Brookings: Topics - China's Currency

How the China Development Bank is Rewriting the Rules of Finance: Debt, Oil and Influence

Thu, 18 Apr 2013 14:30:00 -0400

Event Information

April 18, 2013
2:30 PM - 4:00 PM EDT

Saul/Zilkha Rooms
Brookings Institution
1775 Massachusetts Avenue NW
Washington, DC 20036

The China Development Bank may be the most powerful financial institution in the world, argue Beijing-based Bloomberg News reporters Henry Sanderson and Michael Forsythe in their new book, China’s Superbank: Debt, Oil and Influence – How China Development Bank is Rewriting the Rules of Finance (Bloomberg Press, 2013). The China Development Bank has been the enabler of the government's policies both at home and abroad. It invented the system of local finance that helped China weather the global financial crisis and has financed the China-Africa Development Fund, bankrolled the global expansion of Chinese companies and extended tens of billions of dollars in energy-backed loans to borrowers around the globe, including Brazil, Russia and Venezuela.

On April 18, the John L. Thornton China Center at Brookings hosted a discussion on China’s Superbank with Forsythe and Sanderson. Brookings Fellow Erica Downs provided introductory remarks and moderated the discussion.

The Road Ahead for China’s Economy

Tue, 16 Apr 2013 09:00:00 -0400

Event Information

April 16, 2013
9:00 AM - 4:30 PM EDT

Falk Auditorium
Brookings Institution
1775 Massachusetts Avenue NW
Washington, DC 20036

In recent years, China has increasingly confronted new challenges in economic policy, including rising labor costs, low household consumption, rapid urbanization and inefficient domestic investment. While it is now widely acknowledged in Beijing that major structural adjustments are needed to address these issues, implementing serious reforms pose major challenges for the newly installed leadership.

On April 16, the John L. Thornton China Center at Brookings and China’s Caixin Media Group hosted a conference to examine the daunting challenges confronting China’s new leaders. The morning panels featured a discussion of the financial sector as well as the relationship between the domestic agenda for financial reform and China’s evolving strategy for outbound investment. The afternoon panels took a close look at the political obstacles to implementing major economic reform in areas such as tax policy, the household registration system and land transfers, as well as explore the impact of environmental and natural resource constraints on China’s economic growth.

Audio

Transcript

Uncorrected Transcript (.pdf)

Event Materials

20130416_china_economy

Soaring Reserves Put Renminbi Back in the Spotlight

Eswar Prasad and Karim Foda — Mon, 15 Apr 2013 12:26:00 -0400

Editor's Note: The following commentary originally appeared on the Financial Times website, and is based on data by the authors presented in the Financial Times' China Currency Tracker interactive feature.

View the China Currency Tracker at ft.com » (subscription required)

With China’s foreign exchange reserves soaring, the renminbi is back in the spotlight. Rising capital inflows have led to a surge in accumulation of reserves as China’s central bank tries to fend off pressures for the renminbi to appreciate. Further liberalization of capital outflows could help ease the pressure on the currency. Greater exchange rate flexibility remains in China’s interest and would also help pave the way for eventual convertibility of the renminbi.

Last year was a calm one for the renminbi. China’s trade and current account surpluses fell below 3 percent of GDP in 2012, suggesting that the economy was on its way to resolving its protracted external imbalances. Capital inflows eased off and capital outflows rose as the government liberalized controls on outflows. Net accumulation of foreign exchange reserves was just over $130 billion, compared to $330 billion in 2011 and an average of nearly $450 billion per year in the four years preceding that.

Pressures on the renminbi appeared to have become more balanced. In fact, for most of the year, the offshore non-deliverable forwards (NDF) market indicated expectations of mild renminbi depreciation relative to the U.S. dollar.

Pressures on the renminbi appeared to have become more balanced. In fact, for most of the year, the offshore non-deliverable forwards (NDF) market indicated expectations of mild renminbi depreciation relative to the U.S. dollar. In April 2012, the government increased the flexibility of the exchange rate, allowing the renminbi to rise or fall by 1 percent each day relative to the midpoint of the trading range determined by the People’s Bank of China (PBC). Soon after that, the renminbi briefly retreated in value against the dollar before returning to a slow pace of appreciation.

2013 could prove to be a more interesting year on the currency front. Capital inflows into China seem to have picked up due to a mix of pull and push factors. The economy’s short-term growth prospects seem solid, although Chinese equity markets have not performed well. The major advanced economies are likely to maintain protracted low interest rate and easy money policies, pushing capital out to China and other emerging markets.

The economy seems to have settled down to a pace of 7-8 percent GDP growth. Inflation appears under control, leaving room for a strong policy response to counter any slowdown in growth. There are many risks to this relatively benign scenario, including concerns about local government debt, the housing market, and financial system weaknesses.

Still, capital flows to China are likely to increase, particularly since the government has been easing restrictions on inflows. This will maintain appreciation pressures on the currency barring any major global financial turmoil—for instance from a flare-up of the euro zone debt crisis—that could pull capital back from emerging markets to the traditional safe haven currencies.

On a trade-weighted basis, the renminbi’s nominal effective exchange rate relative to its major trading partners has appreciated by 3 percent over the past twelve months. The inflation-adjusted real effective exchange rate has appreciated by 5 percent over this period--although China has maintained moderate inflation, many of its advanced economy trading partners have even lower inflation rates.

With the U.S. bilateral trade deficit with China hitting a new high of $314 billion in 2012 and U.S. job growth still at dismal levels, China’s currency policy could once again become a source of tension between the two countries.

Over the past twelve months (March 2012 to March 2013), the renminbi has appreciated relative to the currencies of virtually all of its major trading partners. In inflation-adjusted terms, the renminbi’s value has risen sharply against the yen--by nearly 18 percent. By this measure, the renminbi has also appreciated by 5.9 percent relative to the euro and 1.5 percent relative to the U.S. dollar. Measured relative to its recent low against the dollar in August 2012, the renminbi is now up by about 3 percent against the dollar.

The renminbi’s modest appreciation relative to the dollar suggests that the exchange rate is still being tightly managed by the PBC through its intervention in foreign exchange markets. Indeed, in the first quarter of 2013, China added $128 billion to its stockpile of reserves, pushing them to a level of $3.44 trillion.

With the U.S. bilateral trade deficit with China hitting a new high of $314 billion in 2012 and U.S. job growth still at dismal levels, China’s currency policy could once again become a source of tension between the two countries. This would not bode well for the bilateral economic relationship and could also raise global trade tensions, particularly as China and other emerging markets continue to feel victimized by aggressive monetary easing in the major advanced economies.

Continued liberalization of capital outflows will help take some of the pressure off from any increase in inflows. Still, there is a strong case for allowing more flexibility in China’s exchange rate. This would have many other domestic benefits as well. As China continues to open up its capital account, greater exchange rate flexibility will be important to make the process smoother and to facilitate the move towards free convertibility of the renminbi. It will also boost monetary and financial sector reforms.

Authors

Eswar Prasad
Karim Foda

Publication: Financial Times

Image Source: © Jason Lee / Reuters

China’s Global Currency: Lever for Financial Reform

Arthur R. Kroeber — Thu, 11 Apr 2013 12:09:00 -0400

Following the global financial crisis of 2008, China’s authorities took a number of steps to internationalize the use of the Chinese currency, the renminbi. These included the establishment of currency swap lines with foreign central banks, encouragement of Chinese importers and exporters to settle their trade transactions in renminbi, and rapid expansion in the ability of corporations to hold renminbi deposits and issue renminbi bonds in the offshore renminbi market in Hong Kong.

These moves, combined with public statements of concern by Chinese officials about the long-term value of the central bank’s large holdings of US Treasury securities, and the role of the US dollar’s global dominance in contributing to the financial crisis, gave rise to widespread speculation that China hoped to position the renminbi as an alternative to the dollar, initially as a trading currency and eventually as a reserve currency.

This paper contends that, on the contrary, the purposes of the renminbi internationalization program are mainly tied to domestic development objectives, namely the gradual opening of the capital account and liberalization of the domestic financial system. Secondary considerations include reducing costs and exchange-rate risks for Chinese exporters, and facilitating outward direct and portfolio investment flows. The potential for the currency to be used as a vehicle for international finance, or as a reserve asset, is severely constrained by Chinese government’s reluctance to accept the fundamental changes in its economic growth model that such uses would entail, notably the loss of control over domestic capital allocation, the exchange rate, capital flows and its own
borrowing costs.

This paper attempts to understand the renminbi internationalization program by addressing the following issues:

Definition of currency internationalization;
Specific steps taken since 2008 to internationalize the renminbi;
General rationale for renminbi internationalization;
Comparison with prior instances of currency internationalization, notably the US dollar after 1913, the development of the Eurodollar market in the 1960s and 70s; and the deutsche mark and yen in 1970-90;
Understanding the linkage between currency internationalization and domestic financial liberalization;
Prospects for and constraints on the renminbi as an international trading currency and reserve currency.

Download » (PDF)

Downloads

Download the paper

Authors

Arthur R. Kroeber

Image Source: © Bobby Yip / Reuters

The Steady Hand of China’s Central Banker

Eswar Prasad — Wed, 13 Mar 2013 09:46:00 -0400

Editor's Note: Fear of inflation and hope for reform in China’s monetary policy are both rising. Lesser men might have balked, but People’s Bank of China governor Zhou Xiaochuan is facing the challenge.

Two months ago, Mr. Zhou was expected to step down after a decade at the helm of China’s central bank, but banking and Communist Party officials have recently indicated that China’s leaders want him to stay on a little longer. During a nationally televised news conference on the sidelines of China’s annual parliamentary meetings on Wednesday, Mr. Zhou refused to say whether he would stay or go.

China Real Time caught up with Eswar Prasad, an expert on China’s economy at Cornell University, and threatened to keep 20% of his bank deposits in low-yielding reserves unless he shared his insights on Mr. Zhou’s record.

Tom Orlik: What was the economy that Zhou Xiaochuan inherited in 2002?

Eswar Prasad: When Governor Zhou became the head of the People’s Bank of China in December 2002, the economy was growing fast and recovering from a brief spell of falling prices. Foreign trade was expanding rapidly and foreign investors were thronging at China’s doorstep. However, some domestic policy tensions were also becoming apparent. The rate of bank credit expansion was already above nominal income growth and surging higher, there were concerns about bad loans in the banking system, and the PBOC was having to intervene heavily in foreign exchange markets to maintain the yuan’s peg to the dollar.

Tom Orlik: What did that mean for China’s monetary policy?

Eswar Prasad: China’s monetary policy was constrained by the need to keep the yuan’s value constant relative to the dollar. The trade surplus and capital inflows were putting pressure on the yuan to appreciate, which could have hurt China’s export competitiveness. The PBOC had started intervening aggressively in foreign exchange markets to offset these appreciation pressures by buying up dollars and other hard currencies. Low interest rates in many advanced economies were preventing the PBOC from raising domestic interest rates as that would draw in even more capital inflows. This also meant that interest rates could not be used to guide banks to tighten or loosen credit conditions; instead, the PBOC had to resort to quantity targets and other means that hampered banking reforms.

