the chinese yuan.docx

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The Chinese Yuan: The Revaluation Dilemma

Introduction

Chinas central place in the global economy had been widely acknowledged in recent times. The

countrys economic policies were attracting significant international attention. In early 2005, the

Chinese government indicated that it intended to liberalize capital controls. Having already eased some

controls on capital outflows, in the past one year, Chinese officials mentioned that they would open up

the capital account further during 2005.

Meanwhile, the Yuan had been pegged to the dollar for a decade. There was a widespread belief that

the Yuan was unfairly cheap. The increase in China's official reserves seemed to be clear evidence in this

regard. But senior Chinese politicians believed that China could not let its exchange rate move morefreely before it had fixed its weak banking system. Otherwise, there would be a large outflow of capital.

Advocates of a more flexible exchange rate system argued that, even if it led to the appreciation of the

Yuan, it would create long-term benefits. It would assist the development of a deeper financial market.

For example, firms would have more incentive to hedge foreign-exchange risk. This would encourage

the development of suitable financial instruments including derivatives. The experience of greater

exchange-rate flexibility would also help the economy over time, to prepare for a full opening of the

capital account. If capital controls shielded the economy from volatile flows, China would have time for

reforms to strengthen the banking system.

Chinese policy makers faced a dilemma. What should they do first - liberalize capital flows or allow the

Yuan to float? The dilemma was further with pressure on China from many western countries, especially

the US, to revalue the Yuan.

Background Note

Only a few years ago, when "the world economy" was discussed, China would at bestget a brief mention. But in 2005, China became too big to ignore. Since 1978, whenDeng Xiaoping first set his country on the path of economic reform, its GDP had

grown by an average of 9.5% a year, faster than in any other economy in the world.

China had been the largest economy for much of recorded history. Until the 15th century, China had thehighest income per head and was the technological leader. But then it suddenly turned its back on theworld, imposing restrictions on international trade and use of technology.

Measured by GDP per person, China was overtaken by Europe by 1500, but it remained the world'sbiggest economy for long thereafter. In 1820 it still accounted for 30% of world GDP. However, by 1950,


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after a century of anarchy, warlordism, foreign suppression, civil war and conflict with Japan, its share ofworld output had fallen to less than 5%[1].

Most of China's growth over the past quarter-century had been due to the high rates of investment and themovement of workers from subsistence farming to more productive use in industry. But goodinfrastructure, an educated workforce, a high rate of saving and an extremely open economy, had also

been significant growth drivers.

China's average tariffs had fallen from 41% in 1992 to 6% after it joined the WTO in December 2001,giving it the lowest tariff protection of any developing country. Many non-tariff barriers had also beendismantled.

China's GDP accounted for 13% of world output (at purchasing-power parity), second only to America's.At the end of 2004, China was the world's third-biggest exporter (after America and Germany). It wasalso the largest recipient of foreign direct investment. Many multinationals had moved their operations toChina to take advantage of its low labor costs and huge domestic market. The country produced two-thirds of all photocopiers, microwave ovens, DVD players and shoes, over half of all digital cameras andaround two-fifths of personal computers. As a result of the large capital inflows, China's foreign-exchange reserves had more than doubled since early 2002 to over $480 billion. Most of these dollarswere invested in American government securities.

China was also a big market. During 2001-04, China had accounted for one-third ofthe total increase in world import volumes. China had become the growth engine forthe rest of East Asia, accounting for half the total export growth of the other EastAsian economies in 2003. China's demand for commodities had also boomed, drivingup world prices.

China was already the world's biggest consumer of steel, copper, coal and cement, and the second-biggest

consumer of oil, after America. So changes in Chinese demand had a big impact on world prices. Chinahad been responsible for nearly 40% of the increase in global consumption since 2000. Chinese demandwas also the main reason for the doubling in the world price of coal in 2003. During the year, Chinaconsumed 40% of all the coal and 30% of all the steel in the world, and accounted for most of the increasein world demand for copper and steel.

For such a big economy, China was unusually open to trade and investment. In 2004,exports and imports of goods and services together amounted to about 75% of China'sGDP, far more than in other big countries. In America, Japan, India and Brazil, thefigure was 30% or less. At its peak, Japan's trade reached only 32% of its GDP.Similarly, the stock of total investment in China by foreign firms was equivalent to

36% of its GDP, compared with 2% in Japan.

China seemed to be opening markets far more than India or Brazil.

China had a trade surplus with America and Europe but a deficit with most of Asia. Itsoverall trade position was close to balance. Much of the increase in America's importsfrom China had been at the expense of the exports of other emerging economies rather
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than domestic production. For example, in 1988, some 60% of American shoe importshad come from South Korea or Taiwan and only 2% from China. In 2004, China had ashare of 70%, and imports from South Korea and Taiwan had declined sharply. Overthe same period, America's imports of computers from the rest of East Asia had fallenwhile those from China had jumped.

