Globalization of financial services in China:
implications for capital flows, supervision and monetary policy
Saturday, 19 March 2005
Bank for International Settlements (BIS)
Research Institute of Economy, Trade, and Industry (RIETI)
Bank of China (Bank of China)
Dr. Yoshitomi, President of RIETI and Chief Research Officer, Chair of the Panel Session:
Since we may have just one hour or so instead of one hour and 30 minutes as originally planned, I would like to ask the panelists to discuss the following four issues:
First, on the impact of financial services trade liberalization of China on capital flows through the bank loans. Since we discussed that the capital controls may not be so effective, it may suggest that such liberalization may lead China to de facto capital account openness or convertibility. And also it has been mentioned that in terms of sequencing issues between infrastructure to be strengthened for the markets and open capital accounts, then what should China do when China already has committed to liberalization of the financial services trade. That's the number-one question.
Number two is sort of on the renminbi issue as to the level of the exchange rate of the renminbi. We have been a bit puzzled that, you know, so far, except early this year, the current account surplus of China has not been so large, and the surplus doe not have a clear upward trend, either. And yet there is an expectation of renminbi appreciation because of the reserve accumulation, which has been so rapid and resulting in massive intervention by the authorities. But the main source of such reserve accumulation, until say a year ago, was not the current account surplus, but the so-called basic balances (i.e., FDI plus the current account surplus), 20 billion versus 60 billion or something like that. Then the question arises - and many people mention that - there are no clear estimated trends of undervaluation for the renminbi or if any, 5% or so, except the recent one year or so when the dollar started to depreciate. I am going to raise that question a bit later. That raises the question if there is neither a particular trend of upward surpluses nor an estimated undervaluation of the renminbi, how should we justify appreciation of the renminbi? And that raises a related question that is: the effectiveness of renminbi appreciation. If the source of accumulation of reserves is incoming FDI, will appreciation of the renminbi have an adverse impact on incoming FDI? If not, will it simply reduce the current account surpluses to some extent? Then on the current account surplus, as we all know, China exports are dominated by processed trade, exports by importing sophisticated intermediate materials and processing them for final export with relatively cheap labor. What kind of impact do you expect from the appreciation of the renminbi on such Chinese process exports, which, you know, a large portion of the processed exports are intermediate goods. And the value-added portion of Chinese labor would be, say, 10% to 15% of such exports. Then the impact should be very limited. So the second question is related to the level of the renminbi.
The third question is the exchange rate regime issue. Everybody says that capital controls won't be so effective; the capital account will become more open; and then the monetary policy should be more independent. So the direction toward a free float would be desirable, but in the meantime somehow we fear free float for various reasons. Then many people advocate for an intermediate exchange rate regime between a free float and a fixed exchange rate regime. Then the question arises - two questions at least - one is what would be the most desirable central rate for such a crawling peg or wide band. And then is the reference rate supposed to be a currency basket? If so, what kind of currency basket? There are two types of arguments on the currency basket. One is that in order to maintain the competitiveness of Asian economies, why not include the dollar, the euro, and the Japanese yen and the major Asian currencies so as to maintain a sort of effective exchange rate in line with productivity improvement and price inflation if we talk about real effective exchange rates? The other basket we discussed today, particularly by Professor Ogawa, is a basket that is essentially composed of only Asian currencies from the region. That could also be a reference rate for the band. So then the next question would be what determines the width of the band, 5% plus/minus respectively at the beginning? Or 10%? Or 15%, like the Chilean case over the past 20 years, which eventually reached a free float in 1999 or so? So what's the width of the band, and as a function of what? And could you kindly clarify the determinants of the width of the band?
The last question is on the global imbalances. Until very recently, as we have observed, the renminbi may not be too much undervalued. But now, if the U.S. has to devalue the dollar by 20%, 30%, or more because of the unsustainability of the U.S. current account deficit, then we all face the further large depreciation of the U.S. dollar, including the renminbi. And as Professor Ito already mentioned, over the past one year or so, the renminbi has been depreciating against other Asian currencies, then we are stuck with this relationship between the renminbi problem and global imbalances. Here we have to talk about the possible exit of the renminbi from a fixed regime in order to resolve global imbalances but in a consistent manner with the Asian economic integration.
