China Should Maintain a Stable RMB Policy (hktdc.com)

Up till now, the RMB is freely convertible only on the current account, thus susceptible to trade and direct investment flows. The trading band has been set at 8.2760-8.2800 or a wafer-thin 0.02% up or down since April 2000. But in 2002, China's exports were up 22.3% YoY with the trade surplus reaching USD30.35bn or up 34.5% YoY. Meanwhile, utilized FDI rose to USD52.7bn or the largest intake in the world. Significant foreign currency inflows resulted in strong demand for the RMB, putting upward pressure on the currency.

The reality that the RMB is not yet freely convertible could not prevent the FX market from reflecting the uptrend. The actively traded one year non-deliverable RMB forward contract has turned to sizable discount to the spot rate in recent two months. The chart below shows that such a lasting and sizable discount is the first in many years. On January 6 2003, the discount exploded to 1400bp on speculation of the reappointment of the Head of PBOC and the possible widening of the RMB trading band. The market was speculating that the RMB might be trading at 8.1370 against the dollar one year later, up 1.7% from the spot. But the lack of turnover gave away the market's less than certain conviction that the change would come soon. The discount of the contract now returns to a more reasonable 600bp level.

In the US, the argument to revalue the RMB has gained wide support in both the economics and the corporate circles. The former White House Economic Advisor Larry Lindsey also lent his support to the idea, echoing some of Washington's views. In Japan, the MoF Chief Masajuro Shiokawa and the man who took over Mr. Yen's post Haruhiko Kuroda have long been advocates of an RMB revaluation. Even in Korea where officials rarely comment on exchange rates, its deputy Finance Minister Kim Yong-duk expressed concerns about the effects of a weak RMB. Such arguments were founded mostly on the theories of China exporting deflation globally and the RMB being grossly undervalued, which we find are nothing but false accusations. In our October 2002 issue of Economic Review titled "Is Deflation Made in China?", we made our case against accusations of China exporting deflation globally. Hereinafter, we will evaluate the argument of the RMB being grossly undervalued.

In Shanghai's national foreign exchange market, the dollar/Yuan trade makes up the majority of transaction and other direct trades lack respectable history. Thus we use the US dollar as the medium currency and calculate the cross rates of RMB against the Euro, the Yen and other major Asian currencies, and examine their changes over the years. We select several interesting spots in the past ten years: January 1994 when the RMB underwent a one-time devaluation, October 1997 when the Asian Financial Crisis swept across Asia, and January 2002 when the USD peaked. The calculations and findings are as the follows:

Besides the fact demonstrated by the simple calculations, review of history shows that back in 1997-1998, China was urged to resist devaluing the RMB to forestall a vicious currency devaluation tidal wave in Asia. China obliged and held the RMB steady to act responsibly in consideration of helping to calm the nervous Asian financial markets. It is thus clear that China's economic achievements today did not originate from the extra competitiveness gained by currency devaluation. Therefore, the demand for China to revalue the RMB because of China's economic out-performance is simply illogical.

A country's foreign exchange policy is designed to serve its own interest. For instance, the US has been advocating that a strong dollar is in its best interest. ECB's Wim Duisenburg openly stated that a strong Euro would not affect EU's competitiveness. And Japan's finance officials have been pushing for a weak Yen to promote exports. In consideration of these and the need of a sustained growth environment, China should maintain an independent and stable RMB policy in the foreseeable future.

The free convertibility of the RMB and the complete opening of the capital account are the ultimate prize of China's reform. Although an RMB revaluation is favorable to reducing import cost, facilitating overseas expansion and reducing foreign debt, it may not benefit the overall economy. Besides, it is not the most urgent task for China to undertake and China should stay clear from fighting on different fronts. Instead, China should concentrate its resources to tackle the urgent problems facing the economy, namely maintaining high growth while forestalling any bubbles, further stimulating domestic demand to combat deflation, and expediting and deepening financial reforms.

China's rapid growth in 2002 brought to the agenda the need to prevent overheating and bubbles in certain markets. Also, measures should be taken to encourage private consumption and investment. An RMB revaluation at this time may not achieve these objectives, rendering it a less than optimal policy measure. In 2002, China's CPI was down 0.8% YoY, failing to reach the target of a 1% growth. The surge in productivity, coupled with the inadequate demand from the lower income population and declining import prices post WTO entry all contributed to the fall in prices. An RMB revaluation may worsen deflation through the import price mechanism. And lastly, the prerequisites for a freely convertible RMB are the success of financial reforms and the cleansing of NPL in the banking sector. A radical RMB reform at this juncture does not seem appropriate.

