Can Media Reports of a "Yuan Revaluation Before the End of the Year" Really Be True? - "Inflation Prevention" is the point that needs to be understood

Senior Fellow, RIETI

Major Japanese newspapers reported around Feb. 12-13 that, "The yuan may be revalued by the end of the year." These media reports originated directly from a working conference of the People's Bank of China (China's central bank, affiliated with the State Council) in Beijing on Feb. 10, when its governor Zhou Xiaochuan listed the need to "improve ['perfect'] the yuan's exchange rate mechanism" as one of the bank's 10 great missions of the year.

Just several days before that, on Feb. 7, the finance ministers and central bankers of the Group of Seven issued a joint statement following their meeting in Florida that included the phrase, "more flexibility in exchange rates is needed in major countries and economic areas that lack it."
What did Governor Zhou mean when he said "exchange rate mechanism?" In recent months, speculation has been mounting that China is contemplating the adoption of a currency basket system to replace its current dollar peg. Upon hearing this phrase, then, it would not be unreasonable to think that China had finally made up its mind to act. Many firms in Japan may have begun to incorporate the idea of a yuan revaluation by the year's end into their business strategies, but what would they think if told that the Chinese perception of the situation is different?

The Chinese are well aware of the foreign pressure to raise the value of the yuan as symbolized by the G7 statement. There were some newspapers that went so far as to say that, "[Demands for] the yuan's revaluation were the largest international pressure China faced in 2003" (China Business Times, Feb. 12).
It is not just a matter of foreign pressure. The yuan has come under heavy buying pressure in foreign exchange markets as a result of speculation, with the dollar-buying intervention by Chinese monetary authorities to counter this also leading to a surge in money supply, and China is on the brink of inflation and an economic bubble. It is obvious that it would be impossible to maintain the current exchange rate, and there is no doubt that Chinese authorities also feel that time is running out.

Three suspicions surrounding media reports of the yuan's impending revaluation

However, just because this is the case, it does not justify interpreting the aforementioned speech at the working conference of the People's Bank as meaning that the yuan will be revalued by the end of the year, let alone claiming that the governor said that such a thing would even happen. There are three reasons why I feel this way.

Firstly, there were two things that foreshadowed the way the Japanese media reported this news. The first was that the timing of the working conference coincided with the G7 summit, as if it had been prearranged. However, all government ministries and agencies in China hold working conferences from the end of the year to the Chinese New Year, ahead of the National People's Congress in March, to decide the course of policies for the following fiscal year. It is an annual event (in the political calendar) much like the period between the completion of the state budget at year's end and the opening of the ordinary Diet session in Japan. This is a major task that requires a lot of time for preparation, as it involves coordinating with the State Council regarding policy directions, drafting and adjusting key speeches and summoning a large number of participants. It is unlikely that authorities possess the flexibility to choose a time right after the G7 summit to hold their meetings or revise agenda in line with the results thereof.

The other hint was that a series of speculative news articles were published, directly after the G7 summit, in mainland China and Hong Kong which claimed that, "The yuan will soon be revalued by 5%," making it seem as if the authorities had launched a trial balloon to see how relevant parties would react. However, the People's Bank immediately denied these reports.
What actually needed to be "observed" by launching such a balloon? It had just been made clear that there was no change in the G7's position. Companies have been expecting the yuan to rise for quite a long time and have been making all-out efforts to take measures accordingly, such as changing their deposits to yuan-denominated ones, frontloading repayments of yuan-based debts and using leads and lags (intentional acceleration or delay of forward foreign exchange contracts by companies involved in trade based on the belief that exchange rates will fluctuate in the future) to the fullest extent possible. All of these steps are obvious and can be seen without "observation"; launching a balloon would only invite further speculation.

Secondly, the phrase "improve the yuan's exchange rate regime," which was the catalyst for these media reports, has been used by the People's Bank since last spring (around the time when foreign pressure regarding the yuan rose) and there is nothing new about it. For example, in its Monetary Policy Report for the second quarter of 2003 that was released last August, the bank said that one of its working goals for the latter half of the year was to "further improve the yuan's exchange rate regime." It is illogical to interpret use of the expression in this instance as "a decision to do so by year's end," as such interpretation would predicate that measures had already been implemented during the latter half of last year. From the viewpoint of the People's Bank, which has been using the same phrase for nearly a year, it is probably difficult to comprehend why the foreign media interpreted the use of the wording this time as a sign that it has decided to raise the value of the yuan before the year is out.

