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Introduction
Chinas central place in the global economy had been widely acknowledged in recent times. The countrys economic policies were attracting significant international attention. In early 2005, the Chinese government indicated that it intended to liberalize capital controls. Having already eased some controls on capital outflows, in the past one year, Chinese officials mentioned that they would open up the capital account further during 2005. Meanwhile, the Yuan had been pegged to the dollar for a decade. There was a widespread belief that the Yuan was unfairly cheap. The increase in China's official reserves seemed to be clear evidence in this regard. But senior Chinese politicians believed that China could not let its exchange rate move more freely before it had fixed its weak banking system. Otherwise, there would be a large outflow of capital. Advocates of a more flexible exchange rate system argued that, even if it led to the appreciation of the Yuan, it would create long-term benefits. It would assist the development of a deeper financial market. For example, firms would have more incentive to hedge foreign-exchange risk. This would encourage the development of suitable financial instruments including derivatives. The experience of greater exchange-rate flexibility would also help the economy over time, to prepare for a full opening of the capital account. If capital controls shielded the economy from volatile flows, China would have time for reforms to strengthen the banking system. Chinese policy makers faced a dilemma. What should they do first - liberalize capital flows or allow the Yuan to float? The dilemma was further with pressure on China from many western countries, especially the US, to revalue the Yuan. Background Note
Only a few years ago, when "the world economy" was discussed, China would at best get a brief mention. But in 2005, China became too big to ignore. Since 1978, when Deng Xiaoping first set his country on the path of economic reform, its GDP had grown by an average of 9.5% a year, faster than in any other economy in the world.
China had been the largest economy for much of recorded history. Until the 15th century, China had the highest income per head and was the technological leader. But then it suddenly turned its back on the world, imposing restrictions on international trade and use of technology. Measured by GDP per person, China was overtaken by Europe by 1500, but it remained the world's biggest economy for long thereafter. In 1820 it still accounted for 30% of world GDP. However, by 1950,
after a century of anarchy, warlordism, foreign suppression, civil war and conflict with Japan, its share of world output had fallen to less than 5%[1]. Most of China's growth over the past quarter-century had been due to the high rates of investment and the movement of workers from subsistence farming to more productive use in industry. But good infrastructure, an educated workforce, a high rate of saving and an extremely open economy, had also been significant growth drivers. China's average tariffs had fallen from 41% in 1992 to 6% after it joined the WTO in December 2001, giving it the lowest tariff protection of any developing country. Many non-tariff barriers had also been dismantled. China's GDP accounted for 13% of world output (at purchasing-power parity), second only to America's. At the end of 2004, China was the world's third-biggest exporter (after America and Germany). It was also the largest recipient of foreign direct investment. Many multinationals had moved their operations to China to take advantage of its low labor costs and huge domestic market. The country produced twothirds of all photocopiers, microwave ovens, DVD players and shoes, over half of all digital cameras and around two-fifths of personal computers. As a result of the large capital inflows, China's foreignexchange reserves had more than doubled since early 2002 to over $480 billion. Most of these dollars were invested in American government securities.
China was also a big market. During 2001-04, China had accounted for one-third of the total increase in world import volumes. China had become the growth engine for the rest of East Asia, accounting for half the total export growth of the other East Asian economies in 2003. China's demand for commodities had also boomed, driving up world prices.
China was already the world's biggest consumer of steel, copper, coal and cement, and the second-biggest consumer of oil, after America. So changes in Chinese demand had a big impact on world prices. China had been responsible for nearly 40% of the increase in global consumption since 2000. Chinese demand was also the main reason for the doubling in the world price of coal in 2003. During the year, China consumed 40% of all the coal and 30% of all the steel in the world, and accounted for most of the increase in world demand for copper and steel.
For such a big economy, China was unusually open to trade and investment. In 2004, exports and imports of goods and services together amounted to about 75% of China's GDP, far more than in other big countries. In America, Japan, India and Brazil, the figure was 30% or less. At its peak, Japan's trade reached only 32% of its GDP. Similarly, the stock of total investment in China by foreign firms was equivalent to 36% of its GDP, compared with 2% in Japan.
China seemed to be opening markets far more than India or Brazil.
China had a trade surplus with America and Europe but a deficit with most of Asia. Its overall trade position was close to balance. Much of the increase in America's imports from China had been at the expense of the exports of other emerging economies rather
than domestic production. For example, in 1988, some 60% of American shoe imports had come from South Korea or Taiwan and only 2% from China. In 2004, China had a share of 70%, and imports from South Korea and Taiwan had declined sharply. Over the same period, America's imports of computers from the rest of East Asia had fallen while those from China had jumped.
The tigers shipped capital-intensive components such as motherboards, memory chips and other parts to China for labor-intensive processing and assembly and exported personal computers to developed countries.
