A Structural and Macroeconomic Approach to Renminbi’s Valuation.

1. A Structural and Macroeconomic Approach to Renminbi’s Valuation. Li-Gang Liu Assistant Professor School of Public Policy George Mason University. CAPEC (March 2004)

2. Structure of the presentation: • Introduction: Why renminbi’s valuation issue has become a global economic issue? some background • Should renminbi be revalued? A look at trade structure, export rebate taxes, fiscal incentives, and export sector wage rates • What should be the proper response to the calls of renminbi’s revaluation: Some short- and medium-term policy suggestions CAPEC (March 2004)

3. 1. Introduction: Some Background. • Former senior officials of Japanese MOF first raised the issue: China is exporting deflation to the world because of an under-valued renminbi (Kuroda and Kawai, Financial Times, 2002). • However, the argument can not be verified by the trade statistics. CAPEC (March 2004)

4. China’s status in the world. CAPEC (March 2004)

5. Both China and Asian-6 have gained in world manufacturing export share since 1990. CAPEC (March 2004)

6. Because of a large Sino-US trade surplus and recent large losses of US manufacturing jobs (2.7 million), the Bush administration is pressured to do something about the large imbalances of US trade deficit with China. • On trade Front: Relying on more active trade policies • anti-dumping investigation by the US commerce department on Chinese TV imports and import quota on 3 fast growing categories of textile and garments. • On the financial Front: Pushing for RMB revaluation • Secretary John Snow spoke public and repeatedly that RMB need to revalue so to reduce US-China trade deficit • Federal Reserve Chairman Alan Greenspan also publicly raise the RMB valuation issue from the view that large inflow of capital will make the current RMB-dollar peg unsustainable. Therefore, RMB would have to be revalued to reflect the market pressure. CAPEC (March 2004)

7. The high-profile campaign to pressure China to revalue its currency has also gained some intellectual backing from an influential Washington-DC based think tank: Institute for International Economics (IIE). • Two senior fellows of IIE, Morris Goldstein (former IMF deputy research director) and Nicolas Lardy (a Chinese economy expert), first suggested RMB was undervalued by 15-25 percent (Financial Times ) and then they propose an exchange regime change: RMB abandons the dollar peg and adopts a basket currency with dollar, yen, and euro (Asian Wall Street Journal). CAPEC (March 2004)

8. But these views may be misguided: • US trade deficit is fundamentally determined by its savings and Investment imbalance: CA (Current account balance)= Savings – Investment • China’s trade surplus with the US is large (10%) of its GDP, but its global surplus is rather small, only 2% of GDP. • China’s trade surplus help finance the US budget deficit and thus help US dollar’s smooth adjustment • Thus, a revaluation of RMB will not change the US trade deficit, let along bringing to a halt of the its manufacturing job loss • But unintended consequence of a RMB revaluation will fulfill market expectation and induce further short-term capital inflow. CAPEC (March 2004)

9. Therefore, an appreciation of RMB will not solve Sino-US trade deficit but may potentially lead to a financial bubble given its fragile financial system. • As China is implementing its WTO commitment by reducing both its average tariffs from 15% to 10% by 2005 and its non-tariff barriers, it should expect some trade deficit soon according to the experiences of most of the developing countries. • That said, China should not revalue its currency at this time, rather it should focus on addressing its structural issues and keeping its commitment of the WTO. CAPEC (March 2004)

10. 2. Would a revaluation work? Four underlying factors affecting RMB’s real valuation: • China’s trade structure: • More 50 percent of China’s trade is processed trade: China import intermediate products and assemble them for final exports, mainly to the US. Intermediate goods are from China’s neighbors: Japan, South Korea, and Taipei, China. • China’s value-added in this process is limited: Very inexpensive labor force. CAPEC (March 2004)

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12. For example, in 2002, $68 billion, or just over 20 percent, of Chinese exports were classified as “high tech”. • Most of these “high-tech” exports were low margin commodity consumer electronics (laser printer, DVD players…) • Nearly 85 per cent of China’s high tech exports were produced by enterprises backed by foreign companies • 61 percent high-tech exports come from wholly owned foreign enterprises: no chance of technology transfer • Value added of high tech exports is only 16 percent, compared with 35 percent of all other process trade (Rosen, 2003). CAPEC (March 2004)

13. Although China is running a large trade surplus with the US, it also runs a trade deficit with Japan, South Korea, and Taipei, China. • China’s overall trade surplus is rather small, less than 2 percent of GDP. CAPEC (March 2004)

14. 2. China has ample room to maneuver before consideration of revaluation: • 17 percent export tax rebate initiated in 1998 contributed a real depreciation of RMB. • Two expensive to maintain it: $24 billion per year, about half of China’s FDI inflow. The government has to backlog the payments to exporters. • Distortion and adverse income distribution effect: The most profitable sector is further subsidized. • It is also bad for China’s terms of trade (export price/import price). • Thus, it is a good time to consider its phase-out or removal CAPEC (March 2004)