These are the four major issues I have got from the discussions, particularly in the afternoon, so each participant in the panel discussion is free to choose any of the issues I have just mentioned, or you can add. But please clarify what you are talking about first. You will have five minutes first. Then we go around for another five minutes for questions. Then we will have a second round if we have to discuss further. So Professor Ito, would you like to start?
Professor Ito, University of Tokyo:
I will answer the second question on whether FDI or capital inflows are resulting in reserve accumulations rather than current account surpluses resulting in reserve accumulations. I think the standard, neoclassical, "Washington Consensus" answer would be - this is not my answer - that capital inflows do not justify the reserve accumulation. By the same reasoning, the renminbi should appreciate when the capital is coming as FDI so that the current account will go into deficit. Because developing countries, when receive more capital from outside to build factories and so on, which will produce more output later, will have to repay the liabilities they accumulate now. So developing countries should run current account deficits. When capital flows in, the currency has to appreciate. As a result, the country runs current account deficits. Those current account deficits will turn into current account surpluses eventually.
But again, history has shown that sometimes running current account deficits for a long time for a developing economy will result in a currency crisis because capital inflows may sometimes turn into capital outflows. If the country doesn't have the necessary reserves, then the currency of the country will depreciate excessively. So my answer would be different from the Washington consensus. I believe that developing economies have the right to intervene and accumulate reserves when there are large capital inflows. It is justifiable even when the estimated currency valuation is undervalued.
So I would go with an intermediate solution. I think the Chinese authorities, by intervening 100% through reserve accumulation, are providing a nice subsidy to foreigners who want to invest in China. So this is a transfer of welfare from Chinese people to foreign corporations. If the Chinese authorities want to do it, that's fine. It's a present to foreign capital which wants to come in. And as a result China may develop inflation or an asset bubble. This is a problem. But if policy makers are wise enough, China is well advised to allow the currency to appreciate a little bit. And at the same time, China can still intervene but such interventions should have an aim to moderate the appreciation and reduce the current account surplus. That would be a better option. And by the way, I think all the arguments in the afternoon show that probably China's current account surplus is overestimated in the statistics. So there is some room to reduce current account surpluses through moderate appreciation, and that's good for China.
Mr. Hori, Director General of the International Department, Bank of Japan:
I would like to make my comments on issue two, the appreciation of the renminbi, whether it's in the offering or it's likely to happen, or even desirable, followed by the choice of regime of the exchange rate exchange rate system, and finally the sequencing problem, perhaps. But before I begin, I have to make a disclaimer. The views I express here are my own and do not necessarily represent those of the Bank of Japan. I'm feeling as if I am a Chinese authority in that regard.
Let me begin with the second issue. China's trade balance is still registering only a small surplus. Yoshitomo-san is still right. The current account surplus is growing, and yet it's bloated by overseas Chinese remittances, which are similar to capital transactions in nature. So it's not clear that a fundamental disequilibrium exists in the case of China. But in my view, massive capital inflows, including some items recorded as part of the current account balances, may become a source of concern in terms of monetary policy, going forward.
I read an annual report of the open market operations of the People's Bank of China, 2004, recently. It says that the bank's liquidity management and monetary policy - money supply control were under strong pressure in 2004. That's not my opinion, that's what they say. And 1.6 trillion renminbi worth of liquidity was supplied through exchange market intervention. Well, in order to facilitate sterilization of liquidity associated with exchange market intervention, PBOC has begun to issue three-year paper, as well as future-dated paper - predated one-year notes or paper. They call it paper. Well, it's easy to imagine. The longer the maturity of those instruments for sterilization, the more effective the sterilization but the higher the cost for PBOC. And this cost will increase in line with the amount of reserve accumulation.
On the other hand, from a macroeconomic point of view, inflation is still under control in China and therefore there appear to be no obvious economic problems associated with liquidity supplied by exchange market intervention at the moment. However, if large capital inflows continue, that would complicate monetary policy, possibly to the extent of damaging PBOC's capabilities in monetary policy. So that's my concern.
