhouseholdsavingsrate is precautionaryavingsagainstpotentiallyhigh out-of-pocketexpensesfor healthcare, education,and retirement.6Keepingin place the bulk of existingcontrolson capital lows is a prudentmeasureagainstpo-tential capital flight, should there be bad newsabout he stateof the still-fragile anking ystem.

4 In contrast,Barry Eichengreen(2004) has arguedthatother Asian currencies would not necessarily follow theRMB upward f China revalued.

5This is close to our original formulationof the "two-stage" approach o China'scurrencyreform(GoldsteinandLardy,2003).6 Olivier J. Blanchardand FrancescoGiavazzi (2005).


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426 AEAPAPERSAND PROCEEDINGS MAY2006True,this would leave a sizeable,real appre-ciationof the RMB to be carriedout later, over,say, the next two years, with all the expecta-tions-cum-capitalflow problems that such a

phased adjustmententails. Indeed,that is whywe pushedfor China to remove,in one step, theundervaluation n 2003-2004.7 Butthatwindowof opportunity as passed-now that the under-valuationof the RMBis largeranddomesticde-mand growth has slowed. While speculativeinflows have recentlydeclined from the recordpaceof 2003-2004, one cannotbe confident hattheywouldnotrevive; n such a case, theauthor-ities would need to choose between an accelera-tion of the RMB appreciation nd a temporaryrecourse o tightercontrolson capital nflow.In the final stage of currencyreform-whenChina'sbanking system is on firmerfooting-China would float the RMB and remove theremainingcontrols on capital flows. Appropri-ate sequencingof capital-account iberalizationwouldprevent currencyreform fromundermin-ing the continuedstrengtheningof the bankingsystem.Admittedly,this is not such an elegant plan.But if it avoids the international rain wreckthat would otherwise take place, it meritsconsideration.

REFERENCESBlanchard,Olivier J. and Giavazzi,Francesco."RebalancingGrowth in China: A Three-Handed Approach."Massachusetts Institute

of Technology,MITDepartmentof Econom-ics WorkingPaper:No. 05-32, 2005.Cline, WilliamR. "The Case for a New PlazaAgreement."Institute for InternationalEco-nomics, IIE Policy Brief: No. PB05-4,2005.

Dooley,MichaelP.; Folkerts-Landau, avidandGarber,Peter. "TheRevived Bretton WoodsSystem." International Journal of Financeand Economics, 2004, 9(4), pp. 307-13.Eichengreen,Barry."ChineseCurrencyContro-versies." Center for Economic Policy Re-search,CEPR Discussion Papers:No. 4375,2004.Goldstein,Morris."AdjustingChina'sExchangeRate Policies." Institute for InternationalEconomics, IIE Working Paper: No. 04-1,2004.

Goldstein,Morris. "RMB Controversies."CatoJournal, 2006, 26(2).Goldstein, Morris and Lardy, Nicholas R."China'sRole in the Revived BrettonWoodsSystem:A Case of MistakenIdentity."Insti-tute for InternationalEconomics, IIE Work-ing Paper:No. 05-2, 2005.Goldstein,MorrisandLardy,NicholasR. "Two-Stage CurrencyReform for China,"AsianWall StreetJournal. September12, 2003.Lardy,NicholasR. "ExchangeRate and Mone-tary Policy in China." Cato Journal, 2005,25(1), pp. 41-47.Mussa, Michael. "Sustaining Global GrowthWhile ReducingExternalImbalances,"n C.FredBergsten,ed., TheUnitedStatesand theworldeconomy:Foreign economicpolicyforthe next decade. Washington,DC: Institutefor InternationalEconomics, 2005.oldstein and Lardy(2004).

china's exc.rate policy

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