Tom Orlik: Mr. Zhou faced challenges with inflation in 2004, 2008 and 2011 – how did he deal with them?

Eswar Prasad: In each of these episodes, Mr. Zhou recognized that the expansion of bank credit needed to be controlled and took measures to limit this expansion. Unable to raise interest rates to the level that would be compatible with domestic price stability, he had to resort to measures such as quantity restrictions (setting ceilings for each bank’s credit expansion) and higher reserve requirements on banks.

Tom Orlik: In 2005, Mr. Zhou broke the yuan’s peg to the dollar – why was that?

Eswar Prasad: By 2005, the pressures on monetary policy were ratcheting up. Inflation had begun to come under control after the spike in 2004 but it was clear that the exchange rate regime had become a millstone around the neck of monetary policy. China’s interest rates could not deviate too much from U.S. interest rates, which were much lower than the rates that the PBOC would have preferred domestically. There were also increasing pressures on the yuan to appreciate, with the PBOC accumulating over $200 billion in foreign exchange reserves each year through its exchange market interventions. To start on the road to monetary independence, Mr. Zhou convinced China’s leaders that it was time to depeg the yuan from the dollar and allow it to appreciate. While there was considerable pressure from the U.S. and other advanced economies for this to happen, Mr. Zhou made the strong argument that such a move would be in China’s own interest and that the rate of appreciation could be managed in a manner that would give Chinese exporters time to adjust.

Tom Orlik: What’s the relation between China’s exchange rate regime and the U.S. financial crisis?

Eswar Prasad: China’s tightly managed exchange rate regime is one side of global current account imbalances. China’s purchases of U.S. Treasuries as part of its exchange market intervention helped keep interest rates lower for longer in the U.S., giving financial institutions cheap money with which they eventually wreaked havoc. While these imbalances were not at the root of the crisis, they played a role in perpetuating financial market excesses in the U.S. that eventually resulted in the global financial crisis. The case that some U.S. policymakers have made that these imbalances were the proximate cause of the crisis is, however, not tenable.

Read the full interview at the Wall Street Journal »

Authors

Eswar Prasad

Publication: The Wall Street Journal's China Real Time Report

U.S.-China Relations under Barack Obama and Xi Jinping

Thu, 29 Nov 2012 03:00:00 -0500

Event Information

November 29, 2012
3:00 AM - 4:30 AM EST

School of Public Policy and Management Auditorium
Brookings-Tsinghua Center

Beijing, China

Time: Thursday, November 29, 2012, 4:00 p.m. - 5:30 p.m. (China Standard Time)
Venue: Auditorium Hall, School of Public Policy and Management, Tsinghua University

For more information on this event, please call the Brookings-Tsinghua Center at (+8610) 6279 5601 or email btcevents@brookings.edu.

The reelection of President Barack Obama and the convening of China’s 18th National Congress marks a new era for U.S.-China relations.

On November 29, the Brookings-Tsinghua Center for Public Policy hosted Jeffrey Bader for a public forum to discuss these and related issues facing the Obama and Xi administrations. Bader is the John C. Whitehead senior fellow in international diplomacy at the Brookings Institution. He served as senior director for East Asian affairs on the National Security Council during President Obama’s first term, and is the author of Obama and China’s Rise: An Insider’s Account of America’s Asian Strategy.

In Bader’s view, U.S.-China relations are in pretty good shape right now. Interdependence is the most important characteristic of this relationship, and a crucial aspect is that the two countries continue to maintain strategic cooperation in many fields. America’s foreign policies and strategies toward China will not change significantly under President Obama’s second term, and the key issue will be how to react properly to China’s continued rise and its increasingly important role in global society.

Meng Bo, associate director of the Brookings-Tsinghua Center, gave the opening remarks for this event. Professor Zhang Ruizhuang from Nankai University made comments and shared his insights on U.S.-China relations from the perspective of realism theory.

After the program, Bader took audience questions. The event was held in both English and Chinese with interpreters.

Read the event transcript » (Chinese PDF)

Dr. Jeffrey Bader

Transcript

Event Materials

The New Renminbi Landscape

Eswar Prasad and Karim Foda — Tue, 30 Oct 2012 00:00:00 -0400

Editor's Note: The following commentary originally appeared on the Financial Times website, and is based on data by the authors presented in the Financial Times' China Currency Tracker interactive feature.

View the China Currency Tracker at ft.com » (subscription required)

The renminbi is in the spotlight again. The U.S. Presidential election campaign features both candidates vowing to be tough on China, with Mitt Romney promising to “call China a currency manipulator on day one” if elected. In fact, based on data for this year, there isn’t a strong basis for a charge of currency manipulation. Meanwhile, with growth slowing and the leadership transition taking many unexpected twists, there are concerns about capital flight from China that could also have implications for the renminbi. While capital inflows have fallen and outflows have increased, there is little evidence of massive capital flight that could destabilize the economy.

During 2012, the renminbi has continued on its path of gradual appreciation relative to the U.S. dollar. Since end-2011, the renminbi has appreciated by 1.2 percent against the dollar. But it has not been a slow and steady one-way march. The renminbi in fact depreciated modestly by about 0.7 percent over the summer. Since the end of July, the currency has resumed its appreciation and risen in value by 2 percent against the dollar.

One reason for these fluctuations is that China, like many other emerging market economies, has experienced significant swings in its net capital flows during 2012. This has led to two-way movements in the currency. The People’s Bank of China has accommodated these fluctuations and appears to be increasingly comfortable allowing the currency’s value to be determined by market forces. Nevertheless, it still keeps a tight lid on day-to-day volatility in the currency.

Interestingly, in inflation-adjusted terms, the renminbi’s value relative to the dollar is now almost exactly where it was at the beginning of this year. During 2012, inflation in the U.S. has been higher than in China, with the differential offsetting the nominal appreciation of the renminbi.

Since the value of the euro relative to the dollar is now almost exactly at the same level as at the end of 2012, the year-to-date nominal appreciation of the renminbi relative to the euro is also 1.2 percent.

On a trade-weighted basis, the nominal effective exchange rate is barely unchanged from its level at the end of 2011. Given lower inflation in China than in most of its trading partners, the real effective exchange rate has in fact depreciated slightly.

Seen from a broader context, movements in the currency indicate an altered landscape for the currency’s short-term prospects. Based on data for the first three quarters of 2012, the current account surplus is likely to remain under 3 percent of GDP while the trade balance could come in at around 2 percent of GDP in 2012. The nondeliverable forwards market is not indicating expectations of renminbi appreciation; in fact, for much of the last year, it has been signaling market anticipation of a slight depreciation.

The level of foreign exchange accumulation, which is one measure of intervention in foreign exchange markets, has been substantially lower since mid-2011 than in preceding years. During the first three quarters of 2012, net accumulation of foreign exchange reserves was just over $100 billion, compared to $330 billion in 2011 and nearly $450 billion per year in the four years preceding that.

In short, recent data make it harder to support the case that foreign exchange market intervention by China’s central bank is perpetuating undervaluation of the renminbi in the short run. Pressures on the renminbi appear to have become more balanced.

Weaker inflows and stronger outflows (including an increase in foreign currency deposits) have led to a more balanced position on the financial account. These swings seem to be quite similar to those experienced by many other emerging markets. While gross capital outflows have increased significantly over the past two years, these are consistent with the government’s steps to liberalize outflows. Non-government outflows are likely to increase further as Chinese corporations look for investment opportunities abroad and as financial market development allows households to take advantage of avenues to diversify their savings into foreign investments

All things considered, there is still a strong case to allow for greater flexibility in China’s exchange rate, which would have many domestic benefits. However, recent data should dispel the notion that what’s needed is a big appreciation of the currency rather than more flexibility. There is also little reason (so far) to panic about China’s rising capital outflows—they may be a sign of a maturing economy rather than a troubled one.

Authors

Eswar Prasad
Karim Foda

Publication: Financial Times

Image Source: © Petar Kujundzic / Reuters

U.S.-China Relations Under a Romney Presidency

Richard C. Bush III — Mon, 22 Oct 2012 00:00:00 -0400

Governor Romney has promised he would name China as a “currency manipulator” on “Day 1.” He evidently assumes that the Chinese economy needs the U.S. more than the other way round, and that China will accommodate to his pressure.

But what if he’s wrong? Bill Clinton had the same assumption when he threatened to take away China’s MFN status if it did not improve human rights, in 1993, a time when China’s economy was much smaller than it is today. Chinese leaders believed, in contrast, that the United States needed China more, and, what’s more, their opposition to economic sanctions was fundamental and long-standing. So in the end, it was Clinton who backed down.

In the worst case, a Romney decision to go to the brink with Beijing on the value of its currency would result in a mutually damaging trade war that slowed economic growth and increased unemployment in both countries and caused inflation and higher interest rates in the United States. (For details, see Stephen Roach, “How Romney could go wrong from day one,” Financial Times, August 28, 2012).

But the worst is unlikely to happen. First, Romney has already hedged his threat. In the first debate he promised to “crack down on China if and when they cheat.” And the fact is that China’s currency, the Renminbi, has been gradually appreciating.

Second, even if Romney decides to go ahead and have his Treasury Secretary designate China as a currency manipulator, all that current law requires is that China and the United States have “negotiations,” and China will claim that the current strategic and economic dialogue already fulfills that requirement.

Third, should China refuse to accommodate to U.S. demands, which is likely, the president does not have the authority under current law to impose the countervailing duties that Romney has promised to impose. So he would have to go to Congress to get the authority. But that is easier said than done. The business community would likely voice strong opposition to sanctions, because they would threaten its substantial interests in China. Japan, Korea, Taiwan, and other countries whose companies use China as the manufacturing and assembly platform for products that they ship to America with labels "made in China" would lobby hard against retaliatory tariffs.

So the policy and political logic will likely lead a President Romney to accept the advice of his more moderate foreign policy and economic advisers and abandon his campaign pledge. He will lose some credibility by doing so, but it won’t be the first time that a candidate has walked away from a campaign pledge. And he will have laid down a marker with the Chinese that may make it easier to address other important issues in the economic relationship.

Authors

Richard C. Bush III

Image Source: © Rick Wilking / Reuters

Thoughts on China and American Elections

Richard C. Bush III — Tue, 09 Oct 2012 00:00:00 -0400

Follow @BICampaign2012
Editor's Note: For Campaign 2012, Kenneth Lieberthal and Jonathan Pollack wrote a policy brief proposing ideas for the next president on America’s relationship with China. The following paper is a response to Lieberthal and Pollack’s piece by Richard Bush. Joshua Meltzer also prepared a response arguing that the next president must build stronger economic ties with China and work to resolve several outstanding trade disputes between the two nations.

