China Today and Lessons from the Past

Shanghai, the Paris of the East! Shanghai, the New York of the West! Shanghai, the most cosmopolitan city in the world... (All About Shanghai and Environs - a 1934 guidebook)¹

For decades China’s economic progress was stifled and hidden from the rest of the world behind Chairman Mao’s “bamboo curtain.” However, the remarkable growth over the post-1978 reform periodhas launched the coun­try into a major player in the world economy.

Such issues as the causes and consequences of exchange rate pressures are interpreted in terms of standard economic principles and past experi­ences - taking into account some illustrative lessons deriving from events in China’s own history prior to the days of the bamboo curtain. Besides considering how past lessons help put current pressures in perspective, this book looks forward to the ongoing challenges posed by China’s accession to the World Trade Organization and the potential for Chinese monetary

¹ As quoted by Wasserstrom (2003, p. 51). ^[1] hegemony within the Asian sphere. The goal throughout is to present the reader with relevant empirical analysis and an explanation of the theoretical underpinnings but to do so in an accessible fashion that does not assume prior immersion in the underlying formal economic models.

The pegged exchange rate between China’s currency, the renminbi, and the US dollar that was maintained until July 2005 ensured that, as the US dollar weakened against most other world currencies in the early twenty-first century, the renminbi automatically followed. This had the effect of making the renminbi cheaper and cheaper in world terms. The apparent exchange rate misalignment tended to boost Chinese exports because these exports were now being priced on the basis of this cheaper currency. China’s export growth continued unabated even after the modest 2.1% revaluation of the renminbi against the dollar on July 21, 2005, and the subsequent gradual movement upwards. Meanwhile, accelerating inflows of foreign exchange reserves required increasingly large-scale interventions by the People’s Bank of China in order to offset upward pressure on the exchange rate and domestic money supply growth and, hence, inflation. This pressure has been augmented, at times, by “hot money” flowing into China as holders bet on new appreciation of the renminbi against the dollar that would yield capital gains to those exchanging dollars for renminbi at the original, lower rate.

In addition to exploring the current situation in detail, Chapter 1 seeks to put it in perspective by assessing the evolution of the People’s Republic’s exchange rate policy over the years and the gradual movement toward more market-based rates. One key episode was during the 1997-1998 Asian financial crisis when, even as most Asian currencies depreciated dramatically against the US dollar, China stuck with its commitment to a constant, pegged exchange rate with the US dollar. While “taking one for the team” and resisting pressures for devaluation, China was hit by deflation in 1998. The pressures for devaluation of the renminbi in the late 1990s were abruptly replaced by pressures for revaluation, however, in the face of the reversal in the upward trend of the US dollar against other world currencies after 2001.

Chapter 2 assesses the recent pressures on the renminbi in the light of global economic imbalances. Worsening US current account deficits have been accompanied by a widespread trend toward growing trade surpluses among emerging economies, which is certainly not just a “China phe­nomenon.” Recent strains appear to largely reflect downward pressure on the dollar in the face of rising US trade deficits with the world as a whole - accompanied meanwhile by high savings rates in the surplus countries and low savings rates in the United States. China has itself been running a rela­tively balanced trade position with countries other than the United States, while incurring deficits with other Asian nations like Japan. Especially given the cautionary lessons from the Japanese and Taiwanese experiences with rapidly rising currency values in the 1970s and 1980s - which are reviewed in Chapter 2 - there certainly seems to be no good reason for China to accede to US pressure for sudden exchange rate appreciation. The chapter also reviews the move toward the creation of new state investment agencies (known as “sovereign wealth funds”) by China and other large holders of dollar reserves. These agencies seek to achieve higher returns on their dollar assets by moving beyond the US Treasuries that have served as the typical mainstay of China’s holdings in the past.

Chapter 3 turns to the inflationary and deflationary cycles experienced in the People’s Republic of China, beginning with the inflationary spiral that was already in full sway when Chairman Mao originally proclaimed the People’s Republic on October 1, 1949.

The closing discussion of post-2002 inflationary pressures in Chap­ter 3 feeds into the focus on the recent policy of the People’s Bank of China in Chapter 4. The growing liquidity of the interbank market is assessed along with the People’s Bank’s increasing reliance on more market-based methods of monetary control such as open market operations. A major policy tool in “sterilizing” the inflationary effects of China’s large reserve inflows has been the sale of “central bank bills,” the rapidly growing issuance of which is documented in the chapter. Chapter 4 also provides some new empirical evidence on People’s Bank monetary policy responses to reserve flows and exchange rate changes. The results are consistent with the effects of reserve inflows on the Chinese money supply being largely offset over our 1994-2006 sample period.

Part IIof the volume offers three case studies of episodes that illustrate the past and present importance of international factors to China. The 1930’s experience reviewed in Chapter 5 shows that it is certainly nothing new for the Chinese economy to be pressured by a weakening US dollar. In this regard, Federal Reserve Chairman Ben Bernanke (2002) once credited the 40% devaluation of the dollar against gold in 1933-1934 as a “key policy shift that permitted sufficient monetary expansion to reverse US deflation during the Great Depression.” The expansion in Federal Reserve notes was generated, in part, via Franklin D. Roosevelt’s silver purchase program, which actually had severe deflationary effects on China in the mid-1930s because its currency was linked to silver.

