China's currency will continue to strengthen, but its awesome export machine is unlikely to lose much steam
The renminbi is widely considered to be substantially undervalued. Although this helps China's exporters, it also has costs for the country. These include the impact of massive foreign-exchange interventions on domestic liquidity, and rising tensions with the US stemming from the yawning bilateral trade imbalance. There are some elements within the Chinese government that would be prepared to see a faster rate of appreciation. But others are concerned about the future competitiveness of China's exports if the renminbi is allowed to strengthen to a level closer to its 'fair' value.
Some of the supposed pressures for currency appreciation are often overstated. For instance, Chinese authorities have been somewhat successful thus far in sterilising foreign-exchange inflows, limiting the scope for the exchange rate to be a source of liquidity-driven overinvestment (a problem widely regarded as one of the big downsides of China's undervalued currency). At the same time, fears of the negative impact of a stronger currency on China's export performance are possibly overblown: recently policymakers have overseen an accelerated, albeit gradual, strengthening of the currency with no ill effects so far on exports.
On balance, as a result of the interplay of these various forces, the Economist Intelligence Unit expects China to allow the renminbi to appreciate by around 5% a year this year and next. This would leave the currency averaging around Rmb7.6:US$1 in 2007 and Rmb7.2:US$1 in 2008. Various factors will lead to slowing appreciation thereafter, with the renminbi strengthening to around Rmb6.6:US$1 in 2011.
What is the issue?
Signs that the Chinese currency is heavily undervalued are striking. In 2006 the Chinese current-account surplus reached an estimated US$208bn, or 7.7% of GDP, which is unprecedented for a continent-sized economy. Chinese trade data for January and February 2007 showed a surplus almost twice as large as the one for the full first quarter of 2006, suggesting that the trade and current-account surpluses will continue to expand, at least in the short run. US politicians and media naturally focus on America's bilateral trade deficit with China, which stood at US$232.5bn in 2006 according to US statistics. (A weak currency tends to promote exports by making the goods a country sells relatively cheaper in overseas markets.) And as a result largely of massive foreign-exchange intervention by the People's Bank of China (PBC, the central bank), China's foreign reserves rose above the US$1trn threshold in October 2006. The pace of reserve accumulation lends credibility to accusations that the Chinese are manipulating the exchange rate to boost exports.
Why is it critical?
The prospects for the renminbi are a concern in China for several reasons. The PBC's issuance of renminbi in order to purchase foreign currency (particularly US dollars) has boosted liquidity in the Chinese economy. This is widely seen as having contributed to overinvestment in some industries. However, the PBC has for the most part been effective in sterilising its foreign-exchange purchases by issuing bonds to mop up excess cash in circulation. In 2006 alone, the central bank issued US$118bn worth of bonds for this purpose. Nonetheless, complete sterilisation is difficult to achieve, which suggests PBC's foreign-exchange purchases have at least been something of a factor in driving investment demand.
There is also a widespread fear in China that a strong appreciation of the renminbi would hit the export sector. This is a particularly important issue for policymakers because low-margin export-oriented companies, such as those in the garment and textile sectors, are major employers. The country needs to create large numbers of new jobs just to absorb the increasing supply of workers. If this is not achieved, the risk of destabilising civil unrest will rise sharply.
In addition to domestic concerns, the international view of China's exchange-rate policy is important. Some politicians and labour leaders in the US and other industrialised countries claim that a faster revaluation of the renminbi is necessary to protect the welfare of households in their countries, by stopping the loss of manufacturing jobs to China. This argument is weak. Estimated labour costs in China were around US$1.35 an hour in 2006, compared with US$24.50 an hour in the US. Even adjusting for different skills and infrastructure in both countries, a sharp rise in the value of the renminbi would not come close to eliminating the gap in labour costs. Moreover, if costs in China became too high, manufacturers would not return to the US but would simply move to other low-cost countries, such as Vietnam. Nonetheless, political relations between the US and China will be determined to some extent by Beijing's willingness to give ground on the exchange rate.
What is the government doing about it?
