By 1991, exports and imports subject to central planning had fallen to 30 percent of their totals, while exports and imports under the agency plan accounted for only 20 percent. As the roles of central planning and the agency plan have decreased, direct control over exports and have continued through a licensing system that covered 55 percent of exports and 40 percent of imports in 1991. (Bell et al, 1993).
A dynamic relationship exists between the exchange rate and the trade balance of a country, as well as the price and quantity components of the trade balance. When a country devalues its currency, the imports value of the economy will initially rise in local currency due to the rising of import price. The export value will remain unchanged. In the short run, the trade balance will deteriorate, but over a longer period of time, both export and import volumes will react to the changes in relative prices following the devaluation. Downward adjustment in import volume will occur while export volume will rise as export prices expressed in dollars become more competitive. This results in an improvement in the country’s trade balance (Fong, 2002).
As part of its overall foreign trade system reform, China has repeatedly devalued its currency to promote exports and the balance of trade in the 1980s and early 1990s. In 1991, China changed its foreign exchange policy from the large one-step currency devaluations of the past to more frequent fine-tuning of the renminbi’s value with respect to the current economic conditions. The unification of China’s two main currency rates in the beginning of 1994 and the deregulation of foreign invested enterprises’ abilities to exchange funds freely at selected banks without approval from the State Administration for Exchange Control (SAEC) early in 1996 drove the renminbi a step further toward full convertibility. The IMF has formally classified the exchange rate of renminbi as a more flexible management system.
The reform of the foreign trade system has contributed significantly to the rapid expansion of China’s foreign trade. In 1978, the total of international trade for all of China was only $20.6 billion USD; it rose to $165.6 billion USD in 1992 – increasing by a factor of eight. Exports experienced similar growth, from $9.75 billion USD in 1978 to $84.9 billion USD in 1992 (Zhang, 1995).
The pre-reform exchange system of China was characterized by strict control of foreign exchange transactions and rigidity of the renminbi’s exchange rate. Under such conditions, it was impossible to respond flexibly to changes in price parities between China and the rest of the world. It was also impossible to to make quick adjustments as needed according to the changing money supply and demand of foreign exchange. This was consistent with the highly controlled manner that the state controlled China’s foreign trade. All import and export contracts with foreign firms could only be signed by a few authorized import and export corporations. By 1978, only ten national import and export corporations under China’s trade ministry had been solely authorized to sign import and export contracts with foreign firms. Consequently, those working in this economic environment had no incentive to make trade adjustments in response to price changes and exchange rate policy.
In the early stages of reform, various arrangements were tested for managing foreign exchange with the goal of improving incentives for exports. Finally, a retention system was set in place. Exporters would surrender their actual foreign exchange earnings and were issued ‘retention quotas’ by the SAEC equivalent to a portion of those earnings. The system evolved with a complex set of regulations on allocating foreign exchange according to industry and location before a uniform retention rate for businesses was set throughout the country in 1991.
Other ways used to promote exports included various export subsidies and the facilitation of trading units or foreign trade corporations, the number of which had risen to more than six thousand by 1989 (World Bank, 1990). The introduction of the agency system further increased the abilities and the freedoms of those authorized to conduct importing and exporting.
In 1981, China introduced a dual exchange rate system, one for non-trade transactions and a more favorable rate for international settlement of trade transactions. The dual rate system was abandoned in 1985, but was re-established in 1996 when foreign exchange adjustment centers (FEACs) were set up. FEACs were government- approved enterprises that were permitted to buy and sell retention quotas.
After freer trading was permitted in 1988, the premium on exchange rates in the FEACs was up to about 80 percent – the number of participants was steadily increasing and so was the total demand. The FEACs came to dominate China’s foreign-currency transactions, accounting for 80 to 85 percent of all such activity.
The exchange rate at FEACs was set by a combination of government forces and market conditions, although the government intervention was rare.
In 1986, the official exchange rate was, in effect, pegged to the U.S. dollar. In 1991, the exchange policy was altered to make smaller, more frequent adjustments in response to free market conditions. The policy began with a devaluation of 0.95 percent on April 9, 1991 to renminbi 5.2935 per dollar and another on May 20, to 5.4066 per dollar. Several subsequent small adjustments were made through the year. By April, 1993, the real effective exchange rate had depreciated 33 percent more than in 1986 and 70 percent more than 1980 (Bell et al. 1993).