The current presidential campaign will be the eleventh U.S. presidential election since Richard Nixon began America’s opening to the People’s Republic of China. It is the sixth election in which an elected incumbent seeks a second term. On one of those six occasions (1972), China policy arguably worked to the advantage of the incumbent; twice (1984 and 2004) it figured little or not at all in the contest; and in three instances (1980, 1992, and 2000), the challenger tried to make a case that the incumbent had not stood up for American interests and values against Beijing.

It is not yet clear how Barack Obama’s policy toward China will feature in the 2012 campaign. There has been no huge China controversy under Obama thus far, as there was under Jimmy Carter and George H. W. Bush. However, China’s revival as a great power poses greater challenges for the United States than ever before.

Chinese leaders and analysts have developed a certain confidence about American presidential elections. They have concluded that even if a challenger adopts an anti-China stance during the campaign and then wins, he will moderate his position once he takes office and learns the complexity of

issues that infuse the relationship and takes account of interest groups that favor constructive ties. In short, the quadrennial struggle for the American presidency has only temporary consequences for U.S. policy toward China. Therefore Beijing need not overreact to campaign rhetoric, because given sufficient time, all will be well.

This year may prove the Chinese logic correct once again. If Barack Obama wins a second term, he will likely continue what from Beijing’s perspective have been balanced and positive relations. And whatever the Republican challengers say during the campaign, the Chinese likely believe it will mean little or nothing in the long run. China has survived such hiccups in the past when it was relatively weak, and it can certainly survive another, in part because it is much stronger today than it was even in 2008.

Then again, the next president may not revert to type. Kenneth Lieberthal and Jonathan Pollack demonstrate that conflicts of interest are becoming more prominent in the U.S.-China relationship, and the areas for cooperation are shrinking. The growth of China’s economic, diplomatic, and military power has called into question the four-decade-old assumption that the bilateral relationship produces mutual benefit. Those who argue that Chinese prosperity has come at the expense of America’s and that Beijing will challenge the U.S. role in East Asia get a wider response than ever before. In 2012 both Obama and his opponent may well “run against” China.

Lieberthal and Pollack properly pay attention to the tendency in both Beijing and Washington to read malign intentions into the actions of the other. Mutual mistrust then makes it harder to forge areas of bilateral cooperation and manage points of difference, which both capitals say they wish to do. Lieberthal and Pollack are correct that the new leaderships in each country (China is having its own transition in 2012–13) should place a high priority on reducing this mutual mistrust. This is true whether or not the American political elite take their advice to get the domestic house in order. And the Chinese and American governments have both acknowledged publicly that strategic mistrust is a problem, though each targets different issues. For China, it is Taiwan, Tibet, and Xinjiang; for the United States, it is potential conflict in new security domains: maritime, cyber, and space. Mistrust can stem from different sources, and some present deeper problems than do others.

First and simplest are cases of pure misunderstanding. One side takes an action that the other concludes has malign intent when in fact none exists. China believes it has not been able to complete the unification of Taiwan because of U.S. obstruction, while Washington believes China has not given Taiwan an offer that its people feel is worth considering. Second are cases in which one party commits or intends to act in a way that is not harmful to the other but has problems in implementing its course of action, and is then thought to have negative motives. China’s periodic and failed pledges to protect the intellectual property of American companies fall in this category. So does the case of the Rumsfeld Pentagon’s unwillingness in the early 2000s to carry out President George W. Bush’s instruction to resume military-to-military exchanges. Third, at times the two sides may legitimately share the same objective but differ on how to achieve it and thus may conclude that actually it is the objectives that differ. Differences between Washington and Beijing over North Korea and Iran have had this character. Finally, in some instances the United States and China really do have conflicting goals. The People’s Liberation Army is building capabilities to extend China’s strategic perimeter away from the east and southern coast. That is a traditional area for patrol and surveillance by the U.S. Navy and Air Force, which Washington believes contributes to regional stability.

These distinctions have several implications for U.S. policy on China. First of all, how to reduce mistrust depends on its source. Dialogue is useful for rectifying simple misunderstandings and may help to improve implementation and align means and ends. In fact, the United States and China already have a lot of dialogue. Such mechanisms may be less useful when goals are in conflict. In that case, the best option may be to establish conflict management and risk reduction mechanisms.

Reducing mistrust does obviously depend on leaders forging common understandings. But if they have problems ensuring appropriate implementation, it may only reinforce mistrust.

Domestic factors besides implementation difficulties also have an impact. Analytic agencies in each country can misperceive the motives of the other. Leaders in each may shy away from correcting negative public opinion about the other. Experts in each government who have a benign view of the motives of the other may have too little power to shape policy. Some agencies in each government, particularly the militaries, may see a value in feeding uncertainty and mistrust in the other.

The optimistic vision for U.S.-China relations in the next administration is that the two countries, along with other major powers, can cooperate to tackle the major challenges to the international system. That will have the positive side effect of encouraging each to have a benign view of the other’s intentions. But that vision will be difficult to realize in the existing climate of mistrust. It will be even more difficult if China believes that the United States needs China more than China needs America, and vice versa. If the next administrations in both Washington and Beijing wish to reduce mistrust, as they should, they will have to be smart in the way they go about it.

Downloads

Thoughts on China and American Elections

Authors

Richard C. Bush III

Image Source: © Kevin Lamarque / Reuters

Campaign 2012: The Global Economy and China

Tue, 09 Oct 2012 13:00:00 -0400

Event Information

October 9, 2012
1:00 PM - 2:30 PM EDT

Falk Auditorium
Brookings Institution
1775 Massachusetts Avenue NW
Washington, DC 20036

United States-China relations have been at the forefront of domestic and foreign policy discussions throughout this campaign season. Since joining the World Trade Organization in 2001, China’s economy has been established as a major player in the global economy and continues to grow. The country’s rise has significant implications for U.S. trade and defense policies, particularly on contentious issues like the global financial crisis, nuclear proliferation, military operations in nearby waters and air space and intellectual property rights. As both nations face daunting political and economic challenges, how can the next president improve relations with China while ensuring America’s success in the global economy?

On October 9, the Campaign 2012 project at Brookings held a discussion on the global economy and China, the last in a series of forums that have identified and addressed the 12 most critical issues facing the next president. Campaign 2012 Project Director Benjamin Wittes moderated a panel discussion with Brookings experts Kenneth Lieberthal, Jonathan Pollack, Richard Bush, and Joshua Meltzer, who presented recommendations for the next president.

Participants may follow the conversation on Twitter using the hashtag #BIChina.

Download papers from the event:

Establishing Credibility and Trust, by Kenneth G. Lieberthal and Jonathan Pollack
Continue Progress on an Key Trade Relationship, by Joshua Meltzer
Thoughts on China and American Elections, by Richard Bush

Campaign 2012: Twelve Independent Ideas for Improving American Public Policy is an indispensable guide to the key questions facing White House hopefuls in 2012.

Video

Audio

Campaign 2012: The Global Economy and China

Transcript

Uncorrected Transcript (.pdf)

Event Materials

Options Open on Economy

Eswar Prasad — Mon, 10 Sep 2012 15:33:00 -0400

China’s economy has been the leading contributor to global growth since 2009 and became the second largest in the world in 2010. Small wonder that fears of a growth slowdown in China are causing trepidation around the world.

The fears are palpable given that virtually all indicators of economic activity are pointing down. Growth in gross domestic product, industrial production and retail sales have all slowed markedly. Alternative indicators like electricity consumption suggest an even sharper slowdown. Foreign trade has not helped, with export and import growth falling sharply as well.

Then there are the longer-term concerns that a rapidly aging population is going to limit the economy’s growth potential, snaring China in the “middle-income trap.” With fear in the air, foreign capital is no longer pouring into China and some domestic investors are even taking capital out.

Inflation has eased to 2 percent and some of the froth has come off the property market, but these are seen by many as signs of deeper malaise rather than as positive developments. All told, it appears to be the season for China bears, who are exulting as their views appear — finally — to be validated.

The burden of pulling along world growth while the major advanced economies — the United States, Europe and Japan — continue to post anemic growth and remain in a state of policy paralysis has clearly taken its toll on the Chinese economy. Moreover, many emerging markets and even some advanced economies that rely on commodity exports have been riding on China’s coattails during a difficult period in the world economy. Thus, China’s growth is seen as a bellwether of an even rockier period ahead for a global economy whose recovery has stalled.

For all the angst about China’s growth, the government does have room to stimulate the economy through fiscal and monetary policies. This is in contrast to many advanced economies, which seem to have exhausted their policy options. With a leadership transition looming, the Chinese government appears to be holding some of its fire to be able to respond strongly to external shocks.

Attaining this year’s growth target of 7.5 percent is likely to be difficult but not insurmountable. The real challenge Chinese policy makers face is how to sustain growth in the short run without creating more risks over the longer term.

A bank-financed investment surge lifted economic growth during the global financial crisis. The temptation to use this policy tool again is strong. But another wave of bank-financed investment would also create big risks, including excess capacity in many industries and more bad loans in the banking system.

The mix of policies also has implications for making growth more balanced. Until recently, the Chinese economy was beset by two imbalances — an external one, reflected in a high trade surplus, and an internal imbalance, reflected in a low and falling ratio of private consumption to G.D.P.

The external imbalance has dissipated, at least temporarily. China’s trade surplus has fallen steadily from its recent peak of 7.6 percent in 2007 to 2.1 percent in 2011, and below 2 percent in the first half of this year. Part of this decline is because China has been growing far more strongly than its trading partners. Another factor is that the currency, the renminbi, has appreciated in value against the currencies of China’s major trading partners, reducing export competitiveness.

By contrast, domestic growth remains unbalanced, with investment still accounting for a major share of G.D.P. growth. The share of private consumption in G.D.P., which is only about one-third — already much lower than in virtually every other economy — continues to decline.

There was a spark of hope in the first quarter of 2012, when private consumption accounted for the major share of G.D.P. growth. But this proved fleeting, and investment has once again taken over as the main driver of growth. Investment-led growth of the sort China has experienced is not entirely a plus — it does not lift employment growth by much, has deleterious environmental consequences and limits the benefits that the average household gets from fast growth.

What is to be done? Fiscal policy, if well targeted, would be a better tool to stoke demand in the short run without creating too many long-term risks. For instance, a better safety net would help spread the benefits of China’s strong economic performance more evenly and reduce the incentives for households to “self-insure” against risks of unemployment by saving more. Raising social expenditures on health and education would not only give households more incentive to spend rather than save but also help improve the productivity of labor.

For the longer term, the main priority for the government is to improve productivity rather than rely on high investment or an expanding labor force. This will also require a better financial system and more effective policy tools.

The financial system needs to improve its efficiency in allocating capital to more productive uses, including providing capital for small and midsize enterprises that could generate more employment, and providing savers with a higher return on their deposits. A better monetary policy would help in this objective and that, in turn, requires a greater freeing up of the exchange rate over time so that the central bank can use interest rates to guide credit allocation.

