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��Home>>China Observer
RMB Appreciation to create its own bubble?
www.chinanews.cn 2005-01-20 09:56:31
���� China Newsweek special article
���� The pressure on RMB devaluation has surfaced. To disregard this
pressure and let the RMB appreciate can only lead to the currency's
bubble.
Newsweek reporter Wang Chenbo
"Hot money" attacks seem to be no more than false alarms. In other words,
the immediate pressure on RMB appreciation is not so serious. The
follow-up question is, should the RMB appreciate or not?
Some people hold an optimistic view that, after the RMB appreciates,
Chinese citizens can travel around the world with a strong currency and
enterprises will also be able to buy cheaper petroleum and iron ores. On
the other hand, China's export edge will not be weakened in that
manufacturing industries will face no major obstacles due to lower prices
of imported raw materials after the currency appreciates.
Economists obviously do not have a consensus on such a positive outlook.
"RMB may be creating its own bubble. Its apparent strength may have an
underside of weakness", said Zuo Xiaolei, chief economist of the Silver
River Securities Company.
���� Root of pressure for RMB appreciation
Rome was not built in one day, so is the pressure on the RMB to
appreciate. The root cause is the "Chinese-style" exchange rate formation
mechanism.
The most obvious characteristic of this kind of exchange rate system is
the fixed rate. The RMB has been basically "pegged to the US dollar" at
the level of 1 Dollar to 8.27 RMB since 1998.
"Pegging to the US dollar" is accomplished by two compulsory policies.
The first policy targets enterprises and compels them, irrespective of
their wishes, to sell to commercial banks the portion of their foreign
exchange revenues, generated by foreign trade, above their quota of
foreign exchange. The second policy targets commercial banks and compels
them, irrespective of their wishes, to sell to the Central Bank all their
excess foreign exchange above their turnover quota.
Therefore, China's foreign exchange revenues are pushed upward, one level
after the other, all the way to the Central Bank and eventually form the
mainly dollar-denominated foreign exchange reserves of the country.
China's foreign exchange reserves have risen from US billion at the end
of 1998 to more than US billion at the end of 2004.
Meanwhile, the US dollar started to depreciate steadily and broadly.
Compared with the world's main currencies, the effective exchange rate of
the US dollar has decreased about 30%. "The problem is not whether the US
dollar will crash but when it will crash", said Sheng Hong, president of
the UniRule Institute of Economics, to our reporter. Against this
backdrop, the RMB's continuation to "peg to the US dollar" made China's
foreign exchange reserves face huge problems of appreciation.
What's more troublesome, in the face of this trend, domestic residents
and enterprises are also unwilling to hold U.S. dollars and expect to
convert dollars into RMB. According to China's exchange rate system, the
Central Bank must accept and exchange all foreign currencies tendered
domestically, whatever the amount tendered.
The Central Bank accepts foreign currencies by issuing RMB in return. "It
is definitely unsustainable for the growth in foreign currency to outpace
the growth of the domestic currency. Based on its current modus operandi,
the window of choices for the Central Bank is narrowing." opined Dr.
Zhang Bin of the Institute of World Economics and Politics (IWEP) of the
Chinese Academy of Social Sciences (CASS).
These problems, accumulating day by day, finally turned into the current
pressure on the RMB to appreciate. Around this time, China's Central Bank
announced a rise in interest rates. "In terms of the order of financial
marketization, exchange rate marketizatisation follows interest rate
marketization." said Ba Shusong, deputy director of the Finance Bureau of
the Development Research Center under the State Council. In this case, if
the Central Bank's interest rate increase is likened to "the first shoe",
people are now waiting for "the second shoe"--a change in the currency
exchange rate.
Viewing the situation this way, it seems that a RMB appreciation is a
done deal.
���� Dangerous "RMB bubble"
However, the aforementioned considerations of appreciation may have
neglected an important reality-- the "false high" of the RMB.
At present, almost the whole world has an optimistic view on the RMB's
appreciation. But what is the actual situation? Zuo Xiaolei believes that
several large potential holes exist in the Chinese financial system,
which can only be filled by the government loosening its purse strings.
"Any problem that must be resolved by government money will likely bring
pressure on the RMB to depreciate." She said.
In fact, such depreciation pressure is quite frightening. The most
evident example is the shareholding reform of the Bank of China (BOC) and
the China Construction Bank (CCB), for which the central government
deployed 45 billion US dollars of its foreign reserves. Thereafter, the
Industrial and Commercial Bank (ICBC) and the Agricultural Bank of China
(ABC) are in the queue for more money. The scale of bad debts of the
latter two banks is bigger than that of the first two. It was reported
recently that ICBC would get a capital injection of 400 billion RMB,
while the capital demand of ABC would not be less than ICBC's.
In addition, several commercial banks with stock-holding structures are
clamoring in unison for capital injection by the government. Finally, one
must not forget the rural credit cooperatives system with its ponderous
historical baggage as well as the large number of defunct securities
firms dying collectively since the second half of 2004.
