What is the chance of Yuan revaluation

Economic Outlook …………………… What is the chance of Yuan revaluation? ………………………………………………………………………………………………...………...…….…… From a Chinese perspective, chances of any change in the Yuan exchange rate look pretty slim. If you were an official in Beijing, would you stick your neck out even recommending this idea? If the status quo looks fairly acceptable, and it is ‘stability oriented’ (a very Chinese preference), why go rocking the boat? You certainly do not make any changes just because Japan or the US tell you to. And financial markets are not that persuasive – after all they wanted a devaluation only a short while ago. In this article, Vanessa Rossi and Simon Knapp assess the likelihood of a Yuan revaluation and its implications for the economic outlook. …………………………………………………………………………………………………………………...… 1. Introduction As part of WTO entry, China is committed to a more open capital account and flexible exchange rate at some time in the future, but this may be some way off yet. Indeed, few expect a rapid move to completely free up these variables. Tackling issues such as banking sector reform and interest rate policy (and its effectiveness) will need to come first. And given a recent history of quite substantial volatility in non-FDI capital flows (from large, albeit mostly illegal, outflows of about $50 billion per annum in 1997-2000 to inflows of perhaps $20-30 billion now), it is not at all clear what would happen to these flows under a free float. Nevertheless, eventually, a more open regime would be helpful to China itself to allow freedom of movement in both capital flows and exchange rates – and in both directions. Apart from present pressures (upward), in 1997-1999 China found itself boxed into a fixed $ peg that it might not have chosen if analysts had known the rest of Asia would blow up into crisis. Bailing out then was rightly seen as a mistake and avoided – to the benefit and thus applause of all concerned. Now opinions are more divided - but who knows what risks may crop up a few years from now? So what is possible in the short term? Options must be a new peg (but at what rate?) or a slightly wider exchange rate band, perhaps testing the waters of flexibility before considering a greater opening up? An interesting point would arise if China were to choose a band of, say, 7.5-9.0 (about +/- 10%): this would encompass the 7.7-7.8/US$ rate for the Hong Kong dollar. Might this open the door to a HK$ float – or an ERM/EMU style currency union? And with Asia-wide trade pacts progressing, might the move to ‘AMU’ come next? Well, not just yet. In this review, we look firstly at China’s economic prospects and thus the case for the Yuan revaluing – the two are inextricably linked. We then examine bilateral trade issues before turning to model scenarios to illustrate the possible consequences of a new exchange rate regime for China. Asian growth looks set for a strong 2004 While China, and much of Asia, saw an unexpected setback due to SARS in 2003Q2, not only did this have no appreciable impact on goods trade (or FDI) but also the economies affected already appear to be rebounding quite strongly. Hopefully, we can assume the SARS problem is past (albeit this is not completely certain as cases could reappear). So, with the rest of the global economy looking forward to a pick-up through the rest of 2003 and into 2004, driven by the US, prospects for Asia look pretty rosy. Indeed, 2004 could see a repeat of the 2000 surge in growth. Table 1: GDP Forecasts for Asia % pa growth China Hong Kong Korea Malaysia Thailand Singapore Asia ex Japan Japan US Source: OEF 2002 forecasts: 8.0 2.3 6.3 4.1 5.2 2.3 5.7 0.2 2.4 2003 8.7 1.9 2.6 4.4 6.2 0.5 5.0 2.6 2.7 2004 8.2 4.0 5.5 5.3 6.3 6.2 6.2 1.9 3.9 Within this context, China should do well and a rebound to 9.1% GDP growth has already been reported for Q3. So, do the circumstances warrant the pressure on China to revalue? Indeed, do they 15 What is the Chance of Yuan Revaluation? October 2003 Economic Outlook …………………… suggest a revaluation would be appropriate for China as well as its trade partners? % year China: Exports & Imports % year 80 80 Clearly, the longer China’s exports and GDP growth stays high, the more demands for a change in the Yuan will escalate, especially if other Asian currencies stay firm or even appreciate, leaving China as the anomaly in the pack. For example, since early 2002, the Thai Baht, Japanese Yen and Korean Won have already appreciated by 10-15% whilst the Rupiah has soared 25% - although, notably, little change has been seen in the Taiwanese dollar. Given the widespread calls for substantial revaluations of the Chinese currency – some pressing for changes as high as 30-40% - on what evidence does the case for such massive revaluations rest? Is China’s trade imbalance so high – and is it growing? It may seem as if the answer must be clear