China’s exchange rate policy dilemma

Author: Yiping Huang, ANU

U.S. Treasury Secretary Tim Geithner’s accusation that China was manipulating its currency during his confirmation hearing once again placed China’s exchange rate policy under the spotlight.

Although the White House quickly clarified that it would wait for Treasury’s assessment on the issue in April, the timing of this accusation from a top incoming U.S. economic policymaker could not have been worse.

Not only is China now the only major stabilizing force in the global economy, but the U.S. desperately needs China to support its own efforts in arresting the downward spiral of the financial crisis.

Yet financial market investors do not seem to buy the argument that China will be forced to appreciate its currency. In fact, the non-deliverable forward (NDF) market prices in a 1.3 per cent depreciation of the Chinese yuan against the U.S. dollar (USD) within 12 months.

Many investors believe that, Chinese policymakers will soon be forced to depreciate the currency, given sharply worsening economic conditions, especially declining exports.

During the past year, expectations for the Chinese exchange rate took a dramatic U-turn. At the beginning of 2008, the key macroeconomic challenges for China were inflation and overheating. The People’s Bank of China (PBOC) tried hard to tighten monetary policies. Alongside increases in both base interest rates and reserve requirement, the Chinese yuan appreciated by more than 6 per cent against the dollar during the first half of 2008, while its real effective exchange rate strengthened by 4 per cent. In early 2008, the NDF market expected Chinese yuan to appreciate by more than 11 per cent within 12 months.

In the second half of the year economic conditions changed significantly. The U.S. financial crisis deepened and the global economy fell into recession. The Chinese economy also cooled rapidly and its inflation rate dropped sharply. From September, the PBOC began to ease monetary policies.

The appreciation of the Chinese yuan came to an abrupt halt around mid-July. This probably also led to reversal of cross-border capital flows. During the first quarter of 2008, the difference between net foreign exchange reserve accumulations and the sum of trade surplus and utilized foreign direct investment (FDI), which is often used as a proxy to measure hot money flows, was US$85 billion. The gap turned to negative US$91 billion during the fourth quarter.

The most difficult time for Chinese exchange rate policy is yet to come. The current pessimism about the currency is mainly driven by weakening economic conditions in China, especially decelerating industrial production, collapsing power generation, falling exports and a devastating Purchasing Managers’ Index (PMI). In fact the current account remains very stable. Even though exports declined, a faster drop in imports pushed up the monthly trade surplus to around US$40 billion during the past three months, from around US$20 billion earlier.

This will change. The expected rebound of domestic demand, likely as early as the second quarter of this year, could lead to significant recovery of imports. The recent collapse of imports was pushed to by the extreme de-stocking taking place in Chinese companies. This factor will probably disappear before the end of the first quarter. And fiscal stimulus measures will boost infrastructure development and lift commodity imports. Meanwhile, global recession shall keep Chinese exports under heavy pressure, at least for the remainder of the year.

All this implies that China’s trade balance could deteriorate sharply, most likely during the second half of the year. This would strengthen investors’ expectation of a yuan depreciation, further complicating the task of policymakers in maintaining a relatively stable exchange rate amidst global turbulence.

But is it possible for the yuan to depreciate steadily over the coming year? We don’t think so.

To start with, given China’s relatively strong growth performance and large foreign exchange reserves, it isn’t clear whether China will actually be ‘forced’ to devalue the currency unless policymakers conclude that the benefits of depreciation outweighs costs. If China was able to defend its currency in 1998, it is in a much stronger position to do the same today.

The most important benefit of currency depreciation, as suggested by some experts, is that it supports growth. In the current environment, currency depreciation is not likely to generate any real export gains. The latest decline of exports was not because of China’s loss of export competitiveness. It was caused by a collapse in external demand, which will not change until the global economy recovers.

Steady depreciation of the Chinese yuan would likely lead to higher pressures for the depreciation of other Asian currencies and destabilize regional financial markets. As China’s own experience suggests, expectations of currency depreciation could be a prelude to capital outflows. In the middle of a global financial crisis, ‘forced’ depreciation could contribute to a significant loss of confidence and therefore trigger outflows of foreign and domestic capital.

The international politics surrounding the Chinese exchange rate could become even more complicated, as unemployment rates skyrocket in the industrial world. Geithner’s ill-timed comment was only an illustration of how western politicians are tempted to make China’s currency policy a scapegoat for their own problems, whatever the rights and wrongs. The pressure on depreciation of the Chinese yuan is likely to escalate in the later part of 2009 when we can expect China’s trade account to worsen sharply. But the costs of letting that happen would seem very high relative to the benefits.

China has become a victim of its own rigid exchange rate policy. In 2005, policymakers introduced a new ‘managed float’ exchange rate regime ostensibly pegged against a basket of currencies. But the regime was never rigorously put in place. The PBOC still pays disproportionate attention to the bilateral USD rate. Whenever the USD exchange rate moves dramatically, the government loses flexibility in maintaining the stability in real exchange rate. So the most important next step should not be adjusting the value of the Chinese currency, but reinforcing the managed float regime.

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Yiping Huang is Professor of Economics in the Crawford School of Economics and Government at the ANU and was formerly Citigroup’s chief economist for Asia.