If I may, Mr. Chairman, I can go on to speak about my preference about the exchange rate regime. I personally believe in floating. And an alternative is a wider band, as wide as perhaps 10% on each side, just like the successful Israeli wider band, after a number of mistakes they made with trial runs for a narrow band. In contrast, a currency basket, in my opinion, is very inconvenient. First of all, the lion's share of foreign exchange transactions in China is captured by the U.S. dollar. Secondly, interventions to keep the renminbi in line with a basket will put operational burdens on PBOC when they move cross-rates. In fact, no large country in the world adopts a basket peg. Likewise, the market does not like cocktails. They like pure malt, just like myself.
So China may need to adopt a flexible exchange rate regime by end 2006, that's my opinion. From 2007, foreign banks will be allowed to conduct a full line of renminbi business, in addition to foreign currency business. In this circumstance, capital controls will become less and less effective, de facto. Japan's experience in the 1970s and '80s shows that money will flow in through all possible channels, including trade in goods. So for the comfort level of commercial banks in China, as well as the monetary authorities, it may perhaps be advisable to begin the new regime sometime before the end of 2006. It's better to have a running-in period rather than a jump-start. Let me stop.
Eli Remolona, Deputy Chief Representative of the BIS Hong Kong Office:
Perhaps like Hori I should start with a disclaimer. The views I'm going to express are not my own, they are Bob McCauley's views [laughter]. So any errors in this discussion are solely Bob's responsibility [laughter]. Well, hard as he tried, Bob couldn't make it here today so I'm standing in for him.
Let me try to do the first question, the role of globalization. Especially in a country with high savings rates, high investment rates, and where the engine of growth is exports, what would the role of globalization be capital flows and in external adjustment?
First, I think it's useful to distinguish between what we call international banks and global banks. This distinction was not useful in the past, but these days it's important to make the distinction. International banks come to a country and they come to deal in cross-border transactions, and they come to deal in foreign currency transactions. Global banks, when they come in, do domestic currency transactions. And today, when banks enter a country, they want to be global banks. They don't want to be just international banks.
There is something very interesting about the way global banks do business in a country and the way they affect the strategies of other domestic banks in the country. The strategy these days is to go for consumer lending, not to go for commercial and industrial lending. So they take deposits in local currency, but they lend money, not so much to commercial or industrial firms, but to households. The strategy has been to offer mortgages, to offer credit card loans. And because of this strategy, the other domestic banks in the market tend to go the same way - tend to compete in the same kind of strategy.
Now when we looked at the experiences of other countries in this regard, we were shocked. We were shocked at the effect of the introduction of consumer lending, credit cards, mortgages. When consumer lending starts, the savings rate will drop and it will drop very sharply. This also happens in low savings rate countries like Australia and New Zealand, and their savings rates become negative once you introduce consumer lending. The drop in savings rates can be as large as 9%. So you can start from a savings rate of 20% and then, with a few years of consumer lending, you can have a savings rate of 11%.
Now, I don't think this will happen as quickly in China. I don't think the drop will be quite so sharp and quite so dramatic, but nonetheless I think if consumer lending becomes a big strategy of global banks in China, the effects on consumption could be significant. And so you have a kind of transformation from an economy that's led by exports to an economy that may be led by domestic consumption.
Now China, as you know, has a modest recorded current account surplus and even if this is underestimated, it's not that large. The current account surplus is not that large. It would not take very much, I think, for a surge in consumption to turn this current account surplus into a deficit. Now, I think we should ask ourselves if the U.S. continues to sustain a current account deficit - and if China has a current account deficit. Who is going to finance those deficits? Now let me stop there.
Zhu Min, Assistant Executive President of Bank of China:
This is very much the end of the day and, unfortunately, our chairman has posed such big issues. It will take another year living in the hotel to figure out these big questions.
I guess everybody is tired so let me start by offering you one of my personal stories. In late January of this year, on a typical snowy day in a place called Davos in Switzerland, I had a very early-morning breakfast with Sam DiPiazza, who is global CEO of Price Waterhouse. It was a small group of CEOs including Michael Dell, and a few others. Sam showed us some Pricewaterhouse data of a survey of 1,300 global CEOs. The question of the survey was something like, "How do you feel for the year 2005?" And most of the surveyed CEOs answered in a very positive way. They have very high cash flows. They feel the economic environment is more stable. And they feel they will get more investment projects done. The CEOs think that 2005 will be a little better than 2004, which was a bit shocking for me because 2004 was already such a magnificent year for companies. How can we have another good year?
