Is China the hero or the villain? The country is resisting calls for an appreciation in the renminbi (RMB), claiming any such move would destabilise its less than robust financial system. Unimpressed, the governments of the US, Japan and Korea are insisting that China must revalue.

Economist David Hale explains; “Many Americans blame China for the fact that manufacturing employment has been declining for a year after the economy bottomed. China is perceived as a threat because it has been enjoying export growth of 35%. As a result of booming foreign direct investment and the return of flight capital, China also has foreign exchange reserves of $355 billion, the second highest in the world after Japan.”
China maintained currency stability during the Asian financial crisis of 1997-98 and it was precisely this policy, claims Beijing, that prevented further contagion in the region. Tang Xu, director of the Graduate School of the People's Bank of China says drastic amendments of the reform process would adversely affect the national economy: “To a profound extent, the stability of the exchange rate safeguarded the country's daily financial operations.” The big four state-owned banks have $300-400 billion of non-performing loans (30-40% of the total) and face greater foreign competition because of the WTO rules.

If China freed the exchange rate, the speculative "hot money" would advance into the country's foreign exchange market and the RMB would surely fluctuate severely, says Tang: “It would be a disaster, since China's financial capability to withstand the exchange rate upheaval is so weak.”

Hale comments: “China also argues that since it joined the WTO two years ago, it has slashed import barriers. Imports are growing at a rate of 40% per annum, and China’s trade surplus is likely to fall sharply this year, despite robust exports. China is deeply concerned about rising unemployment because of layoffs at state-owned companies. These firms have shed over 50 million jobs. As exports are now 28% of GDP, China regards the foreign trade sector as a growth locomotive for containing unemployment.

“The major cause of China’s booming exports is not an undervalued currency. It is an upsurge of foreign direct investment, almost $500 billion, which has significantly boosted China’s productive capacity and managerial competence. With FDI expanding by $55-60 billion per annum, China will soon have the second-largest stock of FDI in the world. Foreign companies produce over half of China’s exports and accounted for 65 percent of export growth during the past decade. China’s openness to FDI is also in striking contrast to the policies of Japan and Korea, which tried to restrict trade in the past by discouraging FDI. On the eve of the Asian financial crisis six years ago, Japan had only $17 billion of FDI while Korea had just $12 billion.”

The major risk posed by China’s decision to retain a stable exchange rate lies in the area of monetary policy. The boom in forex reserves is encouraging rapid growth of money and credit. What the central bank cannot fully regulate is the tendency for easy credit and surplus liquidity to promote an inefficient allocation of capital throughout the economy. China now has the highest rate of investment in the world. There is a danger that such a high level of investment could encourage the creation of so much excess capacity that firms will find it difficult to achieve profitability. Hale suggests that in such a scenario, the investment boom could set the stage for corporate liquidity problems and an investment recession in two or three years.

He notes the irony of the U.S. government calling upon China to revalue. “The U.S. is now able to finance its large fiscal deficits and current account deficits only because of currency intervention by Asian central banks, especially Japan and China. The central banks of China and Hong Kong have purchased nearly $100 billion of U.S. government securities during the past 18 months. The East Asian central banks now have 70% of the world’s foreign exchange reserves, compared to only 30% in 1990 and 21 percent in 1970. They keep their $1.7 trillion of reserves 80-90% invested in U.S. government securities.

Zhang Shengman, managing director of the World Bank, rejects the idea of appreciating the RMB, but he does accept that some kind of mechanism for changing the exchange rate of the Renminbi could be developed, depending on China's economic circumstances, such as widening the fluctuating range of the Renminbi.

Singapore-based fund manager Chris Wong takes the view that “China stands out as the culprit leading to the economic imbalance experienced by every other country in the world.” He agrees with other observers though, that the renminbi exchange rate will stay put as it is until Beijing manages to resolve its weak banking system: “No arm twisting from the US Treasury would be strong enough to forego what we see as the number one national priority. One obvious counter argument is why can’t the Chinese expedite the whole refinancing process? Instead of selling non-performing loans at US$6 billion in one go, can they not escalate that to a magnitude of US$60 billion. Equally, should they not let the currency move up in an orderly step basis and do it sooner rather than later? Rational as it may be, China is nevertheless a country with a long horizon and we can only hope their membership of the WTO makes their horizon synchronize better with the rest of the world.

Hamon Investment Group’s Kenneth Chong says China may dilute some of the incentives and rebates that it offers to its exporters: “We think that as a result of heightened focus on currency related issues, the shares of exporters are likely to be more volatile and come under pressure in the near-term. The third issue

relates to the proactive measures that China has initiated to slow- down some of its over-heated sectors like auto, property and steel.
“The monetary tightening in China is aimed at achieving a more balanced economic growth by slowing down the rapid credit expansion and cool-down excess momentum in investments. The outlook, therefore, for domestic infrastructure related sectors and global commodities sector appear to be muted over the next few quarters. However we still believe in the long term secular economic growth of China and would be using weakness in the China related stocks to add positions.”

Published in INVESTMENT & PENSIONS EUROPE, November 2003