Despite these impressive achievements, China faced many obstacles to growth: its fragile banking system, the lack of a transparent legal system, corruption, the risk of social and political unrest caused by widening income inequalities and the abuse of human rights and severe environmental pollution. Yet if reforms continued, there were good reasons to believe that rapid growth could be sustained. With over 60% of China's population still living in the countryside, Chinese manufacturers had access to an almost unlimited supply of cheap labor. By some estimates, there were almost 200 million underemployed workers in rural areas who could move into industry. This surplus labor might take at least two decades to absorb, helping to hold down wages for low-skilled workers.The steady shrinking of the stateowned sector would also boost productivity by ensuring a better use of resources. China's private sector, which accounted for about half of its GDP in 2004 was growing twice as fast as the rest of the economy. China's GDP per person was still well under a third of South Korea's and one-fifth of Japan's, so there was plenty of room to catch up. China's share of world trade was also lower than that of Japan or the combined trade of the East Asian tigers at a similar stage in their development process, suggesting that China might maintain rapid export growth for a few more years. For example, in 2004 it accounted for 13% of all American imports, whereas Japan's share of the American market peaked at 22% in 1986.
If China could sustain an annual growth of 7-8% for at least another decade, the countrys GDP, measured at PPP, would overtake America's before 2020, although its GDP per head would remain much lower, measured at market exchange rates. But China could overtake Japan as early as 2016 and America by about 2040.
remained unwilling to let banks fail, because of the impact not only on thousands of employees, but also on millions of depositors. Most analysts believed that Chinas financial system was far too weak for such a rapidly liberalizing economy. China's 'Big Four' state banks, Bank of China (BoC), China Construction Bank (CCB), Industrial and Commercial Bank of China (ICBC), and Agricultural Bank of China, which together accounted for around 60% of total bank lending had officially ended up with around US$200bn in Non Performing Loans (NPLs). In order to reduce the NPL burden, the government had tapped into China's US$600bn forex reserves, having injected US$45bn into BoC and CCB in early 2004. The government had also announced a similar bailout for the other two lenders in late 2003. In February 2005, the authorities announced a new reform plan for ICBC, which might include a US$50bn capital injection. The NPL burden of the Big Four had fallen to 15% of total loans in the third quarter of 2004 from around 25% in 2002. But, this seemed more due to an increase in the total loans made, rather than a major improvement in the banks' operating environment or lending practices. There were fears that some of the new loans being issued would still turn non-performing, which in turn would aggravate problems in future. While bailouts were not desirable, the government might decide to keep the banks alive, which in turn would allow them to keep lending to unprofitable state-owned enterprises (SOEs). This policy would keep people employed, and thereby maintain political stability, an important consideration because any labor unrest could eventually threaten the communist partys grip on power. Most analysts argued that to improve the state of affairs, increased transparency and better risk management were needed. Transparency would reduce lending based on fraudulent practices while risk management would encourage greater prudence while giving loans. By the end of 2004, the value of bad loans had reached $205 billion[2] 13% of total banking assets. Most banks in China were technically insolvent, as their NPLs far exceeded their equity. But these institutions were still highly liquid because of a large retail deposit base that continued to expand as a result of a robust economy and thrifty consumers whose savings equaled 40% of China'sGDP. Since Chinas capital markets remained largely underdeveloped, banks served as the primary source of long-term funds. Bank lending would have to expand by about 15% a year for China to meet its growth target. Analysts estimated that China's banking system could safely sustain an annual loan growth of only 5 to 7%, which was far below the level needed to maintain economic momentum and keep unemployment in check. The higher growth rate could be sustained only if regulators, banks, and investors worked together to improve risk management skills in a big way. Meanwhile the government had attempted to modernize the banking system by increasing foreign participation in the sector through the purchase of strategic stakes in Chinese banks. Foreign banks in China had a bad loan ratio of just 1.3%. The government hoped that a greater foreign presence of foreign banks would encourage Western-style banking practices and help turn local lenders into worldclass institutions. There had also been efforts to speed up the recovery of bad loans. But China's asset-management companies sold only a small fraction of those transferred to them. Inexperience in this area and the lack of a vibrant vulture-fund[3] industry that specialized in buying distressed assets explained the lack of progress. In addition, banks in China had little incentive to sell their distressed assets because once they did, they had to anticipate a loss. The boards of some of the largest banks, such as the CCB and the Bank of Communications, had been restructured to a certain extent. They had been made smaller, and foreign bankers had replaced a number of government officials. But these measures had largely failed to prevent the state's meddling in often
well-intentioned though unprofitable lending decisions. The government not only fully owned the big four banks but also, directly or indirectly, controlled 95% of the assets of most others through shares held by local municipalities and state owned enterprises outside thebanking sector. There were no private banks, and foreign ownership was extremely limited. On a positive note, the state's influence over lending decisions had become more transparent in recent times. A decade ago, banks had existed essentially to disburse money as per the directives of the Communist Party. Doling out loans to finance loss-making state-owned factories in far-off provinces was an accepted practice to maintain centrally planned production targets and employment levels. But in 2005, some banks did try to understand and monitor their real risk management skills and performance by marking bad loans in their books to distinguish between those made on commercial grounds and those extended, at the behest of the central authorities or local governments. But despite the slow down in statedirected lending, there was still pressure from local party officials or local businesses with political connections, on banks to make uneconomic lending decisions. Chinese accounting practices also looked outdated. Many Chinese banks did not recognize bad loans, because even if they were nonperforming on a cash-flow basis, they did not meet certain technical criteria. Chinese banks often considered a loan whose interest was being paid but not principal to be performing, though the principal was clearly at risk. Since introducing a consistent loan classification system several years ago, the regulators of China's banks had made some progress getting them to report their NPLs. The system defined different levels of risk classes and established when banks had to allocate reserves and how much. For example, a bank had to build up reserves equal to 100 percent of a loan's book value if the principal was not paid. This newsystem represented progress, but much more needed to be done to improve financial transparency in general and the reporting of NPLs in particular. In the short term, banking regulators were attempting to develop and implement detailed risk management guidelines that would require every bank to appoint its own chief risk officer and to be capable of reporting, on a weekly basis, the loans it approved and the new risks it added to its books. Some of the larger and more sophisticated Chinese banks had already made such changes. But many other smaller regional institutions had not. Despite the challenges involved, most analysts believed that the Chinese central authorities had the capacity to manage the badly needed reform of the banking system. The recent experience of some of the largest state-owned institutions seemed to suggest that risk management systems could be substantially improved, using existing resources, in a few months. China also appeared to have the fiscal capacity needed to implement banking sector reform.