The tigers shipped capital-intensive components such as motherboards, memory chips and other parts toChina for labor-intensive processing and assembly and exported personal computers to developedcountries.

Despite these impressive achievements, China faced many obstacles to growth: itsfragile banking system, the lack of a transparent legal system, corruption, the risk ofsocial and political unrest caused by widening income inequalities and the abuse ofhuman rights and severe environmental pollution. Yet if reforms continued, therewere good reasons to believe that rapid growth could be sustained.

With over 60% of China's population still living in the countryside, Chinesemanufacturers had access to an almost unlimited supply of cheap labor. By someestimates, there were almost 200 million underemployed workers in rural areas whocould move into industry. This surplus labor might take at least two decades to absorb,helping to hold down wages for low-skilled workers.The steady shrinking of the state-owned sector would also boost productivity by ensuring a better use of resources.China's private sector, which accounted for about half of its GDP in 2004 wasgrowing twice as fast as the rest of the economy. China's GDP per person was stillwell under a third of South Korea's and one-fifth of Japan's, so there was plenty of

room to catch up. China's share of world trade was also lower than that of Japan or thecombined trade of the East Asian tigers at a similar stage in their developmentprocess, suggesting that China might maintain rapid export growth for a few moreyears. For example, in 2004 it accounted for 13% of all American imports, whereasJapan's share of the American market peaked at 22% in 1986.

If China could sustain an annual growth of 7-8% for at least another decade, the countrys GDP,measured at PPP, would overtake America's before 2020, although its GDP per head would remain muchlower, measured at market exchange rates. But China could overtake Japan as early as 2016 and Americaby about 2040.

The Chinese Financial System

As the debate on the revaluation of the Yuan intensified, media attention had been drawn to Chinasfinancial system. Even as the Chinese government privatized other sectors of the economy, it had beenreluctant to relinquish control over banking. Lending had traditionally been the Communist Partys chiefinstrument for controlling the economy. In recent times, the government had begun to loosen its grip oninterest rates by letting banks adjust them more freely within a widening range. But it had a long way togo before it managed the economy solely through macroeconomic tools. Moreover, the government


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remained unwilling to let banks fail, because of the impact not only on thousands of employees, but alsoon millions of depositors.

Most analysts believed that Chinas financial system was far too weak for such a rapidly liberalizingeconomy. China's 'Big Four' state banks, Bank of China (BoC), China Construction Bank (CCB),Industrial and Commercial Bank of China (ICBC), and Agricultural Bank of China, which together

accounted for around 60% of total bank lending had officially ended up with around US$200bn in NonPerforming Loans (NPLs). In order to reduce the NPL burden, the government had tappedinto China'sUS$600bn forex reserves, having injected US$45bn into BoC and CCB in early 2004. Thegovernment had also announced a similar bailout for the other two lenders in late 2003. In February 2005,the authorities announced a new reform plan for ICBC, which might include a US$50bn capital injection.

The NPL burden of the Big Four had fallen to 15% of total loans in the third quarter of 2004 from around25% in 2002. But, this seemed more due to an increase in the total loans made, rather than a majorimprovement in the banks' operating environment or lending practices. There were fears that some of thenew loans being issued would still turn non-performing, which in turn would aggravate problems infuture. While bailouts were not desirable, the government might decide to keep the banks alive, which inturn would allow them to keep lending to unprofitable state-owned enterprises (SOEs). This policy would

keep people employed, and thereby maintain political stability, an important consideration because anylabor unrest could eventually threaten the communist partys grip on power.

Most analysts argued that to improve the state of affairs, increased transparency and better riskmanagement were needed. Transparency would reduce lending based on fraudulent practices while riskmanagement would encourage greater prudence while giving loans.

By the end of 2004, the value of bad loans had reached $205 billion[2]13% of total bankingassets.Most banks in China were technically insolvent, as their NPLs far exceeded their equity. But theseinstitutions were still highly liquid because of a large retail deposit base that continued to expand as aresult of a robust economy and thrifty consumers whose savings equaled 40% of China'sGDP.

Since Chinas capital markets remained largely underdeveloped, banks served as the primary source of

long-term funds. Bank lending would have to expand by about 15% a year for China to meet its growthtarget. Analysts estimated that China'sbankingsystem could safely sustain an annual loan growth of only5 to 7%, which was far below the level needed to maintain economic momentum and keep unemploymentin check. The higher growth rate could be sustained only if regulators, banks, and investors workedtogether to improve risk management skills in a big way.