However, it must be noted that the Chinese currency was highly over-valued and therefore, an ‘expensive’ currency making products more expensive abroad and therefore less attractive to importers and, ultimately, the consumers. One of the key reasons for the devaluation was to reduce price distortion and promote exports. Wang (1993) found and wrote that there was a positive relationship between real exchange rate and exports; and Brada, Kutan and Zhou (1993) found that in both the short and long run, devaluation of the renminbi served to improve the balance of trade.
A significant step in foreign exchange reform in the early 1990s was the joining of the two main currency rates (the trade rate and the official rate) and the subsequent allowance of a limited amount of ‘room’ for the renminbi to freely float from the beginning of 1994. This led to a significant devaluation; since then the exchange rate has remained stable. During this time, China’s exports grew rapidly, raising a question over the relationship between the real exchange rate and the balance of trade in China’s transitional and emerging economy. However, the World Bank reports (1990) that the management of the exchange rate in the Chinese economy has played a major role in the level and composition of exports and imports.
It is expected that China will eventually introduce a floating exchange rate regime. This will depend on a number of other conditions. One precondition would be a major improvement in the business practices of the banking sector. The ratio of non-performing loans to total bank assets as about 25 percent before the crisis began, is actually much higher than those in the crisis-affected economies, and some state-owned banks were technically insolvent. The banks could face major problems if bank runs were to be triggered by a loss of depositor confidence – the major role of these banks could cause widespread instability in the economy (Lardy, 1998).
The banking sector cannot be reformed separately; it works together with state-owned enterprises and public finance policy. Although the state-owned enterprises are undergoing consistent reform as China works to become internally and internationally competitive in all areas, they are still very inefficient by Western standards. In 1996, these enterprises had a net loss of 38 billion renminbi, a trend that has continued to this day (SSB 1997).
The major proportion of fiscal resources is spent on personnel and administrative activities. The estimated 30 million redundant government workers also cause a strain on the economic system, creating more inefficiency and cost. Issues such as social security, infrastructure development and regional disparity are still hardly addressed.
These factors are mutually induced; for example, the inefficient state-owned enterprises demand budget subsidies and contribute to non-performing loans. This worsens the already poor financial and fiscal conditions. Due to shortages in revenues, the government has often had to shift its financial responsibilities onto the state-owned banks in the form of policy loans that are often set at low interest rates and are rarely paid back. These factors and many, many others create an interlocking web providing a complexity of relationship that inhibits the government’s ability to fix the situation on a sector-by-sector basis. The problems also contribute to other difficulties facing China, such as unemployment pressures and regional disparity. The financial system has become more fragile due to the preponderance of non-performing loans; real estate bubbles and excess production capacity are widespread.
Current Situation
China's renminbi currently trades in a narrow range of about 8.2760 to 8.2800 to the dollar, kept in check by the Central People's Bank of China, which uses foreign-exchange reserves to intervene and keep the currency within this range.
According to foreign policy experts at Reuters News Service (5 May, 2002), China's top priority is to keep its currency as stable as it can during what promises to be a turbulent breaking-in period in the World Trade Organization, and ahead of a reshuffling in the top Chinese leadership later in this year.
China has recently been under pressure from the International Monetary Fund to gradually get rid of the RMB virtual peg to the dollar and replace it with a peg to a more flexible “basket of currencies”. The Chinese authorities have said they are studying the proposal but have no plans to make changes in the near term. Last month, Chinese Premier Zhu Rongji said China had no plans to devalue the renminbi or shift the domestic currency from its virtual peg to the dollar to a peg to a basket of currencies any time soon. "Out of consideration for the interests of the region, and its own needs, China insisted on not devaluing its own currency. We have continued to adhere to this policy, and this policy will not change," Zhu said (Reuters, 2002)
Weakness in the Japanese yen this year has sparked concern around the region that China might devalue their currency, sparking a round of competitive devaluations by Southeast Asian nations. U.S. manufacturers live in fear of a Chinese devaluation, as it could result in a flood of cheap Asian goods onto world markets undermining exports of U.S. products, which they say are already under pressure from U.S. dollar strength.
