Thu, Jun 17, 2004 page8

• Yuan forex rate needs adjustment

  • By Tung Chen-yuan童振源
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  In recent months the Chinese government has tried administrative measures to rein in its overheated economy. These measures have included proposals that the central bank should strengthen credit management, restrict land development, increase the self-financing ratio for companies in overheated industries, attempt to terminate unreasonable investment projects, request that local governments control commodity prices and implement restrictions to slow expansion of the money supply and credit.

  But why doesn't China want to cool its overheated economy through traditional monetary policies, such as by raising interest rates or revaluing its currency?

  China does not want to raise interest rates for four reasons. First, the Chinese government worries that a sudden big cut in expenditures or an across-the-board increase in interest rates will affect the economic growth rate, leading to high unemployment and social instability. Late last year, registered urban unemployment reached 4.3 percent. According to official Chinese statistics, 29 million urban workers will need jobs this year. High economic growth is required to supply the job opportunities needed to meet the demands of such huge numbers of employment seekers.

  Second, industrial investment in China is seriously imbalanced -- some industries are overheated, yet for about 80 percent of products, supply exceeds demand. Raised interest rates will affect investment in every industry, which will bring serious deflation to some industries.

  Third, although fixed industrial investment in China grew by 43.5 percent in the first quarter, investment in agriculture, forestry, fisheries and livestock only increased by 0.4 percent, and even experienced negative growth in the first two months of this year.

  Increased interest rates will make it more difficult for agricultural industries to obtain loans, and this will aggravate problems for the agricultural sector, villages and farmers.

  China's current macroeconomic controls aim to both cool down and heat up different parts of the economy. This is far more difficult than simply cooling down the economy as a whole.

  Fourth, if the US government does not raise interest rates, the Chinese government may not be able to solve its problems by raising interest rates to slow credit expansion. The interest rate for one-year yuan deposits is 1.98 percent, while the interest rate for one-year US dollar deposits is 0.5625 percent, a difference of 1.4 percentage points. An increase in Chinese interest rates will attract more hot money in search of arbitrage profits, and that would increase the domestic money supply.

  Following China's adoption of several policies to cool down the economy in April, the fixed-asset investment growth rate for that month fell from 43.5 percent to 34.7 percent, industrial added value fell slightly from 19.4 percent in March to 19.1 percent in April, and new projects in April only increased by 5.9 percent year-on-year. These figures are evidence of the efficacy of the cooling-down policies.

  Although the problems of overheating and imbalance in the Chinese economy already have been somewhat alleviated, the overall trend remains unchanged. The increase in the consumer price index (CPI) grew from 3 percent in March to 3.8 percent in April, while growth of the broad money supply, M2, remained at 19.1 percent both in the first quarter and at the end of April.

  Last last month, Bank of China president Zhou Xiaochuan (周小川) and Li Yangjun (李揚均), a Monetary Policy Committee member, hinted that the Bank of China may raise interest rates if the CPI increases by 5 percent. It is not at all certain, however, that raising interest rates will solve the problem. It might even aggravate matters, including such things as increasing the imbalance in investments and leading to a continued increase in the money supply.

  For the time being, the yuan exchange rate remains the key issue. Merrill Lynch estimates that the yuan is undervalued by about 20 percent, that maintaining an essentially fixed exchange rate will lead to inflation growth in China by 2 percent to 3 percent annually, and that the aftereffects of the recent credit expansion may add another 1 percent to 2 percent to the inflation rate. That means that before the end of the year, China's inflation rate may reach as high as between 6.5 percent and 9.5 percent, or even into the double digits. That would force the Chinese government to face head-on the problems posed by an undervalued currency.

  Given the nominally fixed exchange rate, the Chinese government estimates that the 3.8 percent CPI increase, lowered import taxes and export tax refunds have caused the actual yuan exchange rate to increase by between 5 percent and 8 percent.

  During the first four months of this year, however, the amount of unexplained foreign exchange increased by 72.4 percent year-on-year, implying that China probably will not attract less international hot money this year than it did last year. This will put heavy pressure on the money supply.

  Clearly, foreign exchange markets have not understood China's assessment of the situation, but remain filled with expectations of a revaluation of the yuan. It therefore seems that if China wants to cool down the overheated economy and correct its imbalances, an appropriate adjustment of the exchange rate level and system is unavoidable.

  Tung Chen-yuan is an associate research fellow at the Institute of International Relations at National Chengchi University.

  TRANSLATED BY Perry Svensson
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