Should RMB Appreciate? 人民幣應該升值 ?

Should RMB Appreciate?人民幣應該升值? Shih-Hsin Economics Seminar (世新經濟2003年學術研討會) October 4, 2003 Erh-Cheng Hwa 華而誠 echwa@cc.shu.edu.tw

A Preamble Lately, RMB, the Chinese currency, has certainly become one of the hottest subjects in international finance. For instance, G7 without implicating China by name called for a more flexible Asian currencies a couple of weeks ago. That the currency of a developing economy with an average income of merely US3,500 or so should command such an attention comes as a bit of a surprise. Why RMB all a sudden occupies the international spotlight? My speech will (I) analyze the background of the international call for an RMB appreciation, (II) answer the question: is RMB undervalued? And (III) ask if the revaluation will indeed solve the US deficit problem and for that matter restore global economic imbalance? And if not, what need to be done (conclusion).

I. Background: Global Economic Imbalance • The global economy is characterized by a significant structural imbalance with the US economy running a large current account deficit of over 5% of GDP in 2003 while Europe, Japan, and the rest of East Asia running significant current account surpluses. (Table 1)

Table 1 current account balance Note : Dynamic Asia includes Taiwan ;Hong Kong ; China ; Indonesia ; Malaysia ; Philippines ; Singapore and Thailand Source : OECD Economic Outlook NO.73 June 2003 Annex Table 50 and 52

This large and rising US current account deficit has triggered a US dollar depreciation since early 2002. This is a clear sign that US current account deficit appears to be no longer sustainable and is indeed of correction. Why an ever rising deficit is not sustainable? This is because eventually the rising debt service will have to come out of national output and start to hurt consumption and investment. Since the US has a negative net international investment position already one quarter of GDP, the day of reckoning would arrive, if the deficit continues. (“Perspectives on the U.S. Current Account Deficit and Sustainability”, Catherine L. Mann, Journal of Economic Perspectives---Volume 16, November 3---Summer 2002---Page 131-152.)

The global economic imbalance stems from a number of factors including foremost a much stronger economic growth in the US than most of her important trading partners in Europe and Asia. That is to say, US has been the only growth driver in the global economy, though lately there appears signs of life in Japan and Germany, the next two largest economies in the world.

Global trade imbalance logically calls for the corresponding adjustment in the exchange rates for closing the trade gap, even though exchange rate adjustments do not necessarily provide the ultimate cure. • The consequences of rigid exchange rates in the face of trade imbalance are the persistence in the imbalance and a growing misalignment in the exchange rates.

This escalates the risk of unexpected sharp adjustments in exchange rates and in this case the US dollar that could create havoc to global economic stability. • US dollar has indeed fallen and mostly against the euro, not so much with the currencies of East Asian surplus countries.

The reason is that East Asia central banks have intervened heavily in the foreign exchange markets to prevent their currencies from rising in value. As a result, East Asia central banks see a bulging in their foreign exchange reserves.

Background: A Weak US Labor Market • The above presents an economic argument for the US dollar to depreciate, in particular, against Asian currencies from the viewpoint of global economic perspective. • However, the major impetus calling for an revaluation of RMB stems from the US that are echoed by the Japanese authorities and increasingly also by others such as South Korea and European capitals.

The US pressure stems from an unusually lackluster US job market in the third year of an economic recovery as well as a growing bilateral US-China trade deficit that exceeded US 100 billion (2002) and constituted one-fifth of overall US trade deficit. • An under-valued RMB is blamed to have contributed to the US trade deficit and job losses in the manufacturing sector.

The Bush administration faces the political pressure from manufacturing groups urging the US government take a tough stance against China that the administration would be hard to ignore in the light of the forthcoming US presidential election in late 2004. • In early September, Democratic senator from New York state Charles Schumer sponsored a draft resolution demanding the imposition of 27.5% import tariffs on Chinese goods unless the China agrees to revaluate the Chinese yuan.

II. Is RMB undervalued? • First, let’s try to answer the charge that China has maneuvered the exchange rate to under-price RMB for gaining unfair trade advantage. • On the surface, China has maneuvered the RMB/US$ exchange rate since China has allowed a very narrow fluctuations in the exchange rate ever since the inception of a managed floating exchange rate regime in China January 1994.

This also says China’s current exchange rate policy is more a choice of the exchange rate regime that has been maintained for long rather than the result of short-term opportunistic exchange rate maneuvering to gain trade advantage. • Since RMB has largely pegged to the US dollars, the RMB/US$ exchange rate has traced closely the fluctuations in the US$. Over the last two years, as US dollar has begun to depreciate, so followed the RMB (Chart 1).

Chart 1 real exchange rates Source: US Federal Reserve System、International Financial Statistics, IMF

The recent devaluation in RMB is the basis for accusing China’s exchange rate policy and for urging China to adopt a more flexible exchange rate policy, the code word for “appreciation”. But the critics chose to ignore that RMB equally appreciated in the preceding years when the US dollar was strong.

More importantly, RMB does not seem to be grossly undervalued. The evidence is China does not run a persistent large current account surplus. Recently the surpluses have been in the neighborhood of 1-2% of GDP. (Table 2) • The surplus indeed rose in 2002 as the exchange rate fell, but it is destined to decline in 2003 since the trade surplus fell to US$4.5 billion in the first half of 2003, or just 0.7% of GDP, that is US$ 8.9 billion less than a year earlier.

