CHINA: Beijing will tread carefully on revaluation

Analysis

China is resisting strong political pressure to revalue the renminbi from the narrow band of around 8.28 to the dollar, where it has been fixed for over ten years (see CHINA: Beijing mulls exchange rate options - March 18, 2005). US manufacturers have lobbied Congress, which is holding out the prospect of a 27.5% tariff on Chinese imports if Beijing does not act on the exchange rate. They say that an under-valued renminbi represents unfair trade, which is costing the United States jobs.

A more nuanced argument for exchange regime change would involve understanding the costs to the Chinese economy of maintaining a fixed peg when there is such strong upward pressure on the renminbi from large inflows on the current and capital accounts of the balance of payments (see CHINA: Monetary conditions suit RMB-dollar peg - May 17, 2005). There are several factors to consider:

• Differential loss. The People's Bank of China (PBoC) sterilises inflows of foreign exchange that it must buy and add to reserves to avoid an inflationary increase to the monetary base. However, selling securities to mop up liquidity causes an income loss because of the differential between the yield on the reserve holdings and those paid on the issued securities.
• Capital loss. Rising world interest rates -- as well as currency fluctuations -- can cause capital losses on the fixed-income securities held as reserves. The World Bank has estimated that a 200 basis point rise in US interest rates would cause a 27 billion dollar loss on the dollar portfolio of the six emerging market economies with the largest holding in US Treasuries in late 2004. Last year, foreign exchange reserves in developing countries rose by almost 400 billion dollars to 1,600 billion dollars, of which about 70% is actually held in dollars. China accounted for nearly 40% of this rise.
• Bank pressure. China's banking sector is mainly government-controlled and interest rates are not set by the market, so that losses pass to state-owned commercial banks that are required to buy the paper sold by the PBoC at below market-clearing interest rates (see CHINA: Pressures militate against slowdown - April 11, 2005). In the fourth quarter of last year alone, the central bank sold 80 billion dollars worth of bonds this way, so that the outstanding value of such bonds more than tripled. This practice puts added pressure on the major banks at a time when they are trying to strengthen their fragile balance sheets (see CHINA: Capital injections reflect serious intent - January 12, 2004).
• Policy constraints. The peg offers certainty for exporters but hinders the development of the financial markets by blocking the creation of a link between domestic interest rates and market-based demand for the currency, as evidenced in trade and capital inflows. It also constrains interest rate and monetary policy, where the peg is widely believed to be out of line with estimates of the market value of the currency.
• Speculative inflows . The peg fuels speculative investment where the currency is thought to be under-valued. Inflows of short-term speculative capital can exit rapidly if conditions deteriorate.

Impacts. A large, one-off revaluation, would have a number of important effects:

1. Exports. The government estimates that a 15% revaluation would lead to a sharp and immediate drop in exports, causing export growth to turn negative this year and costing nearly 6 million jobs in 2005-2006. However, while it is certain that export growth would slow, only a dramatic fall would turn it negative this year, given that exports rose 34% year-on-year in January-April. A steep fall in external demand would also reduce domestic demand by cutting industrial production and reducing manufacturing profits -- to the detriment of the banking system and already weak capital markets -- and it would hurt employment.
2. Imports. Revaluation would cut the renminbi costs of imported inputs, notably oil and other commodities, thereby reducing producer price inflation, which has been fuelled by sharp rises in the international prices for raw materials and fuels, sparked in large part by rising demand from China.
3. Manufacturing. Renminbi revaluation would have differing impacts on industries depending on factors such as the currency composition of revenue/cost balances, the degree of competition in third markets and the price elasticity of demand for the products on world markets. A sharp rise in the dollar cost of Chinese products abroad would hurt exporters whose competitive edge lies primarily in cost, whose costs are primarily in domestic currency and where international buyers can quickly react by diverting orders to other sources, as in textiles and clothing. The State-owned Assets Supervision and Administration Commission (SASAC) says that cost pressures reduced the combined profits of 37 major state-owned textile companies by 37.4% to 370 million renminbi (44.7 million dollars) in January-April, despite an 11.8% year-on-year growth in exports to 3.39 billion dollars. There is downwards pressure on prices and profits in the domestic market in other sectors suffering from over-capacity, where higher production costs -- especially for imported raw materials -- have not been passed on (see CHINA: Investment to slow but exports will surge - April 25, 2005).
4. Services. Revaluation would have an impact on tourism. This is a labour intensive sector of increasing importance to the economy -- with annual revenues estimated at over 20 billion dollars. In financial services, domestic banks would benefit as their share in carrying the costs of reserve accumulation fell. However, there would be capital losses on dollar assets held by banks and individuals. Furthermore, a fall in manufacturing profits would hurt bank profits and reduce investment opportunities.
5. Debt servicing. Revaluation would reduce the domestic cost of servicing dollar-denominated debts.
6. Capital flows. The only realignment comparable to a large revaluation in recent years was the 29% appreciation of the yen against the dollar in 1986 (following the Plaza Accord). However, this occurred in a very different economy and was the result of a major loosening of monetary policy. It contributed to the bubble economy and the past hollowing out of Japanese manufacturing (see EAST ASIA: ASEAN carves niche in regional FDI patterns - January 19, 2005). A renminbi revaluation could see some capital leave, including foreign investment, but it could also discourage new inflows. Part of the problem of altering an exchange rate that is not market-discovered is that the potential impact of reactions and expectations is the more uncertain.