Thirdly, if they really did mean "revaluation by year's end," the most fundamental and direct question is then what would China have to gain by using such ambiguous language? If we were to argue that, "Since the United States is strongly demanding it, there must be some significance in expressing the will to meet those demands," we would probably be laughed at by the Chinese for having had our ways of thinking warped as a result of our long history of bilateral trade frictions with the U.S.
Needless to say, there will be a presidential election in the U.S. in November. If China had really sent a signal to the U.S. that it was willing to meet its demands, what would the administration of President George Bush say? "If you've already made up your mind, you can surely do one better. Speed it up so that the yuan is revalued during the first half of the year [so that we can flaunt it before voters]." I do not believe that the negotiation-savvy Chinese would take such an approach, making concessions little by little and thus allowing the other party to take advantage of them.

When and how will the yuan's revaluation be decided?

So, when and how will authorities decide to revalue the yuan? There are probably two keys to this answer. First, there are many issues that need to be tackled before implementing changes to the exchange rate mechanism and expanding capital movement, which will follow the former. The greatest problem lies in strengthening China's financial institutions and galvanizing a monitoring framework for them, but because this cannot be realized in a short period of time, let us put it aside. Reading media reports regarding the working conference, various other issues have been listed, as shown in the following table. It is a race against time to see the extent to which such matters can be settled.

Table: Issues that need to be resolved before the exchange rate mechanism can be changed

Attention should also be paid to China's efforts to probe the true intentions of the G7, which has continuously called for "exchange rate flexibility." Whether these nations approve of new exchange rate system or not will have a great impact on the stability of the yuan's exchange rate. Even if China revalues the yuan, should these countries dismiss such a move with disappointment, saying it is not enough, I would hate to think what might happen in the future.

When Premier Wen Jiabao visited the United States last December, the U.S. side announced that the two countries had agreed to set up a panel to discuss the yuan issue, and there were also reports of a plan to dispatch a team of experts from the U.S. Treasury Department to China. However, would China, which always makes a fuss over "principles," agree to "discuss" foreign exchange, which is a matter of its sovereignty, with other countries?
China simply announced at the time that "[Wen had] explained China's yuan rate mechanism in response to President Bush's requests." At the same time, however, there were no denials of the U.S. announcements.

It would not be strange for China, which needs to probe Washington's real intentions, to place priority on pragmatism rather than principles. When we look at recent statements made to Congress by U.S. Treasury Secretary John Snow, it appears that contact has already begun. Regardless of whether such contact can be called "discussions," I believe that dialogue will continue between these two countries on the issue.

Progress in the two issues mentioned above is needed to decide the timing for changing the yuan's exchange rate regime (although, needless to say, it will also be affected by the domestic and international economic climate at that time). And when it comes to progress there is no other option but to wait for China's efforts in tackling their homework to bear fruit, but as for probing the G7's true intentions, much depends on the attitudes of Japan, the U.S. and Europe.
Japan has more pressing interests regarding the future of the yuan than the U.S. does, economically if not politically. China, for its part, no doubt has a need to discover the true intentions of Japan, which is its largest trading partner and instigator of the debate on the yuan's revaluation. There needs to be dialogue between Japan and China just like between the U.S. and China. I hope that there is some probing of intent between the authorities of both countries.

Focus of this year's People's Bank working conference was inflation prevention

So, despite being hijacked by the issue of the yuan's revaluation, what was the real focus of this year's working conference of the People's Bank? It was the prevention of excessive investment and the economic overheating and inflation brought about by it. Indeed, this was also what Premier Wen Jiabao stressed in his speech at the start of the Feb. 10 meeting.
Furthermore, Governor Zhou said during the second day of the talks that "Up until a short while ago, we had been saying that 'we must not only prevent inflation but also deflation,' but now we must focus on preventing inflation." This gave participants the impression that the focus of monetary policy, which since 1997 had been to keep deflation in check, has entered a period of all-out adjustment (China Business, Feb. 16).
As a result, during the working conference of the China Bank Regulatory Commission (CBRC) held on Feb. 10, parallel to the People's Bank meeting, it was decided to adopt a policy of limiting bank lending this year.

"Banks should by no means extend loans to large companies that lack competitiveness, have little ability to repay debts, have a poor credit record and operate in high-risk industries, "image projects" (spearheaded by some regional governments) or low-level infrastructure investments that are redundant. In particular, there needs to be greater control of loans for investing in bonds or credit given for real estate loans, land-collateral loans, or to the industrial park." (Beijing Times, Feb. 11)

The loans that "should not be extended," as cited above, are in many cases those to state-owned enterprises. The reason why it is stressed that the loans should be extended "by no means" is because the reality is that lending at the four major state-owned banks is still influenced by mediation and intervention by local governments.
In February, the CBRC announced that it would conduct special inspections of loans extended to businesses operating in such industries as steel, electrolyte aluminum, cement and automobiles (where lending is often conducted blindly).