The economy faces other enormous challenges, including corruption and dismal corporate governance at Chinese enterprises. The twelfth five-year plan, issued last year, laid bare these problems and deficiencies in the policy-making process. An authoritarian government can certainly do what would be infeasible in a democracy, where such an admission would be politically fatal. But it is difficult to think of another government, democratic or not, that so bluntly acknowledges major problems and areas where its policies have failed to deliver much progress. In the midst of the gloom, that allows a glimmer of hope that Chinese policy makers will continue to embrace an agenda of much-needed reforms.

Despite the difficult economic environment and a looming, rockier-than-anticipated political transition, there has been progress. This includes modest but significant steps taken in recent months toward greater flexibility of the renminbi’s exchange rate, liberalization of domestic interest rates, and freeing up of restrictions on capital inflows and outflows.

This opportunistic and gradual approach to economic overhauls is one way to make progress given the significant constraints, both political and institutional, that the government faces. But China’s leaders may not have the luxury of time or a benign environment, either domestic or global, to limit themselves to such a slow, even if steady, pace.

The country’s policy makers have proven adept at managing a high-wire balancing act for a number of years, keeping growth strong even while managing the many problems the growth process has created. Gusting winds from abroad have now exposed many of these tensions and threaten to bring the act crashing down.

A more aggressive push for reforms is needed to help secure short-term growth while improving future prospects and reducing risks. Not moving forward on these reforms may be the biggest risk of all.

Authors

Eswar Prasad

Publication: The New York Times

Image Source: © Darley Shen / Reuters

The Downside of Renminbi Flexibility

Eswar Prasad and Karim Foda — Thu, 16 Aug 2012 10:27:00 -0400

The renminbi has become more flexible but, in light of global financial market turmoil and concerns about China’s growth, the notion that the renminbi can only go in one direction has been repudiated.

Greater flexibility of the renminbi should serve China well, but could prove to be a mixed blessing in the short run for China’s major trading partners.

In view of the economic slowdown and the upcoming leadership transition, the Chinese government is likely to do what it can to keep the renminbi’s value reasonably stable relative to the dollar. An appreciation would hurt export growth, which is already weak, while a significant depreciation could suggest a loss of economic control and sharpen concerns about China’s growth prospects.

The FT China currency tracker summarises the twists and turns in the renminbi’s fluctuations relative to the currencies of China’s major trading partners.

Over the past 12 months, the renminbi has appreciated by just 1 per cent relative to the US dollar, although the renminbi-dollar rate has fluctuated significantly in both directions over this period. The dollar’s strength during a period of continued global financial turmoil has resulted in the renminbi’s appreciation against the currencies of virtually all of China’s major trading partners.

On a trade-weighted basis, the renminbi has appreciated by about 8 per cent over the past year in both nominal and inflation-adjusted (real) terms relative to the currencies of a broad group of China’s major trading partners.

Despite the much higher inflation rates in Brazil and India compared to China, the weaknesses of the real and rupee over the past year have resulted in the renminbi’s sharp appreciation relative to those currencies even in inflation-adjusted terms (19 per cent versus the rupee; 30 per cent versus the real).

More troubling for China is that the renminbi has appreciated by about 17 per cent relative to the euro over the past year. The EU is the leading market for China’s exports. The eurozone’s economic weakness coupled with the renminbi’s appreciation relative to the euro will continue to dampen prospects for China’s export growth.

Since the beginning of 2012, and especially since the widening of the floating band in April, the renminbi has shown some flexibility in both directions. On a broad trade-weighted basis, the renminbi has appreciated by about 1.6 per cent relative to the currencies of its major trading partners (0.9 per cent in inflation-adjusted terms).

Interestingly, the renminbi has depreciated by about 1 per cent relative to the US dollar, in both nominal and inflation-adjusted terms, since the beginning of this year. This probably reflects weaker capital inflows due to concerns about the Chinese economy and global economic uncertainties, as well as greater outflows as China continues to open up its capital account and reduce outflow restrictions. The renminbi has, however, continued to appreciate sharply relative to the euro.

During 2012, the renminbi has appreciated in both nominal and real terms relative to the currencies of some its major Asian trading partners such as Korea, Malaysia and Singapore. The falling Indian rupee has resulted in a sharp nominal appreciation of the renminbi relative to that currency. However, the much higher inflation rate in India relative to China implies that, in inflation-adjusted terms, the renminbi has in fact depreciated against the rupee.

The prognosis for the renminbi’s value over the remainder of this year is one of stability relative to the dollar and a rollercoaster ride relative to other currencies, in tandem with the dollar’s fluctuations against other major currencies.

Of course, whether concerns about the US economy or global financial turmoil will push the dollar up or down is anyone’s guess.

Authors

Eswar Prasad
Karim Foda

Publication: Financial Times

Image Source: © Stringer China / Reuters

Renminbi Flexibility, Not Price, Should Be the West’s Concern

Eswar Prasad — Tue, 01 May 2012 12:58:00 -0400

The political pressure for China to allow for more currency appreciation remains strong even as the economic pressure on China’s currency to appreciate in value has temporarily dissipated. Liberalising China’s currency regime is now less about correcting external imbalances than it is about helping to deal with domestic imbalances and promoting the currency’s international use.

Popular discussion about the renminbi tends to focus on its nominal value relative to the US dollar, which has been managed tightly on a day-to-day basis by China’s central bank. Extensive intervention by the central bank to prevent China’s currency from appreciating too rapidly has resulted in an eye-popping $3.3tn in foreign exchange reserves.

Despite this extensive intervention, on a cumulative basis the renminbi has in fact appreciated considerably against the dollar in recent years, especially when adjusted for inflation in China versus the US. The renminbi has also appreciated against the currencies of most of its major trading partners.

The real exchange rate is a better measure of a country’s external competitiveness as it accounts for domestic inflation relative to foreign inflation. The real effective exchange rate (REER), a composite measure that weights bilateral real exchange rates against each of China’s major trading partners by their shares in China’s total trade, provides a broader view of the country’s external competitiveness.

An interactive graphic on the FT website shows how the renminbi’s real effective exchange rate and also real exchange rates versus the currencies of China’s main trading partners have fluctuated over time. Since 2000, just prior to China’s WTO accession, its REER has appreciated by about 20 per cent. China experienced a bout of deflation around 2002-03 and its REER actually depreciated from 2003 through 2005. The REER has appreciated by 30 per cent since June 2005, when China de-pegged its currency from the dollar. Over the past year, the REER has appreciated by 5 per cent.

Since 2000, the renminbi’s real exchange rate has appreciated significantly versus Japan, the UK and the US, appreciated modestly relative to Germany, and stayed almost unchanged relative to the euro. One would expect eurozone countries to be a lot more critical than the US about China’s currency regime! The renminbi has depreciated significantly relative to the Australian dollar, Indian rupee and Brazilian real, mostly because of higher inflation in those countries.

Over the past year, the renminbi has appreciated in both nominal and real terms relative to all of its trading partners. The real appreciation ranges from 15 per cent versus the Brazilian real, 12 per cent versus the euro, 5 per cent versus the US dollar to 2 per cent versus the Singapore dollar. This renminbi appreciation says nothing about whether or not the renminbi is at its “equilibrium” market-determined value. The following data should make it harder to support the case that Chinese intervention in the foreign exchange market is perpetuating undervaluation of the renminbi in the short run:

The current account surplus has declined steadily from a surplus of 10.1 per cent of GDP in 2007 to 2.8 per cent in 2011.
The trade surplus fell from its peak of 7.5 per cent of GDP in 2007 to 2.1 per cent in 2011, and was essentially zero in January-February 2012.
Capital inflows have slowed down while capital outflows have picked up as controls on outflows continue to be liberalised.
There was no net accumulation of reserves in the last half of 2011, a sharp fall from accumulation of $150-200bn per quarter in the preceding four quarters.

It is an open question how much of the decline in China’s trade and current account surpluses is purely cyclical, reflecting global financial turmoil and strong growth in China while its major advanced economy markets remain weak. Indeed, as world financial markets stabilised in the first quarter of 2012, reserve accumulation bounced back to $124bn.

Over the long term, the renminbi is likely to appreciate further. Long-term exchange rate movements tend to be driven by productivity differentials and China is expected to continue delivering higher productivity growth relative to its trading partners, especially the advanced economies.

China’s central bank recently announced a significant step in the road towards greater exchange rate flexibility ‑ a widening of the trading band for the renminbi relative to the dollar. The benefits of currency flexibility are well recognised: It would help China develop a more independent monetary policy; its central bank could set interest rates to meet domestic objectives, rather than being driven by concerns over inflows or outflows of foreign capital due to differences between domestic and foreign interest rates. This would help promote financial sector reforms by allowing the central bank to use interest rates to guide credit allocation. In turn, the reforms would help rebalance growth by boosting domestic consumption.

If China is serious about making the renminbi a powerhouse global currency, liberalising its currency regime is a prerequisite. A more flexible currency is an important step on the path to an open capital account, as well as broader and stronger financial markets.

Focusing on flexibility of the currency rather than a “desirable” level of the renminbi is a more productive approach for the US and the international community to engage with China on the currency issue. And one that Chinese policymakers ought to take to heart as being in their own interest.

Authors

Eswar Prasad

Publication: FT.com

Image Source: Petar Kujundzic / Reuters

Structural Reforms and China’s Economy

Tue, 01 May 2012 14:00:00 -0400

Event Information

May 1, 2012
2:00 PM - 5:00 PM EDT

Falk Auditorium
The Brookings Institution
1775 Massachusetts Ave., NW
Washington, DC

The rapid pace of economic development in China over the last 30 years has begun to expose a new set of economic and social challenges. To deal with these challenges, China’s leaders will need to employ a new set of policy tools that may be very different from what has been successful in the past. In addition, China’s leaders must adapt to the growing influence of a broad array of non-state actors. Making these adjustments in the midst of a major transition of China’s political leadership will be no small task.

On May 1, the John L. Thornton China Center at Brookings and Caixin Media hosted a conference examining China’s major economic policy challenges, the substance of economic reform measures and the issues concerning their implementation. The first panel examined the reforms China should adopt to avoid the middle-income trap and the growing role of civil society in encouraging economic reforms. The second panel focused on the priorities for significant structural adjustments to address key issues such rising labor costs, low household consumption, rapid urbanization, inefficient domestic investment, and international competition.

Transcript

Event Materials

Participants

Panelists

Chen Zhiwu

Professor of Finance
Yale School of Management

Vikram Nehru

Senior Associate, Asia Program and Bakrie Chair in Southeast Asian Studies
Carnegie Endowment for International Peace

Zhou Wenzhong

Secretary General
Boao Forum for Asia

Moderator: Hu Shuli

Editor-in-Chief
Caixin Media

Barry Naughton

Professor of Chinese Economy and So Kwanlok Chair of Chinese International Affairs, University of California, San Diego
Nonresident Senior Fellow, The Brookings Institution

Wang Tao

Chief Economist
UBS Securities

Zhang Lanlan

Managing Director
CICC US Securities, Inc.