Meanwhile the government had attempted to modernize the bankingsystem by increasing foreignparticipation in the sector through the purchase of strategic stakes in Chinese banks. Foreign banksin Chinahad a bad loan ratio of just 1.3%. The government hoped that a greater foreign presence offoreign banks would encourage Western-style banking practices and help turn local lenders into world-class institutions.

There had also been efforts to speed up the recovery of bad loans. But China'sasset-managementcompanies sold only a small fraction of those transferred to them. Inexperience in this area and the lack ofa vibrant vulture-fund[3] industry that specialized in buying distressed assets explained the lack ofprogress. In addition, banks in China had little incentive to sell their distressed assets because once theydid, they had to anticipate a loss.

The boards of some of the largest banks, such as the CCB and the Bank of Communications, had beenrestructured to a certain extent. They had been made smaller, and foreign bankers had replaced a numberof government officials. But these measures had largely failed to prevent the state's meddling in often
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well-intentioned though unprofitable lending decisions. The government not only fully owned the bigfour banks but also, directly or indirectly, controlled 95% of the assets of most others through shares heldby local municipalities and state owned enterprises outside thebankingsector. There were no privatebanks, and foreign ownership was extremely limited.

On a positive note, the state's influence over lending decisions had become more transparent in recent

times. A decade ago, banks had existed essentially to disburse money as per the directives of theCommunist Party. Doling out loans to finance loss-making state-owned factories in far-off provinces wasan accepted practice to maintain centrally planned production targets and employment levels. But in 2005,some banks did try to understand and monitor their real risk management skills and performance bymarking bad loans in their books to distinguish between those made on commercial grounds and thoseextended, at the behest of the central authorities or local governments. But despite the slow down in state-directed lending, there was still pressure from local party officials or local businesses with politicalconnections, on banks to make uneconomic lending decisions.

Chinese accounting practices also looked outdated. Many Chinese banks did not recognize bad loans,because even if they were nonperforming on a cash-flow basis, they did not meet certain technicalcriteria. Chinese banks often considered a loan whose interest was being paid but not principal to beperforming, though the principal was clearly at risk. Since introducing a consistent loan

classification systemseveral years ago, the regulators of China'sbanks had made some progress gettingthem to report their NPLs. The systemdefined different levels of risk classes and established when bankshad to allocate reserves and howmuch. For example, a bank had to build up reserves equal to 100 percentof a loan's book value if the principal was not paid. This newsystem represented progress, but much moreneeded to be done to improve financial transparency in general and the reporting of NPLs in particular.

In the short term, banking regulators were attempting to develop and implement detailed risk managementguidelines that would require every bank to appoint its own chief risk officer and to be capable ofreporting, on a weekly basis, the loans it approved and the new risks it added to its books. Some of thelarger and more sophisticated Chinese banks had already made such changes. But many other smallerregional institutions had not.

Despite the challenges involved, most analysts believed that the Chinese central authorities had the

capacity to manage the badly needed reform of the bankingsystem. The recent experience of some of thelargest state-owned institutions seemed to suggest that risk management systems could be substantiallyimproved, using existing resources, in a few months. Chinaalsoappeared to have the fiscal capacityneeded to implement banking sector reform.

The Road Ahead

The stable Yuan pegged at 8.28 to the dollar since 1995, had undoubtedly played a major role in Chinaseconomic growth. The peg had stood the country in good stead during the Asian Currency Crisis of 1997-98.

But by pegging the Yuan to the dollar, China had allowed its monetary policy to be influencedsignificantly by Americas loose monetary policy. Interest rates were far low for an overheated economy.The booming property market in the coastal areas signaled an economy flush with liquidity.

Meanwhile, Chinas current account surplus had increased sharply from 1.5% of GDP in 2001 to 4.2% in2004. In 2005, it was expected to increase further. Chinas foreign currency reserves were rising by about817 billion per month. To suck out the excess money supply created from buying these reserves, Chinascentral bank had to issue even more domestic currency bonds. With more than 1 trillion Yuan of these

bonds outstanding in the middle of May 2005, the countrys commercial banks were becoming morereluctant to buy them.


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An appreciation of the Yuan would also ease the pressure on the banking system. At the same time, therewould be global fallouts. A stronger Yuan would allow Asias other emerging economies to let theircurrencies rise. Some economists believed that by allowing the Yuan to move up and in the processreducing the pace of accumulation of foreign currency reserves by China, America would be forced toraise interest rates. They felt this would have a healthy cooling e ffect on Americas consumption, whichwas going out of control.

In the past decade or so, the combination of fixed exchange rates and open capital accounts had causedfinancial crisis in many emerging economies, especially where financial systems were fragile. Thailand,Malaysia, the Philippines, Indonesia and Argentina had been some of the countries affected.

