Posted by: mulrickillion | November 8, 2011

China’s economy: Adjustments aren’t easy

Oct 25th 2011, by R.A. | WASHINGTON | The Economist

READING American coverage of China’s currency policy, one is often left with the impression that the Chinese government isn’t allowing the yuan to rise faster because it doesn’t realise the harm it’s doing to its own economy, or because its simply too greedy to give up its competitive edge in trade. In reality, China is facing very difficult choices and is struggling to undo its previous decisions without destabilising the world’s second-largest economy. Here (via Menzie Chinn) is Chinese macroeconomist Yu Yongding (apologies for long, but I think appropriate) block-quoting:

It is clear that China should have brought to an end to the endless piling up of foreign exchange reserves long time ago. There have been two basic approaches for achieving this objective. The first approach is to reduce current account surplus indirectly via narrowing the saving-investment gap. The second one is to reduce current account surplus directly by dismantling trade promotion policy, such as abolishing tax rebate and allowing renminbi to appreciate. China has tried the two approaches at the same time with a very cautious fashion. To reduce the saving gap by lowering the saving rate could be an ideal solution. Unfortunately, due to various reasons, to achieve the balance between saving and investment may take long time. By the time when the Chinese economy has been rebalanced, no one knows how much more foreign exchange reserves China would have accumulated. Since 2005, with some interruptions, China has let the RMB to appreciate in a gradual way. This gradualist appreciation encourages one-way bet by international investors. As a result, huge among of capital that has no profitable uses in China, has flown into China and contributes in a big way to the building up of China’s foreign exchange reserves.

To stop the further accumulation of foreign exchange reserves, the most direct and effective way is to stop the PBOC’s intervention in foreign exchange market and allow the renminbi to float freely. To float the renminbi is not costless. First, as a result of the end of intervention, the renminbi may rise significantly, China’s current account will suffer and so will economic growth and employment. Second, due to speculative capital inflows, an overshooting can happen and hence China’s current account and growth may be hit hard though temporary. Third, because China holds a large stash of dollardenominated foreign assets vis-à-vis a significant amount of renminbidenominated liabilities, reminbi appreciation may cause large revaluation losses for China.

Hence, China is faced with a stark choice between bearing increasingly large capital losses in its foreign exchange reserves and tolerating immediate losses 6 in terms of significant drop in current account surplus and large revaluation losses. Certainly, neither choice is pleasant. However, this is the bitter fruit of China’s past hesitating and dithering and it has to swallow now.

I think it’s very difficult to argue that intense American pressure will obviously improve the dynamics of this situation.

China’s economy: Adjustments aren’t easy | The Economist


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