The unbearable cheapness of the Chinese Yuan

Goldman Sachs China economist, Hong Liang, explains why the government needs to adjust the currency peg.

The Chinese economy started 2005 with a better-than-expected report card, propelled by strong headline growth and mild inflation in goods and services. The only surprises were a much stronger-than-expected export performance and much weaker-than-expected import growth. But the latest trade data have again put the RMB peg under the global spotlight and underscored the awkwardness of government policies that merely try to address the symptoms of a misaligned currency.

The combined first quarter trade surplus totaled $16.6 billion, in contrast to a trade deficit of $8.4 billion in the same period last year. In real terms, the swing in net exports is likely to be even sharper as import prices have risen faster than China's export prices.

This means changes in net exports alone would have pushed growth above 9% in the first two months of the year even if domestic consumption and investment ceased to grow! Put simply, beneath the Goldilocks headline numbers China's growth seems to have become more imbalanced, fuelled by external demand.

There are a number of factors that may have contributed to the sharp swing in net export growth, including the base effect, the elimination of textile quotas at the beginning of this year, and possible inventory adjustment in the IT sector. Structural factors such as Chinese exports moving up the value chain may have also played a role. However, there is little doubt that the sharp swing in trade balances is largely cyclical on account of a weaker US dollar and policy-induced weaker domestic demand.

China's export growth has defied gravity in the last three years thanks to China's entry into the WTO and a falling US dollar. The impact of currency on trade balances is most visible in Sino-EU trade figures.

The EU is now China's largest trading partner, contributing $5 billion plus trade surpluses every month. Exports to the EU have been consistently growing faster than overall exports, while imports from the EU are growing more slowly.

On the other hand, import growth has notably lagged behind export performance since late 2004, breaking down the close historical correlation between these two.

The culprit? Slowing domestic demand induced by policy tightening.

Thanks to capacity expansion over the past two years it is not surprising that Chinese producers in the tradable sectors are turning to the global markets to sell their surplus to compensate for slowing demand at home. Such "market switches" are most notable in the three sectors targeted as overheating by the central government last year: steel, cement, and automobile.

Although China may enjoy formidable competitive advantages in the steel and automobile industries for years to come, the timing and intensity of trade adjustment in these sectors clearly had more to do with the blunt tightening on domestic demand last year. For example, import growth of iron and steel dropped from around 50% year-on-year in early 2004 to negative territory towards the end of the year, while export growth jumped from below 40% to above 300%!

Will such a trade pattern continue? Until domestic demand picks up more steam, it is likely. In this vein, China is unlikely to be a source of inflation for finished products as long as domestic demand remains capped.

However, a bigger question/risk is how quickly the strength in exports is going to feed through to the rest of the economy through the income multiplier? It will probably not take very long, given how resilient domestic demand has been. This highlights the awkwardness of the authorities' sectoral or micro approach towards macro imbalances.

Early last year, investments in three sectors (steel, cement, and aluminum) were singled out as targets for policy tightening. The list later expanded to nine sectors.

Most of these "blacklisted" sectors are no longer offenders for overheating. Although fixed asset investment recorded a 24.5% year-on-year growth in January-February this year, these blacklisted sectors were not among the drivers for this growth. In fact, investment in ferrous metal smelting and construction decreased by 9.0% and 28.9% respectively.

The only sector that remains at the centre of the government's radar screen is property. However, even here, the concern seems to be more about rising prices, since investment growth in the sector has been trending down markedly since last year.

The government recently raised mortgage lending rates by 20bp and tightened mortgage lending rules. While these measures will help banks manage their risks better, they may prove insufficient to dampen buoyant demand as incomes rise with a stronger economy and the undervalued RMB continues to attract large FX inflows.

The January-February data confirm that, aside from efficiency costs, the authorities' sectoral approach has failed to cool down one important source of overheating: buoyant external demand for China's goods and assets. In my view, excess demand in China has also been and is still being generated by the undervalued RMB, which has made Chinese products and assets too cheap.

Moreover, owing to policy tightening on domestic demand, China's growth, rather than being fueled by domestic demand, has become more external demand driven. Therefore, one year after the tightening began, China is saving more and consuming less. This is the kind of adjustment the market has been hoping to see from US economy, not China where the opposite is desirable.

As buoyant trade performance is likely to quickly feed through to domestic demand, the need for policymakers to tighten macro policy clearly persists. A RMB revaluation followed by a subsequent move towards a more flexible currency arrangement remains the best policy option for the government.

Without a RMB adjustment, the required tightening through interest rate hikes would be too costly for the weak domestic financial system to bear. Likewise, administrative/micro measures to deal with symptoms of an overheating tradable sector are not only inefficient, but also increase the risks of policy overkill.

Another risk of inaction on the RMB is that it exposes China's economy to more risks than are justified by the fundamentals of an eventual slowdown in external demand, led by either a weakening US economy or rising trade protectionist measures. Complaints about an undervalued RMB are likely to get louder and potentially more teeth, from the US, Europe, as well as from China's Asian neighbors.

With a sustained rise in trade surpluses and capital flows, China's wait for an opportune time to initiate the RMB move is getting more costly and more burdensome for the authorities in their pursuit of other policy objectives. Each data point from China of rising trade surpluses and FX reserves (the flip side is worsening US trade and current account performance) would cause more speculation on the RMB, and the need for the government to reassess the benefits and costs of keeping the peg.

Premier Wen Jiabao's latest remarks suggest that a RMB move could happen any time. For China's own benefits, an adjustment in the RMB peg is better sooner than later, as it would help China help itself to directly tackle the root cause of overheating in external demand while opening up more room for domestic demand to grow.

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