Even if China agrees to revalue the RMB to mitigate international pressure, how much impact will it have? The US, Japan and some Asian countries intended to recapture some of the lost competitiveness through an RMB revaluation. But further analysis shows that it may not work as they wished. The single most competitive force of China is its labor cost due to the nearly unlimited supply of low skill workers and abundant supply of medium to high skill workers, judging from two million college graduates per annum. Thus, wages in China are far less rigid than other countries. According to the US Department of Labor's survey, the hourly compensation of manufacturing workers in the US, Japan, Korea, Singapore, Hong Kong, and Taiwan in 2001 was USD20.32, USD19.59, USD8.09, USD7.77, USD5.96 and USD5.70 respectively. And we all know workers in Hong Kong command salaries several times higher than those in Shenzhen. Low wage stickiness and even lower base mean that any competitiveness lost in an RMB revaluation can be restored through wage adjustments. In other words, only a massive revaluation of the RMB can change the relative landscape of international competitiveness. But this is obviously an outrageous demand given China's stable development strategy.

There also lies the issue of whether a flourishing China or a struggling China brings more to the global economy. As some representatives pointed out in the latest World Economic Forum in Switzerland, China accounted for 15% of the world GDP growth and 60% of the world export growth in 2002, but only a 4% share of the world GDP. Although China has yet to become the world's growth engine given the size of its economy, imagine what the world growth would look like if not for China. China's contribution to global demand has been growing steadily. It is the world's largest mobile phone market, the fourth largest automobile market and the second largest PC market. The US, Germany and Korea, for example, all recorded surging exports to China in 2002. Therefore forcing an RMB revaluation by overstating the loss of competitiveness may choke off the only source of strong growth in the world economy, which makes no sense at all economically.

The analysis above demonstrates that maintaining a stable RMB policy is in the best interest of both China and the world economy. Even so, China can still take advantage of the revaluation pressure and turn it into reform impetus. Firstly, the strength of the RMB originated from the current account surplus is a great opportunity to build up foreign currency reserves. By using the automatic stabilizer to maintain the trading band, China can increase its forex reserves. Take Japan as an example, since 1997, about USD180bn of its world number one reserves of USD450bn came from more than forty times of foreign exchange market interventions instead of normal trade and investment. An upward trending RMB provides the same opportunity for China. The ultimate opening of China's financial markets has to be backed by strong foreign currency reserves. Hong Kong's currency peg is nearly untouchable because of its huge forex reserves amounting to more than six times of currency in circulation. China's current reserves of USD286.4bn are about 1.4 times of its currency in circulation, or equal to fourteen months of imports, far higher than the minimum safety level of three months by international standards. Although direct comparison of China and Hong Kong is not appropriate given their vast differences in economic scale and degree of openness, Hong Kong's case serves as a good reminder that China's buildup of forex reserves should target fighting against as well as deterring possible currency attacks. Therefore such a hard-to-find market opportunity should be fully taken advantage of.

Secondly, studies on expanding the RMB trading band and the ultimate liberalization of the RMB should continue. The PBOC has set the widening of the trading band as a long-term goal. But China should also seriously remind the international community that expanding the trading band is only one step of the exchange rate reform. And the currency market must accept that once the band is widened, the RMB could well trade close to the upper band as well as the lower band. In other words, widening the band is not a one way street for RMB appreciation.

Lastly, feasibility studies should be carried out on utilizing Hong Kong, which has advanced financial risk supervision and control mechanism but no currency control, as a testing ground for RMB reforms. Considerations may include allowing related banks to participate in the RMB NDF market under close cooperation between China and Hong Kong, allowing Hong Kong banks to take RMB deposits initially, and gradually expand related businesses in coordination with the RMB reform timetable. The objective is to test and prepare for the ultimate opening of the RMB, and ensure that when it comes, Hong Kong as a Special Administrative Region of China will establish itself as an offshore RMB center, injecting new growth impetus into the economy and securing its status as an international financial center.