Tracking China’s Currency Ahead of the U.S.-China Strategic & Economic Dialogue

Eswar Prasad and Karim Foda — Tue, 01 May 2012 09:15:00 -0400

The political pressure for China to allow for more currency appreciation remains strong even as the economic pressure on China’s currency to appreciate in value has temporarily dissipated. Liberalizing China’s currency regime is now less about correcting external imbalances than it is about helping to deal with domestic imbalances and promoting the currency’s international use.

View the interactive at FT.com »

As the U.S.-China Strategic and Economic Dialogue begins this week, it is important to remember that the renminbi has in fact appreciated considerably against the dollar in recent years, especially when adjusted for inflation in China versus the U.S., as recently highlighted by U.S. Treasury Secretary Timothy Geithner at Brookings. It has also appreciated against the currencies of most of its major trading partners.

The interactive feature China Currency Tracker at FT.com shows changes in the present value of the renminbi (as of March 2012) relative to four reference points: January 2000, just prior to China's WTO accession; June 2005, when China depegged its currency from the U.S. dollar; May 2010, when China again depegged its currency (after repegging it to the dollar during the global financial crisis); and March 2011, one year ago.

These changes are tracked not just for the U.S., but also China’s most important trading partners. Country by country, the China Currency Tracker illustrates the performance of the reniminbi in real and nominal terms.

Since 2000, the renminbi has appreciated in real terms significantly versus Japan, the U.K. and the U.S., appreciated modestly relative to Germany, and stayed almost unchanged relative to the euro. The renminbi has depreciated significantly relative to the Australian dollar, Indian rupee and Brazilian real, primarily due to higher inflation in those countries compared to China.

Over the past year, the renminbi has appreciated in both nominal and real terms relative to all of its trading partners.

On the policy front, China’s central bank recently announced a significant step in the road toward greater exchange rate flexibility— a widening of the trading band for the renminbi relative to the U.S. dollar. A more flexible currency is an important step on the path to an open capital account, and liberalizing its currency regime is a prerequisite if China is serious about making the renminbi a powerhouse global currency.

Increasing exchange rate flexibility will help promote the balance and sustainability of China’s economic development as well as the renminbi’s role in the global monetary system. Focusing on flexibility of the currency rather than a “desirable” level of the renminbi is a more productive approach for the U.S. and the international community to engage with China on the currency issue. And one that Chinese policymakers ought to take to heart as being in their own interest.

Authors

Eswar Prasad
Karim Foda

The Right Time for China to Liberalize the Renminbi

Eswar Prasad — Mon, 26 Mar 2012 09:48:00 -0400

The Obama administration has raised the stakes in its increasingly tense stand-off with Beijing on trade and currency issues. It has set up a new agency to investigate China’s trade practices and, along with Japan and the European Union, recently initiated a process through the World Trade Organisation to challenge the restrictions that China places on exports of rare earth minerals.

Despite the improving employment picture in the U.S., the economic and political arguments for taking a tougher line against China in an election year are overriding longer-term strategic considerations. With China in the throes of its own leadership transition, the situation is ripe for an escalating trade conflict that could damage the global trade system and wreck the fragile world economic recovery.

There is a simple solution for Beijing to disarm its critics, make progress on its own domestic reforms and show the kind of leadership that would help cement its role as a global economic power.

This is a perfect time for China to move towards a more flexible currency regime by announcing a wider trading band for the renminbi. The benefits of currency flexibility are well recognised, including by its central bank.

The shift in currency regime would help China develop a more independent monetary policy. Its central bank could set interest rates to meet domestic objectives, rather than being constrained by fears it might be swamped by flows of foreign capital responding to differences in interest rates. This would help promote financial sector reforms by allowing the central bank to use interest rates to guide credit allocation. In turn, the reforms would help rebalance growth by boosting domestic consumption.

China has been hesitant about widening the renminbi’s trading band because of the worries over surges of speculative inflows, which would result in severe appreciation pressures on the renminbi. Such forces could be offset by intervening in the foreign exchange market, but it would be at the cost of further complicating domestic monetary policy and adding to its large stockpile of reserves.

But in recent months, pressures for renminbi appreciation have eased, creating an opportunity to make headway on currency policy. China’s strong economy has kept import growth high, yet export growth has slowed as a result of weaknesses in the major advanced economies. Over the past two months, China recorded a small trade deficit, a reversal from the large surpluses of recent years.

As in other emerging markets, the flight to safety as the eurozone debt crisis drags on has diminished capital inflows, resulting in virtually no net accumulation of reserves in the second half of last year.

All signs suggest that markets anticipate little or no appreciation of the renminbi over the next year, an expectation that is unlikely to be drastically altered by a shift to a more flexible currency regime.

These favourable conditions for a shift in policy may not last long. China needs to grab this opportunity before resurgent trade surpluses or capital inflows again induce the renminbi to resume its appreciation.

However, selling the move domestically will be tricky because it could be seen as yielding to external forces. During a time of leadership transition, it will be even more difficult. How can China’s leaders present this change in policy to a very sceptical audience?

There’s a simple answer, one that even the People’s Bank of China recently endorsed in a paper by one of its staffers. A more flexible currency is an important step on the path to an open capital account, as well as stronger and broader financial markets. In other words, this shift would serve China well in the process of making its currency more widely accepted internationally.

The notion of making the renminbi a powerhouse global currency ought to resonate well with nationalistic sentiments and help blunt domestic opposition to currency reform.

Timing is everything in global finance and politics. China has a perfect opportunity to sharpen its macroeconomic policy tools, promote its own balanced economic development, elevate the global stature of its currency and help avert a trade war that nobody wants.

Authors

Eswar Prasad

Publication: Financial Times

Challenges and Opportunities for a Growing China

Mon, 26 Mar 2012 14:00:00 -0400

Event Information

March 26, 2012
2:00 PM - 5:00 PM EDT

School of Public Policy and Management Auditorium
Brookings-Tsinghua Center

Beijing, China

On March 26 the Brookings-Tsinghua Center, a joint venture of Tsinghua University and the Brookings Institution, hosted a public forum exploring the challenges and opportunities that China will face in the next five years.

In the first panel, speakers discussed the opportunities and challenges that China faces in its continued economic growth and social transformations. In the second panel, speakers explored the impact of China’s rapid growth on regional and global dynamics and outline challenges and opportunities for China’s foreign policy.

Participants

Panelists

Zuo Xuejin

Senior Research Fellow and Executive Vice President
Shanghai Academy of Social Sciences

Cui Liru

President
China Institutes of Contemporary International Relations

Yu Keping

Deputy Director
Central Compilation and Translation Bureau

Why Financial Reform is Crucial for China’s Growth

Arthur R. Kroeber — Mon, 19 Mar 2012 00:00:00 -0400

Editor's Note: In the coming decade, China’s economic growth is projected to slow from its long-run average annual rate of 10 percent, sustained over the past three decades. The imminent slowdown also reflects a variety of specific structural challenges. Arthur Kroeber argues that responding effectively to these challenges requires a broad set of reforms in the financial sector, fiscal policy, pricing of key factors such as land and energy which are now subject to extensive government manipulation, and the structure of markets.

In the coming decade, China’s economic growth will certainly slow from the long-run average annual rate of 10% sustained over the past three decades. In part this is a natural slowdown in an economy that is now quite large (around US$7 trillion at market exchange rates) and solidly middle-income (per capita GDP of about US$7,500, at purchasing power parity). Despite the certainty of this slowdown, China’s potential growth rate remains high: per-capita income is still far below the level at which incomes in the other major northeast Asian economies (Japan, South Korea and Taiwan) stopped converging with the US level; the per-capita capital stock remains low, suggesting the need for substantial more investment; and the supply of low-cost labor from the traditional agricultural sector has not yet been exhausted. All these factors suggest it should be quite possible for China to achieve average annual real GDP growth of at least 7% a year through 2020.[1]

But the imminent slowdown also reflects a variety of specific structural challenges which require active policy response. Inadequate policies could result in a failure of China to achieve its potential growth rate. Three of the most prominent structural challenges are a reversal of demographic trends from positive to negative; a substantial secular decline in the contribution of exports to growth; and the very rapid increase in credit created by the 2009-10 stimulus program, which almost certainly led to a substantial reduction of the return on capital. Responding effectively to these challenges requires a broad set of reforms in the financial sector, fiscal policy, pricing of key factors such as land and energy which are now subject to extensive government manipulation, and the structure of markets. This paper will argue that financial sector reform is the best and most direct way to overcome these three major structural challenges.

1. China’s growth potential

There are several strong reasons to believe that China has the potential to sustain a fairly rapid rate of GDP growth for at least another decade. We define “fairly rapid” as real growth of 7% a year, which is a very high rate for an economy of China’s size (US$7 trillion), but substantially below the average growth rate since 1980, which has been approximately 10%.

The most general reason for this belief is that China’s economic growth model most closely approximates the successful “catch-up” growth model employed by its northeast Asian neighbors Japan, South Korea and Taiwan in the decades after World War II. The theory behind “catch-up” growth is simply that poor countries whose technological level is far from the global technological frontier can achieve substantial convergence with rich-country income levels by copying and diffusing imported technology. Achieving this catch-up growth requires extensive investments in enabling infrastructure and basic industry, and an industrial policy that focuses on promoting exports. The latter condition is important because a disciplined focus on exports forces companies to keep up with improvements in global technology; in effect, a vibrant export sector is one (and probably the most efficient) mechanism for importing technology.

A survey of 96 major economies from 1970 to 2008 shows that 14 achieved significant convergence growth, defined as an increase of at least 10 percentage points in per capita GDP relative to the United States (at purchasing power parity). Eight of these countries were on the periphery of Europe and so presumably benefited from the spillover effects of western Europe’s rapid growth after World War II, and from the integration of eastern and western Europe after 1990. The other six were Asian export-oriented economies: Japan, South Korea, Taiwan, Malaysia, Thailand and China. Most of these countries experienced a period of very rapid convergence with US income levels and then a sharp slowdown or leveling off. On average, rapid convergence growth ended when the country’s per capita GDP reached 55% of the US level. The northeast Asian economies that China most closely resembles were among the most successful: convergence growth in Japan, Taiwan and South Korea slowed at 90%, 60% and 50% of US per capita income respectively. In 2010 China’s per capita income was only 20% of the US level. Based on this comparative historical experience, it seems plausible that China could enjoy at least one more decade of relatively rapid growth, until its per capita income reaches 40% or more of the US level.[2]

So China’s growth potential is fairly clear. But realizing this potential is not automatic: it requires a constant process of structural reform to unlock labor productivity gains and improve the return on capital. The urgency of structural reform is particularly acute now. To understand why, we now examine three structural factors that are likely to exert a substantially negative effect on economic growth in coming years.

2. Challenges to growth

When considering China’s structural growth prospects, it is necessary to take account of at least three major challenges to growth. Over the past three decades, rapid economic growth has been supported by favorable demographics, a very strong contribution from exports, and a large increase in the stock of credit. The demographic trend is now starting to go into reverse, the export contribution to growth has slowed dramatically in the last few years, and the expansion of credit cannot be safely sustained for more than another year or two at most.