Beijing would be reluctant to allow the renminbi to fall back too far as that would put new pressure on Hong Kong's currency, which has already come under attack. A devaluation of Hong Kong’s currency so soon after the transfer of power would be a blow to China's prestige. A reduction in the value of the renminbi would also aggravate trade friction with the US. China's trade surplus with the US is expected to reach $50 billion USD this year and Beijing officials have said they were concerned over the imbalance (Reuters, 2002).
While the Chinese leadership has clung to its commitment not to devalue the currency this year, the government has stepped in to stop illegal capital outflows through the cracks in China's foreign exchange controls. The central regulatory authorities have seen that Chinese companies are thinking there is a devaluation coming, so they have acted in an aggressive manner against perceived capital flight. Since mid-September, China's foreign exchange authorities have issued more than 20 different notices and regulations, tightening the supervision of foreign exchange transactions and raising the requirements for official documentation, conversion and remittance on hard currency transactions. The tougher implementation of foreign exchange controls is a sign of the underlying concern in China about the stability of the currency, the illegal flows of hard currency out of the country and hidden exposure to foreign exchange debt.
The tightening of foreign exchange controls gives significant insight into Chinese perceptions of the stability of their currency and ongoing concerns about infection from the Asian disease. Zhu Rongji, the prime minister, and Dai Xianglong, the central bank governor, are committed to holding to their commitment not to devalue the reminbi, not just for the sake of international economic stability, but more crucially, in the interests of China's own economy.
Devaluation would impact China's ability to raise hard currency. One of its priorities is to strengthen state enterprises, and they hope to use Hong Kong capital markets to raise cash. If Hong Kong dollars were no longer securely pegged to the U.S. dollar, international investors would avoid investing in new Chinese securities, which would lose their value.
A weaker currency could even destroy confidence inside China. Collectively, ordinary Chinese people maintain saving deposits totaling around 8 trillion renminbi (worth about $1 trillion USD) in deposits at local banks; however, many people would be tempted to take their funds out of their bank and buy black market U.S. dollars if their country’s currency fell in value, creating a run on the bank.
China cannot afford a run on its banks. A run would destroy Beijing's credibility and ability to extend credit to businesses and projects that help keep the economy growing.
A positive to devaluing the renminbi would allow China to hang on to the market and prevent its exports from being undercut by products from the rest of Asia now that drops in other Asian countries have reduced local costs, such as labor. Devaluing the currency would undermine the efforts of other Asian countries to restore their economies setting off another cycle of devaluations. Devaluation also would make it more attractive to foreigners to invest in China, which draws more than half its foreign investment from elsewhere in Asia (Mufson, 1998).
China has some distinct advantages in comparison to other East Asian and Southeast Asian Countries. Its trade surplus is supporting the strength of their currency. In 1997, exports were an impressive $182 billion, $40 billion more than imports. China also has $140 billion in foreign currency reserves, which covers its $119 billion in foreign debt. When the crisis broke, China had a current account surplus of nearly $30 billion USD, which was maintained in 1998. This was in sharp contrast to the persistent current account deficits in Thailand and Indonesia before the crisis began. (See table below).
Table 2: Chinese Economic Indicators for the External Economy, 1995-1998
1995 1996 1997 1998 1999
Current Account Balance (US $ Billion) 1.6 7.3 29.7 29.3 13.4
Growth of Foreign Direct Investment Inflow (%) 5.9 12.3 7.0 0.0 -6.7
Foreign Exchange Reserves (U.S.$ billion) 73.6 105.0 139.9 145.0 154.7
External Debt (US $ billion) 94.6 104.6 118.6 146.0 130.0
External debt service ratio (% of imports) 9.1 9.9 11.8 14.3 12.6
Source: State Statistics Bureau, Chinese Statistical Yearbook, 1998 and CEIC Data Company Limited, Hong Kong.