This type of capital injection will always involve tens of billions, if
not hundreds of billions of Yuan, and these sums are considered to be
necessary costs. If these holes were not filled and the system
rejuvenated, the financial liberalization in the near future would bring
calamitous consequences.
The reason is very simple. "If the large international banks only capture
half of the current 20% high-end customers of state-owned commercial
banks, Chinese banks may lose half of their existing deposits. If that
were to happen, Chinese banks would face the risk of a run on their
remaining deposits if their deposit to loan ratios fail to meet banking
requirements." said Zuo Xiaolei.
By that time, the status of "state-owned bank" would be of no help.
Therefore, the government is trying every possible means to fill these
holes. Yet one cannot make bricks without straw. Governments at all
levels have already been operating in a fiscal deficit environment.
Moreover, the central government has issued several trillion Yuan of
national debt, not to mention the multiple trillion Yuan gap in China's
Social Security Fund.
According to customary practice, since there is no extra money, the
government has to work through the central bank to borrow, or issue more
currency to cope with the problem. This will create pressure on the RMB
to depreciate, not appreciate.
It seems that the pressure on the RMB to depreciate has surfaced. An
appreciation that ignores the aforementioned factors will only create a
RMB bubble. And the speculations of domestic "hot money" as well as
international hedge funds are one version of this bubble.
If RMB appreciates a lot at this moment, "hot money" would withdraw
rapidly after the currency appreciates to their expected targets. "The
danger is not the inflow of hot money, but its outflow which can easily
ignite a financial crisis," Zuo Xiaolei pointed out.
The sudden exodus of "Hot Money" will possibly produce the "RMB bubble".
Accordingly, China's financial risks will be thoroughly exposed. If both
factors reinforce each other at the same time, the consequence will be
unimaginably catastrophic. Similar tragedies repeated itself again and
again during the Asian Financial Crisis.
���� The mechanism's Dilemma
In view of the "bubble" inherent in the RMB, fine-tuning the level of
currency adjustment involves considerable risks.
In the meantime, "forecasts about currency rate changes would be no
better than the result of tossing dice because people do not have the
ability to predict currency demand and its change in supply" said
Greenspan, US Federal Reserve chairman, at the G-20 Central Bankers'
Conference held at the end of 2004.
Therefore, compared with adjusting the exchange rate, adjustment of the
"Chinese-style" rate-forming mechanism appears to be even more necessary.
The main idea of such a reform is how to enhance the RMB��s flexibility
so it will no longer rigidly "peg to the US dollar".
In the face of the inevitable adjustment of the rate-forming mechanism,
China seems unprepared. At present, one of the plans being floated is to
encourage commercial banks to undertake part of the responsibility of the
Central Bank in buying foreign currencies so the the country's foreign
exchange resreves can gradually evolve into a marketized system. However,
with the prospect of a RMB appreciation, commercial banks have no
intention at this moment to undertake this task of absorbing and managing
China's massive holdings of foreign currencies.
In recent years, a heated discussion on the rate-forming mechanism has
been raging within China. China tried to find an exchange rate system
most appropriate to its state of economic development but regrettably it
finally failed to do that. Xie Ping, General Manager of the Central
Huijin Investment Company said that Chinese economists contributed
nothing to the currency policy theory.
There is even no answer for the question whether to choose a fixed
exchange rate system or a floating rate system. On the current
international scene, some developed countries adopt floating exchange
rates, while many Asian countries and regions still choose fixed exchange
rate systems that peg the local currency to the dollar or a basket of
currencies. Both systems have their pros and cons. As Jeffrey Frankel, a
professor at Harvard University, pointed out, there is no single exchange
rate system which is proper for all countries or for all times.
According to Huang Haizhou, senior economist of the International
Monetary Fund (IMF), when we compare developing Asian countries with
developed European countries, we will discover two interesting facts: for
developed European countries, the choice of exchange rate systems has
little or even no bearing on their economic growth or fluctuations.
Although more flexible exchange rate systems are interconnected with
higher economic growth rates, this has not shown itself in the
statistics. For developing Asian countries, the choice of exchange rate
systems does influence their economic growth rates. Managed floating rate
and fixed exchange rate systems are superior to other systems, but do not
affect fluctuations in economic growth.
This means that whether exchange rate systems influence economic growth
depends on the level of economic development. When the market is mature,
choice of exchange rate systems would not matter much. It does matter if
markets are immature, but still would not amount to the most important
factor.
Actually, people should look at the RMB exchange rate system in a broader
perspective. "For the macro-economy of a new market-oriented country, the
choice of exchange rate mechanism cannot compare in importance with good
fiscal, financial and monetary systems," concluded Professor Frederic
Mishkin of Columbia University in his latest research report.
E-mail: zhangqinghua@chinanews.com.cn Tel: 8610-88387443 Fax:
8610-68327649
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