cut. But, in fact, it is not, as we shall show, although there may still be a case for policy adjustments, possibly including some form of revaluation of the Yuan. 60 Exports (US$) 40 Imports (US$) 60 40 20 20 0 3 month moving average -20 1995 1996 1997 1998 1999 Source: Datastream 0 -20 2000 2001 2002 2003 surplus this year, with a dip into deficit in Q1 leading some forecasters to predict a trade deficit for the year (although this now looks most unlikely). After a surplus of $30 billion in 2002, a surplus of $15-20 billion is widely expected in 2003, slightly less in 2004. This is quite modest as a percentage of GDP, probably less than 2%. If, indeed, China’s export growth does fall sharply next year, in line with most forecasts, this would seem to limit support for pressure on the Yuan. But how certain are these forecasts? They do appear to be supported by the ‘cyclical’ view of China’s trade patterns. Consensus forecasts point to a slowdown in export growth into the 10-15% range. And import growth is expected to be about 15% too, cutting further into the trade balance. However, what we observe in the data may not be a systematic trade cycle at all but pure coincidence, so the ‘cycles’ may be misleading. At least three of the four peaks correspond to particular events that promoted high export growth (the effects of the Yuan unification and opening up of trade in 199394, the US and Asia boom of 2000 and now WTO entry). It seems fortuitous that these beneficial events have occurred at apparently regular intervals for some years. These past trends may be no help in predicting next year’s performance. What other indicators can we use to provide a rationale for trade forecasts? Unlike other countries, for China we cannot even rely on world trade growth as a good indicator. China’s export growth has massively outstripped this measure for the last three years. In the medium/long run, such a strong performance may be impossible to maintain. But this does not provide much of a clue regarding growth for the next 2-3 years. However, world 16 October 2003 Asia: Exchange rates 1 Jan 2002 = 100 130 appreciation v US$ 125 120 115 110 Thailand 105 100 95 90 Jan-02 Source: Datastream Taiwan Philippines Jan-03 105 100 95 90 Indonesia Korea 125 120 115 110 1 Jan 2002 = 100 130 China’s export growth and imbalances: the recent evidence Certainly, it is undisputed that China’s export growth has been stupendous: 30-40% growth rates are extremely high and have been more or less sustained from mid-2002. This is not the first time China’s trade figures have surged. Indeed, since 1994, trade growth appears to have run in (approximately) 3 year cycles with growth peaks of about 40%, as seen recently and in mid-2000. But the most unusual feature of the last two cycles has been the equally high growth seen in imports (on average, imports growth was about zero in 1997-98 and some 20% below export growth in 1994-95). In fact, burgeoning imports have cut back the trade What is the Chance of Yuan Revaluation? Economic Outlook …………………… Table 2: Alternative, more optimistic, export and GDP forecasts for China 2003 8.7 32.0 40.0 15.0 Present estimates 2004 2005 8.2 7.1 17.5 13.2 19.0 13.1 14.0 17.0 2003 8.7 32.0 40.0 15.0 Alternative estimates 2004 2005 8.9 8.5 23.0 16.0 26.0 22.0 9.0 -18.0 GDP % growth Exports % growth Imports % growth Total trade balance $bn Source: OEF trade growth of 8-10% and lack of ‘special events’ (post WTO) would tend to point to a sharp fall off in China’s export growth even compared with the consensus estimates referred to above. In contrast to these predictions of a weakening export performance, China’s trade growth could be faster, staying in the 20-30% range (with GDP growth remaining well over 8%). Given the expectation that the US will grow rapidly and the rest of Asia will rebound strongly, it would not be too surprising if these factors did act to prolong China’s trade upswing, making 2004 another stellar year for growth. That really would add more fuel to the revaluation fires! This higher export growth scenario is illustrated in Table 2. In this case, we note that higher growth need not imply that China’s trade surplus would rise – imports would also remain very buoyant, possibly cutting the trade balance. So, it is possible that maintaining high growth, jobs and domestic demand may redress China’s imbalances without revaluation. Apart from high export growth, the rapid rise in China’s forex reserves is also viewed as a sign of serious imbalances and is cited as another reason for Yuan revaluation. However, looking at reserves from a trade perspective, China’s reserves are low versus Japan or even Taiwan and Hong Kong. Reserves cover is about 10 months of imports, about half that of these three NE Asian economies and similar to South Korea. The $100 billion increase in China’s reserves over the last 12 months also looks less unusual when