On the same day, 7:30 in the evening, I attended another dinner organized by the chairman of Merrill Lynch International, also roughly 20 CEOs, some from steel and other resources related industries. Over the dinner, Merrill Lynch provided two papers called the "Global Risk Assessments." One was written by the former Australian foreign minister, who led the project. The other was led by a professor of Harvard, Richard Cooper. They named all the risk factors in the world, political and economic. They think 2005 will be a very unstable year. The world will have a lot of troubles economically and politically, particularly politically.
After dinner, I was very confused. How could I put these two pictures together? I had no clue at all. On my way back, at 30,000 feet above the earth, I tried to put these two pictures together and suddenly I realized this probably was what the picture for the year 2005: There are a lot of risk factors, but we will be still able to contain them - I don't want to use the words "control" or "manage" here to sound like we'll have quite a stable or smooth year. Let me give you my analysis.
Clearly there are two bubbles at this time. By the way, Chairman, I will answer your last question about global imbalances. One is the bubble in the United States: It's a consumption bubble. We talk about trade deficits, we talk about the budget deficit, but at the end of the day it is the American consumption behavior, a 0% net savings rate, and the 18% household debt ratios. I think that is the fundamental issue. On the other side of the world, we have China where there is an investment bubble, caused by a 40% savings ratio and 44% of GDP of investment, which was, of course, caused by all the demand from the United States, particularly with a bilateral $150 billion trade surplus. We have a very big imbalance over the last few years. Chinese have a lot of savings and put the money in treasury bills, into manufacturing that in turn ships products overseas. Americans borrow money and print green paper. As long as Chinese buy American Treasury Bills, everybody is happy. We've got jobs and Americans have consumption. The global growth rate is good.
Now the Americans are facing constraints because the real constraint on the American side is the debt ratio is increasing in a dramatic way. If they don't restrain their consumption behavior in some way - currently consumption debt is 18% of GDP; in five years it could rise to 40% to 45%. I don't know whether Jonathan Anderson or Frank Gong have better statistics. By then, I think it will be difficult for Americans to pay the interest rate, let along the principal. Even before the market panics on the dollar, the interest burden will be a problem. The dollar will go down further, and the capital market will be affected. I think that is the real issue on the U.S. side.
On the Chinese side, we face a constraint. On the surface, it is energy, transportation and others. But the real issue facing China today is a very uncertain American market but at the same time, China has an investment bubble that has created an overcapacity problem because we have invested heavily in the past few years. As far as energy is concerned, I don't think it is a big issue. The infrastructure can quickly come up as long as we have savings and FDI.
So there are two bubbles here and people are really concerned whether the two bubbles will go bust, when, and how. Here we observe something very interesting: First of all, Alan Greenspan has been raising interest rates in a very steady and slow way, 25 basis points at a time. In theory, or in everybody's eyes, Alan Greenspan should raise interest rates much, much faster. If you look at the yield curve, I don't have a curve with me, you will see the Fed has really lagged behind in comparison with other cases after an economic bubble and recession in the U.S. history.
Secondly, Treasury Department will issue fewer Treasury Bills this year, not more. And they used more than 50% of their quota for this year in the first two and a half months already. If you compare rates between short-term Treasury Bills and the Japanese Government Bonds, there's only small yield difference; but the Japanese government has no other choice but to buy American Treasury Bills.
So this obviously creates a very flat yield curve. That's exactly what we see. A flat yield curve, obviously, will keep the current pattern of consumption on the U.S. side. Because it will keep the pattern on the U.S. side, probably it will keep the current pattern of investment on the Chinese side. I think three things go very well: the Fed policy, the U.S. administration's policy to maintain economic growth, and the hedge funds. Last year, hedge funds were in a terrible position and they were very much concerned whether the dollar will bottom. If the dollar bottoms out, they will shift their position. That will cause a global capital reallocation, and I think we will have the problem then.