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16. 3. Real wages in the export sector have not grown much: • China’s exports in terms of value-added has increased, but export-sector wages have not ($100 month for 10 years) • It is because of large surplus of rural labor and rapid restructuring of the state-owned enterprises. • Global production and distribution networks are in the hand of monopolistic multinational firms (Wal-Mart Story). Competition for production contracts drives down Chinese supplier’s prices. • This could explain a puzzle in China: Generally, one of benefits associated with FDI is that FDI raised productivity and wage rates. • However, wages in the export sector have not played a role in uplifting domestic wages because FDI funded firms are mostly with low technology content and labor intensive industries such as textiles, toys, shoes, and plastics. • Wages in China has downward flexibility and upward rigidities! CAPEC (March 2004)

17. 4. Fiscal incentives to attract FDI may help lower costs of FDI-funded firms, thus contributing to a real depreciation of RMB: • More than 60 percent of FDI are from Taiwan, Hong Kong and China’s own rounded tripped capital to take advantage of fiscal incentives, cheap labor, and better protection of property rights of foreign capital. • Mainly small and medium firms with low technology contents. • Both central government and local government fiscal incentives provided are generous: 2 years of no income tax and the following 3 years by half, in addition to generous local government concessions in land, energy, raw materials, and labor usage CAPEC (March 2004)

18. These 4 underlying factors ought to have contributed real depreciation of RMB in the past. • China could first address these distortions before considering any nominal appreciation of RMB since no one knows the equilibrium exchange rate with these distortions. • It is also in China’s interest to address these distortions because they are potential impediments for China’s long term growth aspect. • These policy initiatives are in line with China’s WTO commitments. CAPEC (March 2004)

19. 3. What Should China Do? The RMB valuation policy could be framed with China’s Short-term and long-term policy objectives: • In the short-run, phase out or even revoke the export tax rebate tax since the policy is out of date and too expensive to maintain as China’s export growth is fast growing. • It also removes distortions: other sectors are subsidizing the most profitable and faster growth sector of the economy. It does not make any economic sense! CAPEC (March 2004)

20. It is also a good opportunity to review China’s FDI regime and take steps to make its FDI policies in line with China’s WTO commitment. • China has quantity success in attracting FDI, but in terms of quality, it is still a underachiever: less FDI from large transnational corporations of the OECD economies than that received by major emerging market economies in Latin America and Asia • In fact, fiscal incentives are less important than a predictable, mature, and transparent FDI regime. • For example, a survey of Japanese FDI firms shows that predictability, maturity and transparency matter a lot than tax incentives. • A McKinsey study also shows fiscal incentives are less important than a predictable FDI regime. CAPEC (March 2004)

21. In the medium run, the fiscal pump and priming should focus more on the rural sector, largely ignored over the last two decades • More investment in agriculture research and extension, irrigation system, education and health • These policies would reduce regional, urban-rural, and individual income inequality and raise productivity of Chinese farmers. • These economic convergence factors will generate additional growth by improving human capital and productivity of the rural sector. • Growth convergence domestically will assure China with another two decades of rapid economic growth CAPEC (March 2004)

22. The question is how these rural investment needs can be funded: obviously what the central government can do is limited. • It needs private and local government involvement via developing the municipal or local government bond market. • China is no longer a capital deprived country. In fact its savings is at 40 percent of its GDP. Total saving stock is more than 100 percent of GDP. This is in addition to more 400 billion FX reserves. • The issue is how to use these savings. CAPEC (March 2004)

23. Bond market development is a right way to go since it matches long term savings (pension funds and retirement savings) with long term investment (infrastructure needs in the rural sector). • It is fixed income and its return is predictable. • If it is done properly (by enforcing balanced budget, credit rating and market monitoring, and government monitoring via some approval at the initial stage of market development), local governments are less likely to default. This has been the experiences of the US municipal bond market. • It also offers financial instruments for hedging risks and enhancing overall efficiency of the China’s stock market. CAPEC (March 2004)

24. 4. Concluding remarks. • The renminbi issue is a wage issue: an insight of Henry Ford may be helpful even today! • Integrating large developing countries into the world market brings a lot of benefits but also challenges. If not properly handled, it could impede the globalization process. • The rise of wage rates in China is key: This can be facilitated by paying attention to rural investment, reducing market imperfection in the world production and distribution networks, and of course enforcing labor protection laws and standards. • The new leadership in China has an image of pro-poor, pro-rural sector, and pro-peasants. Maybe it is the right time to address these long-ignored structural issues first before tinkering with China’s nominal exchange rate. CAPEC (March 2004)