compared with the rest of emerging Asia, which has also seen an increase of nearly $100 billion. Of course, all regional governments have become very risk averse since the Asian crisis, implying high surpluses and reserves. Another factor should be taken into account in comparing the reserves positions: for China, these reserves more or less represent total foreign assets (officially anyway), unlike Japan, which has total foreign assets of over $3 trillion (about $1 trillion net). Other Asian economies have permitted free movement of capital for a long time and therefore asset adjustment is by now incremental. But the previous lack of opportunity to diversify private asset holdings out of China (except illegally) implies that, once the capital account is opened up, there could be a flood of money out of as well as into China. So, China must view high reserves as a buffer to withstand such a risk and will seek to hold more than the ‘normal’ number of months’ imports cover. Turning now to the current account data, Japan’s surplus is way higher than China’s even though China’s total exports and imports of goods are higher than Japan’s. The current account to GDP ratio is also higher for Japan. Even allowing for its low GDP growth record, Japan looks more unbalanced than China. The same goes for Taiwan and Hong Kong. Emerging Asia: Official fx reserves $bn 200 180 160 140 120 100 80 60 40 20 0 1998 1999 Source: OEF 2000 2001 2002 2003 China Emerging Asia (inc. China) Change in official fx reserves over previous 12 months $bn 200 180 160 140 120 100 80 60 40 20 0 So, if China’s trade balance and reserves are not particularly high or unusual in an Asian context, what is the problem? Well, the problem with the US is certainly more to do with the bilateral balance and where this may head over the next few years. However, before looking at the US-China data, we present a brief reminder of how China’s trade looks versus its main trade partners, putting the US relationship in context. October 2003 17 What is the Chance of Yuan Revaluation? Economic Outlook …………………… Table 3: External balances for China and key Asian economies, 2003 estimates Reserves $bn China Japan Hong Kong Taiwan South Korea Source: OEF 350 550 115 175 130 Reserves months of cover 10 19 22 18 9 Current account $bn 25 120 16 24 5 Current account % GDP 1.7 3.0 10.0 8.0 1.0 Current account % total trade 3.0 13.0 3.0 8.0 1.0 As shown in Table 4 below, China exports a large proportion of its manufactures to the US, and to Asia, but the US share of China’s imports is very low, in contrast to China’s trade with Asia, which is more balanced. Indeed, China runs a trade deficit with the rest of Asia. China’s trade is also fairly balanced versus Europe (including Russia and East Europe). But there is a deficit with the rest of the world, mostly raw material (eg oil) suppliers to China. As China ran a surplus of just over $100 billion with the US in 2002 (data from US trade reports), then clearly it had a total deficit of some $70 billion with the rest of the world combined. To be fair, the share of the US in China’s imports is practically identical to China’s share of US imports (both are about 10%) – but no-one wants to be fair when 10% of US imports is $130 billion versus the meagre $30 billion that the US exports to China. Table 4: China trade partners % shares in China trade (2002 estimates) Asia US EU Other China’s Exports to 30% 40% 15% 15% Imports from 60% 10% 15% 15% China exports to US as a % US imports = 11% US exports to Chinas as a % US exports = 4% Source: OEF estimates and China’s own producers may well respond fast in terms of upgrading to more competitive models. Both anecdotes and evidence from trade patterns suggest that the Japanese and Taiwanese are setting up shop in China – along with existing Hong Kong enterprises, which operate largely in the southern region. Thus, China is being increasingly used as a conduit for Asian merchandise trade with the US (and the EU). This is hardly surprising – it follows the long-established Asian trade and development model. And China has a potentially huge home market as well, so development can be on an even bigger scale. If we believe the Asian story that successful achievement of economies of scale in manufacturing has been the engine of much of its past economic success, then regarding China, as the phrase goes, “we ain’t seen nothing yet”. This story lends support to the case made above for much more aggressive forecasts for China’s export growth in the next few years. But, if this is true, we may reasonably ask whether any exchange rate change is simply a finger in a breaking dyke as regards China’s exports to the US, Europe and ‘old’ Asia. Table 5: China expands US market share % of US imports from China Hong Kong Taiwan Korea Singapore Japan Other 1996 6.4 1.2 3.7 2.8 2.5 14.3 2002 10.7 0.8 2.8 3 1.3 10.4 ‘swing’ +4.3 -0.4 -0.9 +0.2 -1.2 -3.9 +1.9 The stark contrast between China’s export and import destinations is also more or less reproduced in sectoral terms, which is not too surprising. Broadly speaking, China imports materials and components as inputs for the production process and then exports manufactures. Over 75% of exports are manufactures, principally consumer products and ‘investment goods’ (a large ‘catch all’ category, covering equipment and components, and accounting for about half of both exports and imports). China imports raw materials and intermediate goods (including equipment), which account for 90-95% of imports, but relatively few consumer products (5-10% of total imports). Although some consumer goods are currently enjoying faster growth - even, it seems, in some rather surprising segments such as washing machines (post WTO entry) - it is from a low base, What is the Chance of Yuan Revaluation? 18 Source: OEF estimates From a US perspective, manufacturers get the impression that the dyke is breaking for them, leading to another huge flood of imports from Asia/China, with little chance of raising US exports to this region. Looking at 2002, it is not just that China has low imports from the US but growth in US-origin imports was very low (about 4% in October 2003 Economic Outlook …………………… Table 6: Overall trade balances: The stylised facts Balance in US$bn China* US Japan (* based on China data) Source: OEF estimates Asia -70 -215 +35 EU +10 -80 -80 US +90 N/a +60 2002) versus China’s total imports growth and compared with growth in China’s exports to the US (29% in 2002). 2003’s growth in US exports to China looks likely to be much higher but the China-US trade balance is still swelling. Given the structure of China’s trade, it is not easy to see how the bilateral balance with the US can be significantly reduced. In the absence of specific special measures to target US-China trade, such as bilateral deals aimed at raising China’s imports of US goods (eg grains, aircraft and equipment), ‘normal’ changes in China’s exports and imports are not likely to create much improvement in the balance versus the US. This is largely because the level of US exports to China is so low. But also US imports (in current dollar terms) from China may not be very sensitive to changes in factors such as the Yuan/$ rate. We will look at this issue together with the scenarios presented below. But, roughly, even a Yuan appreciation of 40-50% would be unlikely to create a swing as high as US$30 billion in the US-China bilateral deficit. Indeed, the gain would quite probably be much less than this. Yuan appreciation, or increased flexibility, may make sense for a number of reasons but cannot be the only key to the huge US trade deficit – certainly Yuan appreciation on its own would be like using a hammer to crack an asteroid (to reverse the usual analogy). The US has deficits against all its main trade partners and the total is some five times the US-China deficit. As China’s overall trade is relatively balanced, with deficits against a number of countries, this begs the question of where blockages in the world trade system are occurring and preventing feedbacks to the US. The countries with which China runs trade deficits are the oil producers, including Russia, and other Asian countries, chiefly Taiwan and Korea (where the current weakness in demand will not help redress the imbalance). If these economies stepped up imports, this would help ‘square’ the global trade picture. The raw data do not make it clear whether China runs a small deficit or surplus versus Japan: China reports a small deficit of about $5 billion (ie it imports relatively more from Japan). But looking at the Chinese data in the Japanese statistics, it looks as if there is a surplus in favour of China of about $20 billion. However, the data can be reconciled by adding the China and Hong Kong data in the Japanese accounts to allow for transit trade through Hong Kong to China – this data indicates a small deficit of about the same size as that shown in China’s data. It looks as if this deficit will widen in 2003 as Japan’s exports to China have raced ahead faster than China’s exports to Japan. So, Japan is doing well even at the present exchange rates. Table 7: China bilateral trade balances, $bn Versus Taiwan Korea SE Asia Russia Saudi Arabia Australia US (China basis) US + HK (China basis) and other Total trade balance Source: OEF estimates 2002 -31 -13 -8 -5 -2 -1 43 90 0 30 12 mths to July -36 -19 -12 -5 -3 -1 50 105 -8 21 It may also be thought unusual that China has such a small surplus versus the EU: a larger surplus may be considered a more appropriate equilibrium. So, China may also be suffering from the EU’s ‘demand deficit’. Viewed from a China and US perspective combined, the world imbalances seem to lie with the oil producers, the EU and the more developed economies of NE Asia (‘old’ Asia). The US