An appreciation of the Yuan would also ease the pressure on the banking system. At the same time, there would be global fallouts. A stronger Yuan would allow Asias other emerging economies to let their currencies rise. Some economists believed that by allowing the Yuan to move up and in the process reducing the pace of accumulation of foreign currency reserves by China, America would be forced to raise interest rates. They felt this would have a healthy cooling effect on Americas consumption, which was going out of control. In the past decade or so, the combination of fixed exchange rates and open capital accounts had caused financial crisis in many emerging economies, especially where financial systems were fragile. Thailand, Malaysia, the Philippines, Indonesia and Argentina had been some of the countries affected. Although the International Monetary Fund (IMF) did not believe that the Chinese banking system would fall under pressure when the Yuan was eventually floated, analysts thought that a more secure financial system would leave Chinese banks in a better position when the foreign exchange market and capital account were liberalized. China seemed intent on relaxing capital controls before setting its exchange rate free. Was China better off moving cautiously in liberalizing its capital account, and moving more rapidly towards greater exchange-rate flexibility? What should China do?
Exhibit 1
China
Source: www.economist.com
Exhibit 2
GDP per head ($ at PPP) GDP (% real change pa) Government consumption (% of GDP) Budget balance (% of GDP) Consumer prices (% change pa; av) Public debt (% of GDP) Labour costs per hour (USD) Recorded unemployment (%) Current-account balance/GDP Foreign-exchange reserves (mUS$)
3,980 8.00 13.08 -3.62 0.35 30.40 0.59 8.20 1.90 168,278
4,340 7.50 13.39 -2.97 0.73 30.60 0.69 9.30 1.48 215,605
4,720 8.00 13.20 -2.96 -0.77 31.10 0.80 9.75 2.80 291,128
5,180 9.10 12.90 -2.50 1.17 29.60 0.92 10.10 2.20 401,036
Source: www.economist.com
Exhibit 3
Item GDP Growth GDI/GDP Inflation (CPI) Money Supply (M2) Growth Fiscal Balance/GDP Merchandise Export Growth Merchandise Import Growth Current Account/GDP 5.7 23.5 1.5 -1.2 12.2 12.6 7.7
2007
CPI = Consumer price index, GDI = Gross domestic investment, GDP = Gross domestic Product. Source: Census & Statistics Department; Hong Kong Monetary Authority.
Exhibit 4
Source: Goldstein, Morris and Weatherstone, Dennis. Adjusting Chinas Exchange Rate Policies, Working Paper, May 2004.
Exhibit 5
Source: Census and Statistics Department, Hong Kong Annual Digest of Statistics, 2004 edition.
Exhibit 6
Source: www.economist.com
Exhibit 7
Source: www.economist.com
Exhibit 8
Source: Goldstein, Morris and Weatherstone, Dennis. Adjusting Chinas Exchange Rate Policies, Working Paper, May 2004.
Exhibit 9
Source: Goldstein, Morris and Weatherstone, Dennis. Adjusting Chinas Exchange Rate Policies, Working Paper, May 2004.
Exhibit 10
10.4
5.3
Source: www.economist.com
Exhibit 11
Source: Chandrasekhar C P; Ghosh, Jayati. The Dollar vs. the Chinese Yuan, International Development Economics Associates, 25th December 2004.
Exhibit 12
Source: Chandrasekhar C P and Ghosh, Jayati. The Dollar vs. the Chinese Yuan, International Development Economics Associates, 25th December 2004.
Exhibit 13
Source: Goldstein, Morris and Weatherstone, Dennis. Adjusting Chinas Exchange Rate Policies, Working Paper, May 2004.
Exhibit 16
Chinas Renminbi Real Trade Weighted Exchange Rate Index 1994-2004 (2000=100, data Monthly Averages)
Source: J P Morgan.
Bibliography