China Unscathed
For Beijing, the currency crisis can be an opportunity
Lawrence J. Lau, the author of this article, is Professor, Center for Economic Policy Research, Stanford University
pathfinder.com
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THE FALL OF ONE East Asian currency after another has led to much speculation about the fate of the Chinese yuan. Will China devalue? While the currency crisis will have some adverse effects on the Chinese economy, I believe there is no need for the renminbi to devalue. The first effect is trade diversion. China competes with countries such as Indonesia, the Philippines and Thailand in labor-intensive goods. A devaluation in their currencies by 40% or more will definitely cause shifts in the sourcing by importers away from China to these countries. Thus, China will face a slowdown in its export growth in the coming year if its exchange rate remains unchanged.
The second effect is foreign investment diversion. With East Asia under a cloud, foreign investment flows to the region, including China, will slow, as will investment flows from within the region to China. Investment diversion, however, will have a relatively small effect on China because foreign investment accounts for less than 10% of its total (and an estimated one-third of the supposedly foreign investment is actually round-tripped Chinese investment).
The third effect is a rise in the cost of funds to China on international capital markets. Chinese enterprises, like others in East Asia, will have to pay a higher risk premium for their loans. They are also likely to face a less hospitable reception in the world equity markets. But the overall adverse impact is likely to be relatively small because fundamentally China relies on its own domestic savings -- at a rate of almost 40% of GDP -- to finance its investment and growth. So, with the exception of trade diversion, the overall effects are likely to be small. Moreover, while a devaluation of the yuan may restore competitiveness for some exports, it may also rekindle inflation in China.
China is actually under pressure to appreciate its currency. This is the result of having official foreign exchange reserves of more than $135 billion, a significant current account surplus, an estimated foreign direct investment inflow of more than $20 billion in 1997, and inflation of almost zero. In fact, in October, the People's Bank of China (central bank) decided to permit Chinese exporters to retain foreign exchange proceeds rather than sell them to it because it did not wish to purchase more U.S. dollars.
The three basic causes for the currency problems in East Asia can be identified as a large savings-investment gap, an excessive reliance on foreign portfolio investment, and an appreciating real exchange rate. For China, unlike in Thailand, savings and investment are approximately balanced. The foreign capital used by China consists mostly of foreign direct investment and intermediate- to long-term debt and very little portfolio investment -- unlike in South Korea and Thailand. The result is that foreign capital cannot be readily withdrawn from China and hence affect adversely the exchange rate. Third, in terms of the real exchange rate -- that adjusted for the relative rates of inflation -- the Chinese currency has been devaluing since the late 1980s whereas most of the currencies in trouble have been appreciating. In addition, China still maintains controls on capital flows. The scope for speculative attacks on the renminbi is thus quite limited.
Moreover, a devaluation of the renminbi will severely undermine the efforts of the Monetary Authority of Hong Kong to defend its fixed peg with the U.S. dollar. After all, a successful defense of the exchange rate is really based on maintaining the confidence of the domestic population, which in turn depends on the credibility of the monetary authorities. If China is unable to maintain its own exchange rate, despite favorable economic fundamentals, it will have no credibility when it comes to the defense of the Hong Kong dollar.
Chinese banks are known to have massive non-performing loans in their portfolios, with an estimated aggregate stock of between 20% and 30% of GDP, not unlike the situations in South Korea and Thailand. Does that pose a similar risk for China? The short answer is no; because in the Chinese case the debt is entirely internal, whereas in the South Korean and Thai cases, the banks themselves are in turn massive debtors of foreign banks. China's non-performing loans are almost all owed by state-owned enterprises, and thus should be viewed as loans made by the banks to the government, which also owns the banks.
The East Asian currency crisis presents a challenge as well as an opportunity to China. With slowing export growth, China will have to stimulate domestic demand. This it can do in at least two directions, simultaneously. First, it can undertake more infrastructural projects, especially those that link the underdeveloped interior and west with the more developed east. Second, it can promote the expansion of the residential housing sector by developing appropriate institutions that facilitate long-term mortgage financing. There is an almost infinite demand for affordable housing in China, if only the financial intermediation mechanism is available. The currency crisis can thus provide precisely the impetus for China to realize its potential as an internal demand-driven economy. |
