China readies to pull the pegInterest rate prelude
On October 28, China raised interest rates for the first time in nine years - not exactly enthusiastically: the one-year lending and deposit rates went up just 27 basis points to 5.58% and 2.25%, respectively. The government and the People's Bank of China (PBoC) had long resisted the move. Selective credit controls and restrictions on lending to overheated sectors of the economy (property, autos, steel, cement, aluminum) seemed the better policies to curb over-investment.
One can't blame them. Unlike the 1993/94 overheating episode, which saw consumer price inflation climb to double digits on excess demand, the consumer price index (CPI) this time around has remained tame - 5.2% in September, dropping to 4.2% in October. What we are witnessing since last year is severe supply-side imbalances and infrastructure (energy, transport) bottlenecks caused by excessive investment in some, insufficient capital expenditure in others. The rationale for applying targeted administrative measures to restore equilibrium - for example, no new lending for steel projects, increased expenditure for power production - was that a catch-all interest-rate hike might lead to funding shortages precisely in areas where added investment was most needed.
Such cooling measures, applied with increasing severity over the course of the first half of this year, have had their effect. Since April, investment projects totaling some US$100 billion have been shut down. Funding for numerous others has been cut. As a result, overall growth of fixed asset investment slowed from over 50% year-on-year in the first quarter of 2004 to little more than half that pace in the third quarter. However, with real interest rates (lending rate minus CPI) near zero, a huge black credit market in the tens of billions of US dollars (by some estimates nearer US$100 billion) developed, circumvented the banking system and thwarted state controls. And this, of course, was further exacerbated as real deposit rates were deep in negative territory and savers saw their deposits dwindle in real terms.
Under the circumstances, financial authorities finally bit the bullet and decreed the rate hike that had become inevitable.
For well over a year now, massive foreign pressure has been exerted on China to revalue its currency, the yuan, which has been pegged to the US dollar at the 8.28 level since 1994. The US Treasury Department under Secretary John Snow has been the vociferous protagonist. But calls for yuan revaluation were even shriller on the other side of the US political spectrum. Democratic presidential candidate John Kerry at one point called the yuan a "predatory" currency, which gave Chinese exports an unfair competitive advantage and stole jobs from the US (which was, of course, utter nonsense unless Kerry thought US workers would labor for two dollars a day). The International Monetary Fund, similarly, has called for greater currency flexibility.
China to date has resisted revaluation pressure, has insisted that it is steadily moving toward greater flexibility in its own good time, and will not step prematurely into untested waters. As with the rise in interest rates, there are compelling reasons for reluctance. The Chinese banking system is in bad shape and ill-equipped to cope with added pressure. According to a report by the Standard & Poor's ratings agency, 40% of all loans in the banking system are non-performing. A yuan revaluation would inflate the value of these NPLs and simultaneously deflate the value of the $45 billion in US treasury bonds injected into two major state banks this past January as well as other banks' holdings of foreign reserve assets. Moreover, the financial system overall is ill-prepared to deal with a more flexible exchange rate. Interest rates remain largely state controlled. There exists no on-shore forward (currency derivatives) market to allow exporters to hedge their exchange-rate exposure. Revaluation would disproportionately affect the earnings of foreign-invested exporters that constitute the most dynamic sector of the economy and its principal driver.
And yet there are also excellent reasons why China would want to move to a more flexible currency regime - and probably will take the first small steps in that direction in the relative near term, perhaps as early as around the Chinese New Year next January. If and when the move is made, it will likely come in the form of a widening of the trading band of the yuan against the US dollar from the present minuscule 0.3% to the 3-5% range.
The reasons are these: In the broadest policy terms, a relaxation of the dollar peg would be in line with gradual transformation of the financial system toward greater reliance on market rather than administrative measures as already signaled with the October interest rate rise. More specifically, given that initial band-widening would almost certainly lead to yuan appreciation, such a measure would complement the rate hike's effect on slowing the economy: exporters' earnings would tend to decline, forcing them to cut back on capital investment, the main culprit in the current overheating episode. A yuan appreciation could also discourage, at least slow down the growth rate, of speculative capital inflows to China, which total in excess of US$50 billion this year and have made it difficult to control money supply and bank-lending growth.
Nothing in China's economic and financial policy moves is cast in stone or predictable simply on the basis of economic policy logic. Fast moves in large steps - in particular, in response to foreign pressure - are anathema. But a modest widening of the yuan trading band would conform to the pragmatic, experimental steps former pre-eminent leader Deng Xiaoping took in the early phases of moving toward a market economy with the establishment of special economic zones to test the waters. It would make sense and the risks would be contained. And it would be a stepping stone toward the goal China must aim to attain: a fully flexible currency regime as the precondition for full control over monetary policy unencumbered by a currency peg to another nation's money and policies.