Demographics. From 1975 to 2010, China’s “dependency ratio”—the ratio of the presumably non-working (young people under the age of 15 and old people above the age of 64) to the presumably working (those aged 15-64) fell from approximately 0.8 to 0.4. Over the same period the “prime worker ratio”—the ratio of people aged 20-59 to those 60 and above—stayed roughly stable at above 5. Both of these ratios indicate that China’s economy enjoyed a very high ratio of workers to non-workers. This situation is favorable for economic growth, because it implies that with a relatively small number of dependent mouths to feed, workers can save a higher proportion of their incomes, and the resulting increase in aggregate national saving becomes available for investment in infrastructure and basic industry.

Over the next two decades, however, these demographic trends will reverse. The dependency ratio will rise, albeit slowly at first, and the prime worker ratio will decline sharply from 5 today to 2 in the early 2030s. These demographic shifts are likely to exert a drag on economic growth, for two reasons.

The first impact, which is already being felt, is a reduction in the supply of new entrants into the labor force—those aged 15-24. This cohort has fluctuated between 200m and 230m since the early 1990s, and in 2010 it stood at the upper end of that range. By 2023 it will have fallen by one-third, to 150m, a far lower figure than at any point since China began economic reforms in 1978. Because the supply of new workers is falling relative to demand for labor, wage growth is likely to accelerate above the rate of labor productivity growth, which appears to be in decline from the very high levels achieved in 2000-2010. As a result, unit labor costs will start to rise (a trend already in evidence in the manufacturing sector since 2004) and inflationary pressures will build. In order to keep inflation at a socially acceptable level, the government will be forced to tighten monetary policy and reduce the trend rate of economic growth.

The second impact will be the large increase in the population of retirees relative to the number of workers available to support them. This is the effect described by the prime worker ratio, which currently shows that there are five people of prime working age for every person of likely retirement age. As this ratio declines, the overall productivity of the economy slows, and the health and pension costs of supporting an aging population rise. The combination of these two effects can contribute to a dramatic slowdown in economic growth: during the period when Japan’s prime worker ratio fell from 5 to 2 (1970-2005), the trend GDP growth rate fell from 8% to under 2% (though demographics, of course, does not explain all of this decline). Over the next 20 years China’s prime worker ratio will decline by exactly the same amount as Japan’s did from 1970-2005.

Export challenge. Another element of China’s extraordinary growth was its rapidly growing export sector. Exports are a crucial component of catch-up growth in poor economies because, as explained above, they act as a vector of technology transfer: in order to remain globally competitive, exporters must continually upgrade their technology (including their processes and management systems) to keep up with the continuous advance of the global technological frontier.

Precisely measuring the impact of exports on economic growth is tricky, because what matters is not headline export value (which contains contributions from imported components and materials), but the domestic value added content of exports. In addition, a dynamic export sector is likely to have indirect impacts on the domestic economy through the wages paid to workers, the long-run effect of technological upgrading and so on. If we ignore these second-round impacts and focus simply on the direct contribution to GDP growth of domestic value added in exports, we find that exports contributed 4.6 percentage points to GDP growth on average in 2003-07. In other words, exports accounted for about 40% of economic growth during that period.[3]

Such a high export contribution to growth is on its face unsustainable for a large continental economy like China’s, and in fact the export contribution has slowed substantially since the 2008 global financial crisis. In 2008-11 the average contribution of export value added to GDP growth was just 1.5 percentage points – about one-third the 2003-07 average. It is likely that the export contribution to growth will fall even further in coming years.

Credit challenge. China responded to the global financial crisis with a very large economic stimulus program which was financed by a large increase in the credit stock. The ratio of non-financial credit (borrowing by government, households and non-financial corporations) rose from 160% in 2008 to over 200% in 2011. While the overall credit/GDP ratio remains lower than the 250% that is typical for OECD nations, a rapid increase in the credit stock in a short period of time, regardless of the level, is frequently associated with financial crisis. In China’s case, it is evident that the majority of the increase in the credit stock reflects borrowing by local governments to finance infrastructure projects which are likely to produce economic benefit in the long run but which in many cases will result in immediate financial losses.[4] To avert a potential banking sector crisis, therefore, it would be prudent for government policy to target first a stabilization and then a decline in the credit/GDP ratio.

The good news is that China has recent experience of deflating a credit bubble. In the five years after the Asian financial crisis (1998-2003), the credit/GDP ratio rose by 40 percentage points (the same amount as in 2008-11) as the government financed infrastructure spending to offset the impact of the crisis. Over the next five years (2003-08), the credit/GDP ratio fell by 20 points, as nominal GDP growth (17% a year on average) outstripped the annual growth in credit (15%). This experience suggests that, in principle, it should be possible to reduce the annual growth in credit significantly without torpedoing economic growth.

The bad news is that the 2003-08 deleveraging occurred within the context of the extremely favorable demographics, and unusually robust export growth that we have just described. Not only are these conditions unlikely to be repeated in the coming decade, both these factors are likely to exert a drag on GDP growth. Given this backdrop, any reduction in the rate of credit growth must be accompanied by extensive measures to ensure that the productivity of each yuan of credit issued is far higher than in the past.

3. The role of financial sector reform

The three growth challenges described above are diverse, but they are reflections of a single broader issue which is that China’s ability to maintain rapid growth mainly through the mobilization of factors (labor and capital) is decreasing. Much of the high-speed growth of the last decade derived from a rapid increase in labor productivity which was in turn a function of an extremely high investment rate: as the amount of capital per worker grew, the potential output of each worker grew correspondingly (“capital deepening”). But the investment rate, at nearly 49% of GDP in 2011, must surely be close to its peak, since it is already 10 percentage points higher than the maximum rates ever reached by Japan or South Korea. So the amount of labor productivity gain that can be achieved in future by simply adding volume to the capital stock must be far less than during the last decade, when the investment/GDP ratio rose by 10 percentage points.

The obvious corollary is that if China’s ability to achieve rapid gains in labor productivity and economic growth through mobilization of capital is declining, these gains must increasingly be achieved by improved capital efficiency. More specifically, the tightening of the labor supply implied by the demographic transition means that unit labor cost growth will accelerate; all things being equal this means that consumer price inflation will be structurally higher in the next decade than it was for most of the last. This in turn means that nominal interest rates will need to be higher. As the cost of capital rises, the average rate of return on capital must also increase; otherwise a larger share of projects will be loss-making and the drag on economic growth will become pronounced.

On the export side, the dramatic slowdown in the contribution to economic growth from exports means the loss of a certain amount of “easy” productivity gains. Greater productivity of domestic capital could help offset the deceleration in productivity growth from the external sector. Finally, as just noted, the need to arrest or reverse the rapid rise in the credit/GDP ratio means that over the next several years, a given amount of economic growth must be achieved with a smaller amount of credit than in the past—in other words, the average return on capital (for which credit here serves as a proxy) must rise.

Conceptually this is all fairly straightforward. The problem for policy makers is that measuring the “productivity of capital” on an economy-wide basis is not at all straightforward. In principle, one could measure the amount of new GDP created for each incremental increase in the capital stock (the incremental capital output ratio or ICOR). But in practice calculating ICOR is cumbersome, and depends heavily on various assumptions, such as the proper depreciation rate. Moreover, in an industrializing economy like China’s, the ratio of capital stock to GDP tends to rise over time and therefore the ICOR falls; this does not mean that the economy misallocates capital but simply that it experiences capital deepening. Sorting out efficiency effects from capital deepening effects is a vexing task.[5]

A more practical approach is simply to examine the ratio of credit to GDP. There is no one “right” level of credit to GDP, since different economies use different proportions of debt and equity finance. But the trends in the credit to GDP ratio in a single country (assuming there is no major shift in the relative importance of debt and equity finance), which are easily measured, can serve as a useful proxy for trends in the productivity of capital, and provide some broad guidelines for policy.

Figure 1 shows the ratio of total non-financial credit to GDP in China since 1998 (all figures are nominal). Total non-financial credit comprises bank loans, bonds, external foreign currency borrowing, and so-called “shadow financing” extended to the government, households and non-financial corporations; it excludes fund-raising by banks and other financial institutions. This measure is similar to the measure of “total social financing” recently introduced by the People’s Bank of China.

Figure 1

This shows, as noted previously, that the credit to GDP ratio rose sharply from 160% of GDP in 2008 to 200% in 2010. The current ratio is not abnormally high: many OECD countries have credit/GDP ratios of 250% or so, and Japan’s is around 350%. But it is obvious that the trend increase is worrying: if credit/GDP continues to rise at 20 percentage points a year then by 2015 it would hit 300%, a level much higher than is normal in healthy economies. It seems intuitively clear that to ensure financial stability, policy should target a stabilization or decline in the credit/GDP ratio. Success in this policy would imply that the productivity of credit, and capital more generally, improves.

The large increase in the credit/GDP ratio in 2008-10 is not unprecedented. Following the Asian financial crisis of 1997-98, the total credit stock rose from 143% of GDP in 1998 to 186% in 2003, an increase of 43 percentage points in five years, as a result of government spending on infrastructure and the creation of new consumer lending markets (notably home mortgages). During this period the credit stock grew at an average annual rate of 15.9%, but nominal GDP grew at just 10% a year.

Over the next five years, 2004-08, the average annual growth in total credit decelerated only slightly, to 14.8%. But thanks to a gigantic surge in productivity growth—caused by a combination of the delayed effect of infrastructure spending, deep market reforms (such as the restructuring of the state owned enterprise sector), and a boom in exports—nominal GDP growth surged to an average rate of 18.3%. As a consequence, the credit/GDP ratio declined to 160% in 2008, a decline of 26 percentage points from the peak five years earlier.

This experience shows that, in a developing country like China, it is quite possible to deflate a credit bubble relatively quickly and painlessly. To do so, however, two conditions must be met: the projects financed during the credit bubble must, in the main, be economically productive in the long run even if they cause financial losses in the short run; and structural reforms must accompany or quickly follow the credit expansion, in order to unlock the productivity growth that will enable deleveraging through rapid economic growth rather than through a painful recession. These conditions were clearly met during the 1998-2008 period: the expanded credit of the first five years mainly went to economically useful infrastructure such as highways, telecoms networks and port facilities; and deep structural reforms improved the efficiency of the state sector, expanded opportunities for the private sector, and created a new private housing market. This combination of infrastructure and reforms helped lay the groundwork for the turbo-charged growth of 2004-08.

The credit expansion of 2008-10, following the global financial crisis, was about the same magnitude as the credit expansion of a decade earlier: the credit/GDP ratio rose 40 percentage points, from 160% to 200%. But the expansion was much more rapid (occurring over two years instead of five), and while the bulk of credit probably did finance economically productive infrastructure, there is evidence that the sheer speed of the credit expansion led to far greater financial losses. A large proportion of the new borrowing was done by local government window corporations, often with little or no collateral and in many cases with no likelihood of project cash flows ever being large enough to service the loans. A plausible estimate of eventual losses on these loans to local governments is Rmb2-3 trn, or 4-7% of 2011 GDP.

