Issues and Problems with Trade Imbalance: The Chinese Experience

1
Issues and Problems with Trade ImbalanceThe
Chinese Experience

• Economic Changes Pressure Beijing to WSJ
  (5/2/2005)
• A Yuan-Revaluation Surprise BW (7/22/2005)
• Chinas Surging Credit Growth and WSJ
  (4/28/2006)
• Beijing Takes Steps to WSJ (12/6/2007)
• Beijing Lets Yuan Rise at a WSJ (12/28/2007)

2
Economic Changes Pressure Beijing to Let the
Yuan Float WSJ (5/2/2005)

• In May 2005, the Chinese yuan was allowed for the
  first time to be traded outside its tight trading
  bands. The market viewed this as a sign that
  Chinas currency policy could be about to change.
• Threatened by possible protectionist trade
  measures by the U.S. and European Union, China
  was under growing pressure to make a move to
  tackle the ballooning trade imbalance with these
  countries. Nonetheless, with regard to the U.S.
  trade deficit, Chinese leaders still contended
  that only the U.S. could fix its problem by
  cutting spending and saving more.
• Changing economic conditions could also play a
  role in compelling China to alter its exchange
  rate policy. To maintain the currency peg, the
  Bank of China needed to purchase dollars, which
  were flooding into the country, with yuan. To
  prevent the resulting surge in yuan liquidity
  from igniting inflation, China sterilized the
  money by issuing bonds and sold them to
  state-owned banks at low interest rates.
  However, with Chinas economy expanding fast,
  banks were able to get greater returns on their
  money by making loans to the private sector than
  by buying bonds from the government.

3
A Yuan-Revaluation Surprise A Baby but Key
StepBusinessWeek (7/22/2005)

• On July 21, 2005, the yuan was permitted to
  appreciate about 2.1 against the dollar. China
  abandoned the yuans decade-old peg to the dollar
  and shifted to a crawling peg system. The yuan
  would still move within a narrow band around the
  central rate against the U.S. dollar in a given
  day, but the rate could be adjusted over time.
• While the policy change was an important first
  step, the currency revaluation remained too small
  to have any significant impact on Chinas
  enormous trade surplus. China would need to
  allow its currency to appreciate much more.
• The relatively small currency revaluation would
  also have little impact on Chinas vast foreign
  currency reserves (estimated at about 700
  billion in 2005), 70 of which were in dollar
  assets like U.S. Treasuries.
• Unless the yuan could appreciate to a high enough
  level, currency traders would continue betting on
  a stronger yuan. The Bank of China would still
  be strained in dealing with massive capital
  inflows and huge export earnings. To keep the
  yuan at some target level, the central bank would
  have to sell yuan for foreign currency. With too
  much yuan circulating in the banking system, the
  central bank would also need to sell bonds to
  soak up the extra yuan and prevent it from
  igniting inflation and overheating the economy.

4
Chinas Surging Credit Growth and Growing Trade
SurplusWSJ (4/28/2006)

• Chinas problem with runaway credit growth
• Facing the risk of an overheated economy, Chinas
  central bank raised banks lending rates. The
  rate hike the first since October 2004 aimed
  to rein in the explosive credit growth that
  fueled a bubble-like investment boom in the
  Chinese economy. Latest data showed that
  business investment already accounted for nearly
  half of Chinas GDP. If the investment bubble
  burst, it could seriously damage the financial
  system and take down the economy.
• Chinas exchange rate policy was largely
  responsible for the problem with runaway credit
  growth. The undervalued currency bred
  revaluation speculation and enticed speculative
  capital inflows. The cheap yuan also boosted
  exports, producing a huge trade surplus for
  China. The booming exports, along with enormous
  inflows of foreign direct investment and
  speculative money for portfolio investment,
  generated an excess demand for yuan. To keep the
  yuan from strengthening, the Chinese central bank
  had to sell yuan in exchange for foreign
  currency. As a result of these foreign exchange
  purchases, Chinas banking system was flooded
  with yuan liquidity. Funds were so abundant that
  commercial banks and other credit institutions
  were eager to expand lending, thereby propelling
  the investment boom and supporting inflated asset
  prices.

