How and When Should China Flexibilize its Exchange Rate Regime?
The Chinese economy has sustained the Yuan pegged to the dollar and strong capital account controls for more than a decade. The government intends, in the medium term, to adopt a more flexible exchange rate and to liberalize capital controls. However, it is reluctant to move in that direction until the banking system is in a better shape. The international community, by contrast, is calling for an early move towards flexibilization. Recent growth has been such that the government raised interest rates in October 2004, for the first time since 1995, due to fears of overheating. Inflows of capital and excessive investment are putting pressure for a revaluation on the Yuan. Administrative controls have proved ineffective to curb fast credit growth and a growing asset bubble. These pressures may sway China to unpeg its currency from the dollar. To counter these inflows the government has responded by freeing up some of the controls on capital outflows so that money can be invested abroad. However, liberalizing capital controls before taking steps towards more a more flexible exchange rate may increase China’s vulnerability to capital volatility and speculation.
This policy brief intends to assess the arguments for and against an early adoption of a more flexible exchange rate policy in China. Given the tight link between capital-account controls and China’s ability to sustain a fixed exchange rate for such a long time, these two issues must be dealt with together. The memo argues that it makes more sense for China to make its currency more flexible than to repeg it at a higher rate. Additionally, it suggests that exchange rate flexibilization along with a more stable and robust financial system, should be regarded as a precondition for undertaking an extensive liberalization of the capital account.
Pros: Greater flexibility of the exchange rate would be in China’s interest
• Independent monetary policy. China will benefit from a more effective monetary policy to help the economy adapt to economic shocks. China’s degree of exposure to these shocks, both internal and external, is increasing as the economy gets more integrated with the global economy. Adopting a more flexible exchange rate will translate into a more autonomous monetary policy. Thus, the authorities will have the option of using market-oriented instruments such as interest rate changes to control economic activity.
• More efficient investment. By fixing the yuan to the dollar, China has been forced to hold interest rates at a very low level, leading to inefficient investment and excessive bank lending. A more flexible exchange rate will allow the authorities to have a more prudent and efficient interest rate policy.
• Curbing inflationary pressures. Fundamental factors such as relative productivity of growth create persistent pressures for real exchange appreciation. These pressures eventually tend to force adjustment rather through nominal exchange rate or through inflation. Even if the economy is under exchange controls and a repressed financial sector, these pressures can only be sustained for a limited time. The Chinese economy would be better off by channeling these overheating pressures by letting the nominal exchange adjust than through inflation and real appreciation.
• Having a buffer against external shocks. A flexible exchange rate will allow China to absorb external shocks through a nominal adjustment of the exchange rate, for instance an increase in US interest rates.
• Avoid the proliferation of a currency blackmarket. Given that the exchange rate is unrealistically priced and that there are capital controls in place, the country is exposed to the quick development of a black market. Additionally, market agents adopt several strategies to introduce or withdraw capital. The artificially undervalued exchange rate encourages capital inflows through underinvoicing of imports and overinvoicing of exports. This reduces the ability of the authorities to curb inflows of speculative capital.
• Taking advantage of the current conditions and avoiding excessive costs. The movement toward a flexible and independent monetary policy regime should not be deferred to avoid a hard landing. While China may be capable of maintaining its present exchange rate regime for a long period, there are large costs to upholding the peg that will potentially increase over time. As aforementioned, in light of China’s increasing integration with global markets and having the authorities explicitly mention their intentions to gradually liberalize the capital account and to eventually move to a more flexible exchange rate, expectation pressures and costs for flexibilization only tend to increase over time.
• Prepare the economy for a full opening of the capital account. Under a more flexible exchange rate, while capital controls shield the economy from volatile flows, China would have time to embark on reforms to strengthen the banking system. Subsequent to an exchange rate flexibilization, the liberalization of the capital account although in a cautious and gradual way shall be undertaken. There is considerable evidence that the effectiveness of capital controls tends to diminish over time, especially when strong exchange rate pressures are resisted by official intervention.
Cons: There are fears that China is unprepared and will lose its competitiveness
• An appreciation of the renminbi could hurt China’s external competitiveness thereby reducing export growth and weakening prospects for continued FDI inflows. The main argument against a more flexible exchange rate regime has been that the peg is an essential source of export growth needed to absorb every year millions of rural workers moving to urban areas. However, China’s export model relies heavily on imports. As their cost lowers from currency appreciation, the foreseen growth in costs and its related loss in competitiveness may be significantly countered.
• China is not ready to adopt a more domestically oriented growth model. An appreciation of the exchange rate will require a more competitive production and a more effective and transparent banking system. The Chinese banking system requires thorough reforms that will take time. However, as argued above, without a step to a more flexible exchange, there may not be the necessary incentives to promote such a reform.
