A Modest Proposal for China's Renminbi

Op-ed from the Financial Times

August 26, 2003

The current debate on the renminbi exchange rate is appropriate given China's role as a leading economic and trading power. But the debate has become so politicised that crucial facts are being ignored and dubious arguments are replacing sound analysis. A medium-size revaluation of the currency may not be as "sexy" as a large revaluation or no revaluation but it rests on a firmer foundation and is more consistent with China's long-term interest.

Those arguing for a large revaluation of the renminbi-35 per cent or more-sometimes confuse bilateral trade balances with overall current account balances. While China is running a large (Dollars 100bn in 2002) bilateral trade surplus with the US, its trade balance with the rest of the world is in deficit, at Dollars 75bn (Pounds 47bn). Bilateral trade balances are especially misleading in this case because China processes goods previously exported to industrial countries by other emerging Asian economies.

During the first half of this year, China's current account surplus declined to about 1 per cent of gross domestic product. Adjusting for the recent overheating of its economy and other factors, China's underlying current account surplus is probably no greater than 2 or 3 per cent of GDP.

China's capital account surplus is often overestimated by focusing too much on foreign direct investment. The overall capital account surplus during the 1999-2002 period averaged a modest 1 per cent of GDP-far below the 4 per cent surplus for FDI.

When China does liberalise capital account outflows, there will be downward pressure on the renminbi. With a stock of household savings equal to about 100 per cent of GDP, it would not take much international diversification to turn net capital flows from surplus to deficit.

China's build-up of Dollars 135bn in international reserves over the past 18 months does not imply that it is passing up profitable investment opportunities. The investment share of GDP and the rate of expansion of bank lending are both too high. The real risk of an undervalued exchange rate is that it will handicap China's efforts to achieve long-term financial stability.

Those who maintain that a revaluation of the renminbi is unnecessary have done no better in their analysis. As long as China maintains controls on capital outflows, runs surpluses on both the underlying current account and capital account and accumulates reserves, there is a compelling argument that the renminbi is undervalued. Export processing means that it takes a larger revaluation to change China's trade balance.

China's average import tariff rate has fallen following entry to the World Trade Organisation and future trade reform is likely to expand imports further. But clothing, one of China's main exports, is likely to receive a big boost from the scheduled expiry of the multi-fibre agreement at the end of 2004, potentially doubling China's share of the market. Thus, China will not necessarily switch to running current account deficits in the future.

China's exchange rate cannot be analysed in isolation from the pattern of global payment imbalances. At 5 per cent to 6 per cent of GDP, the US current account deficit is not sustainable and its correction would be aided by a further depreciation of the dollar.

But an appropriate dollar depreciation will be frustrated if the Asian economies do not do their part on currency appreciation. China has a weight of nearly 10 per cent in the dollar's trade-weighted index and an appreciation of the renminbi is a sine qua non for Asian currencies to appreciate more generally.

Consumer prices have risen over the past two quarters and, with monetary growth expanding and good prospects for economic growth, exports and FDI, renminbi appreciation need not drive China into Japan-style deflation, as some have argued.

If China does not adjust its exchange rate, it risks further over-expansion in its financial sector, a reversal of the progress made against its bad loan problem, an upsurge of protectionism in the US and Europe against China's exports and increased regional tensions within Asia. A medium-size revaluation of the renminbi-between 15 and 25 per cent-would be the best response to the current disequilibria. It would be an investment in China's financial stability and could set the stage for a wider international agreement on a more sustainable pattern of exchange rates and payments positions. By acting soon, China can lead the way.