Tuesday, April 26, 2005

Lawrance Lau and Joe Stiglitz, both economists, recently penned an editorial on FT arguing against RMB revaluation. Needless to say, this revived the whole revaluation discussion. There was one interesting aside this time as people mulled over the impact of revaluation on the PBOC's assets. Is it a simple matter of the PBOC taking a "hit" with devaluation? I try to elucidate, sort of, this matter below and once again make my usual anti-revaluation statement that the cost of the current course actually isn't that great:

The effect of revaluation on the PBOC's position is more complicated than a simple "hit" that it will take. On the other hand, I tend to think that the PBOC (or actually Wen Jiabao) has strong reasons to stay on the current course.

On the first issue of the PBOC's losses or gains in the event of a revaluation, I think China as a whole will gain from revaluation because, as some pointed out, China's international liabilities will decrease and purchasing power increase. For the PBOC, I think it will take an accounting loss since in the official PBOC balance sheet, foreign exchange reserve is an asset that is valuated in RMB terms. So, a revaluation would necessitate some kind of adjustment in its liability column, probably in the form of reduced currency in circulation as people exchange RMB for dollars. Although this would presumably have a negative impact on money supply, the PBOC can always counteract by buying back PBOC or gov't bonds to expand money supply (but would PBOC bonds be part of the PBOC's assets??).

As an aside, I wonder what would happen to the capital adequacy ratio of BOC, CCB, and now ICBC. In theory, they each received an injection from the foreign exchange reserve that went toward their core capital, so if their capital is denominated in USD, would revaluation all of the sudden decrease their capital?? I suspect not. I suspect that through some mechanism, the injections into these banks have been converted into RMB. Is it a simple matter of selling the dollars right
back to the PBOC? If someone knows the answer to this, it would be very enlightening.

Overall, however, I think Lau and Stiglitz are right that revaluation would further increase competition in the domestic goods and farm market as increasing purchasing power allow Chinese consumers and producers to look for options from abroad. Also, revaluation would have a negative impact on employment as wages rise (true, the effect might be small). At the same time, keeping the current course is actually less costly than most people think. Sure, there is enforcement cost and sterilization cost, but believe me, the PBOC has experienced far greater policy costs in the past than the current sterilization cost (just think issuing currency to pay for IOUs to farmers). As long as inflation is kept at bay, they can continue this for the near future, especially if oil prices pick up (actually, that's another interest issue, but basically China is using its foreign exchange reserve to subsidize cheap oil for domestic consumers). Finally, I tend to agree with Lau and Stiglitz's point about credibility. If you revaluate, you might invite more speculation, or, if you do it too much, there might be a flight from China.

The Lau-Stiglitz Editorial

Financial Times
China's alternative to revaluation
By Lawrence Lau and Joseph Stiglitz Apr 24 2005 19:12

China export taxWestern pressure has been mounting on China to revalue the renminbi, from hardening rhetoric in the US Congress to recent calls by the Group of Seven leading industrialised nations for more flexibility from China. However, there is currently no credible evidence that the renminbi is significantly undervalued, and an adjustment in its exchange rate at this time is neither warranted nor in the best interests of China or global economic stability.

The two symptoms of undervaluation are a large multilateral trade surplus or high inflation. China's measured trade balance has been in slight surplus (a surplus no doubt exaggerated by over-invoicing of exports and under-invoicing of imports); but with the volatility of oil prices and the international economy more generally, this could quickly be reversed. And while China's trade surplus has grown, China's multilateral surplus is far from the world's largest.

America blames China for the bilateral trade deficit; but America's trade deficits are a result of its huge fiscal deficits and the fact that Americans simply do not save. America's defence that it is doing the world a service by consuming vastly beyond its means is self-serving and rings hollow: US fiscal policies and low savings have become the fundamental source of global imbalances.

China has experienced large capital inflows (beyond foreign direct investment), but these are symptoms of speculative pressures that have been so destabilising throughout the developing world. It would be a mistake - and only a temporary palliative - to reward the speculators by appreciating the currency.

Some in China would revalue the currency not because they believe there is a fundamental economic problem, but to get the Bush administration off their backs. But currency appreciation is not likely to reduce significantly the US balance of payments deficit with China or the world. Because the prices China pays for imports would be lowered, and because of the high import content of China's exports to America - as much as 70-80 per cent - even a 10 per cent revaluation would have miniscule effects. Moreover, China should receive some comfort from having joined the World Trade Organisation: there are the beginnings of an international rule of law. A unilateral imposition by the US of import duties would most likely contravene WTO rules; it is hard to call a country that has adopted a fixed exchange rate system a currency manipulator.

If China were to contemplate a revaluation, it should consider as an alternative the imposition of a tax on its exports. Export taxes are generally permitted under WTO rules. Indeed, China has already moved in a limited way in this direction on textiles. There are several reasons voluntary imposition of a tax on its exports may be preferable to a renminbi revaluation. Both would have similar effects on Chinese exports - they would make them appear more expensive to the rest of the world. Because of this similarity, an export tax would provide an empirical answer to the question of whether a revaluation would work. But it would do this without some of the significant costs attendant on revaluation.

One of the advantages of an export tax is that, unlike a revaluation, it would not lead to financial losses for Chinese holders of dollar-denominated assets, such as the People's Bank of China or commercial banks and enterprises. China's central bank currently holds about $640bn in foreign exchange reserves. Assume that only 75 per cent is held in dollar-denominated assets. A renminbi revaluation of 10 per cent would result in a loss of $48bn or about 400bn yuan for the central bank.

Another cost of revaluation would be possible further deterioration in the distribution of income, in cluding increasing the already large rural-urban wage gap. Revaluation would put downward pressure on domestic Chinese agricultural prices; an export tax would not. An export tax, by contrast, would have a beneficial side effect: it could generate substantial government revenue for China. Given the high import content of Chinese exports to the US, a 5 per cent export duty would be equivalent to a currency revaluation of some 15-25 per cent, generating about $30bn-$42bn a year.

Finally, an export tax would not reward currency speculators. It may even discourage the speculation that has com plicated macro-economic management of China's economy. If potential speculators can be convinced that China would rather impose an export tax than revalue, less "hot money" will flow into China. By contrast, nothing encourages speculators more than a "victory", especially where, as here, it is likely to do little to correct the underlying problems.

An export tax can be easily lifted if and when Chinese balance of payments conditions so warrant. It could be stipulated that the tax would be reduced or lifted if the Chinese current account balance turned significantly negative. America's China policy has been driven more by domestic politics than hard economic reasoning or thoughtful, quiet diplomatic initiatives.

It would be better for the world if the international rule of law prevailed - and within those rules, China could unilaterally impose an export tax, while it is dubious whether America could impose an import duty. Most importantly, we should not let bad politics drive out good economics.

Lawrence Lau is professor of economic development at Stanford University and vice-chancellor at the Chinese University of Hong Kong; Joseph Stiglitz is University Professor at Columbia University and Nobel laureate in economics

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