To prevent such unpleasant scenario, I think the dollar will go down slowly. Interest rates will rise slowly. And this will give enough time for hedge funds to reposition themselves. At this time, the three parties will join together, everybody's calm, so far so good. So I think that is exactly the situation we see today.
In that sense, the Americans will let the dollar manage the bond market. I think the dollar will go down a little further - another 5%, no more than that - about the same amount against the yen. So I think we will have a quite manageable situation. In that sense, the pressure on the renminbi is very limited.
From the Chinese economy point of view, we do have a desire; we do have a goal; and we want to achieve those targets. But from the external market point of view, I don't see any pressure this year. Hence, I don't think things will change. However, that doesn't mean we'll have an easy life. Everything that is happening this year is that everybody is trying to maintain what they had in the past - postpone everything until next year that we still don't know. Thank you.
Frank Gong, JP Morgan, Greater China Economist:
I agree with Zhu Min. The imbalances could last for a while. It's sort of like some kind of dynamic equilibrium. People always ask this question: Can Asian central banks finance the U.S. twin deficits forever? I mean, not forever, but for a considerable period of time. It's like an automaker in a down cycle or recession: He doesn't care about yield so he just gives his customers zero-cost financing. People keep asking, "Why does Asia keep buying U.S. Treasuries? Why don't they buy euro?" Similarly, here the yield is not the issue. You want to keep the buyers of your product afloat. You know, that's the Asian growth model. Asia has been relying on running a current account surplus for growth and until Asia can have a functioning bank system, like Eli Remolona pointed out earlier, then you can change the engine of growth from export-led - relying on current account accumulation - to domestic demand. Before that, if you don't have a functioning bank system, you've got to keep the game going. In this sense, Asian central banks are just like an automaker. They have to extend zero-cost financing to their customers and the customers then recycle the money back to them to buy their product. And that's the so-called dynamic equilibrium, and it will last for some time.
The question is - I think a lot of people in China are focusing on right now---growth engine issue. I think the question posed by Eli is a very big one. In a country with such a huge savings rate and a huge investment rate, why is growth still being led by exports? The obvious answer is you don't have effective financial intermediation. And that is what China is addressing now. And I think the currency regime issue is part of the financial engineering issue. And we have to put the exchange rate regime issue into that context. That's why I think it's a necessary move. It probably won't move much in the near term, but it will move eventually because basically it's part of the strategy to change the growth engine. That is my comment.
Jonathan Anderson, Chief Asian Economist, UBS:
Thanks very much, Chairman. I have the honor of being the last commentator in today's session, as far as I know. So in the interest of leaving you entertained I want to say a few outrageous things about what we've heard today. And I'd like to take the chairman's questions in reverse order. I'll try to be brief.
First and foremost, the global imbalance, let my say outrageous statement number one: Global imbalances have nothing to do with exchange rates. The U.S. has a 5% of GDP current account deficit; Asia has a 5% of GDP current account surplus. Asia does not have a surplus because its currencies are cheap. Actually, currencies are not far in real terms from where they were in 1995-96. Asia at that time had a balanced current account position. How did we get to 5%? Very simple: Asia stopped investing after the collapse in '97-'98 and then again in '99-2000. There is no reason to put capital on the ground. Investment ratios in Asia are far below what they were at any time in the 1980s and 1990s. So you have savings high, investments collapsed; here we sit with surpluses. The U.S. exactly is the opposite story. Investment has basically been stable, savings have collapsed; consumers are spending too much. Again, this is not a problem that is going to be resolved simply by making the U.S. dollar weaker. So basically currencies can move and they will move, but we are sitting around waiting for the U.S. to go through some sort of retrenchment on spending and for Asia to start spending again on the corporate side. That's equally true of Japan and non-Japan Asia. It's not so true in China, but that's where we sit.
Which brings me to question three: What about the effect of a renminbi move on exports - what would it do to the economy? My suspicion is: nothing. If we woke up tomorrow and the renminbi were 20% more expensive than it is today you would see exports pretty much going on as they have. Why? Because I just don't think it matters if wages in China are $100 a month or $120 dollars a month. It's still a cheap place to do business. You'll still see outsourcing. FDI will still come. I don't think it's an issue for the Chinese. And I simply don't think that the currency should or is being considered as a means of balancing China's external position or this cycle.