Additionally, while China was the largest capital importer in East Asia, more than 60 percent of the capital inflow was in the form of foreign direct investment (mostly multinational corporations establishing businesses, commerce and infrastructure to support their presence there and direct international investment into Chinese firms by Western institutions and private individuals). Therefore, it had not borrowed as much as other companies and its debt-service ratio was maintained at low levels. In contrast, the other countries had borrowed short-term money from agencies and institutions. When their currencies were devalued, they were forced to pay back more in their own currency, which they no longer had available.
China still exercised strict controls over the capital account, although they did realize their goal of full convertibility of the renminbi in compliance with the IMF’s Article VII stipulations. The controls served as a layer of insulation from the instability of the recent capital markets of the region (Huang and Yang, 1998). These strict controls working in concordance with deep integration into the world commodity markets, increasing flexibility of structural adjustment and the current account surpluses were important factors in China’s ability to weather the storm of the Asian crisis.
The controls also prevented attacks on the Chinese currency by international speculators in the overseas capital markets; and significant capital flight has been avoided through the periodic tightening, as recent evidence shows. The controls also have the negative effect of slowing down trade and being counter-facilitative to efficient transactions, since the controls provide tight monitoring of transactions, additional paperwork and closer inspection of how business is done. All this takes time and non-productive (non-income producing effort). However, as has been shown, the Chinese are willing to forego short-term profits in the effort to maintain long-term strength and stability of the entire economy.
Conclusions
In retrospect, China’s performance in averting a currency crisis in the last few years has been smooth. The positive contribution to regional economic stability by maintaining the value of the renminbi despite probable adverse trade effects has been noticed internationally.
The main difference in China’s performance versus that of crisis-affected countries was the degree of liberalization immediately prior to the crisis. Capital account controls have efficiency costs, but they helped to protect China’s vulnerable financial sector from instabilities in the international capital market.
Additionally, capital controls were an important contributor to other advantageous conditions, such as the large foreign exchange reserves and the dominance of foreign direct investment in total capital inflows that helped China avert a currency crisis.
References
- Bell, M.W., Khor, H.E. & Kochhar, K. (1993). China at the Threshold of a Market Economy, IMF: Washington, DC.
- Brada, C.J., Kutan, A. & Zhou, S. (1993). “China’s Exchange Rate and the Balance of Trade”, Economics of Planning, 26:229-242.
- Chan, G.H. (1999). The Chinese Economy in the Asian Financial Crisis: The Prospect of the Stability of the RMB. HIID Development Discussion Papers No. 669, Harvard Institute for International Development, Cambridge.
- Dornbusch, R. (1997). “A Thai-Mexico Primer”, The International Economy, September/October: 20-3, 55.
- Huang, Y. (1999). The Last Steps Crossing the River: Chinese Reforms in the Middle of the East Asian Financial Crisis. New York: Graduate School of Business, Columbia University.
- Lardy, N.R. (1998). “China and the Asian Contagion”. Foreign Affairs, 77(4): 78-88.
- Mufson, S. (1998) “China not Going to Devalue Currency , U.S. Official Says”, Washington Post, A17.
- Perkins, D. (1986). China, The Next Giant? Seattle: University of Washington Press.
- Song, L. (1998). “China”, in R. McLeod and R. Garnaut (eds), East Asia in Crisis: From Being a Miracle to Needing One? New York: Routledge: 105-109.
- State Statistical Bureau of China. (1999). Statistical Report of National Economy and Social Development in 1998. Beijing and New York: China Statistical Publishing House.
- Wang, H. (1993), China’s Exports Since 1979. New York: St. Martin’s Press.
- World Bank (1990). China: Between Plan and Market. Washington: World Bank.
- Zhang, Z.Y. (1995) China’s Foreign Trade Reform and Export Performance, Singapore: National University of Singapore.
[Appendix 1]
Blame the Chinese
PINCHAS LANDAU
Financial Times (The Original Copy From Jerusalem Post – Israel), Oct 08, 2004
The official statement at the end of the G-7 meeting said nothing new, so the dollar strengthened a bit, because there is no real pressure on the Chinese to revalue.
Since that sentence may not be entirely clear to readers who fail to spend most of their waking hours following the international markets, there now follows a translation: The finance ministers of the world's major developed economies (US, Canada, Japan, France, Germany, Italy, UK = 7, hence "G-7") gather periodically (at "G-7 meetings"). At the end of each meeting, they issue a press release summarizing their discussions and conclusions ("official statement").
