Wednesday, January 26, 2005

IMF Hint to China: Revalue

The IMF posted a paper on its website today that discusses the Chinese exchange rate. It goes through the arguments in favor and against exchange rate liberalization, capital account liberalization, and touches upon the issues of sequencing. In the end, (surprise!) it comes out (weakly, in my opinion) in favor of exchange rate liberalization as soon as possible, even ahead of capital account liberalization.

There were some interesting observations along the way. For example, here they discuss the vulnerability of the financial system, and dismiss concerns.
...the banking system is unlikely to be subject to substantial stress simply as a result of greater exchange rate flexibility. Domestic banks do not have a large net exposure to currency risk, and exchange rate flexibility by itself is unlikely to create strong incentives (or channels) to take deposits out of the Chinese banking system.

The current overall exposure of the corporate sector and banks in China to foreign exchange risks appears to be low; however, there are some indications that the degree of exposure has been on the rise in recent years. As shown in Table 1, in 2003, banks’ net foreign assets accounted for 3 percent of broad money and 6 percent of GDP, and foreign currency lending constituted about 5 percent of domestic credit and 9 percent of GDP.

These indicators seem relatively innocuous when compared with those of other countries. Their recent evolution, however, points to a trend that bears watching closely: during 2001-03, banks’ foreign currency loans to domestic residents have increased by over 60 percent, net foreign currency liabilities are up by nearly 50 percent, and total short-term external debt (which is denominated in foreign currencies) has risen by over 50 percent. These are trends that are likely to continue with China’s increasing global integration and the opening of the financial system as part of the terms of World Trade Organization (WTO) accession. (italics mine)
They admit, however, that there could have been excessive lending in the recent Chinese boom...
...rapid growth of bank credit has contributed to a surge in investment growth, leading to the possible buildup of excess capacity and associated nonperforming loans in several sectors of the economy, as well as potential problems of more generalized overheating.
...and are not concerned about the impact on Chinese exports of an exchange rate appreciation (conversely, this has implications for the US trade balance).
...the direct impact on exports of a moderate appreciation of the exchange rate is likely to be considerably muted by the high import content of China’s exports, as well as China’s strong productivity growth and low labor costs. Indeed, during the period 1999- 2002, China’s total exports (in value terms) rose by 37 percent despite a 7 percent real effective appreciation... An appreciation of the renminbi, while raising the cost of processing and assembly in China, would also lower the cost of imported intermediate inputs. Hence, an appreciation of the renminbi may not put much of a dent in China’s external competitiveness.
Finally, here is an interesting observation: they assume that the PBOC has been investing toward the long end of the curve. Hmm...I wonder what will happen to US interest rates when the Chinese bid for treasuries goes away.
The sterilization of capital inflows has been facilitated by the fact that domestic interest rates related to the main sterilization instrument (central bank bills) have been lower than interest rates on medium and long-term industrial country treasury bonds, which is where much of China’s reserves are presumed to be held. Thus, the traditional net costs of sterilization are absent in this case.


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