Double-edged sword of RMB exchange rate stability
(China Daily)
Updated: 2004-10-19 09:08

Editor's note: Following is the fourth part of the article by Guo Shuqing, director of the State Administration of Foreign Exchange and deputy governor of the People's Bank of China. It deals with the relationship between the exchange rate, industrial structure and capital flows.

The exchange rate has a direct and noticeable impact on economic indicators like exports, the utilization of foreign investment and employment.

But the exchange rate does not have such a direct impact on the industrial structure, something which tends to be neglected by most people.

China still has serious industrial structure problems. The main ones are: tertiary industries lag far behind secondary industry in terms of their growth rate; exporting and importing sectors have grown fairly rapidly, but sectors providing products and services to them are growing at a much slower rate; coastal areas are experiencing rapid economic growth, but the pace of development is slow in the inland areas, among others.

These problems are not entirely a result of the exchange rate policy, but are related to the exchange rate mechanism to varying degrees.

An unchanged renminbi exchange rate staying unchanged for a long period of time reduces uncertainty and helps businesses plan ahead. But holding the renminbi exchange rate at a certain level is also likely to encourage the production and export of low value-added commodities and energy-hungry and highly polluting products such as coking coal.

Domestic businesses will also become insensitive to domestic and foreign market fluctuations, neglect technical and management innovations, brand building, marketing and after-sales services, with the resultant inadequate attention being paid to the technological content of their products, hampering their international competitiveness.

Exchange rate stability is conducive to China taking advantage of its relatively low labour costs, helping to create a stable industrial environment and strengthening the nation's role as a global manufacturing base.

But the prospects are not all rosy, as this situation can also have a negative impact on structural adjustment.

Exports requiring massive amounts of raw materials and energy get the upper hand in a situation where the exchange rate remains fixed for long periods of time, which led to massive amounts of poor quality and repetitive construction in the export sector.

Besides, the external sectors, especially the export sector and the foreign-invested enterprises, enjoy greater policy support, are more flexible in terms of international competition, use more advanced technologies and equipment, and have easier access to financial resources.

But sectors providing products and services to external sectors generally lag behind in those areas. Tertiary industries have long accounted for around 32 per cent of the domestic economy. The breakdown among primary, secondary and tertiary industries last year was 15:52:33, which compares with the global average of 5:31:64.

The service sector's pace of reform and opening has been noticeably slower than manufacturing industries.

This has led to the slow development of tertiary industries in China, a sector that is more capable of job creation, which led to the failure to meet consumers' increasingly diverse demands and the national economy's failure to create enough jobs.

Exchange rate stability created favourable conditions for externally oriented economies in coastal regions, but aggravated the geographical imbalance.

The nation's coastal areas opened up before the inland areas, leading to an earlier take-off in economic growth. But given the existing price elements of the interest rate, exchange rate, rents, wages, and taxes, the coastal areas lack the pressure and incentives required to upgrade their industrial structure and remain enthusiastic about export-oriented processing and low value-added production.

Although proposals to give a fillip to the nation's central and western regions were made a long time ago, substantial results have yet to be achieved. Coastal areas' share in national gross domestic product has continued to rise in recent years, and these eastern regions remain the prime target of foreign direct investment.

It is a quite unique phenomenon that the trend of geographical balance has not started to emerge after 25 years of rapid economic growth.

The structural imbalances and resource misallocation are long-term problems and cannot be solved by an aggregate expansion or contraction.

They should, instead, be solved by deepening economic reform and innovation. This should include reforms in the forex management system and exchange rate forming mechanism, although they are only a very small part of the effort.

Capital flows

The relationship between the exchange rate and cross-border capital flows is closer than that between the exchange rate and foreign trade. That is especially the case when it comes to short-term capital flows, which are not necessarily determined by real exchange rates, but driven by exchange rate expectations to a large extent.

China's international balance of payments is witnessing persistently huge surpluses, and foreign exchange reserves are rising rapidly. Net capital inflows are playing a growing role in that process.

China's current account surplus was US$45.9 billion last year, while the capital account came in at US$52.7 billion. Taking the recapitalization at pilot banks into account, last year's net capital account inflow was nearly US$100 billion, far outstripping the current account.

The role of net capital inflows is more evident this year. Given the foreign trade deficit, China's foreign exchange reserves are expected to increase by more than US$60 billion in the first half of this year (The State Administration of Foreign Exchange said last week China's forex reserves rose by US$67.4 billion in the first six months of this year Editor).

Given the market expectations of an appreciation in yuan and the fact that interest rates on renminbi are higher than US rates, domestic businesses and individuals, as well as overseas Chinese, tend to trim their foreign currency-denominated assets and increase foreign currency-denominated liabilities, speed up forex settlement, reduce forex purchases when making international payments, and make more use of their own forex.

But such asset liability adjustments are profit-driven and change easily. In the event of changes in exchange rate expectations and interest rate differentials, such funds may possibly reverse their direction and put opposite pressures on forex supply and demand as well as renminbi exchange rate.

We started to think about perfecting the renminbi exchange rate forming mechanism as early as the Asian financial crisis ended. But the changing market expectations and the existence of pressures from currency speculation have complicated the renminbi exchange rate reform.

If the floating range for renminbi exchange rate was broadened before 2001, it would likely have amplified depreciation expectations in the marketplace and increased the pressure of capital outflows. Expectations of appreciation will be increased if the exchange rate becomes more flexible, further stimulating the inflow of speculative capital.

Therefore, either an appreciation or a depreciation may overshoot, which risks turning exchange rate floating into excessive fluctuations.

International experience suggests that exchange rate fluctuations are harmful to developing countries, given their underdeveloped financial markets, a lack of hedging instruments and other reasons.

There is a major defect in the existing international financial system without a real lender of last resort, when a country is hit by financial crisis, nobody can help. Therefore, developing countries, including China, have to sacrifice interest rate flexibility and accumulate massive forex reserves to enhance their ability to withstand the impact of capital flows.

China's forex reserves, accumulated through trade surpluses and foreign direct investment, are mostly invested in developed financial markets, mainly the United States.

China's investments in US Treasuries now rank the second in the world, and its investments in US corporate bonds are at least second, if not the first. This plays an active role in financing the US fiscal deficit, promoting its financial markets, maintaining US interest rates at low levels and stabilizing the exchange rate of the dollar.

If things go wrong in China as a result of its exchange rate reform, it will inevitably affect financial market stability in developed countries.

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