Although the International Monetary Fund (IMF) did not believe that the Chinese bankingsystem wouldfall under pressure when the Yuan was eventually floated, analysts thought that a more securefinancial system would leave Chinese banks in a better position when the foreign exchange market andcapital account were liberalized.

China seemed intent on relaxing capital controls before setting its exchange rate free. Was China betteroff moving cautiously in liberalizing its capital account, and moving more rapidly towards greaterexchange-rate flexibility? What should China do?

Exhibit 1

China

Source: www.economist.com

Exhibit 2

Chinas Economic Indicators

2000 2001 2002 2003


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GDP per head ($ at PPP) 3,980 4,340 4,720 5,180

GDP (% real change pa) 8.00 7.50 8.00 9.10

Government consumption (%of GDP)

13.08 13.39 13.20 12.90

Budget balance (% of GDP) -3.62 -2.97 -2.96 -2.50

Consumer prices (% changepa; av)

0.35 0.73 -0.77 1.17

Public debt (% of GDP) 30.40 30.60 31.10 29.60

Labour costs per hour (USD) 0.59 0.69 0.80 0.92

Recorded unemployment (%) 8.20 9.30 9.75 10.10

Current-account balance/GDP 1.90 1.48 2.80 2.20

Foreign-exchange reserves(mUS$) 168,278 215,605 291,128 401,036



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Exhibit 3

ChinasEconomic Indicators (Projections)

Hong Kong, China, 2004-2007, %

Item 2005 2006 2007

GDP Growth 5.7 4.1 5.6

GDI/GDP 23.5 23.3 22.6

Inflation (CPI) 1.5 1.6 2.1

Money Supply (M2) Growth - - -

Fiscal Balance/GDP -1.2 -0.8 0.1

Merchandise Export Growth 12.2 12.3 14.2

Merchandise Import Growth 12.6 12.1 13.5

Current Account/GDP 7.7 7.3 5.4

CPI = Consumer price index, GDI = Gross domestic investment, GDP =Gross domestic Product.

Source: Census & Statistics Department; Hong Kong Monetary

Authority.Exhibit 4

Chinas GDP Growth, 1992-2004 Q1

(Annual Percent Change)


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Source: Goldstein, Morris and Weatherstone, Dennis. Adjusting ChinasExchange Rate Policies, Working Paper, May 2004.


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Exhibit 5

Consolidated Fiscal Position Hong Kong, China, FY 1998-2004

Source: Census and Statistics Department, Hong Kong AnnualDigest of Statistics, 2004 edition.

Exhibit 6

Chinas One-Year Bank Lending Rate, %


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Exhibit 7

Chinas Consumer Prices (% Change on a Year Earlier)


Exhibit 8

Chinas Capital Account, 1994-2003


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Source: Goldstein, Morris and Weatherstone, Dennis. Adjusting Chinas Exchange

Rate Policies, Working Paper, May 2004.

Exhibit 9

Chinas Current Account, 1994-2003


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Exhibit 10

Chinas Foreign Trade

Major exports 2004% of

TotalMajor Imports 2004

% of

Total

Office machines & data-processing equipment

14.7 Electrical machinery 19.7

Telecommunicationsproducts

11.5 Crude oil & fuels 7.9

Apparel & clothing 10.4

Office machines &data-processing

equipment

5.3

Electrical machinery 10Machinery for

particular industries4.7

Leading markets 2004% oftotal

Leading suppliers2004

% oftotal

US 21.1 Japan 16.8

EU 18.1 EU 12.5

Hong Kong 17 Taiwan 11.5

Japan 12.4 ASEAN 11.2


Exhibit 11

Imports and Exports of Goods and Services as Percentages of GDP


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Source: Chandrasekhar C P; Ghosh, Jayati. The Dollar vs. the Chinese Yuan,

International Development Economics Associates, 25thDecember 2004.

Exhibit 12

Merchandise Exports to and Imports from China 2003 ($ billion)


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Source: Chandrasekhar C P and Ghosh, Jayati. The Dollar vs. the Chinese Yuan,

International Development Economics Associates, 25thDecember 2004.

Exhibit 13

Chinas Exports, % of World Total

Source: International Monetary Fund.

Exhibit 14

Trade Balance (China Vs Japan), % of GDP


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Exhibit 15

Chinas Official Foreign Exchange Reserves, 1991-2004 Q1




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Exhibit 16

Chinas Exchange Rate


Exhibit 17

Chinas Renminbi Real Trade Weighted Exchange Rate Index 1994-2004

(2000=100, data Monthly Averages)


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Source: J P Morgan.


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