China growth controls face interest rate dilemma

Currency appreciation could be the answer to slowing growth and winning friends in the US says Fitch economist.

With China facing a growth surge of the kind last seen during the 1992/1993 boom, higher interest rates would seem to be the answer.

However, Fitch Ratings China economist Brian Coulton points out that putting up interest rates China risks attracting even more huge inflows of capital, adding pressure on its exchange rate to appreciate.

Fitch also expects China' s foreign currency reserves to appreciate by up to $110 billion this year, bringing the total up to a $410 billion - putting still more pressure on the Rmb, which the government keeps linked to the dollar within a narrow range around 8.3.

China's capital account is closed apart from for foreign direct investments and limited equity participation through the Qualified Foreign Institutional Investor scheme.

However, the capital account still manages to show huge inflows and outflows, mainly in a section of the accounts - 'errors and omissions' - for which no explanation can be found.

Historically, China has seen major capital outflows, or capital flight, as Chinese banks, businesses and individuals have exported their assets abroad.

In recent years, Coulton says, that trend has been reversed thanks to interest rates in China which are higher than in the US, where rates are very low in an attempt to help the economy.

Despite China's dilemma about how to slow growth, and reflecting concerns amongst the US trade lobby about the 'cheap' Rmb, Coulton says China need to act.

"Asian countries have not been permitting their exchange rate to weaken - that's especially true of China considering the strong growth phase it's currently going through. It's extraordinary that there has been a 5-6%decline in the Rmb against the US dollar in the last 18 months, making Chinese exports even cheaper," points out Coulton.

China's exports are extremely competitive, many analysts say, largely due to an unusually disciplined, educated and cheap labour force, but also because of hidden subsidies such as VAT tax rebates.

Analysts agree that the US currency is doomed to decline thanks to its immense fiscal and trading deficits, but that the weakening needs to be carefully managed to prevent ructions.

"Other currencies need to rise against the dollar to help manage the decline, but so far the only ones that are strengthening, and therefore the only ones that are sharing in the burden of the dollar's weakness, are the Euro and the Yen. Many other Asian countries, especially Korea and China, are not taking part in this joint burden sharing," says Coulton.

The big danger is that these countries should suddenly wake up to the weakness of the currency and dump their huge holdings in US government debt securities. That would cause interest rates to jump in the US and trigger inflation. Difficulties in the world's larges economy would quickly lead to problems in Asia and Europe, says Coulton.

Coulton believes China one way out of the interest dilemma could be a 10-15% strengthening of its exchange rate against the dollar. This would help rein in China's growth, but not by using rates.

"Strengthening the currency would slow down export growth and hence imports of raw materials, such as iron ore. That would help cool down the economy - and have the advantage of making Chinese consumers richer," he says.

China's exchange rate, like most its interest rates, is set by government fiat, and Coulton says there is little chance in the market playing a stronger role in the setting of the exchange rate through current account liberalization - despite the positive turnaround in capital flows.

"The reason currency is coming back in is cyclical. In general, though, there is little doubt that if Chinese businesses and individuals could put capital abroad, they would," says Coulton.

Any transfer of those assets, which in the banking system total over $1 trillion in domestic savings, would be disastrous, since they provide the necessary liquidity for Chinese banks to survive despite non performing loan levels which make them insolvent.

Yet the insolvency of the banks, despite two bailouts, might just get worse with the current expansion of credit, says Coulter, who estimates new non performing loans to be running at 10% annually.

China's weak domestic situation contrasts with its huge foreign currency liquidity and low external debt, enabling the country to benefit from an A1 long-term foreign currency outlook with a positive outlook.

That's a crucial difference to the Asian countries which saw their currencies collapse in the 1997/1998, who has substantial short-term foreign currency debt to finance long-term, local currency projects.