A G-7 meeting always precedes the IMF/World Bank annual meetings, held in late September/early October; this year, China was invited as a guest participant, in recognition of that country's growing importance in the world economy. The speculation was that the G-7 would use this opportunity to speak sternly to China about how unhappy they all were about China's policy of keeping its currency (the yuan, also known as the renminbi) pegged to the US dollar.
This unhappiness is long-standing. It reflects the belief that the US dollar has to devalue, because the US trade and balance of payments deficits are so huge. Although the dollar did drop quite sharply in 2002-2003, it fell primarily against the European currencies, only slightly against the yen, and not at all against the yuan. This made the Americans marginally better off and the Europeans much worse off - hence the dissatisfaction with China among the G-7, which is a North American and European club.
The Chinese, for their part, have repeatedly expressed their intention of adopting a more flexible exchange-rate policy - code for allowing the yuan's value to rise - but only when they are ready, not under pressure from the West. The invitation to the G-7 meeting provided the Chinese an excellent opportunity to make a nice gesture to their hosts - by at least beginning the flexibility process. But, in the event, nothing of the sort happened.
The official statement repeated previous bland phrases about the need for flexible exchange rates generally, everyone smiled politely and moved on to the main IMF jamboree. The foreign exchange markets, seeing that nothing of substance had been said, marked the dollar slightly stronger - and that was the end of that non-event.
The assumption underlying the foregoing discussion is that a Chinese move to revalue the yuan would have a significant positive impact on the US trade position. This is because the yuan revaluation would trigger a parallel move among all the main Asian currencies, including the yen, so that Asia as well as Europe would bear the cost involved in adjusting the dollar's value downward. The ultimate object of this exercise would be to make US exports cheaper and hence boost demand for them, and to make imports to the US more expensive, so that demand for them would fall. These developments would reverse the relentless rise in the US trade deficit and start setting to rights the imbalances in the world economy.
But would these desirable results in fact be achieved, even if the Chinese announced tomorrow that they were making their exchange-rate regime more flexible? Can a dollar devaluation solve the problem of a US balance of payments deficit now in excess of 5% of GDP? The most likely answer is no.
It would have some impact, no doubt, but a growing number of economists believe that even a huge (and hence unlikely and probably undesirable, because of its side- effects) dollar devaluation would be insufficient to "fix the deficit."
That's because exchange-rate adjustments (devaluation and revaluation) affect only the relative prices of goods and services. But in the case of China and the US, the underlying cause of the growing trade deficit is not that prices are somewhat distorted, but that the cost of producing most goods is vastly cheaper in China than it is in the US (or in Europe, for that matter). That cost advantage is so large that no feasible exchange-rate adjustment and no conceivable jump in productivity in the American economy (which is already highly productive) can hope to cancel it out.
Any way you look at it, China is a huge problem - for the American and all other developed economies. But adjusting the value of the Chinese currency, while necessary for various reasons, will not provide a real solution, only temporary relief. However, for a G-7 devoid of ideas or willingness to tackle tough issues, short-term relief would be very welcome.
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[Appendix 2]
Currency Conundrums
From The Economist Global Agenda
Nov 19th 2004
Finance ministers and central bankers from the G20 meet on Friday, against the backdrop of a weakening dollar and a move into Asian currencies. Can they do anything to assuage the world’s exchange-rate angst?
WHEN the ringmasters of the world economy are flummoxed by a crisis, their instinctive response is to create a new committee, forum or group. In the wake of the 1997-98 Asian financial crisis, they created one of each: the International Monetary and Financial Committee, the Financial Stability Forum and the Group of 20 (G20). This oddball group, which convenes for its annual meeting on Friday November 19th in Berlin, brings together finance ministers and central bankers from the big rich nations, several big oil exporters and some big emerging markets. It meets against the backdrop of a falling dollar and rising economic tensions between its members. Indeed, according to Stephen Jen, an economist at Morgan Stanley, the crisis that befell Asia seven years ago may be about to repeat itself. Only in reverse.
