China’s Role in the Current Global Economic Adjustment Process Li-Gang Liu School of Public Policy George Mason University RIETI CONFERENCE-LIU 1 Structure of the presentation I. II. III. IV. V. Introduction: The Renminbi Controversies Nominal Revaluation and the Sino-US Trade Imbalances The link between overheating and the “undervalued” renminbi Optimal exchange rate regime for China What’s China’s role in the current global imbalances RIETI CONFERENCE-LIU 2 I. China’s Currency Controversies z z z China was first blamed for exporting deflation to the world economy because of its undervalued currency. Thus China was called to either revalue the renminbi (RMB) or reflate the economy (Kuroda and Kawai, FT, 12/2/02). While China’s existing trade positions make it an unlikely force for world deflation, the calls for China to revalue gained attention in Washington DC. Despite China’s overall trade surplus with the rest of the world is rather small, 2% of GDP (2001), Sino-US trade surplus remains large (10 percent of China’s GDP). RIETI CONFERENCE-LIU 3 z z Because of large losses of US manufacturing jobs (2.7 million) and the politics of the presidential election year, the Bush Administration has been pressured to act. Trade front: •Quotas on 3 fast growing categories of Chinese textile/garments •Anti-dumping duties imposed on Chinese-made TVs (up to 78%) •Anti-dumping duties are under review on Chinese-made furniture RIETI CONFERENCE-LIU 4 z Financial Front: • Pushing for RMB revaluation: Treasury Secretary John Snow and Commerce Secretary Don Evans spoke repeatedly in public that RMB needs to revalue to reduce the US-China trade deficit. • Fed Chairman Alan Greenspan also publicly raise the RMB valuation issue from the view that large inflow of capital will make the current RMB-dollar peg unsustainable. Therefore, RMB would have to be revalued to reflect the market pressure. RIETI CONFERENCE-LIU 5 z z Some have put a specific figure for RMB’s revaluation:15-25% (Goldstein and Lardy, 2003) but the methodology is unclear. China is also suggested to move on to a flexible exchange rate regime by adopting a basket peg of dollar, yen and euro or a crawling peg. But a market based RMB-dollar exchange rate, the non-deliverable RMB-dollar future rate, does not indicate a large undervaluation of the RMB. RIETI CONFERENCE-LIU 6 RIETI CONFERENCE-LIU Daily rate from 01/08/96 to 05/17/04 Source: (1) 1996-97: Prebon Yamane (Hong Kong) Ltd. (2) From 1998 onwards: Reuters, and HKMA 7 2004-5-1 2004-2-1 2003-11-1 2003-8-1 2003-5-1 2003-2-1 2002-11-1 2002-8-1 2002-5-1 2002-2-1 2001-11-1 2001-8-1 2001-5-1 2001-2-1 2000-11-1 2000-8-1 2000-5-1 2000-2-1 1999-11-1 1999-8-1 1999-5-1 1999-2-1 1998-11-1 1998-8-1 1998-5-1 1998-2-1 1997-11-1 1997-8-1 1997-5-1 1997-2-1 1996-11-1 1996-8-1 RMB/US Dollar Figure 1: Non-Deliverable Forward RMB-Dollar Rate 10.0000 9.5000 9.0000 NDF RMB/Dollar 8.5000 8.0000 RMB/Dollar 7.5000 z Indeed, China’s underlying structural weakness does not warrant large RMB revaluation: • It’s banking system is still fragile (Large NPLs and weak risk management). • It’s medium-term fiscal sustainability remains a challenge (contingent fiscal liability exceeds 100 percent of GDP). • Domestic structural imbalances pronounced (significant rural-urban, regional, and income inequality and huge unemployment pressure). • Economic transition still unfinished and quality institution yet to emerge. RIETI CONFERENCE-LIU 8 z z z China’s recent soaring growth and its insatiable appetite for raw materials from the rest of the world have also been blamed for causing rapid rise in commodity prices. “Undervalued” currency was thought as one of the causes of macroeconomic overheating. China’s renminbi has been blamed for both world deflation and inflation. RIETI CONFERENCE-LIU 9 II. Dealing the Sino-US Trade Imbalances z An RMB revaluation won’t help reduce the US trade deficit and won’t restore the Sino-US trade balance, either. •US savings-investment imbalances fundamentally determine its external imbalances. •Thus, an RMB revaluation will only have redistribution effect of US trade deficit with the rest of the world RIETI CONFERENCE-LIU 10 z Four underlying factors help explain the Sino-US trade imbalances 1) China’s processed trade structure and the East Asian trade triangle (Processed trade dominates China’s trade structure and contribute to the trade surplus while the ordinary trade originated from domestic firms remains a weak link). RIETI CONFERENCE-LIU 11 China's Trade Surplus with Key Trading Partners 40,000 Taipei, China South Korea Japan 30,000 EU United States 20,000 Millions of US dollas 10,000 0 -10,000 -20,000 -30,000 -40,000 1995 1996 1997 1998 1999 2000 RIETI CONFERENCE-LIU 2001 12 2) The 1998 value-added export-rebate tax can be removed before considering