Furthermore, whereas in the late 1990s restructuring of the state enterprise sector and creation of the private housing market took off at the same time the government began to expand credit, the 2008-10 credit expansion occurred without any significant accompanying structural reforms. In sum we have significantly less reason to be confident about the foundations for economic growth over the next five years than would have been the case in 2003.

On the assumption that the trend rate of nominal GDP growth over the next five years is likely be quite a bit less than in 2003-08, just how difficult will it be for China to stabilize or better yet reduce the credit to GDP ratio? For the purposes of analysis, Figure 1 proposes two scenarios. Both assume that nominal GDP will grow at an average rate of 13% in 2012-2015 (combining real growth of 7.5% a year with economy-wide inflation of 5.5%). The “stabilization” scenario assumes that total credit grows at the same 13% rate, stabilizing the credit/GDP ratio at around 200%. The “deleveraging” scenario assumes that credit growth falls to 9.5% a year, enabling a reduction in the credit/GDP ratio of 25 percentage points to 175%--about the same magnitude as the reduction of 2003-08.

A quick glance suggests that achieving either of these two outcomes will be far more difficult than in the previous deleveraging episode. In 2003-08, the average annual rate of credit growth was just one percentage point lower than during the credit bubble of 1998-2003. In other words, the work of deleveraging was accomplished almost entirely through economic growth, rather than through any material constraint on credit.

In the three years following the global financial crisis, by contrast, total credit expanded by 22.7% a year, generating nominal GDP growth of 14.1% on average. The required drop in average annual credit growth is 10 percentage points under the stabilization scenario and 13 points under the deleveraging scenario, while nominal GDP growth declines by only a point. In other words, this episode is likely to be the reverse of the 2003-08 episode: deleveraging will need to come almost entirely from a constraint on credit, rather than from economic growth.

Figure 2

Another way of looking at this is to examine the relationship between incremental credit and incremental GDP—that is, how many yuan of new GDP arise with each new yuan of credit. This calculation is presented in Figure 2. This shows that in 1998-2003 each Rmb1 of new credit generated Rmb0.39 of new GDP; this figure rose to 0.72 in 2003-08, an 84% increase in the productivity of credit. The GDP payoff from new credit in 2008-10 was far worse than in 1998-2003. Simply to stabilize the credit/GDP ratio at its current level will require a 73% increase in credit productivity. To achieve the deleveraging scenario, a 150% improvement will be required.

The good news is that under the deleveraging scenario, the average productivity of credit in 2011-2015 only needs to be the same as it was in 2003-08. In principle, this should be achievable. But as previously noted, the mechanism of improvement needs to be quite different this time round. In 2003-08, the productivity of credit rose because credit growth remained roughly constant while GDP growth surged, thanks to structural reforms that accelerated returns to both capital and labor. Over the next several years, by contrast, the best that can be hoped for is that GDP growth will remain roughly constant. Consequently any improvement in credit productivity must come from constraining the issuance of new credit, while substantially raising the efficiency of credit allocation and hence the returns to credit.

What are the main mechanisms for improving the efficiency of credit, and of financial capital more generally? Broadly speaking, there are two: diversification of credit channels, and more market-based pricing of credit. Historically most credit has been issued by large state-owned banks, which are subject to political pressure in their lending decisions, and the majority of credit has gone to state-owned enterprises. Diversifying the channels of credit to include a broader range of financial institutions, a more vigorous bond market, and even by encouraging the creation of dedicated small- and medium-size enterprise lending units within the big banks, should improve credit allocation by giving greater credit access to borrowers who were previously shut out simply by virtue of a lack of political connections. Over the past decade government policy has been broadly supportive of the diversification of credit channels: specialized consumer credit, leasing and trust companies have been allowed to flourish, and there is some anecdotal evidence that SME lending at the state owned banks has begun to pick up steam.

The government has been far more reluctant, however, to embrace systematic measures for improving the pricing of credit. Bank interest rates remain captive to the policy of regulated deposit rates. Guaranteed low deposit rates means that banks have little incentive to seek out and properly price riskier assets, and are content to earn a fat spread on relatively conservative loan books. Bond markets, which in more developed economies form the basis for pricing of financial risk, are in China large in primary issuance, but small in trading volumes. The majority of bonds are purchased by banks and other financial institutions and held to maturity, make them indistinguishable from bank loans. Active secondary market trading by a wide range of participants is the essential mechanism by which bond prices become the basis for financial risk pricing.

4. Conclusions and recommendations

China still has potential for another decade of relatively high speed growth, but a combination of structural factors means that “high speed” in future likely means a trend GDP growth rate of around 7%, well below the historic average of 10%. Moreover, a combination of negative trends in demographics and the external sector, and the need to constrain credit growth after the enormous credit expansion of 2008-2010, mean the obstacles to realizing this potential growth rate are quite large. In order to overcome these obstacles, the efficiency of credit, and of capital more generally, must be improved. A large increase in credit efficiency was achieved in the previous economic deleveraging episode of 2003-08, but that increase in efficiency resulted mainly from an acceleration in GDP growth due to capital deepening, rather than from a constraint on credit. Over the next several years, the best that can plausibly be achieved is a stabilization of nominal GDP growth at approximately the current level. Any increase in credit efficiency must therefore come from a constraint on credit growth and direct improvements in credit allocation, rather than from capital-intensive economic growth.

In order to achieve this improvement in credit efficiency, three improvements to China’s financial architecture are urgently needed. First, the diversification of financial channels should continue to be expanded, notably through the acceptance and proper regulation of so-called “shadow financing” activities, which reflect market pressure for higher returns to depositors and greater credit availability (at appropriate prices) for riskier borrowers. Second, the ceiling on bank deposit rates should gradually be lifted and ultimately abolished, in order to give banks incentives for increased lending at appropriate prices to riskier borrowers who (it is to be hoped) will deliver a higher risk-adjusted rate of return than current borrowers. Third, steps should be taken to increase secondary trading on bond markets, in order to enable these markets to assume their appropriate role as the basis of financial risk pricing. Particular stress should be laid on diversifying the universe of financial institutions permitted to trade on bond markets, to include pension funds, specialized fixed-income mutual funds and other institutional investors with a vested interest in active trading to maximize both short- and long-term returns.

[1] This paper draws heavily on detailed work on China’s long-term growth prospects, capital stock and debt by my colleagues at GK Dragonomics, Andrew Batson and Janet Zhang.

[2] Andrew Batson, “Is China heading for the middle-income trap?” GK Dragonomics research note, September 6, 2011.

[3] Janet Zhang, “How important are exports to China’s economy?” GK Dragonomics research note, forthcoming, March 2012

[4] Andrew Batson and Janet Zhang, “What is to be done? China’s debt challenge,” GK Dragonomics research note, December 8, 2011

[5] Andrew Batson and Janet Zhang, “The great rebalancing (I) – does China invest too much?” GK Dragonomics research note, September 14, 2011.

Authors

Arthur R. Kroeber

Will the Renminbi Rule?

Eswar Prasad and Lei Ye — Thu, 01 Mar 2012 16:51:00 -0500

The Chinese economy is now the world’s second largest and a key driver of global growth. It amounts to between 10 percent and 15 percent of world GDP (depending on how it is measured) and, in 2011, accounted for about one-quarter of world GDP growth. But among the currencies of the six largest economies in the world, China’s renminbi is the only one that is not traded easily and accepted worldwide—that is, it is not a hard currency.

China’s government has taken steps recently to promote the international use of the renminbi, even though it has not been willing to open up its economy to the free flow of capital and allow its exchange rate to be flexible. Nevertheless, given the sheer size of China’s economy and its rising shares of global output and trade, these steps portend a rising role for the renminbi in international finance and trade. But a compelling question is whether the renminbi’s global stature will rise to match that of the Chinese economy—perhaps approaching the U.S. dollar.

The answer to that question depends on three related but distinct concepts about the currency:

Internationalization: its use in denominating and settling cross-border trade and financial transactions—that is, as an international medium of exchange;
Capital account convertibility: how much a country restricts inflows and outflows of financial capital—a fully open capital account has no restrictions; and
Reserve currency: whether it is held by foreign central banks as protection against balance of payments crises.

A country’s currency can be used internationally even if its capital account is not fully open. And even in the absence of restrictions on capital flows, a country’s currency may be used little or not at all internationally. But both international use and an open capital account are necessary for a currency to become an international reserve currency.

This article evaluates the current state of and prospects for the renminbi in each of these three dimensions in terms of the balance and sustainability of China’s economic development and the associated implications for the global monetary system.

Becoming a reserve currency

Given China’s size and growth prospects, it is widely seen as inevitable that the renminbi will eventually become a reserve currency. To gauge the likelihood and timing, it is necessary to consider the typical attributes of a reserve currency and evaluate China’s progress in each of these dimensions. The factors that generally affect a currency’s reserve status include:

Economic size: A country’s GDP and its shares of global trade and finance are important, although not crucial, determinants of a country’s reserve currency status.
Macroeconomic policies: Investors in a country’s sovereign assets must have faith in the ability of its economic policies, especially its commitment to low inflation and sustainable public debt, to protect the value of the currency from erosion.
Flexible exchange rate: Reserve currencies are typically traded freely and their external value is market determined, although this does not entirely preclude central bank intervention in foreign exchange markets. An open capital account is not synonymous with a freely floating exchange rate.
Open capital account: Reserves must be acceptable as payments to a country’s trade and financial partners, which requires that the currency be easily tradable in global financial markets. This is difficult if a country imposes restrictions on capital flows and if its foreign exchange markets are thin and subject to the government’s direct control.
Financial market development: A country must have deep and liquid financial markets—that is, markets, especially in government bonds, with many buyers and sellers to provide “safe” assets that can be held by international investors and central banks from other countries. Turnover (trading volume) in these bond markets, which is a measure of liquidity, is also important.

There is no hard-and-fast rule that dictates which of these factors are important or even essential. For instance, the Swiss franc is a global reserve currency even though Switzerland’s shares of global GDP and trade are small. Moreover, many major reserve currency economies—the euro area, Japan, and the United States, for example—have large and rising public debt, which casts doubt on their macroeconomic stability but has not affected their currencies’ reserve status, at least so far. Some analysts have in fact extrapolated from the U.S. experience to argue that China will have to run large current account deficits if it wants to provide reserve assets to the rest of the world. But that is not the case. The currencies of Japan and Switzerland have achieved reserve status despite those countries’ consistent current account surpluses.

How the renminbi fits in

China’s size and importance in world trade are well known. It now accounts for 10 percent of global trade in goods, up from 4 percent a decade ago, and is extensively connected with other economies through trade linkages. Whether China’s fiscal and monetary policies anchor long-run inflation expectations and foster macroeconomic stability is an open question. China has a moderate level of explicit public debt and a small government budget deficit relative to the major reserve currency economies. Moreover, despite its tightly managed exchange rate, which has compromised the independence of monetary policy, China has had a relatively stable inflation rate in the recent past.

