by Ronald McKinnon
| PALO ALTO – The People’s Bank of China (PBOC), it seems, cannot win. In late February, the gradual appreciation of the renminbi was interrupted by a 1% depreciation (to $1:¥6.12). Though insignificant in overall trade terms, especially when compared with the volatility of floating exchange-rate regimes, the renminbi’s unexpected weakening sparked a global furor. The uproar was not surprising. After all, China has been under constant pressure from foreign governments to revalue, in the mistaken belief that a stronger currency would reduce China’s large trade surplus. And, since July 2008, when the exchange rate was $1:¥8.28 (and had been held constant for ten years), the PBOC has more or less complied, with appreciations approximating 3% per year through 2012. However, the international outcry obscured an unintended but perhaps more troubling feature of China’s exchange-rate policy: the tendency for sporadic renminbi appreciation (even small movements) to trigger speculative inflows of “hot” money. With short-term interest rates in the United States near zero, and the “natural” interbank interest rate in faster-growing China at near 4%, an expected 3% appreciation, for example, translates into an “effective” interest-rate differential of 7%. This is an enticing spread for currency speculators who borrow in dollars and circumvent China’s capital controls to buy renminbi assets. The hot-money problem is only made worse by the ongoing international pressure for further renminbi revaluation, usually from Western economists and politicians who blame the exchange rate for China’s current-account surplus with the US and other developed economies. In reality, the trade imbalance reflects the difference between China’s large savings surplus and the even bigger US saving deficiency (largely explained by the US fiscal deficit). Indeed, the wholesale price index – the best measure of tradable-goods prices in China – has been falling by about 1.5% annually, which suggests that the renminbi may even be slightly overvalued. Simply put, exchange-rate movements do not properly correct net trade (saving) imbalances between open economies; but they can increase hot money flows. So the PBOC tried to keep speculators off guard by introducing more uncertainty into the exchange-rate system, as occurred with February’s surprise devaluation. In mid-March, the PBOC announced that the daily movement in the renminbi/dollar rate would be increased from ±1% to ±2%, to further dampen hot-money speculators’ enthusiasm. While this is all well and good, speculative inflows would be further dampened if today’s central rate, say, $1:¥6.1, was stabilized into the indefinite future. There is another, less-discussed justification for holding the currency at a stable rate. The adjustment mechanism usually provided by exchange-rate movements could instead be delivered by wage changes. It is only in more sluggish industrial economies, where wages are assumed to be inflexible, that policymakers advocate exchange-rate movements as a means to overcome wage stickiness. However, in rapidly growing emerging markets, wages are often sufficiently flexible on the upside. For example, if an employer (particularly an exporter) fears future renminbi appreciation, he may hesitate to raise wages in line with productivity increases, in order to keep his costs under control. But if he can be confident that the exchange rate will remain stable, he will not need to restrain wages – and China has experienced 10-15% annual wage growth already. With faster wage growth at a stable nominal exchange rate, and by encouraging unit labor costs to converge to those in developed economies, China’s real international competitiveness would be better calibrated. As a result of policymakers’ heavy focus on the exchange rate, China’s State Administration of Foreign Exchange has now accumulated more than $4 trillion in reserves – far exceeding the amount needed to cover any imaginable currency emergency. Worse, the very act of currency intervention can undermine the PBOC’s control of monetary policy. Buying dollars increases the domestic base money supply, risking inflation and asset-price bubbles. Efforts to “sterilize” these purchases and dampen domestic credit expansion also have adverse consequences. The PBOC frequently does this by selling bonds to commercial banks or raising their reserve requirements. But this has reduced these banks’ effectiveness as financial intermediaries, while encouraging the rise of shadow banking to circumvent the restrictions. What, then, are the PBOC’s options? One approach might be simply to let the renminbi float without official intervention or controls on capital inflows. Again, this would inevitably trigger hot-money inflows, with speculators taking advantage of the spread between Chinese interest rates and the near-zero, short-term rates in developed economies, thereby driving up the renminbi further (and creating yet more opportunities for speculation). There would be no well-defined market equilibrium, or upper bound, for the renminbi/dollar exchange rate. Even without hot-money inflows, the renminbi’s exchange rate would face upward pressure, owing to the absence of corresponding outflows to finance the trade (saving) surplus. As an immature international creditor, China is unable to balance the inflows by making renminbi loans abroad. Nor would it want to make dollar-denominated loans. Private banks, insurance companies, pension funds, and so on have limited appetite for building up liquid dollar claims on foreigners when their own liabilities – deposits, insurance claims, and pension obligations – are denominated in renminbi. The potential currency mismatch would require the PBOC (which cares little for exchange-rate risk) to step in as the international financial intermediary and buy liquid dollar assets on a vast scale. Moreover, foreign investors remain reluctant to borrow from Chinese banks in renminbi, or to issue renminbi-denominated bonds in Shanghai. That will remain true as long as they fear continued outside political pressure to appreciate. China is therefore caught in a currency trap, owing to its own saving surplus (and America’s saving deficiency) and near-zero interest rates on dollar assets. Although fully liberalizing China’s domestic financial markets and “internationalizing” the renminbi may be possible one day, that day is far off. For now, if China tries to liberalize its financial markets, hot money will flow the wrong way – into the economy, rather than out. Thus, China must maintain controls on inflows of financial capital for the time being, with the PBOC intervening to stabilize the renminbi/dollar exchange rate. Until conditions in the world economy improve substantially, China’s policymakers will have no easy way out. But, even if they are constrained, the economy can continue to grow. |
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