• There is not a sufficiently developed foreign exchange market, and thus there are no tools for hedging foreign exchange positions. However, the existence of a perfect foreign exchange market not necessarily precludes a flexibilization of the exchange rate. More over, a more flexible exchange rate may promote the consolidation of a more sophisticated foreign exchange market, as greater currency risk will induce firms to diversify their hedging tools.
• Capital losses will be massive when the Chinese currency is appreciated. However, an eventual appreciation of the Yuan is unavoidable as the Chinese economy integrates with the global market. The costs of an appreciation increase over time. Roubini (2005) has estimated that, currently, such losses would be about $100 billion (or 7% of China's GDP) if the appreciation were to be 20% and would be equal to $300 b (or 20% of GDP) if the currency appreciates by 30% in 2007. So the cost-benefit analysis favors an early on flexibilization. Additionally, the costs of sterilization are nowadays high given the spread between what the Central Bank gets for its dollar reserves and the interest rates it pays for the liabilities used to sterilized
• Greater flexibility could induce China into deflation and a liquidity trap. There is a risk that the Chinese economy faces prolonged deflation, similar to Japan’s recent experience, as an appreciation of the Yuan can generate further expectations of appreciation. This would lower interest rates in China into a liquidity trap that would unable them to offset the expected appreciation. However, a reasonable appreciation that removes the existent imbalances in the Chinese BOP could be sufficient to counter further appreciation pressures.
Implementation: The existent capital controls may facilitate the transition
The Chinese government is inclined to open the capital account further this year without changing their stance on the exchange rate. Various episodes of currency crises, including the neighboring Asian Crisis, have revealed how countries with fixed currencies are exposed to the volatility of capital flows and are subject to speculative attacks. A fixed exchange rate is a cost-free arbitrage target for speculators, which race against a government’s capacity (and will) to sustain the peg. Capital controls have discouraged the accumulation of short-term external liabilities and have acted as a shield against speculators and prevented major losses for China during the Asian crisis. Capital controls, at least in the short-term, may serve as a line of defense while taking steps towards exchange rate flexibilization as they reduce exchange rate volatility. Especially taking into consideration that the banking risk management, regulation and supervisory systems are feeble.
Policy recommendations
• The Chinese economy should take a stance towards a more flexible exchange rate, taking advantage of the current favorable economic conditions: strong growth and positive current account. It doesn’t have to be a free float to begin with. Transitional alternatives such as a broad band or a peg to a basket of currencies with a broader range of flexibility may function as a “learning” float.
• Exchange rate flexibilization should precede capital account liberalization. The latter shall serve as a short-term line of defense to reduce volatility of short-term capital flows and decrease exposure to speculation on the currency.
• China’s priority shall be to strengthen its institutional framework in order to establish a credible monetary policy framework. Banking and financial sector reform must be a priority for the Chinese authorities.
This policy brief intends to assess the arguments for and against an early adoption of a more flexible exchange rate policy in China. Given the tight link between capital-account controls and China’s ability to sustain a fixed exchange rate for such a long time, these two issues must be dealt with together. The memo argues that it makes more sense for China to make its currency more flexible than to repeg it at a higher rate. Additionally, it suggests that exchange rate flexibilization along with a more stable and robust financial system, should be regarded as a precondition for undertaking an extensive liberalization of the capital account.
Pros: Greater flexibility of the exchange rate would be in China’s interest
• Independent monetary policy. China will benefit from a more effective monetary policy to help the economy adapt to economic shocks. China’s degree of exposure to these shocks, both internal and external, is increasing as the economy gets more integrated with the global economy. Adopting a more flexible exchange rate will translate into a more autonomous monetary policy. Thus, the authorities will have the option of using market-oriented instruments such as interest rate changes to control economic activity.
• More efficient investment. By fixing the yuan to the dollar, China has been forced to hold interest rates at a very low level, leading to inefficient investment and excessive bank lending. A more flexible exchange rate will allow the authorities to have a more prudent and efficient interest rate policy.
• Curbing inflationary pressures. Fundamental factors such as relative productivity of growth create persistent pressures for real exchange appreciation. These pressures eventually tend to force adjustment rather through nominal exchange rate or through inflation. Even if the economy is under exchange controls and a repressed financial sector, these pressures can only be sustained for a limited time. The Chinese economy would be better off by channeling these overheating pressures by letting the nominal exchange adjust than through inflation and real appreciation.
• Having a buffer against external shocks. A flexible exchange rate will allow China to absorb external shocks through a nominal adjustment of the exchange rate, for instance an increase in US interest rates.
• Avoid the proliferation of a currency blackmarket. Given that the exchange rate is unrealistically priced and that there are capital controls in place, the country is exposed to the quick development of a black market. Additionally, market agents adopt several strategies to introduce or withdraw capital. The artificially undervalued exchange rate encourages capital inflows through underinvoicing of imports and overinvoicing of exports. This reduces the ability of the authorities to curb inflows of speculative capital.