Which brings up the second question that our chairman posed: Why talk about an appreciation of the renminbi? Answer: I don't think it makes sense to talk about an appreciation of the renminbi and in fact I don't see many people doing it within China. I see a lot of people outside China talking about an appreciation. If you take Ray Brooks in the IMF, I suspect what they are really talking to the Chinese about is flexibility. If you take what the senior Chinese leadership is talking about, it's flexibility. No one is interested in moving the renminbi around because, again, I think the view is that this is not going to be very helpful in addressing imbalances. I think the real issue is that China does need a flexible currency in a long-term sense for two reasons. One, to try to prevent any future speculative attacks, as you're going to liberalize the capital account, and you've talked about the effect on banking flows. Money will leave the system, right? It's helpful if you have a currency that can help take some of the heat. The second is to prevent something like an Asian crisis situation. I mean, the lesson that we have learned over the last five years is that open capital accounts, sudden liberalization of the exchange rate equals disaster. And if that's the lesson that we're getting from the authorities, I think it's the right lesson and it's fantastic.
This leads to the last point, which is how do you manage this thing? Do you go to a pure float? Do you go to a basket peg? Answer: I don't really think it matters. If flexibility is a long-term goal then you should pick some intermediate steps along the way, jump in, get your feet wet, and get on with life. If you can manage it with a closed capital account, beautiful. If not, we'll see how it goes, but whether we go to a basket consisting of a few currencies, many currencies, bands at 5%, 1%, the end goal is to get this thing closer to something closer to the yen than to the Singapore dollar. And I suspect that's where we will end up at the end of the day. Thanks.
Masaru Yoshitomi, President and Chief Research Office, RIETI:
One of the interesting facts we are facing in the global imbalances is as follows: Trying to estimate overvaluation or undervaluation of a major currency, we cannot find any particular overvaluation or undervaluation, including effective exchange rate of the U.S. dollar and the renminbi, and probably the Japanese yen. And yet, because of the imbalances in investment and savings that have emerged both in the U.S. and in Asia, accidentally at the same time, after the crisis of '97-'98 and only after '98, the U.S. did not have a twin deficit. It was a private deficit at that time. And then the US turned into a traditional twin deficit.
But then, as Jonathan mentioned, the investment-to-GDP ratio in Asia - the crisis-hit economies all collapsed by 30% to 35% of the ratio. So that resulted in large surpluses despite the fact that they remain emerging economies. This situation is a bit strange. But because the major source of the imbalances is internal, how can we remedy these imbalances by changes in the relative prices between the tradable and the non-tradable? That is the major question that we face and it is very different from what we faced in the 1980s, when I was in the OECD doing all kinds of things related to this matter. Then in the early part of the 1980s, as you know, President Reagan's fiscal policy was too expansionary, resulting in higher real interest rates, and combined with stronger domestic demand in the U.S., resulting in a larger current account deficit.
So that was when an I-S imbalance emerges, together with a currency misalignment among the major currencies of the G-3 at that time. So the situation was very different 20 years back. Therefore the Plaza Accord may have worked, depending on theories and empirical evidences. But this time, we may need a sort of "Pan-Pacific Accord" this year or next year, but dealing with quite different issues. All of Asia is involved, not just the Japanese economy as last global imbalance. But the origin of the imbalances is quite different from last time.
That's the reason why at RIETI in Tokyo we are working on this issue to provide some useful policy recommendations to the East Asian Summit in December this year.
We are all exhausted. Any other comments?
Sorry, just one final thought. You mentioned a "Pan Pacific accord." Most people forget that currency adjustment was only half the picture. The Plaza Accord was also a coordinated series of measures to stimulate growth in some economies and to close down growth in others. It didn't happen. But again, if you look at global imbalances this time, it's going to take more than currency adjustment to do the trick. You're going to again need coordinated policies to deal with demand-side questions.
Yes, we need to convince American congressmen rather than American economists.