deficit reflects a range of factors, such as persistent ‘demand deficits’ in the EU and Japan, a generally strong dollar and the sectoral aspects of trade, including oil. We will not look in detail at these issues here but we do argue these are not China-specific problems. China is just the latest manifestation of a long-standing trend in US trade. October 2003 19 What is the Chance of Yuan Revaluation? Economic Outlook …………………… The US breaking? perspective: the dyke’s With the US economy forging ahead once more, undoubtedly US imports will surge as well, almost certainly putting the trade balance further into deficit next year. The deficit with China alone is likely to be about $115 billion in 2003. It is worth noting that this still leaves a deficit of over $400 billion with other countries but, as with the fact that China-US trade is ‘balanced’ because both have 10% of each other’s imports, such arguments will fall on stony ground. ‘Panda bashing’ is in vogue and China has become the ‘new Japan’ as far as the DC lobby groups are concerned. Table 8: Japan bilateral trade balances, $bn Main countries deficit with which Japan has a deficit: China (Japan basis) China + HK = surplus Middle East Indonesia Australia Russia and other Total trade balance Source: OEF estimates Attempting to close down trade with China might also damage US companies by letting in other foreign competition instead. If US car companies cannot use low cost components from China to maintain low US car prices, then foreign competitors from the likes of Korea and Japan may force some US producers out of the car market. The survival strategy of some US manufacturers may depend on sourcing from low cost countries like China. This relationship may well not suit other NE Asian exporters, which should be taken into account when considering the possible impacts of Yuan revaluation. Table 9: US bilateral trade balances, $bn 2002 China (US basis) EU Japan Canada Mexico OPEC NIEs and other US total trade deficit Source: OEF estimates 2002 -22 2 -29 -8 -6 -2 122 79 12 mths to July -20 6 -37 -10 -6 -3 139 79 103 82 70 50 37 34 22 86 484 12 mths to July 116 90 69 52 40 46 23 99 565 Trying again to be fair, there is not much evidence of this bilateral deficit being caused by Chinese companies dumping in the US market (unless ‘unfair exchange rates’ are included in the argument) - in the usual sense, most trade is ‘fair’ and cannot be shut down. US imports from China focus on a mix of investment goods (equipment and components) and consumer goods: furniture, clothing, toys – the kind that helped produce the widely quoted figure that WalMart alone is responsible for about $10 billion of the US-China bilateral trade deficit. Analysts regularly point out that US companies are responsible for much of the trade with China through their operations and sourcing of components. (This is not the case for Japan-US trade.) In as much as US-China trade has been driven by such US company operations, this clearly begs the question of what would happen to these if the lobbyists got their way. Presumably, US companies would stand to lose money on investments if they closed operations in China and/or would face higher operating costs. Possibly, it would not be China that would face a loss (in exports) but US companies that would see profits fall: the US deficit with China would hardly change. What is the Chance of Yuan Revaluation? 20 To turn the tide on the trend for sourcing goods from low-cost China, an extremely large swing in Chinese wages would be needed anyway. Table 10 illustrates the scale of the world’s wage differentials. Even if a rising Yuan pushed China’s wage rates up to $1-2 per hour, goods may simply be sourced from other emerging markets, say Mexico or India, rather than from the US. This might rebalance growth across the emergers, but it would do little for the US’s imbalances. Table 10: Hourly wage costs Manufacturing China Mexico Hong Kong and Taiwan Singapore and Korea Japan USA Eurozone average Spain US$ 2002 estimates 0.7 2 5-6 7-9 19 21 21 12 Source : US BLS, Foreign Lab Stat, China Year Book Japan: ‘old Asia’ and ‘new Asia’ Growth in Japan this year looks like exceeding early forecasts. Indeed, Japan is claiming to have higher GDP growth in Q2 than the US, although October 2003 Economic Outlook …………………… there is some scepticism about the measurement accuracy. Certainly, taking the data at face value, there is no reason to predict a significant decline in this growth rate in 2004 as the US economy and world trade should perform well. Overall, this cycle has been boosted by export growth thanks to the surge in China’s imports. Indeed, properly measured, Japan almost certainly enjoys a surplus with China (as we indicated earlier). considering any further policy adjustments at this stage, we can identify that a revaluation has certain rather definite effects: • • Local prices would be