The legacy of that crisis still inhibits Asia’s policymakers. In the seven years since, they have sought to keep the region’s currencies cheap and its dollar reserves deep. The South Korean won, the Indonesian rupiah and the Taiwan dollar, which fell like dominoes after the Thai baht came off its peg in July 1997, have yet to regain their pre-crisis parities. The won is still undervalued by about 5% against the dollar, Mr Jen calculates. The Malaysian ringgit, which is pegged to the dollar, is about 25% below its fair value.
The IMF provides economic statistics and information on the G20 countries. Japan's Ministry of Finance gives information on the country's fiscal policies. The US Treasury Department offers information on monetary and fiscal policy. The People's Bank of China sets monetary policy. The European Central Bank gives information on the euro. The Institute for International Economics posts research and policy briefs on exchange rates and monetary policy. Ronald McKinnon, at Stanford University, publishes a number of papers on the yen, the yuan, and their relationship to the dollar.
On Thursday, however, the won was bid up to its highest price since the crisis. The baht and the Taiwan dollar have also strengthened in recent days. Seven years after they suffered a dramatic run on their currencies, Asia’s emerging markets now find themselves trying to resist a (somewhat less dramatic) run into their currencies.
In 1997, the Asian countries exhausted their foreign-exchange reserves trying to prop their currencies up. Since then, they have dramatically expanded their dollar reserves in an effort to hold their currencies down. These purchases of American assets have helped to prop up its currency and finance its vast trade deficit. But they may not last much longer. For a country such as South Korea, buying dollars is both costly and possibly inflationary. The country’s excess savings, parked in low-yielding American Treasuries, would earn a higher return invested at home. And the finance ministry’s weak won policy, by making imports more expensive, has hampered its fight against rising prices. In the summer, annual inflation reached its highest rate for three years, though it has since eased.
South Korea’s ambivalence about its won policy may be shared by the other post-crisis countries in the region. But their freedom for manoeuvre is limited by China’s dedication to its peg against the dollar. During the financial storms of 1997 and 1998, the peg provided an important anchor for the region. Even as currencies collapsed all around it, China refused to beggar its neighbours by devaluing the yuan. But China’s peg, a bulwark against the financial crisis, is now blocking the “reversal” of the crisis that Mr Jen foresees and the dollar needs. To its neighbours, China is such an important trade partner and competitor that they dare not let their currencies strengthen too far against the yuan. Even Japan is wary.
Much of the G20, then, is now waiting for just one of its members, China, to unpeg its currency. Some speculators can wait no longer. They are already swapping their dollars for yuan, betting it will soon jump in value. To deter such speculation, Chinese banks on Thursday raised the interest they pay on dollar deposits.
If the dollar is not allowed to fall against the yuan, it will probably continue to fall heavily against something else. On Friday, the American currency fell to its weakst level against the yen since April 2000. It also remained around record lows against the euro. Earlier in the week, Nicolas Sarkozy, France’s finance minister, had declared that “the greenback has become unhinged”.
But Europe’s finance ministers can do little about it. They have surrendered control of the currency to an independent central bank that targets inflation, not the exchange rate. The European Central Bank has not intervened directly on behalf of the euro for four years. It is unlikely to do so again without American backing.
Japan’s monetary authorities have no such compunction. The finance ministry happily spent over ￥20 trillion ($170 billion) propping up the dollar last year and over ￥14 trillion in the first three months of this year. For Japan, unlike South Korea, buying dollars is profitable. And if it is also inflationary, so much the better for a country still gripped by deflation. Interest rates on American assets, such as Treasuries, may be low. But they are higher than the zero interest rates on offer in Japan. Moreover, printing yen to buy dollars is one way to inject liquidity into Japan’s moribund financial system.
The constraints on Japan are not economic, but political. Heavy interventions in the foreign-exchange markets always raise a stink at the groups, forums and committees where Japan’s policymakers come face to face with their American counterparts. At the meeting in Berlin, Japan will no doubt promise once again to leave the value of the yen to market forces. But one suspects that Japan’s yen policy, just like China’s yuan policy, is ultimately decided not by a committee of 20 nations, but by a group of just one.
