Thursday, May 22, 2008

China: currency appreciation and inflation

Stephen Jen has a very interesting piece on currency appreciation and inflation. Normally, people would think appreciating currency would bring down import prices thus help to bring down inflation. In China's case, rising Chinese Yuan (CNY) also discourages export, thus keeps fast rising current account surplus at bay, reducing the need for sterilization by central bank and slow down money supply growth in the domestic market. Both tend to ease inflation pressure eventually.

In his piece, Jen hypothesizes another possibility that rising expectations of future currency appreciation attracts large capital inflows (I think he meant hot money) thus dampens central bank's hope that currency appreciation would reduce inflation pressure through the balance-of-payments channel.

One of the key structural forces of inflation in China, as is widely agreed, is the persistent and large rise in its official reserves, roughly half of which have, in recent years, been sterilised. What makes China's case rather remarkable is that China not only runs a large C/A surplus (which averaged 7.4% of GDP during 2005-07), but it has also received very large capital inflows. Official reserves grew sharply from 2002 (US$286 billion) to 2005 (US$819 billion), but really accelerated in 2007 (reserves increased by US$461 billion). What is perhaps even more remarkable is that, while China's C/A surplus has continued to expand, the growth (my emphasis) in net capital inflows in 2007 accounted for 59% of the total increase in reserves. To spell this out, China's massive C/A surplus last year of US$206 billion accounted for 'only' 41% of the increase in official reserves. We argue that much of these large capital inflows may have been motivated by the general expectation that the CNY would continue to appreciate against the dollar at a rapid pace, and that having a short USD/CNY exposure was a high-yield zero-risk investment. Thus, rather perversely, while Beijing's ultimate objective of bringing the value of the CNY more in line with the economic fundamentals should eventually lead to a more sustainable BoP position, the process of getting there is inflationary. In sum, while many have argued that the stronger CNY has helped China to contain inflation, we believe that precisely the opposite is the case.

Theoretically, the only way around this dilemma confronted by China is to have a maxi-revaluation in the CNY against the dollar of a size so large that few investors would believe that the CNY can appreciate further. This is the only effective way to halt the speculative capital inflows into China. The practical obstacle, however, is that it is not clear how big such a move in USD/CNY would have to be. Related to this question are the concepts of the 'fair value' and the 'equilibrium value' of USD/CNY. The former is the value of USD/CNY that is consistent with the underlying economic fundamentals (e.g., productivity, terms of trade, etc.), while the latter is the value of USD/CNY that will help to close China's BoP surplus. We believe that the current spot USD/CNY is already close to the 'fair value'. However, to close China's BoP surplus, USD/CNY would probably need to decline by a massive (50%?) amount. Would Beijing feel comfortable implementing a step revaluation in CNY from 7.00 to 3.50 in one go? We doubt it.

Jen's analysis captures largely what is happening in China. I reckon that this could be a plausible explanation of why Chinese government's inflation-control measures so far have been largely fruitless.

However, there are several issues with his analysis I'd like to point out:

First, he did not differentiate FDI with hot money in the net capital inflows. I suspect a large chunk of the capital inflows would be long-term foreign investment. But arguably, a lot of hot money can also enter under FDI camouflage.

Second, Jen thinks the only solution to the inflation problem is a large one-time currency reevaluation. But there are many other policy possibilities.

1. Tighten up capital control on hot money inflow. This is arguably not the best solution but can be improved at margin.

2. PBoC (China's central bank) allows an even bigger chunk of $ revenue from export be retained at enterprise level. This reduces the pressure of converting $ to CNY immediately thus will not increase domestic money supply.

3. Relax the regulation on domestic US $ conversion and allow one-way free currency exchange without cap (or with a very generous cap). This is to say, Chinese enterprises and individuals are encouraged to freely exchange US $ with CNY, but US $ is not allowed to be converted to CNY within certain time-frame. Be reminded free conversion does not equal lift of capital control but can be the first step towards it.

4. Finally, if Chinese government is really serious about inflation control, they should raise interest rate to an even higher level. Tweaking with bank reserve requirement is not good enough. Currently the real interest rate in China is negative (with inflation adjusted), and the monetary policy is still expansionary. Administrative control or command orders have been ineffective. Only by increasing cost of capital and disincentivize investment can inflation be controlled.