Renminbi reforms will be another false dawn

Rumours that the economic leadership under Premier Le Keqiang sees liberalisation of the Chinese renminbi as a top priority are on the march again, if the viewpoints of prominent Chinese economists and international bankers are to be trusted. Yes, we have heard these before and various ‘liberalisation’ measures have been somewhat underwhelming and involve only allowing the RMB to trade within a 1 per cent band of the prescribed exchange rate vis-à-vis the American dollar dominated ‘basket of currencies’ that the Chinese Central Bank pegs the RMB against.

Should we be more optimistic about the prospects for liberalisation after so many false dawns? Most in the financial world will say ‘yes’ because allowing free exchange and market-determined rates appears to make good economic and commercial sense. This author says that genuine liberalisation is not imminent because the conditions that have prevented liberalisation have not changed.

What’s the case for allowing a freely traded RMB whose rate is determined by the market? For a start, an appreciating RMB (it would almost certainly rise against major currencies if traded freely) would make imports cheaper for the Chinese people. China imports about half of its consumer goods, and only has vast trade surpluses with advanced economies in North America and the European Union. Allowing the RMB to be freely exchanged will create a much larger market for the currency outside China, and beyond its use merely for bilateral trade with China.

This could open up options for a more fruitful use of its foreign exchange reserves – estimated at US$3.66 trillion – that go beyond buying low yielding American government backed bonds. Importantly, liberalising the RMB is an essential step towards developing a wider and deeper corporate bond market in the country since it would encourage international buyers to purchase such bonds in a currency that was freely traded.

Of course, China cannot meaningfully liberalise its currency without liberalising its capital market, which is currently tightly restricted and controlled. There would be poor demand for the RMB if money under the country’s capital account could not easily enter and leave the country. Beijing would also have to liberalise its interest rates in order to prevent huge imbalances being created from the dangerous combination of a liberalised currency and open capital account alongside a fixed interest rate regime.

Economists, who have long attributed many of China’s imbalances to too much state intervention in capital, cost of money and exchange rates, would embrace such a move – another seemingly economically rational prescription. So if the economic reasons appear strong, why doesn’t Beijing allow it?

The first reason is potential instability. If the currency-peg was dismantled and capital controls lifted, Beijing fears domestic capital flight. Organisations like the IMF estimate that this could amount to 2-4 per cent of GDP, while more pessimistic experts such as MIT’s Victor Shih believe that this could amount to US$3 trillion in savings leaving the country. Whatever the accurate figure would be, the IMF estimate seems understated as various studies suggest that Chinese citizens already move an amount equivalent to 2-3 per cent of GDP out of the country even with a closed capital account, for example, through dummy companies in Hong Kong supposedly engaged in trade or through the purchase of expensive assets (such as real estate) for their children studying abroad.

But the greater problem may be speculative capital coming in, which the IMF and others believe would amount to more than 10 per cent of GDP. During the 1997 Asian Financial Crisis when massive amounts of capital first flowed in and then out of the Southeast Asian countries, China was largely unaffected as it was not tapped into global capital markets. The experience has convinced Beijing that it does not want to render its economy vulnerable to the whims of external speculators. Since the RMB has been repressed for so long, currency speculators will pour into capital into China in the hope of making a killing on a rapid RMB appreciation following currency and capital account liberalisation. Such money will leave the country, just as quickly as it enters at the first sign of trouble with the Chinese economy – and there are many such signs.

Then there is the matter of the impact of a rising RMB for China’s export manufacturing sector. Various studies show that a 10 per cent rise in the RMB against the dollar would lead to a 5-10 percent decrease in foreign direct investment entering the country. Remember that around 80 per cent of all FDI is destined for the export manufacturing sector. China is one part – albeit a central part – of a regional manufacturing production chain that encompasses Northeast and Southeast Asia. Many of these countries are competing with each other to attract FDI in order to host a part of the manufacturing process – making products mainly destined for the US and EU. These sectors employ around 50 million people in China directly, and another 100 million indirectly, and create the best jobs in the country. Beijing and the southeast provinces which host these manufacturing firms would not want to jeopardize such a setup.

Then there is the issue of the country’s huge foreign exchange reserves. The trillions of dollars are often described as some kind of economic ‘war chest’ for China. It is no such thing. The reserves largely arise out of a combination of its trade surpluses in the current account with the US and EU, and its fixed currency regime. This takes some explaining.

This is what happens when a Chinese-based manufacturer sells a plasma TV to an American consumer. Let’s say the price of the TV is US$100. The American consumer pays his money to the importer, who subsequently transfers the agreed amount to the Chinese manufacturing firm – let’s make it US$50. The Chinese Central Bank takes possession of the US$50, and issues an RMB equivalent ‘I owe you’ to the bank of the Chinese manufacturer, upon which the RMB equivalent appears in the local bank account of the Chinese manufacturer.

This means that the People’s Bank of China has to hold on to the foreign currency and ‘park’ its money outside China in a foreign currency-denominated asset. The People’s Bank of China generally buys US government backed bonds because it is the only place big and safe enough to ‘park’ that amount of hard currency. It just is not feasible to put it all in euro or Japanese yen-denominated bonds.

All this means that there are liabilities against China’s foreign currency reserves, namely the IOUs to its domestic banks holding money for the accounts of the country’s exporters. Beijing cannot afford to ‘park’ its foreign exchange reserves in too many higher risk assets because it needs the money to be there – hence the grudging support for the American government bond market despite such low returns.

If the RMB were to appreciate against the dollar, then the amount of foreign exchange reserves required to honour the People’s Bank of China’s IOUs given to China’s retail banks would increase proportionately. In other words, a 10 per cent appreciation in the RMB against the dollar could well mean a 10 per cent increase in the amount of American dollar-denominated foreign exchange assets needed by the People’s Bank of China to cover its liabilities. In the event of rapid RMB appreciation, the People’s Bank of China could well be forced to quickly issue its own bonds on the international market to meet its IOU liabilities.

There are other reasons why Beijing will be slow to liberalise its currency. But it’s enough to say that these imbalances preventing currency liberalisation are getting worse, rather than better meaning that liberalisation will administer quite a bit of acute pain before any structural gain becomes apparent.

The bottom line: China’s fear of liberalisation is a sign of its immense economic vulnerabilities and not strength. This applies whether it is the currency, capital account or interest rates that we are speaking about.

Dr John Lee is the Michael Hintze Fellow and adjunct associate professor at the Centre for International Security Studies, Sydney University. He is also a non-resident senior scholar at the Hudson Institute in Washington DC and a director of the Kokoda Foundation in Canberra.