China's currency conundrum
- By Ronald McKinnon
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E-mail China Daily, April 18, 2014
However, in rapidly growing emerging markets, wages are often sufficiently flexible on the upside. For example, if an employer (particularly an exporter) fears future renminbi appreciation, he may hesitate to raise wages in line with productivity increases, in order to keep his costs under control. But if he can be confident that the exchange rate will remain stable, he will not need to restrain wages – and China has experienced 10-15% annual wage growth already. From higher wage growth at a stable nominal exchange rate, China's real international competitiveness would be better calibrated by encouraging unit labor costs to converge to those in developed economies.
As a result of policymakers' heavy focus on the exchange rate, China's State Administration of Foreign Exchange has now accumulated more than $4 trillion in reserves – far exceeding the amount needed to cover any imaginable currency emergency. Worse, the sterilization by the PBOC undermines its control of monetary policy. Buying dollars increases the domestic base money supply, risking inflation and asset-price bubbles.
Efforts to "sterilize" these purchases and dampen domestic credit expansion also have other adverse consequences. The PBOC frequently does this by selling bonds to commercial banks or raising their reserve requirements. But this has reduced these banks' effectiveness as financial intermediaries, while encouraging the rise of shadow banking to circumvent the restrictions.
What, then, are the PBOC's options? One approach might be simply to let the renminbi float without controls on capital inflows. Again, this would inevitably trigger hot-money inflows, as speculators take advantage of the spread between Chinese interest rates and the near-zero, short-term rates in developed economies, thereby driving up the renminbi further (and creating yet more opportunities for speculation). There would be no well-defined market equilibrium, or upper bound, for the dollar value of the renminbi.
Even without hot-money inflows, the renminbi's exchange rate would still face upward pressure, owing to the absence of net outflows of financial capital to balance China's trade (saving) surplus. As an immature international creditor, China would not be able to offset its trade surplus by making renminbi loans abroad. Nor would it want to make dollar-denominated loans. Private (non-State) banks, insurance companies, pension funds, and so on, have limited appetites for building up liquid dollar claims on foreigners when their own liabilities – deposits, insurance claims, and pension obligations – are in renminbi. The potential currency mismatch requires the PBOC to step in as the principal international financial intermediary by buying liquid dollar assets on a vast scale.
Moreover, foreign investors remain reluctant to borrow from Chinese banks in renminbi, or to issue renminbi-denominated bonds in Shanghai, especially if they fear continued outside political pressure to appreciate.
China is therefore caught in a currency trap because of its own saving surplus (American saving deficiency) and near-zero interest rates on dollar assets. If China tries to liberalize its financial markets, hot money finance flows the wrong way—into the economy rather than out. Although fully liberalizing China's domestic financial markets and "internationalizing" the renminbi some halcyon day may be possible, that day is far off. In the meantime, high-growth China best retains controls on inflows of financial capital while the PBOC intervenes to stabilize the yuan/dollar rate. Until conditions in the world economy improve substantially, China's policymakers will have no easy way out — but the economy can continue to grow.
Ronald McKinnon, Professor Emeritus of International Economics at Stanford University, is the author of The Unloved Dollar Standard: From Bretton Woods to the Rise of China.
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