China's government has long stated that its goal is to liberalise the exchange rate, but it has moved only cautiously in this direction. A major step came on July 21st 2005, when the authorities revalued the renminbi by 2.1%. They also stated that the exchange rate would be managed against an unspecified basket of currencies rather than against the US dollar alone (although it was clear that the dollar would continue to be given more weight). The authorities kept the existing trading bands of 0.3% on either side of a central rate against the dollar (with the closing rate of the previous day becoming the central rate of the next day), but they started to use this range slightly more actively.
Although the band may seem small, it theoretically allows an appreciation of more than 100% a year. The government, of course, has been far more conservative than this, initially allowing only slight movements in the exchange rate. Nevertheless, since mid-2006 the pace of appreciation has accelerated, averaging about 4.9% a month at an annualised rate in the second half of 2006. This pace quickened to around 5.4% during the first two months of 2007. It seems that China has grown more confident about the resilience of its economy and of Chinese exporters to the effects of a stronger renminbi.
The EIU view
We expect China to allow the renminbi to appreciate against the US dollar by around 5% a year this year and next. The pace of appreciation will slow thereafter owing to a fall in the trade surplus from 2008 onwards, the impact of increasing capital-account outflows on domestic liquidity and an expected moderation in real GDP growth. The government will also be wary of the social costs presented by continued strengthening of the renminbi. It is important to note that if our forecasts are correct, by 2011 the renminbi will have appreciated by a still substantial 25%, compared with its level prior to the initial revaluation in July 2005.
However, the exact pace at which the government will allow the renminbi to appreciate will depend on a number of factors, and there are several reasons why the currency could appreciate more rapidly than we forecast. One important issue will be the success of sterilisation efforts. Although, as mentioned above, these have been somewhat effective so far, there have been periods when the central bank has found it difficult to mop up the excessive cash in circulation resulting from its foreign-exchange interventions. Going forward, sterilisation will become even more difficult as the sophistication of the domestic financial system increases and as a rising number of investors find ways around restrictions on international capital flows (which in any case will also be in the process of being liberalised moderately).
Another factor is the risk that the further issuance of liabilities by the central bank will lead to fiscal problems. In most emerging-market economies, the interest rates that government authorities pay on liabilities are much higher than the returns they get on their holdings of foreign reserves (most commonly US Treasuries). So far, China's situation has been different, owing to the fact that interest rates on central-bank sterilisation bonds in China remain very low. Again, this will change as the liberalisation of China's financial sector continues, which in turn will lead to rising borrowing costs. Despite this, rates would have to move quite some way before the central bank would need to take into consideration the risk of excessive liabilities on its balance sheets.
The state of Sino-US relations is the final factor that will have an impact on the pace of renminbi appreciation. The US political establishment and media have become obsessed with America's bilateral trade relationship with China. Although there is a risk that this obsession could lead to a deterioration of relations between the two trading giants, China's response is likely to be pragmatic. The US has a number of levers that it can apply to try to persuade China to revalue more substantially. Without breaking World Trade Organisation (WTO) rules, the US could introduce tougher measures against what it considers unfair trading practices by China. Moreover, China will remain reluctant to provoke the US in a way that could have implications for security policy. As such, and despite China's fundamental unwillingness to be seen to be caving into US pressure, Beijing is likely to permit further currency appreciation, albeit at a slower pace than demanded by Washington.
In any event, currency appreciation will not necessarily have a dramatic negative impact on China's overall export success, although a significantly stronger renminbi will undoubtedly make trading conditions tougher for some sectors. More than five years after China's accession to the WTO, a large share of Chinese export growth is driven not by marginal advantages in exchange-rate competitiveness, but by rapid capacity expansion and the country's ongoing adjustment to its integration into the global trading system. This process is a direct result of China's WTO entry. A decade's worth of massive inflows of foreign direct investment into China's export sectors has also played a major role. Given the country's size and the rapid rise in the country's manufacturing capacity, China will continue to grow its share of world markets for some time to come. Global demand should also remain supportive of Chinese export growth. In this situation, standard macroeconomic models, in which export growth is strongly affected by movements in unit labour costs, are misleading. In the Chinese context, the interplay of productivity, wages, other production costs and the exchange rate has only a secondary role, in our view, in determining the country's export growth. China will, in short, remain a daunting export powerhouse irrespective of its appreciating currency.
Editor's note
This is the sixth in a series of articles exploring the most pressing challenges currently facing China as identified by Economist Intelligence Unit analysts.Business China Select
