Main Conclusions

1        There is little support for claims by analysts that China had devalued competitively first in Jan 94, thus triggering the subsequent East Asian export slowdown in 1996. First, China had devalued its official exchange rate, whereas in its dual rate system then, 80% of foreign exchange transactions were already taking place at a more depreciated, market-driven "swap rate". Weighting by the value of transactions at the two exchange rates, the devaluation was only 7% against the US$. Second, any competitive gains from the nominal devaluation in Jan 94 was quickly wiped out by China's high inflation in 1994-96. Third, export data showed that China's export growth over 1994-95 was not at the expense of the ASEAN countries, which also had an export boom. Indeed, the subsequent downturn in East Asian exports in 1996 was more severe for China than for ASEAN.

          The "Price Effect": Would China Devalue?

2        The "price effect" assumes competition between China's and the region's exports. China's export structure overlaps significantly with that of ASEAN-4 countries, and to a lesser extent, with that of Korea. Looking at US import data, low-end ex apparel and clothing, footwear, and miscellaneous manufactured articles such as toys comprise 45% of US imports from China. The US imports essentially these same commodities from the ASEAN-4; these commodities comprise about 10-30% of US imports from ASEAN-4. Data from another major market, Japan, shows less of an overlap, because Japan imports more primary commodities such as oil from ASEAN-4.

3        A summary indicator of China's loss of price competitiveness is the real effective exchange rate. Taking into account competitor effects from ASEAN and Korea, calculations show the renminbi appreciating by 12-24% (depending on the weight given ASEAN) in real effective terms from end-Jun 97 to end-Jun 98. This is a substantial real appreciation, but it is not unprecedented. In 1994-95, the renminbi appreciated by 14% per annum in real effective terms, but this did not substantially affect China's export growth due to strong regional demand. However, with the sharp slowdown in the region, such a large real appreciation in the renminbi now is likely to have a more adverse effect on export growth over the medium term.

4        Media reports show the extent of the official concerns over China's loss in price competitiveness. China has started giving subsidies to certain exporters, e.g. in the textile industry. Domestic producers in heavy industries such as shipbuild steel, facing competition from cheaper Korean and Japanese imports, have also publicly spoken out in favour of a devaluation. Moreover, the more export-oriented provinces in China, which would be disproportionately affected by the external sector slowdown, also account for a substantial share of China's GDP (top 5 export-oriented provinces account for one-fifth of China's GDP), and are among China's highest-growth provinces. These industries, and possibly also the provinces, are likely to be strong domestic lobbies for a devaluation.

          The "Income Effect": Impact of the Regional Slowdown

5        The "income effect" of the crisis on China is apparent in China's slowing export growth (7.6% in 98H1 compared to 26% in 97H1). China's exports to Japan, which absorbs almost 20% of China's exports, have contracted by 6% in the first five mont 1998. Overall, China's export growth has been boosted by continued growth in its exports to the US and EU, which together absorb about 30% of China's exports. Moreover, although China's export growth has fallen sharply from that in 1997, it is relatively strong compared to the near-zero or negative export growth in the rest of the region.

6        FDI inflows into China have held up despite the crisis, and totalled US$20.5 bn in 98H1, roughly the same level as in 97H1. Portfolio inflows, which in magnitude terms are usually less than 10% of FDI inflows, are however expected to slow more in 1998.

7        In all, the income effect of the Asian crisis has not fully affected China yet. China still ran a large trade surplus of nearly US$27 bn in the period Jan-Jul 98, and strong FDI inflows continued to boost its capital account. In 1998-99, howe China's exports and investment inflows are almost certain to slow further as the downturn in the region sets in. A renminbi devaluation, which could accelerate the regional downturn through the contagion effect, would affect China negatively.

China's External Position

8        China large foreign exchange reserves (US$140.5 bn equivalent to 12 months of imports as at end-Jun 98) relative to external debt of US$131 bn, and its closed capital account, are positive factors supporting China's external position. However, are some weaknesses in China's external position. China's capital account is rather porous despite capital controls. The large errors and omissions figure in China's balance of payments - US$22.7 bn in 1997, which was equivalent to net recorded inflows on the capital account - suggests large unrecorded capital outflows. Moreover, data from the Bank for International Settlements (BIS) suggests that China's short-term debt could be US$35 bn larger than the official figure of US$18 bn.

9        Nevertheless, China's external position is strong enough to withstand devaluation pressures. This conclusion is based on China's large foreign exchange reserves relative to external debt, even after taking into account higher estimates of shor external debt and unrecorded capital outflows. The recent slowdown in China's forex reserves growth could be partly explained by a net outflow of trade credit, as well as a change in the foreign exchange system that allowed domestic exporters to retain 15% of their forex earnings.

Scope for Domestic Stimulus

10       With the Asian crisis, China's strong external sector performance in 1997 may not be repeated. The effect of the crisis on China will become more severe in 1998. However, China needs to maintain high growth to ease transition problems in its structural reforms, in particular, to stem rising unemployment from state-owned sector restructuring. The government is therefore under increasing pressure to stimulate domestic demand through monetary and fiscal policy.

11       In monetary policy, China has moved away from direct policy tools, such as administrative controls on credit, to more indirect instruments such as managing the reserve money base and interest rates. However, because China's monetary system is undeveloped, the transmission mechanism for these indirect instruments to GDP growth is still quite weak. For example, the five interest rate cuts since May 96 were ineffective in stimulating either consumption or fixed investment.

12       There has not been a real easing in monetary and credit conditions in China. Despite cuts in nominal rates, real interest rates have continued to rise because of falling inflation, and credit to banks has remained tight. Therefore, Premier Z Rongji's statement at end-Jul 98 that China is indeed suffering from deflation is significant, because it could signal the start of a significant loosening of monetary policy. However, monetary easing in the new regulatory environment may be difficult, as banks are increasingly unwilling to lend for fear of running up bad loans. If banks were ordered to lend in a bid to quicken monetary loosening, banks' balance sheet might be weakened further.

13       Fiscal policy offers a more direct and effective route to boost domestic demand. Given that the government has accounted for more than half of China's total fixed investment in the 1990s, increased government spending can be a significant sti The government is targeting its spending in two areas: infrastructure and housing. Infrastructure spending would be focused on building railways, roads and rural infrastructure such as electricity networks and irrigation systems. With the targeted end to state provision of housing in Jul 98, Chinese households would be encouraged to buy their own homes.

14       Between infrastructure and housing, infrastructure spending, particularly in rural areas, offers more potential for effective fiscal stimulus. In contrast, the boost from housing in the short-term is likely to be limited by the political sens of housing reform. China should be able to finance its increased spending through issuing state bonds. The government's outstanding stock of domestic debt is relatively low at Rmb540 bn or 7.2% of GDP as at end-1997. The increased spending will occur off-budget.

15       To conclude, there is scope for the government to pump-prime the economy through fiscal spending. However, the boost to GDP growth may not be as significant this year; the extensive restructuring in the government apparatus could delay swift implementation of this fiscal spending. As for monetary policy, a balance needs to be struck between a further easing in monetary conditions and the risk of a deterioration in the loan portfolio of the banks.

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