Table 2 Asian Current Accounts(percent of GDP) Source: 1) Asian Development Outlook 2003，Special Chapter，Competitiveness in Developing Asia，Published for the Asian Development Bank by the Oxford University Press，Table A16 2) International Financial Statistics, IMF

Since the current account balance mirrors the underlying the output/demand balance and the tradables/nontrables balance, the modest surplus in the current account suggests that the Chinese economy does not seem to suffer from any significant structural imbalance experienced by economies with persistent and large current account surpluses. Similarly, China has not under-invested in domestic economy in exchange of low-yielding foreign assets such as US treasury bills in any significant way. This very fact suggests the real exchange rate of RMB is not grossly misaligned with its fundamentals.

But if so, why the Chinese monetary authorities are compelled to adopt money tightening measures including a hiking of the reserve requirements? • Indeed, China’s recent monetary supply growth has been above the target that might have been the factor behind the surge in real estate prices in certain localities such as Shanghai, even though the overall inflation rate remains low (CPI grew by 0.6% in the first half of 2003).

The reason behind the fast growth in money supply is central bank’s monetization of a rapidly rising stock of foreign exchange reserves stemming from a rapidly rising capital account surplus over 2002-03 (2.5% and 3.1% of GDP, respectively), on top of the current account surplus. • From a low level of less than 1% of GDP during 1997-1999, the overall balance of payments surplus surged to 4.0% and 5.8% of GDP in 2001 and 2002, respectively, while the foreign exchange reserves rose by US$ 47.4 billion and US$75.2 billion in these two years; both were a record.

Larger FDI flows following China’s WTO accession in November 2001 and much reduced capital outflow (errors and omissions) account for the bulk of the increase in the capital account surplus over the last two years. Speculative capital inflows that are influenced by the media discussions of an impending RMB appreciation might have hidden behind capital repatriation. • It appears this trend continues well into 2003; in the first half of 2003, FDI rose to US$30.3 billion, 34.3% over the same period of last year, while foreign exchange reserves rose by US$60.1 billion.

Since the uses of the foreign exchange involved in the capital account transactions, as well as current account transactions, are strictly controlled by the central bank (e.g. foreign trade companies are required to surrender most of their foreign exchange proceeds to the central bank), most of the net increase in foreign exchange receipts are monetized by the central bank. As capital inflow accelerated in the first half, so did the increase in money supply to beyond the target set by the central bank.

Although the general inflation rate appears low at the present moment, a sustained increase in monetary growth could generate asset price inflation or raise the prices of nontraded goods to the detrimental of income equality as well as international competitiveness. • For this reason, monetary authorities have hiked the reserve requirement and loosened the restrictions on the use of foreign exchange ranging from tourism to foreign trade for reducing the monetary growth.

III. Would a revaluation in RMB a proper solution for reducing the US current account deficit and for restoring global imbalance? • Even if RMB were to appreciate significantly, this would not help to dent the US current account deficit by much. • China’s overall current account surplus accounts only 7.3% of the total US deficit in 2002. In fact, both Japan and Asian NICs’ have a far greater current account surplus. (Table 3)

Table 3 Distribution of US CA Deficit Source: 1) Asian Development Outlook 2003，Special Chapter，Competitiveness in Developing Asia， Published for the Asian Development Bank by the Oxford University Press: Table A3.4，Table A15，Table A16. 2) OECD Economic Outlook NO.73 June 2003: Annex Table 51

Second, historically, the trade balance did not seem to respond to the changes in the real exchange rate with a high elasticity. Nevertheless, as China gradually looses the trade restrictions, the price elasticity should rise overtime.

Chart 2 China Trade Balance and The Real Exchange Rate Source: International Financial Statistics, IMF

Then the question from the US perspective is: how the US is to reduce its overall current account deficit if the largest bilateral deficit with China that exceeded US$100 (2002) could not be reduced? • The answer lies partly in the fact that China has become a surrogate for all the countries that are using China as the platform for exporting to the US in place of their own countries. This suggests that the penchant for foreign goods by the US may be by far the more critical factor to the US trade imbalance than who have supplied them. Similarly, a lower growth in the rest of the world than the US matters.

But does the exchange rate matter? Yes, it does. The following chart shows that at least since 1995 when the US dollar started to rally against other currencies, US current account deficit has steadily worsened from 1.4% of GDP to over 5% in 2003. No doubt, the rise in the real exchange rate has reflected partly the productivity increase associated with the “new economy” phenomenon but the current account balance worsened nonetheless. (Chart 3)

Chart 3 US CA Deficit and The Real Exchange Rate Source: 1) US Federal Reserve System 2) OECD Economic Outlook NO.73 June 2003 Annex Table 51

Nevertheless, with China occupying a weight of 9.0% in the US real effective exchange rate index (2003) and with an overall small current account surplus, Chinese currency appreciation alone cannot be an effective remedy for narrowing the American current account deficit and furthermore, as argued before, there is no ground for a large appreciation in the RMB/US$ dollar exchange rate.

Conclusion:What need to be done? • The above discussion suggests that the world economic imbalance requires a concerted effort among nations to moderate it. First, Asian economies with a large current account surplus should reduce the currency interventions and allow their currencies to appreciate in response to the market forces – the pursuit of a flexible exchange rate. • Second, perhaps more importantly, they should boost domestic demand, either through structural reform or macro-stimulus as the case may be, to stimulate growth thereby gradually reducing the excessive reliance on foreign demand.

Third, US needs to assure the foreign exchange market that the fiscal deficit, estimated to be in the range of 4-5% of GDP over 2003-04, could be brought under control in the medium-term as urged by the IMF, and refrain from adopting the kind of protectionist measure now being considered by the Congress. Finally, China can accelerate the reduction in trade as well as balance-of-payments restrictions imposed on domestic residents for easing the monetary pressure of foreign exchange buildup, as well as for deepening the foreign exchange market to pave the way for a more flexible exchange rate later. Indeed, China has recently loosened the foreign exchange control.

Should RMB Appreciate? 人民幣應該升值 ?