China's currency challenge

Cleaning up China''s forex regime is the best way to achieve a soft landing, says Frank Gong, JPMorgan''s head of research and chief economist for China.

What's been driving the overheating of China's economy and could an appreciation of the currency change this?

Gong: The most immediate cause is the growth in supply, in the form of strong fixed investment growth, often by provincial governments. More fundamentally, the huge excess liquidity in the banking system is the most important force behind the overheating.

If the forex regime issue isn't addressed, then excess liquidity will continue to slosh around China's closed banking system, adding to overheating.

That makes a soft landing more difficult.

Liquidity is bad for the banks too. They become eager to lend it out, increasing the role of bank credit in the economy, which is already a dangerous 150% of GDP. They need to develop alternative instruments for generating business.

Therefore, it's important for China to change its foreign currency regime and allow some of the liquidity out. Then it will be able to develop a more flexible. You need an independent monetary and interest rate policy w hen you have a larger and rapidly growing, domestically-driven economy and huge, undeveloped, financial markets.

Only a freely floating exchange rate can allow independent domestic setting of interest rates. The downside of opting for a fixed exchange rate is that you forego the privilege of setting your own interest rates, since the value of your currency is set by the currency you peg it to.

What's the key to a soft landing for China's economy?

In addition to a revised forex regime, fixed asset investment must slow down, as it has done, but without falling off a cliff. We expect 7.5% GDP growth in the second half, topping out at 8.8% for the whole year. Investment should also be switched to those sectors where bottlenecks exist such as electricity, energy and transportation infrastructure. Continued consumption and robust exports to the US should help cushion the downturn.

One concern is that much of the slow-down is, according to anecdotal evidence, is being born by the private sector, which are seeing working capital lines of credit being abruptly cut off.

Many workers are also being laid off from city construction projects. While it's true many of these projects weren't commercially viable, the workers should be set to work on subway projects, rather than being sent back penniless to their homes in the countryside.

What would motivate China most effectively to widen its band or institute a more flexible regime?

China won't revalue because of external reasons. But it would consider a stronger Rmb to counteract inflation from the weaker dollar, higher commodity prices and a loose stance by the Fed.

China has recently been suffering from inflation, although we expect it to top out at about 6% to 7% in the third quarter. A strengthening currency would slow inflation by making the same goods cheaper in Rmb terms.

The government is keen to avoid the soaring inflation of the earlier years of the reform programme.

What are the main obstacles to changing the regime?

Banks are very vulnerable to increased interest rates or an appreciating currency. Revaluation would inflate the value of the Rmb-denominated NPLs versus the banks' dollar assets. Banks would also be hit by the impact on the broader economy of a slowing economy, so NPLs could rise, slowing down their stock market listings.

Therefore, accelerating banking reform is important. Commercialization and re-capitalization needs to be speeded up.

In addition, there's no real, liquid market for foreign exchange forward transactions. This is because there is no market based benchmark yield curve and interest rates aren't set by market forces and credit standards.

To rectify this, the authorities could increase non-bank financial institutional trading in the domestic inter-bank forex market and allow more currency trading other than just the US dollar, yen and euro against the Rmb.

The capital account also needs to be liberalized for a wider forex band to function normally.

As you know, the government needs to sterilize huge sums of US dollars coming in via trade and foreign direct investment, to avoid pushing up the value of the Rmb.

The government has to buy up the dollars with Rmb, flooding the banks with liquidity. Then the central bank has to borrow back this money from the banks - and pay interest rates on the bonds it issues to the banks. That works in principle, but paying interest on such huge sums is an additional expense for the government. It's a nice bonus for the banks, however.

The current excess demand for Rmb could be rectified by allowing say just 10% the Rmb 20 trillion in the banking system, to leave the country and balance inflows ($100 billion in all last year). This requires a final decision regarding the Qualified Domestic Institutional Investor scheme for investing money abroad.

What's the likelihood of China revaluing its currency this year?

The original idea of Rmb revaluation aros last year when the US dollar looked as if it was heading on a long-term weakening trend. At the same time, it looked like the Rmb would strengthen since there was a wave of bullishness on China, especially given it had the world's largest trade surplus with the US.

But China has been running large trade and current account deficits this year, the US dollar has rebounded and US interest rates are about to rise. There's less speculation, so the near future could be a good bet, maybe a 50% probability by the end of the year.

I expect the trading band to widen to 2% to 3%, from less than 0.1%, and the currency to strengthen by a similar amount. However, China needs to build up the necessary financial infrastructure first, because it's currently inadequate for a more flexible forex regime.