Whereas China suffered from the sudden currency appreciation that was artificially generated by the 1934 US silver purchase program, the opposite dangers arising from keeping the exchange rate at an artificially low level have seldom been more vividly illustrated than by China’s own past experience in the late 1940s, which is analyzed in Chapter 6. The Nationalist government forced Taiwan to maintain a fixed, artificially low exchange rate against mainland China’s gold yuan currency - itself the successor to the heavily depreciated fapi that was adopted after China abandoned silver in 1935. Indeed, in August 1948 the combination of the fixed exchange rate for the gold yuan and Nationalist control over both the Central Bank of China and the Bank of Taiwan created an almost ideal vehicle for massive capital flight from mainland China to Taiwan. The rate of exchange between the gold yuan and the Taiwanese currency was held fixed through the fall of 1948 in spite of rapidly accelerating money growth on the mainland and a collapsing military situation. Holders of gold yuan naturally took advantage of the fixed exchange rate that forced the Bank of Taiwan to accept the depreciating Nationalist currency and exchange it for the separate Taiwanese currency at an overvalued rate. The net capital inflow between August and October 1948 accounted for almost all of Taiwan’s rapid money growth during September-October 1948.

The exchange rate question is, of course, just one aspect of the challenges to monetary control in mainland China today. The credit allocation issue and China’s banking sector problems are discussed in Chapter 7 in the con­text of both the changing macroeconomic landscape and the transition to full foreign bank competition mandated in December 2006 under China’s World Trade Organization commitments. In preparation for this develop­ment, the government began the process of transforming its major policy banks into publicly traded companies. Although three out of the big four state-owned banks enjoyed successful initial public offerings in 2005-2006, their apparent newfound balance sheet strength was achieved only through successive government-funded capital injections. Concerns about remain­ing “hidden” bad loans continued to stoke fears that further large bailouts may be needed in the future. Government funds could also be required to bail out the group of asset management companies established to take many of the bad loans off the banks’ balance sheets, in the process paying prices way above subsequent realized market values. Another concern is the con­tinued concentration on lending to the nation’s state-owned enterprises and correspondingly low levels of lending to China’s growing private sector. The private sector’s reliance on informal finance is also discussed in Chapter 7. Meanwhile, the fresh acceleration of loan growth as foreign capital flooded into China during 2006-2007 raised fears that new nonperforming loans are being generated, illustrating how exchange rate pressures and banking sector pressures may well remain linked.

Finally, Part III of the book considers the People’s Republic of China in the context of the Greater China region (including Hong Kong and Tai­wan) - with a focus on ongoing financial linkages as well as more general economic integration associated with trade ties and flows of foreign direct investment. Chapter 8 includes an assessment of the development of China’s bond, equity, and real estate markets. Whereas in the early 1980s China had no secondary market for government debt and no stock exchanges, the establishment of both these key institutional features in the late 1980s and early 1990s began the progress toward meaningful financial market devel­opment in China. Although many missteps have occurred along the way, including disruptions associated with sudden government policy reversals, China’s financial markets have advanced greatly in recent years with con­siderably higher liquidity and an enhanced array of financial instruments. This includes, for the first time, genuine prospects for a corporate bond market that might chip away at China’s long-standing and near-complete dependence on bank credit.

The growth in China’s stock exchanges accelerated in 2006-2007, leading to record highs in the major market indices. The question of valuations on the Shanghai Stock Exchange is assessed by comparing stock prices there to prices of the same companies’ stock traded on the neighboring Hong Kong stock market. The data suggest that, relative to the more established market in Hong Kong, any overvaluation of Shanghai shares was, for the most part, greater before the rally period that began in late 2005. Although prices in Shanghai did accelerate faster than Hong Kong prices after April 2006, as of June 2007 the differential remained quite low relative to its own past history - thereby rather casting doubt on the timing of any allegations of “irrational exuberance.”

Chapter 9 moves the comparative focus from Hong Kong to Taiwan and offers a detailed examination of the macroeconomic linkages between mainland China and Taiwan. The growing trade links and flows of foreign direct investment from Taiwan to mainland China, in spite of ongoing polit­ical animosity, are indicative of China’s increasing integration with other East Asian economies. Moreover, the importance of external influences on Chinese monetary policy, as emphasized in Part I of this volume, receives further support from the mutual sensitivity of money growth in mainland China and Taiwan to developments on the other side of the Taiwan Strait. The chapter’s empirical work shows that trade and investment ties have been reflected in significant co-movement not only between mainland China and Taiwan money supply growth rates but also inflation rates, output growth, and stock market performance over the post-1994 period. The overall sensi­tivity to mainland China effects appears to be highest for Taiwanese output and money growth. This is combined with evidence of weaker, but still sig­nificant, responses of mainland China variables to developments in Taiwan.

Chapter 10 concludes and also looks forward to consider whether the People’s Republic of China could plausibly serve as the future monetary leader in Asia. The renminbi has become increasingly important as a “vehi­cle” currency in recent years, especially in Hong Kong, where almost all banks now offer renminbi services to their customers. A potentially major step toward greater renminbi penetration in Hong Kong was the June 2007 launch of China Development Bank’s 5-billion renminbi bond issue in Hong Kong. This represented the first renminbi-based issue outside the mainland. More and more transactions are being settled in renminbi, not only in Hong Kong (and Macau) but also as part of the border trade con­ducted with other neighboring Asian economies like Taiwan, Malaysia, and Thailand. Although the renminbi is certainly not yet ready to take on the dollar, or even the euro, as a major world reserve currency, continued slow but steady capital account liberalization should help pave the way for the much greater role it seems destined to achieve going forward.