depressed as import prices fall in Yuan terms. Even with low demand/competitiveness elasticities, export volumes would tend to fall and import volumes rise (at least initially). Profits of exporters fall as they face higher dollar costs (most costs are in Yuan), lower sales volumes and, probably, only slightly higher US$ export prices. Adjustments over time may bring down local wages and prices to improve competitiveness, so exports would start to recover. There would be job losses and less investment in export industries, which have excess capacity. Interest rates may start to edge down in line with lower inflation. Japan: Exports (US$) % year 70 3 month moving average 60 50 40 30 20 10 0 -10 -20 -30 Emerging Asia ex China 2001 2002 2003 -40 1997 1998 1999 2000 Source: Ministry of Finance US China % year 70 60 50 40 30 20 10 0 -10 -20 -30 -40 • • • But effects on other variables are more ambiguous: • Consumers would see import prices fall but low wage growth and job losses act as depressants. Imports: lower exports and investment create less demand for inputs for production and new equipment. As consumers turn cautious as well, then total import demand could fall back sharply. The net effect on China’s US$ import bill may turn negative after an initial surge. While export volumes fall, the impact on revenues will depend on how much US$ export prices rise – prices are unlikely to rise by as much as the Yuan and may even remain stable. Thus, export revenues in US$ terms may not fall a lot. (In Yuan terms this is still a large loss – impacting on producer profits as noted above.) The overall impact on the trade balance may be larger in the first year than subsequent years as imports adjust down and exports start to recover. Overall, it is likely that the trade balance would fall but possibly not much. The capital account results depend on how confident markets are that this is a sustainable move in the Yuan – if it appears unsustainable, then China could see a return to heavy net capital outflows (as seen in 1997-2000) and face a potentially serious balance of payments problem. If markets continue to believe the Yuan is not only sustainable but could see progressive What is the Chance of Yuan Revaluation? A large proportion of the growth in China-Japan trade may be linked to Japanese companies setting up operations in China. Effectively, Japanese companies (and also Taiwanese) seem to be using China as a cheaper production base and as the launch pad for yet another Asian drive into the US and other markets. And to equip these new plants, they export equipment and other intermediate goods to China. This process is also reflected in China’s FDI inflows of $50-60 billion. Switching of trade with the US from ‘old Asia’ to ‘new Asia’ can be seen in Table 5. From 1996 to 2002, Japan’s share of US imports fell by 3.9 percentage points while China’s rose 4.3 points. However, this position seems to make it less easy to explain the Japanese pressure for Yuan revaluation, which has been more persistent than that from the US. In addition, in as much as the Chinese central bank (like the BOJ) has been a heavy buyer of US dollars (bonds), this is supportive of the dollar (and the US bond market). If they stopped buying, and the Yuan appreciated, it is not clear that the pressure on the Yen would be reduced – it may even grow. The Japanese should perhaps take care what they wish for. • • • • • Testing revaluation scenarios Against a background of high GDP growth and still rising exports, how damaging to the Chinese economy would a revaluation of the Yuan be? What impact could we expect? Without October 2003 21 Economic Outlook …………………… appreciation, then this may encourage inflows into Yuan assets and, possibly, overheating in financial markets. Table 11: Yuan revaluation: from 8.3 to 6 Effects in on GDP % loss and Change in: Exports $bn Imports $bn Current acc and Job losses Source: OEF Table 12: Yuan revaluation: from 8.3 to 6 Fiscal policy action props up GDP Effects in 2004 2005 Change in: Budget % GDP 3 4.3 (deficit increase versus base) and Exports $bn -4 -10 Imports $bn 45 100 Current acc -49 -110 Source: OEF 2006 0.5 2007 1.2 2004 -2.3 2005 -3.9 2006 -2.4 2007 -1.1 -28 67 -95 -40 22 -65 -6 22 -28 3m -23 16 -39 8m -30 -8 -23 7m -25 6 -34 5m Using the OEF Global Model, we can examine the likely consequences of a rise from 8.3 to 6 Yuan/US$ (Table 11). The Model reproduces all the features described above and tends to predict that Yuan revaluation would cause a fairly sharp fall in GDP over 2 years before any recovery would start to be seen. Inflation would remain around zero instead of rising as predicted in the base forecast, so here we assume that interest rates would fall from their current rate of 5% to 2% by 2006, helping stimulate a recovery in the economy. The impact on trade partners such as the US is positive but not very large (in line with