Whither the Renminbi
Part I: Is the Renminbi Fairly Valued?
1 Is the renminbi undervalued or overvalued? This question has perplexed analysts because of conflicting signals from the economy. Since the exchange reform of Jan 94, the renminbi has appreciated in real terms against the dollar reflecting the high inflation. This gave rise to concerns that the renminbi was becoming overvalued, thereby eroding China's external competitiveness. This view gained credence when export growth plunged and the trade balance moved into deficit in 96H1. There were further concerns that the renminbi would depreciate when it became convertible on the current account at the end of 1996.
2 At the same time, foreign reserves have surged to a historic high of US$105b at end-1996. This suggests that the renminbi may be undervalued, as it would have appreciated sharply if not for the authorities' interventions.
3 In our view, the contradiction in signals is more apparent than real. The renminbi exchange rate has moved from a position of undervaluation a few years ago to a more or less equilibrium value now. Our assessment is as follows:
- We consider the renminbi to be broadly in equilibrium in 1991, a time of internal and external balance in China. In 1992-93, China's economy became highly overheated. Inflation rose rapidly, and negative interest rates led to financial disintermediation. Given the loose financial policy stance and disequilibrium condition, the renminbi came under intense pressure from 1992 to mid-1993 and depreciated by 30% in real terms over that period. However, in mid-1993 the authorities implemented an effective macroeconomic adjustment programme (the '16-point plan'), aimed at curbing fixed asset investment by state enterprises and restoring confidence in the financial system. As the economy stabilised, the renminbi appeared to have overshot its equilibrium value because of its plunge during the overheating. As a result at the beginning of 1994, the renminbi was undervalued in real effective terms.
- While the austerity programme held back domestic expenditures, large inflows of foreign direct investment (FDI) in 1994-96 helped to sustain aggregate demand which remained strong. Under the circumstances, an appreciation of the exchange rate would help to switch demand to the external sector and alleviate pressures on domestic resources. Such an appreciation could be effected through a rise in the nominal exchange rate or higher prices. In the event, the authorities implemented a reform of the exchange system in Jan 94 which kept the nominal exchange rate within a tight band and stabilised the nominal rate. However, as domestic inflation rose, the real exchange rate appreciated markedly by more than 20% in real terms over 1994-96. From a position of undervaluation, this appreciation has brought the renminbi closer to its equilibrium value by 1996.While the austerity programme held back domestic expenditures, large inflows of foreign direct investment (FDI) in 1994-96 helped to sustain aggregate demand which remained strong. Under the circumstances, an appreciation of the exchange rate would help to switch demand to the external sector and alleviate pressures on domestic resources. Such an appreciation could be effected through a rise in the nominal exchange rate or higher prices. In the event, the authorities implemented a reform of the exchange system in Jan 94 which kept the nominal exchange rate within a tight band and stabilised the nominal rate. However, as domestic inflation rose, the real exchange rate appreciated markedly by more than 20% in real terms over 1994-96. From a position of undervaluation, this appreciation has brought the renminbi closer to its equilibrium value by 1996.
- As the renminbi was undervalued at the start of 1994, the subsequent real renminbi appreciation did little to damage China's export competitiveness. Foreign direct investment also helped boost export capacity, and exports continued growing on average at nearly 20% yoy in 1994-96. At the same time, the government's austerity programme hit domestic demand, particularly fixed investments by state-owned units, as well as imports. Import growth fell from 30% yoy in 1993 to 10% yoy in 1994-96. Domestic enterprises, which had taken advantage of lax credit conditions earlier to ramp up production, turned to the export market. With slowing import growth and rising exports, the trade balance moved into a surplus even as the renminbi appreciated in 1994-96.
4 We also examine the renminbi in relation to recent developments in trade and foreign direct investment (FDI). We find that:
- There is no indication that the renminbi appreciation has hurt the aggregate level of Chinese exports. The steep decline in export growth in 96H1 resulted from an unusually high base in 1995, which was in turn due to institutional changes in the trade system. China's market shares in the US and Japan, and in world exports, have continued to rise, with no indication of loss of export competitiveness. However, given that China's exchange rate is now more or less at equilibrium, further appreciation could adversely affect China's export growth.
- On a more disaggregated level, renminbi appreciation coupled with the withdrawal of tax rebates may have affected the exports of Chinese state-owned enterprises in particular. These state exporters were already weakened by the 1993 austerity programme. A further renminbi appreciation could hurt price-sensitive, lower-end exports such as export processing trade, which has increased its share of China's total trade to 50% in 1996.
- Record inflows of FDI had mitigated the effects of the austerity programme and helped to sustain aggregate demand, thereby contributing to the appreciation in 1994-96. These inflows are likely to moderate, given the more selective policy of the authorities towards FDI. China is keen to clamp down on speculative real estate investment and to redirect investment into economic infrastructure and other productive projects, and also from the coastal to the inland regions. However, a sharp reversal in investor sentiment and an FDI pull-out is unlikely. Hence, FDI inflows will continue to underpin a strong renminbi.
5 There is little indication that the current strength of the renminbi is out of line with either internal or external equilibrium. The authorities have stated that the challenge in 1997 will be to maintain the viability of the renminbi. This, in the context of continued strong FDI inflows, implies that China's foreign exchange reserves - already the second-largest in the world after Japan at US$105b - will swell further. Politically, the high level of reserves has reduced the Chinese leaders' sense of vulnerability to possible sanctions by Western countries (for example the credit sanctions imposed after the Tiananmen incident) and provided them with the confidence to accelerate the reform process, particularly exchange and trade liberalisation and financial reforms.
6 Exchange system reform reduces, rather than increases, the exchange rate risk of doing business in China. Current account convertibility, for example, assures investors, particularly those whose earnings are in renminbi, that they can repatriate their profits in foreign currency. There is no indication that the renminbi has become more susceptible to depreciation as a result of the adoption of current account convertibility in Dec 96, four years ahead of year 2000 as originally scheduled. The risk of huge capital outflows is also small, as China maintains strict controls on its capital account. [However, there is substantial leakage reflected in the large 'errors and omissions' item in the balance of payments.]
7 In the near-term, therefore, the downside exchange rate risk for investments in China is small, although business surveys indicate that other risks of investing in China remain considerable.
Part II: China's Foreign Exchange System 1979 to Present
This note provides an overview of developments in China's foreign exchange (forex) system from the start of reforms in 1979 to the present, with particular focus on recent developments. China's forex system has progressed from an administered exchange rate and rationing of forex earnings to a more market-determined exchange rate. Recent reforms in 1996 established a national interbank forex market for foreign and domestic enterprises, aimed at meeting the forex needs of current account transactions. Further, the renminbi became convertible on the current account on 1 Dec 1996.
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