• Taking advantage of the current conditions and avoiding excessive costs. The movement toward a flexible and independent monetary policy regime should not be deferred to avoid a hard landing. While China may be capable of maintaining its present exchange rate regime for a long period, there are large costs to upholding the peg that will potentially increase over time. As aforementioned, in light of China’s increasing integration with global markets and having the authorities explicitly mention their intentions to gradually liberalize the capital account and to eventually move to a more flexible exchange rate, expectation pressures and costs for flexibilization only tend to increase over time.
• Prepare the economy for a full opening of the capital account. Under a more flexible exchange rate, while capital controls shield the economy from volatile flows, China would have time to embark on reforms to strengthen the banking system. Subsequent to an exchange rate flexibilization, the liberalization of the capital account although in a cautious and gradual way shall be undertaken. There is considerable evidence that the effectiveness of capital controls tends to diminish over time, especially when strong exchange rate pressures are resisted by official intervention.
Cons: There are fears that China is unprepared and will lose its competitiveness
• An appreciation of the renminbi could hurt China’s external competitiveness thereby reducing export growth and weakening prospects for continued FDI inflows. The main argument against a more flexible exchange rate regime has been that the peg is an essential source of export growth needed to absorb every year millions of rural workers moving to urban areas. However, China’s export model relies heavily on imports. As their cost lowers from currency appreciation, the foreseen growth in costs and its related loss in competitiveness may be significantly countered.
• China is not ready to adopt a more domestically oriented growth model. An appreciation of the exchange rate will require a more competitive production and a more effective and transparent banking system. The Chinese banking system requires thorough reforms that will take time. However, as argued above, without a step to a more flexible exchange, there may not be the necessary incentives to promote such a reform.
• There is not a sufficiently developed foreign exchange market, and thus there are no tools for hedging foreign exchange positions. However, the existence of a perfect foreign exchange market not necessarily precludes a flexibilization of the exchange rate. More over, a more flexible exchange rate may promote the consolidation of a more sophisticated foreign exchange market, as greater currency risk will induce firms to diversify their hedging tools.
• Capital losses will be massive when the Chinese currency is appreciated. However, an eventual appreciation of the Yuan is unavoidable as the Chinese economy integrates with the global market. The costs of an appreciation increase over time. Roubini (2005) has estimated that, currently, such losses would be about $100 billion (or 7% of China's GDP) if the appreciation were to be 20% and would be equal to $300 b (or 20% of GDP) if the currency appreciates by 30% in 2007. So the cost-benefit analysis favors an early on flexibilization. Additionally, the costs of sterilization are nowadays high given the spread between what the Central Bank gets for its dollar reserves and the interest rates it pays for the liabilities used to sterilized
• Greater flexibility could induce China into deflation and a liquidity trap. There is a risk that the Chinese economy faces prolonged deflation, similar to Japan’s recent experience, as an appreciation of the Yuan can generate further expectations of appreciation. This would lower interest rates in China into a liquidity trap that would unable them to offset the expected appreciation. However, a reasonable appreciation that removes the existent imbalances in the Chinese BOP could be sufficient to counter further appreciation pressures.
Implementation: The existent capital controls may facilitate the transition
The Chinese government is inclined to open the capital account further this year without changing their stance on the exchange rate. Various episodes of currency crises, including the neighboring Asian Crisis, have revealed how countries with fixed currencies are exposed to the volatility of capital flows and are subject to speculative attacks. A fixed exchange rate is a cost-free arbitrage target for speculators, which race against a government’s capacity (and will) to sustain the peg. Capital controls have discouraged the accumulation of short-term external liabilities and have acted as a shield against speculators and prevented major losses for China during the Asian crisis. Capital controls, at least in the short-term, may serve as a line of defense while taking steps towards exchange rate flexibilization as they reduce exchange rate volatility. Especially taking into consideration that the banking risk management, regulation and supervisory systems are feeble.
Policy recommendations
• The Chinese economy should take a stance towards a more flexible exchange rate, taking advantage of the current favorable economic conditions: strong growth and positive current account. It doesn’t have to be a free float to begin with. Transitional alternatives such as a broad band or a peg to a basket of currencies with a broader range of flexibility may function as a “learning” float.
• Exchange rate flexibilization should precede capital account liberalization. The latter shall serve as a short-term line of defense to reduce volatility of short-term capital flows and decrease exposure to speculation on the currency.
• China’s priority shall be to strengthen its institutional framework in order to establish a credible monetary policy framework. Banking and financial sector reform must be a priority for the Chinese authorities.
posted by Mycraze at 3:08 PM
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