comments made above). There may be some slight appreciation amongst other Asian currencies but these changes would typically not match the rise in the Yuan. What policy offsets could be envisaged to ‘improve’ the high Yuan outcome for China? In the case of a relatively modest Yuan revaluation, then government spending increases could offset the net trade impact on GDP and limit job losses. This would be essential in order to maintain consumer confidence and thus spending. This case is presented in Table 12. Obviously GDP does not change but the budget deficit rises versus the base forecast as the ‘cost’ of the GDP support operation. It is also clear that maintaining higher demand this way would keep imports high – and prices would stay firmer than in the first example (1-2% inflation). The consequence of the big surge in imports dominates the trade balance result: this deteriorates badly. In this example, it is even possible that China would have to step on the brakes to avoid a serious balance of payments crisis by 2007-2008. With or without a revaluation, import growth could be encouraged as a way of making China’s export boom acceptable to its trade partners – but more attention would have to be paid to increasing the share of US imports in this growth to avoid trade disputes and/or pressure for alternative policies. Given the existing trade structure (by origin and type of goods), it looks unlikely that Yuan revaluation alone can achieve much redress in the US-China trade balance. So trade officials may need to identify specific areas in which US goods could be promoted in China. This is probably the best way of tackling the problem from a positive point of view (rather than the negative view of the US trying to cut imports from China). What might a Yuan float look like? Alongside other policy changes, China may put its toe in the water of exchange rate flexibility by testing out a system of floating the Yuan within wider managed bands, say 7.5 to 9 versus the US$. This band would also encompass the Hong Kong dollar rate (7.8/US$). This policy might initially look pretty close to a 10% Yuan revaluation - almost certainly in present mood financial markets would push the Yuan higher to the top of its band, to 7.5. Subsequently, the positive rush of sentiment would settle down and as the economic effects unwound, the Yuan could see more volatility. An improvement in foreign financial markets (after a weak period since 2001) and the lifting of some capital account restrictions might also encourage capital outflows from China, reducing the upward pressure on the Yuan. Taking the exchange rate equations from the OEF Model, and assuming that the authorities allow a free float between 7.5 and 9, we can see how the model would predict the economy and the Yuan to change. The Yuan/US$ rate appears to drift slightly by 2006-2008 into the 7.5-8 range after staying close to 7.5 in 2004 and 2005. This drift is partly because of the projected trade losses but is also due What is the Chance of Yuan Revaluation? 22 October 2003 Economic Outlook …………………… to the impact of lower interest rates. Table 13: Yuan float: settles around 7.8 Interest rates stay at 5% Effects in 2004 2005 on GDP % loss -0.5 -1.2 OR with fiscal action Budget as % of 0.7 1.3 GDP (deficit increase versus base) Source: OEF runs trade deficits with a number of countries (and a rather low surplus versus the EU). • China’s reserves position of $350 billion is not as massive as its portrayed – not scaled against total trade (which is higher than Japan’s) or in terms of months of imports cover (10). • China’s capital flows could turn around and head out again: ‘hot money’ flows can be anywhere from outflows of $50-60 billion (1997-2000) to inflows of $20-30 billion (2003). This behaviour is unusually difficult to predict. • On a long-term basis, starting from near zero (officially), Chinese investors may want to build up diversified portfolios outside China (when they can legally move capital out of the country). This could lead to a stream of capital outflows. • To allow for large uncertainties over capital flows and prevent a serious crisis of the kind that engulfed Asia in 1997, China will need to maintain a high level of reserves (and possibly other forms of capital controls as a backstop). • The Chinese banking sector is still fragile and hampered by bad debts. • Interest rate policy has been domestically oriented and rather pedestrian in the past: this will need to be reviewed to fit with a more flexible exchange rate and monetary system. • To be effective, interest rates must have an impact. This is still limited by banking sector structure, with low levels of household credit and high borrowings from state enterprises. On the pro-revaluation side: • Export growth, and thus GDP, could stay stronger next year than most forecasters expect, with more new investment coming on stream and upgrades