Summary:
Three years after lifting the renminbi's dollar peg, and an appreciation of 20% against the dollar, the currency remains substantially undervalued, and undervaluation has in fact increased. The nominal exchange rate appreciation has not kept up with that of the equilibrium value of the currency, i.e. the value consistent with economic fundamentals. China has remained heavily dependent on investment and growing trade surpluses to sustain its double-digit growth rate. A change to more consumption-driven growth is required, but will be difficult as long as household income continues to decline as a share of GDP. The main source of the problem is a serious misalignments in the real exchange rate and the real interest rate. Unless China narrows gap between the real and equilibrium exchange rate of the renminbi, it will find it ever harder to prevent speculative capital inflows from undermining its pursuit of independent monetary policy. (Published: 22/07/08)
Notes:
- 3 years since lifting of renminbi's dollar peg
- currency has become more flexible and appreciated about 20% against the dollar
- yet: under-valuation of the renminbi has increased
- real trade-weighted exchange-rate has appreciated only 15%
- only about a third of what's needed
- equilibrium value of the currency has risen faster than real trade-weighted exchange rate
- i.e. the value consistent with economic fundamentals
- external surplus has mushroomed
- current account surplus has soared
- from 3.6% of GDP in 2004 to 11.3% last year
- official reserves grew by massive $280b in H1 2008
- rapid productivity growth in export industries has enhanced China's competitiveness
- also:
- central bank has strengthened controls on capital inflows
- consumer price inflation has risen to 8%
- China's new exchange rate policy has not been helpful
- in "rebalancing" economic growth towards consumption and away from investment and net exports
- nor in alleviating the repression in the banking system
- both of which are strongly in China's own interest
- China has remained heavily dependent on investment and growing trade surpluses to sustain its double-digit growth rate
- investment exceeded two-fifths of GDP last year for the fifth consecutive year
- main cause: low interest rates (now negative in real terms)
- in part because the authorities are reluctant to adjust upward for fear of attracting even more speculative capital inflows
- low lending rates
- contribute to an excess demand for loans and thus the high share of investment in GDP
- low deposit rates
- have depressed the growth of household income far below the levels that would have been achieved with less financial repression
- contribution of consumption to GDP growth remains depressed
- last year the government slightly increased its own outlays on health, education and other social programmes as a share of GDP
- first time in more than five years
- but: was not enough to offset the multi-year decline in household consumption, which slumped to a new low of only 35 per cent of GDP
- China will find it hard to change to more consumption-driven growth as long as household income continues to decline as a share of GDP
- rebalancing the sources of growth will require more rapid appreciation of the renminbi as well as other policy adjustments
- bank profitability has suffered as authorities engage in massive sterilisation
- to prevent increases in inter-national reserves from spilling over into an undesirably rapid increase in bank lending
- central bank has raised the level of required reserves 19 times since mid-2005
- note: reserves pay a negative real return
- authorities have also "sold" banks huge volumes of sterilisation bonds that bear negative real yields
- have more than offset these implicit taxes on banks by maintaining a large spread between lending and deposit interest rates
- but: this spread will erode as further domestic financial reform and globalisation expand the alternatives available to Chinese savers and borrowers
- progress on China's currency regime should not be evaluated by focusing exclusively on movements in the renminbi/dollar exchange rate
- China is still suffering from serious misalignments in two crucial relative prices:
- the real exchange rate and the real interest rate
- unless China narrows gap between the real and equilibrium exchange rate of the renminbi, it will find it ever harder to prevent speculative capital inflows from undermining its pursuit of independent monetary policy
- needs to reduce the scale of intervention and sterilisation
- needs to increase interest rates significantly
- or it will continue to face strong headwinds in rebalancing the sources of its economic growth
- needs sharply accelerate the pace of renminbi appreciation
- step revaluation of the renminbi would be helpful
