China’s undervalued currency will eventually appreciate. The timing and amount of this rise are of importance to regional exporters as well as to investors in China, writes Fitzhugh J. Deal in Shanghai.
Analysts and trading partners alike assert that China’s currency, the renminbi yuan, has long been seriously undervalued, giving China’s exporters an unfair advantage in trade. While it is tempting to downplay the importance of the renminbi exchange rate given the continued inconvertibility of China’s capital account, the question is of importance to other exporters in the region as well as to the continued development of China’s capital markets.
The renminbi is theoretically tied to a basket of currencies but in practice is pegged to the US dollar, making any decision on exchange rates a function of policy concerns as well as of economic priorities. A cheap renminbi cushions exporters against the effects of deflation, thereby protecting domestic employment, which is a paramount concern of policy makers.
This natural desire to maintain a lower exchange rate is balanced by upward pressure imposed by high and growing foreign exchange reserves. Lastly, criticism from disgruntled trading partners adds, at most, marginal political pressure to revalue.
The renminbi to US dollar exchange rate has been quite stable since the elimination in January 1994 of China’s bothersome Foreign Exchange Certificates. These were a shadow local currency theoretically only for use by foreigners in China but actually used as shadow foreign currency by locals. Since their elimination, the exchange rate posted a marginal appreciation in January 1997 but has traded within a tight range between 8.296 and 8.277.
Upward pressure
Strong growth in exports gave rise to a 30.4% annual increase in China’s trade surplus in 2002, causing upward pressure on the renminbi. In tandem with a rising surplus, China’s reserves of foreign exchange grew to $316bn in March this year and are rising at an accelerating pace. Forex reserves grew by $20bn in the last two months of 2002 alone and added another $29.6bn in the first quarter of 2003.
Some analysts suggest that the growth in the trade surplus is due to high trade volumes rather than to stronger pricing of exports. However, regardless of the near-term profitability of exports, Eddie Wong, China economist at ABN Amro Asia Securities in Hong Kong, asserts that only a deep recession in the US would reduce China’s trade surplus enough to relieve upward pressure on the renminbi.
China endured annual inflation rates of more than 25% in late 1994 but experienced deflation from first quarter 1998 to fourth quarter 1999, and slipped once more into deflation in early 2002. The China price index emerged into positive growth in the first quarter of this year as prices grew just over 1% through April. China’s return to inflation resulted from growth in housing and food prices, offsetting continued deflation in clothing, household durables and other non-food items.
Tim Condon, China economist at ING Financial Markets in Hong Kong, notes that prices for the non-food items are set by world markets and are subject to continued deflation due to productivity gains as well as to the continuing drag of excess capacity in China’s state-owned sector. Falling employment in the state-owned sector constitutes a separate deflationary factor that Mr Condon expects to continue.
In contrast to non-food items, prices for food and housing reflect domestic monetary conditions, where strong growth in monetary aggregates – a 16.8% rise in 2002 and a new target of 18% growth in 2003 to counter the effects of SARS – has kept buyers flush with cash and prices rising. Strong growth in monetary aggregates results in large part from the rise in forex reserves as inflows of foreign exchange are not being sterilised by the People’s Bank of China (PBoC). The inflationary pressure of continued growth in money supply is supplemented by strong investment in fixed assets, at least some of which will find its way into real estate, indicating another cause of higher factor prices.
Underpriced exports
Although China may be using an undervalued renminbi to boost its trade surplus, there is little substantive pressure from the US to protest against China’s effectively underpriced exports. Andy Rothman, China strategist at CLSA Emerging Markets, says that Washington is not complaining largely because cheap imports from China are supporting US consumption even as China has become one of the main destinations for US exports. Moreover, US firms continue to invest in export-oriented production in China and to gain market access, further deepening the links between the two economies.
Although Japan has been making public noises about the low renminbi, any criticism from Japan practically guarantees inaction from Beijing, so officials are not going to worry about a low renminbi on Japan’s account.
The renminbi exchange rate matters because a more expensive renminbi would raise the effective price of China’s exports, giving other exporters in the region some breathing space to further their own nascent recoveries. In particular, Thailand, Indonesia and the Philippines would benefit because their exports compete with many of China’s exports.
Capital markets
In spite of its convenience in promoting exports, a low renminbi contrasts with the needs of China’s capital markets. Opening capital markets to foreign portfolio investment will itself generate some upward pressure on the renminbi as foreign investors purchase the currency to buy newly opened A shares via China’s recent Qualified Foreign Institutional Investor scheme. While initial inflows of portfolio investment are expected to be modest at best, a rising renminbi also facilitates foreign direct investment.
The dollar’s drop against the euro further aids China’s export sector and accelerates the growth in China’s forex reserves. Since China’s exporters must convert the bulk of their earnings into renminbi, the country’s financial regulators are sitting on a pile of forex. Thus they now have the freedom to grasp the nettle and make the currency convertible for capital account transactions.
They will not do it, though. The recent arrival of a new government will, in the near term, increase the tendency towards consensus-based policymaking, indicating that policy development will continue to be reactive and incremental. The distraction of SARS has further diffused the leadership’s attention, indicating no appetite for any initiative that might rock the economic boat.