5
Chinas Surging Credit Growth WSJ
(4/28/2006) Continued

• Limits to sterilization operations in China
• The Chinese central bank had tried to remove the
  excess liquidity out of its banking system by
  issuing new bonds and selling them to commercial
  banks. However, such sterilization operations
  failed to succeed due to two reasons
• As Chinas trade surplus and capital inflows
  continued to soar, the resulting liquidity
  increase was simply too much for its central bank
  to control through selling bonds. The problem
  was aggravated by the fact that China did not yet
  have a well-developed bond market.
• The domestic appetite for yuan-denominated bonds
  was falling. Commercial banks increasingly
  looked for more profitable ways to deploy their
  surplus funds, including making business loans
  rather than simply buying government bonds.

6
Chinas Surging Credit Growth WSJ
(4/28/2006) Continued

• Raising interest rates did not address the root
  problem
• The runaway credit growth was just a symptom.
  The root cause was Chinas soaring trade surplus.
  While the interest rate hike was intended to
  restrain credit growth, it would not help correct
  the trade imbalance. Indeed, if Chinas monetary
  tightening succeeded in slowing its economy down,
  it could also bring down the demand for imports,
  leading to an even larger trade surplus for
  China.
• A stronger yuan, on the other hand, could cut the
  trade surplus, while holding down credit growth
  in China. A stronger yuan could dampen the
  demand for Chinas exports by making them more
  expensive to foreign buyers. It would also
  reduce speculative capital inflows by making
  Chinese assets more expensive to foreign
  investors.
• Nevertheless, because of the heavy reliance on
  exports as its growth engine, China resisted any
  sharp revaluation of yuan. Strong economic
  growth was still needed to reduce poverty in many
  parts of China, and any steep decline in exports
  could create widespread unemployment. The
  Chinese government, which tried to gain
  legitimacy through rapid economic development,
  did not want to risk facing social instability.

7
Chinas Surging Credit Growth WSJ
(4/28/2006) Continued

• Addressing the trade imbalance between China and
  the U.S.
• Even if China accepted a much stronger yuan,
  currency revaluation alone could not fully
  correct Chinas huge trade gap with the U.S. In
  addition to the undervalued yuan, there were
  other structural factors at work China enjoyed
  a remarkably high national saving rate, while the
  U.S. saving rate was exceptionally low.
• China should take steps to bolster domestic
  consumption. If Chinas households could spend
  more and save less, its trade surplus would
  shrink. By promoting domestic consumption, China
  could reduce its reliance on export growth,
  thereby improving the long-term sustainability of
  its economic expansion. The shift from
  export-led to consumption-led growth would also
  lessen Chinas need to keep a cheap yuan policy.
• The U.S. should also shared major responsibility.
  Its large government budget deficit was a
  significant drain on national saving. Cutting
  government spending would increase U.S. national
  saving. The U.S. should also do more to promote
  household saving. For example, new policy
  initiatives might be implemented to create
  additional incentives for retirement saving.
  With U.S. consumers saving more and spending
  less, the U.S. trade deficit would diminish. To
  cut the trade deficit thus required less spending
  on the part of both the federal government and
  the American public.

8
Beijing Takes Steps to WSJ (12/6/2007)Beijin
g Lets Yuan Rise at a WSJ (12/28/2007)

• Inflation conditions quickly worsen in China.
  Higher inflation lowered peoples living
  standard, thus raising social tensions. This
  compelled the Chinese government to be more
  serious in combating inflation and preventing the
  economy from overheating.
• More interest rate hikes were likely to occur,
  especially if the inflation picture would not
  improve soon. However, the Chinese central bank
  already initiated a series of interest rate
  increases before, but they were relatively
  moderate in size and they failed to have any
  significant impact on inflation.
• Economists also expected China to allow its
  currency to appreciate at a faster pace. A
  stronger Chinese currency could help reduce
  inflation by making imports cheaper and reducing
  exports.
• By the end of the month, the Chinese central bank
  raised the reserve requirement ratio again -- the
  fourth time in the same year. This measure also
  had not been effective enough to reduce the
  excess liquidity in the Chinese banking system.
• Soon after the hike in the reserve requirement
  ratio, the Chinese government finally decided to
  allow its currency to appreciate at a faster pace.