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Thursday, July 24, 2003

A Creative Alternative to Rinban Revaluation

Andy Xie, on why China may have available a very interesting alternative to Rinban revaluation. While some of the details here may be of the 'hard to follow' variety for the non economist, the main point should be clear: an extraordinarily favourable global headwind has pushed up rinban revaluation expectations, in default of any serious contender. This gives the Chinese authorities an exceptional opportunity to clean up the financial system based on the ability to take advantage of the currency revaluation expectations. Could this mean there is 'good' and 'bad' speculation, just like there is good and bad deflation? In any event look at the credit/GDP ratio (157%), a number which in normal conditions would provoke fear of extreme inflationary implications. Now there is some debate about the possibility of rising inflation in China, especially, as Andy Xie notes, due to its heavy dependence on raw material (commodity) imports, and this is a theme which may well be worth exploring on a subsequent occassion (what for example will be the impact of a secular rise in raw material prices on other developing countries: my feeling in general is that China's impact will be felt as much in the third world as it is in the OECD countries). All this being said, the unprecedented upward movement in the Chinese economy would be hard to understand without an appreciation of the underlying demography, and without the aid of something like the Mamlberg model. Those who don't take note are sailing in the open sea with neither charts nor compass - and in many cases with little ability to navigate using only the stars as a guide. (One clear example of someone who although apparently bereft of charts and compass, is good at 'star gazing' is of course Andy's boss: Stephen Roach.

According to Chinese local press reports, China may announce a schedule for the proposed sale of US$240 billion of state holdings in A-share listed companies, which is to be confirmed. This substantial amount of RMB asset supply would completely remove pressure on the RMB to appreciate for the next two years, in my view. Indeed, China could sell down its NPLs (estimated at 25-40% of state bank loans or US$250-500 billion, according to various sources) to further increase the supply of RMB assets. In my view, the additional liquidity inflow due to speculation on RMB appreciation is a golden opportunity for China to come to grips with problems within its financial sector. China could solve its financial sector problems with subsidies from foreign speculators. Financial reform would normally require devaluation. The currency market is paying 2% for the privilege to buy RMB at the current rate one year from now. Why shouldn’t China use liquidity arising from currency speculation on the RMB to repair its financial system?

China’s foreign exchange reserves increased by US$53.7 billion in the first five months of 2003, while its net foreign assets increased by US$21.3 billion. The change in net foreign assets reflects FDI and the trade balance (totaling US$25.5 billion in the first five months). A slower increase in foreign currency deposits and reduction in banking sector net foreign assets have contributed to the excess increase in foreign exchange reserves. The trends reflect the fact (1) that Chinese banks are worried about RMB appreciation, which would entail huge financial losses for them, and (2) that Chinese enterprises and households are not increasing US dollar deposits, as was the case previously, amid talk of RMB appreciation. In short, the rapid increase in foreign exchange reserves appears to be due to expectation shifts rather than a change in fundamentals. Indeed, China’s foreign exchange reserves tend to rise in tandem with capital inflows rather than trade surpluses. When China runs large trade surpluses, as was the case between 1997 and 1999, its foreign exchange reserves did not increase in tandem. Indeed, rising trade surpluses in China usually reflect pressure on the currency and, hence, deflationary pressure results in a rising trade surplus to meet capital outflow demand.

The rapid increase in foreign exchange reserves this year fits the old pattern. As the economy is doing well, there is more speculative demand for RMB. China and Hong Kong combined are running a trade deficit this year. As long as commodity prices remain high, as we expect, China and Hong Kong combined will continue to run a trade deficit. Currency speculators have pushed up the RMB in Singapore’s non-deliverable forwards (NDF) market. The implied interest rate for RMB is -1% for the one-year maturity. This indicates foreign speculative demand for RMB is strong, which should keep China’s financial conditions loose. Ample liquidity in the system can cause overheating and bubbles. We are already seeing some symptoms. Domestic credit has risen by 18.5% YoY in the first five months of this year. It rose by 30.3% YoY last year. With domestic credit at 157% of estimated 2003 GDP, such a rapid increase could certainly lead to tremendous demand creation.

The rapid increase in credit is causing strong investment growth. Most industries are witnessing steep increases in capacity. Property investment increased by 35.2% in the first half from last year. Most major cities are about to face excess supply. Car production increased to 902,000 vehicles in the first half, up from 441,000 a year ago. What is taking place is that income from the 30% increase in exports is being transformed into property and industrial capacity. China is spending its export income and, hence, keeping its trade surplus down via increasing imports. As investments in industry and property rise with export income, imports of raw materials and machinery increase in tandem with exports to keep trade in balance.

Overinvestment is considered a convincing sign of overheating, and currency appreciation is recommended as an option to cool down the economy. However, currency appreciation could backfire and cause further overheating, as the inflow of speculative capital increases, thus making the property sector even more overextended, which in turn could cause problems further down the road.

Overinvestment using export income is a familiar theme, and one that we observed in Southeast Asia prior to the 1997-98 financial crisis. The fundamental cause of overinvestment, however, has more to do with the lack of risk management in the banking system than export strength. Currency appreciation thus cannot solve the problem. Rather, the solution is financial reform, which would lead to better capital allocation. Thus, floating the currency should only follow not lead financial reform. I believe that the current situation presents a golden opportunity for China to solve its two major problems: (1) the high level of non-performing assets in the financial system and (2) the current concentration of economic growth along the Eastern Seaboard.

The current favorable liquidity environment offers a golden opportunity for China to address problems in its financial sector. The huge amount of NPLs in the banking system and the overhang of state shares in the A-share market are the twin legacy problems for China’s financial sector. To unwind the two would require the injection of sizable liquidity by the central bank into the system. This would normally lead to currency devaluation. However, the current strong demand for RMB could allow China to tackle the two problems without depreciating its currency. The value of state shares in the A-share market is around US$240 billion at current prices; however, it is impossible to calculate their value at the market-clearing price. Their sale would help strengthen the national pension system, and would also allow the government to pay laid-off workers. In a way, the sale of state shares would translate foreign liquidity inflow into income for laid-off state enterprise workers. China’s NPLs are currently estimated at 25-40% of the state banks’ loan book, or US$250-500 billion. China has already started to sell some of the NPLs to foreign JVs. However, the amount sold so far is small relative to the total stock. The current favorable liquidity conditions thus allow China to accelerate NPL disposal without having to depreciate its currency.

The five provinces along the Eastern Seaboard (Guangdong, Fujian, Zhejiang, Shanghai and Jiangsu) accounted for 76.4% of China’s export increase in the first five months of 2003, even though they account for only 20% of the country’s population. The other four coastal provinces (Shandong, Tianjin, Hebei, and Liaoning) contributed to 13.8% of the export increase, with 16% of the population. The remaining two-thirds of the population are not in the global economy and live off the income from the coastal provinces, in the form of fiscal transfers and credit redistribution through the state banking system.

China’s economy is less evenly distributed than the euro-zone economy. Per capita income in the richest province in China is 10 times that in the poorest province, while per capita income in the richest economy in the euro-zone, Germany, is about 3 times that in the poorest economy, Portugal. While rapid export growth may make China’s Eastern Seaboard appear to be overheating, the rest of the country is still quite depressed. China can cool down the Eastern Seaboard and transfer growth to its interior provinces by phasing out the preferential tax treatment for foreign and/or export companies there and retaining such privileges in the interior provinces. Such a policy change could both dampen the investment bubble along the coast and increase economic growth in the interior provinces, thus reversing the widening income gap between coastal and interior provinces.
Source: Morgan Stanley Global Economic Forum

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