"Commercial bank lending increased too rapidly in 2003. Loans to the [aforementioned] businesses logged the greatest growth, and because the potential risk of such loans is very great, the correction of loan quality has become a pressing issue." (Beijing Times, as above)

Since last summer, China has moved to tighten monetary policy through "control of teller operations" and the raising of reserve requirement ratios as a precaution against investment overheating and inflation. As the diagram shows, growth in bank lending has since slackened, but authorities say they will clamp down even further on bank lending. The extent to which they are putting the brakes on bank lending is intensifying.

Diagram: Growth in Lending at Chinese Financial Institutions
click on graph to enlarge

There are other data that also point in the same direction. It is said that leaders such as provincial governors and section heads nationwide were assembled together for "training," right on the heels of the working conference. The objective of this gathering was reportedly to correct the "perceptions of development" of regional leaders, who all too often become engrossed in "image projects" and tend to compete for development and personal achievements simply based on CDP growth, as they try to "unify understanding" (and this is a very strong phrase in China) so that they might embrace a new "perception of development" that is based on the improvement of the living standards of the people (China Business, as above). This training was conducted under the auspices of the State Development and Reform Commission, which draws up the blueprints for economic programs and key projects. The prevention of excessive investment and inflation has become a policy issue of the greatest importance and is being tackled by the entire State Council.

The Chinese economy will probably slow down once authorities begin to tighten monetary policy. The annualized growth of 9.1% logged last year was too fast to keep. The high economic growth brought about by excessive investment, especially, is all too often just a fleeting thing, and leaves in its wake a serious imbalance of supply and demand, a reactionary economic downturn and more nonperforming loans.

It is true that there are parts of China, both in terms of region and industrial sector, which are overheating and appear to be on the brink of a bubble. Because China is as large and as varied as Europe, this should not be misinterpreted as meaning that all regions and industrial sectors throughout China are in the midst of a bubble. However, it is highly likely that the sectional bubbles we are witnessing here and there will burst once monetary policy is tightened. The "sections" in question will then have to face serious consequences, but this cannot be helped. Authorities have no choice but to step on the brakes now in order to maintain stable growth for the country as a whole.

Now is the time for Japan to reconsider its China strategies

Japanese companies should also attach great importance to these signals indicating an upcoming adjustment. Over the past two years, we have seen the return of a China boom, and a reversal in the theory, from three years ago, of China as an economic threat. It seems that Japan's "perception of development" of the Chinese economy tends to swing from one extreme to another. Now is the opportune time for firms to once again settle down and review their China strategies.
Since the "financial standing" of firms will deteriorate as monetary policy is tightened, it is highly likely that the incessant problem of collection of accounts receivable will worsen. Japanese companies that are targeting the domestic Chinese market should concentrate on popular products that retailers will be willing to pay cash for. Companies that are not blessed with such products may do well to revise their budgets downward.
However, even if China's growth were to slacken, its economy will still continue to expand. It is better to take a more long-term perspective when considering what will be brought about by China's rise. As a result of the recent explosion in China special procurements, the prices of raw materials such as iron ore and prices of ship chartering have surged. It may be an indication that the global landscape of disinflation or deflation that has pervaded the 1990s or the past quarter of a century has begun to change.

It would be good news if deflation was to end, but things are unlikely to stop there. Some industries and firms in developed countries may see a rise in raw material costs upstream, while suffering a reduction in margins because this increase cannot be shifted to product prices downstream due to the "China cost." This is the second wave of structural reform pressure that China's advancement will have on industrialized economies.

On the other hand, there may be good news on different fronts. There is the impression that the age of disinflation only served to benefit the industrialized nations of the "North" while the developing countries and resource-rich nations of the "South" were always left holding the short straw. The pending issue of the new round of trade liberalization talks of the World Trade Organization is unlikely to regain momentum unless these advantages and disadvantages between North and South are corrected. Looking around the world now after the collapse of the IT bubble, we have become acutely aware that the industrialized nations of the North lack the materials for further economic growth. Perhaps then, they should pass the baton to the South for a little while. And if China's rise can trigger this, it may become the basis for a new "flying geese" model (although it would be tough going for the countries that follow since the leader is so huge).

What is clear is that for better or for worse, the effects this has on us will continue to increase. This time, it is hoped that we do not make extreme swings in perception and view matters with compound eyes so as to deal with them appropriately.

February 24, 2004

February 24, 2004