The next question is whether China is opening up its capital account. Although China still has extensive capital controls in place, they are being selectively and cautiously dismantled. As a result, gross inflows have risen sharply over the past decade, reflecting China’s attractiveness as a destination for foreign investment. Outflows other than foreign exchange reserves, including investments abroad by Chinese corporations and institutional investors such as pension funds, have also grown substantially, albeit from a low base. In short, China’s capital account is becoming increasingly open in actual terms, although even by this measure it remains less open than those of the reserve currency economies—the euro area, Japan, Switzerland, the United Kingdom, and the United States.

Financial market development in the home country is a crucial determinant of a currency’s international status. Historically, each reserve currency has risen to prominence under unique circumstances and spurred by differing motivations, but one constant is that this process has always required strong financial markets. The relevant aspects of financial market development include:

Breadth: the availability of a broad range of financial instruments, including markets for hedging risk;
Depth: a large volume of financial instruments in specific markets; and
Liquidity: a high level of turnover (trading volume).

Without a sufficiently large debt market, the renminbi cannot be credibly used in international transactions. If there is insufficient liquidity in markets for renminbi-denominated debt, the currency will not be attractive to foreign businesses. Both importers and exporters may be concerned about greater exchange rate volatility from an open capital account if they don’t have access to derivatives markets to hedge foreign exchange risk.

Where do things stand? China’s financial system remains bank dominated, with the government directly controlling most of the banking system. Total domestic credit provided by the banking sector outweighs the size of the equity and bond markets combined. The banking system’s size and structure, which protect banks’ profits by limiting competition, and regulatory barriers have stifled broader financial market development.

Debt markets in China lag far behind those of major reserve currency economies in size and liquidity. The government debt market is reasonably large in absolute terms but turnover is low. Turnover is relatively high in China’s corporate bond market, which is still small. Analyzing the shares of international debt securities according to the currencies of issuance reveals a similar picture. The existing reserve currencies dominate; only a paltry 0.1 percent of international debt is denominated in renminbi.

While the absolute size of the debt securities market in China is small from a cross-country perspective, it should not mask the rapid growth of these markets, which is consistent with the country’s intention to make the renminbi accepted as an international currency. Nevertheless, reserve currency status for the renminbi is probably a much longer-term goal.

One area in which China has made significant progress is in the development of equity markets. Following reforms in 2005, market capitalization and turnover surged and have grown sixfold, while trading volume has climbed more than tenfold. However, Chinese stock markets are highly volatile and prone to concerns about corporate governance, so they may be of limited help in promoting the renminbi’s role as an international currency.

The pace of internationalization of China’s currency depends on its use in international financial transactions, not just trade. Foreign exchange market turnover is a good indicator of a currency’s potential as a vehicle currency for transactions involving cross-border trade in goods and financial assets. Currently, the renminbi accounts for less than 1 percent of all turnover in foreign exchange markets in 2010, but that understates reality. China uses Hong Kong SAR as an important financial center for settling foreign exchange transactions, and in 2010, Hong Kong SAR accounted for 5 percent of global foreign exchange market turnover. Hong Kong SAR provides a useful platform that puts the renminbi on a competitive footing relative to other emerging market currencies in terms of reaching international currency status.

Most derivatives markets in China are still nascent, but three of its commodity futures exchanges are among the top 20 derivatives exchanges in the world as measured by the number of futures and options contracts traded. From the perspective of promoting international use of a currency, however, a large commodity derivatives market is not as useful as more diverse and liquid financial derivatives markets.

To some extent, policies that direct activity toward Hong Kong SAR are playing a role generally carried out by vibrant domestic financial markets. Both the amount of renminbi deposits and the number of institutions authorized to conduct renminbi business in Hong Kong SAR have risen sharply over the past year.

Policies to increase offshore renminbi use have effectively promoted its global role without risking the potentially deleterious effects of capital account liberalization. But the full potential of the Chinese currency’s international use cannot be realized without more active onshore development. Ultimately, it will be difficult to fully develop foreign exchange and derivatives markets without substantial capital account liberalization.

To sum up, there has been modest development of the breadth, depth, and liquidity of China’s financial markets over the past decade. But China still comes up short when it comes to the key dimensions of financial market development, and financial system weaknesses are likely to impede its steps to heighten the currency’s international role.

A rising international presence

Despite the weak financial infrastructure supporting it, the renminbi is gaining an international presence. China has been using Hong Kong SAR extensively as a testing ground for initiatives to promote the international use of the renminbi. Personal renminbi business was launched in Hong Kong SAR in 2004, when residents there were allowed to open deposit accounts denominated in renminbi. Other initiatives followed, such as cross-border settlement of trade transactions and renminbi bond issuance.

Given China’s rapidly expanding trade volume, promoting renminbi trade settlement is a logical first step toward the currency’s internationalization. Since it began in 2009, cross-border trade settlement in the Chinese currency has surged. In 2011, renminbi trade settlement amounted to about 8 percent of China’s total trade in goods and services. Monthly remittances of renminbi used for cross-border settlement in Hong Kong SAR rose to nearly $25 billion a month in 2011, more than double the 2010 average.

Issuance of renminbi-denominated bonds (known as dim sum bonds) in Hong Kong SAR is on the rise as well, tripling from 2007 to 2010 and hitting a high of about $10 billion in the second quarter of 2011. Fewer of these bonds were issued during the remainder of 2011, reflecting weaker global market conditions as the debt crisis in Europe continued to fester.

Another way to gauge offshore use of the renminbi is to look at transactions among banks. Such renminbi clearing transactions were virtually nonexistent until mid-2010, when financial institutions in Hong Kong SAR were allowed to open renminbi-denominated accounts. Since then, both the volume and value of transactions have increased dramatically. The total value of transactions hit a peak of more than $500 billion in August 2011.

Although still on a modest scale, the initiation and rapid expansion of various elements of the offshore renminbi market foretell the currency’s significant presence in trade and financial transactions in Asia. Some might argue, however, that dim sum bond issuance and cross-border settlement in renminbi are still narrow in scope, with most of the activity accounted for by Chinese mainland companies and their Hong Kong SAR subsidiaries. Some of this activity may also reflect attempts to circumvent capital controls. In short, even the influence of offshore renminbi use has some distance to go to reach its full potential.

On another front, China’s central bank is establishing and expanding local currency bilateral swap lines with other central banks around the world to facilitate and expand the use of the renminbi in international trade and financial transactions. The amounts of these bilateral agreements are small, but they indicate efforts to make other countries’ central banks comfortable and familiar with renminbi-denominated instruments and financial facilities.

The renminbi has also started to appear in a few central banks’ foreign exchange reserve portfolios. Malaysia and Nigeria first reported renminbi reserves in 2011. Chile’s central bank investment portfolio now has 0.3 percent of its assets in renminbi-denominated instruments. Other central banks are considering adding renminbi assets to their reserve portfolios. These holdings cannot in principle be counted as official reserves, given the renminbi’s lack of convertibility, but that does not seem to deter these central banks, which see renminbi-denominated assets—just like those of other major reserve currencies—as insurance against balance of payments pressures.

These moves are all modest in size but symbolically important in signaling the shift in perception about the renminbi’s stability and its future role in the international monetary system.

Taking on the dollar

Is the renminbi on a trajectory to usurp the U.S. dollar’s role as the dominant global reserve currency? Perhaps, but the day is a long way off. It is more likely that, over the next decade, the renminbi will evolve into a reserve currency that erodes but doesn’t end the dollar’s dominance.

About two-thirds of global foreign exchange reserves are now held in U.S. dollar–denominated financial instruments. Other indicators, such as the dollar’s shares of foreign exchange market turnover and cross-border foreign currency liabilities of non-U.S. banks, confirm the currency’s dominance in global finance. There are growing concerns about U.S. macroeconomic stability that might affect the dollar’s desirability. Although the U.S. central bank, the Federal Reserve, has strong worldwide credibility for its inflation-fighting credentials, rising public debt poses a serious concern. U.S. gross general government debt is about 90 percent of GDP, and IMF forecasts indicate that it could reach 110 percent of GDP, or nearly $21 trillion, by 2016. This is dangerous terrain for the world’s largest economy, but paradoxically—given the weaknesses in Japan and the euro area and emerging markets’ demand for so-called safe assets as they continue to accumulate foreign exchange reserves—rising U.S. debt may cement the dollar’s dominance in the global financial system.

Moreover, a gulf remains between China and the United States when it comes to the availability of safe and liquid assets such as government bonds. The depth, breadth, and liquidity of U.S. financial markets are unmatched. Rather than catching up to the United States by building up debt, the challenge for China is to develop its other financial markets and increase the availability of high-quality renminbi-denominated assets.

The renminbi is attaining more prominence in international trade and finance. While this importance is sure to grow, the renminbi is unlikely to become a prominent reserve currency—let alone challenge the dollar’s dominance—unless it can be freely converted and China adopts an open capital account. The challenge for the Chinese government is to back up its modest international policy actions with substantial domestic reforms. The renminbi’s prospects as a global currency will be shaped by a broader range of policies, especially those related to financial market development, exchange rate flexibility, and capital account liberalization. The path of China’s growth and the renminbi’s role in the global economy will depend on those policy choices.

Authors

Eswar Prasad
Lei Ye

Publication: Finance and Development

The Chinese Renminbi's Prospects as a Global Reserve Currency

Eswar Prasad and Lei Ye — Thu, 16 Feb 2012 00:00:00 -0500

Popular discussions about the prospects of China’s currency — the renminbi — range from the view that it is on the threshold of becoming the dominant global reserve currency to the concern that rapid capital-account opening poses serious risks for China. A number of recent academic studies have pointed to the renminbi’s rising importance in the international monetary system, although these studies are divided on the renminbi’s prospects of becoming a dominant global reserve currency.

These are legitimate and important issues, as the rise of China’s economy and its currency have implications for global macroeconomic and financial stability. It is interesting that, of the currencies of the world’s six largest economies, China’s renminbi is the only one that is not a reserve currency. Even though the economy has neither a flexible exchange rate nor an open capital account, the Chinese government has recently taken a number of steps to increase the international use of the renminbi. Given China’s rising shares of global GDP and trade, these steps are gaining traction and signal a rising role for the renminbi in global trade and finance.

In recent research (Prasad and Ye 2011), we explore the prospect of the renminbi becoming a global reserve currency. The popular debate often conflates three related, but distinct, aspects of the renminbi’s role in the global monetary system:

Internationalisation: Its use in denominating and settling cross-border trade and financial transactions, that is, its use as an international medium of exchange.
Capital-account convertibility: The country’s level of restrictions on inflows and outflows of financial capital. A fully open capital account has no restrictions.
Reserve currency: Whether the renminbi is held by foreign central banks as protection against balance of payments crises.

Read the full article at Voxeu.org »

Authors

Eswar Prasad
Lei Ye

Publication: Voxeu.org