of products to boost demand. • Continued GDP growth of 8% plus would put a lot more pressure on China to revalue. • Forex reserves may continue to soar too, with FDI hitting new peaks and hot money still coming in. • From China’s point of view, handling this money inflow and preventing speculative bubbles in property may be an increasing problem, although there is no overheating in the full sense (prices and wages are rising only modestly). • While China has a rather modest overall trade balance and a deficit with a number of countries, the problem is the rising US-China imbalance, which is a large part of the total US 2006 0.2 -1.2 2007 0.6 -0.8 To be comparable with the exercise above, we illustrate this ‘floating rate’ case without fiscal intervention and then with fiscal policy supporting GDP, so the budget deficit rises (Table 13). As the change in the Yuan here is small compared with the move to 6 Yuan/$, other variables see much more modest changes as well. The Yuan appreciation is about a third that illustrated above and the losses/gains in exports and imports are also, broadly, a third the size of those reported in the first table. The inflation effects are lower and thus we assume here that rates stay at their present level of 5% (instead of rising as in the base forecast or falling as in the Yuan 6 scenario). The current account losses are roughly between $5 billion and $20 billion, with the greatest impact in 2005. The results are helped from 2006 by the slight downward drift in the Yuan. Reserves remain at about current levels. This scenario looks quite plausible and offers a number of advantages versus a fixed Yuan revaluation. But the scale of the changes in the Yuan would hardly satisfy the panda-bashers. Conclusions: a modest change likely We can summarise the case for and against revaluation from the arguments put forward above. Firstly, the case against changing the Yuan/$ rate: • A stronger/floating Yuan may destabilise the Chinese economy and Asian region – risky to rock the boat, very unpopular in China. • China’s export growth may fall sharply in the next 6-12 months anyway as the WTO effect fades. • China’s imports growth is now faster than export growth and the total trade balance is projected to fall this year and next. • As a share of trade or GDP, China’s trade surplus is not as large as Japan’s. And China October 2003 23 What is the Chance of Yuan Revaluation? Economic Outlook …………………… deficit. • Continuation of recent trends may put this bilateral balance on course to reach $150 billion by 2004, up from $103 billion in 2002. At some point a rising imbalance of this size will be seen as intolerable in the US and might well result in recourse to trade sanctions if no concessions are forthcoming from China. So, a move to a flexible exchange rate may be helpful in avoiding other threats. • The additional rationale for pressing China to revalue is that it could encourage other Asian exchange rates to loosen up. There is a much stronger case to argue that Asia as a whole is undervalued than China is undervalued, and a combined exchange rate move might have a larger impact on global imbalances. • Revaluations in China’s (and Asia’s) currencies may help improve growth for other developing countries, such as Mexico and the rest of Latin America and India: this might ‘rebalance’ the emergers and also reduce Asia-US tensions. • Chinese wage rates are incredibly low by international standards – a revaluation of the Yuan would help redress this and raise per capita US$ incomes more quickly than any likely trends in Yuan wage growth. • If a Yuan revaluation could be handled without destroying growth and jobs, this would make Chinese workers feel richer in the world economy. The 2004 forecast for current US$ GDP in China could rise from $1500 billion to over $2000 billion based on 6 Yuan/US$ instead of 8.3. • It is estimated that China will otherwise have to wait until 2007 before achieving per capita GDP over $1500 - with a strong Yuan, 2007’s income might be $2000 per capita versus an estimated $1100 last year (PPP adjustments are not used). As we mentioned at the outset, it is not all that likely that China will undertake any substantial changes in exchange rate policy. Provided the economic outlook stays healthy, an incremental change to a fixed or partially floating Yuan, perhaps around 7.5, may be the most likely scenario. If necessary, a change of this magnitude could be accompanied by other measures to ensure that GDP growth and jobs did not suffer any detrimental consequences. Some additional concessions to encourage imports from the US would also help reduce trade tensions – and would be necessary to redress the US-China imbalance whether the Yuan is 8.3 or 6 – as changes in the Yuan alone would guarantee very little in terms of modifying this source of acrimony. What is the Chance of Yuan Revaluation? 24 October 2003