a nominal revaluation. • The rebate is outmoded and too expensive to maintain ($24 billion or a quarter of China’s trade surplus) • Big fiscal burden and backlogged, endangering government credibility • Bad for China’s terms of trade. RIETI CONFERENCE-LIU 13 Declining Terms of Trade with Key Trading Partners (1993- 2000) Products USA EU Japan All products - 23 - 28 - 26 Non- fuel Primary Products 0 - 36 4 Manufactured Goods - 24 - 27 - 28 - 12 - 37 Labor or Resource Intensive Product - 48 Low- tech Products - 27 - 36 - 15 Medium- tech Products - 42 - 28 - 31 High- tech Products 13 - 23 - 35 NIEs - 17 5 - 20 -2 -5 - 28 - 29 ASEAN -8 34 - 24 -9 - 14 - 26 - 43 Source: Zheng and Zhao (2002) based on statistics from the Chinese Customs Statistical Year book RIETI CONFERENCE-LIU 14 Other LDCs -3 15 - 21 7 - 13 - 59 -7 3) Large reserves of labor exert downward wage flexibility and upward wage rigidity. •Large urban unemployment (10 to 15 percent) and the rural under employment (150-200 million) determines China’s comparative advantage in labor intensive industries for a long time to come. •Real wages in the export sector have not seen much change ($100 for more than 10 years). RIETI CONFERENCE-LIU 15 4) Fiscal incentives in its FDI regime further underscores the trade competitiveness. • Both central government and local government fiscal incentives provided are generous: 2 years of no income tax and the following 3 years by half, in addition to generous local government concessions in land, energy, bank loans, raw materials, and labor usage. • Such fiscal incentives may help China’s quantity success in attracting FDI but not quality success in attracting large-scale and tech-heavy FDI. RIETI CONFERENCE-LIU 16 z z z The Four structural factors ought to have contributed to RMB’s competitiveness in international trade. China could indeed first address these distortions before considering any nominal appreciation of RMB since no one knows the equilibrium exchange rate with these distortions in place. It is also in China’s interest to address these distortions because they are potential impediments for China’s long-term growth. RIETI CONFERENCE-LIU 17 z z z These structural factors are bad for China’s TOT which may lead to immiserizing growth, brought by biased anti-trade technical progress (Harry Johnson, 1958). They are also bad for regional and income distribution because fiscal subsidies biased toward fast growing and profitable export sector and individuals. Furthermore, these policies are also not in line with China’s WTO commitments. RIETI CONFERENCE-LIU 18 What China could do to address the Sino-US trade imbalances? • In the short-run, phase out or even revoke the export tax rebate tax since it is out of date and too expensive to maintain as China’s export growth is fast growing and no need of further stimulus. • The policy also removes distortions: other sectors are subsidizing the most profitable and faster growth sector of the economy. It does not make any economic sense. • In response to the pressure from the US, China can simply draw a shopping list and deal with the US deficit bilaterally (import diversion). RIETI CONFERENCE-LIU 19 • Improve FDI regime: China needs to take steps to make its FDI policies in line with the Trade- Related Investment Measures (TRIMs). • Fiscal incentives are less important than a predictable, mature, and transparent FDI regime (JBIC Survey and McKinsey Study) • Less emphasis on fiscal incentives and more on enforcement of contract, investment transparency, and policy predictability. • Ensure FDI’s quality success (High-tech contents of OECD FDI). RIETI CONFERENCE-LIU 20 III. The link between overheating and the “undervalued” renminbi z z z z z The current cycle of rapid growth is no different from the previous cycles mainly spurred by rapid bank credit growth. Bank lending to property sector and automobile sector, facilitated by mortgage and consumer finance, led to way. Five sectors (real estate development, steel, electricity generation, automobile, and chemical sector) accounted for 59 percent of total fixed asset investment Fixed asset investment reached to 43 percent of GDP, one of the highest in history. Electricity consumption, a good measure of GDP activity, soars. RIETI CONFERENCE-LIU 21 F ig u r e 3 : E le c tr ic t y G e n e r a t io n a n d G D P G r o w th R a te 3 0 .0 0 2 5 .0 0 1 5 .0 0 1 0 .0 0 5 .0 0 02 01 00 99 98 97 96 95 03 20 20 20 20 19 19 19 19 93 94 19 19 92 91 90 89 88 87 86 E le c tr ic ity G e n e r a tio n G r o w th R a te 19 19 19 19 19 19 19 19 84 85 19 19 82 81 80 79 78 77 83 19 19 19 19 19 19 19 76 0 .0 0 19 Percent 2 0 .0 0 G D P G r o w th R a te RIETI CONFERENCE-LIU 22 20 -5 CPI Food RIETI CONFERENCE-LIU 03 -1 0 G r a in 23 20 20 20 04 04 04 -4 -3 -2 1 -1 -1 -1 -1 2- 1 1 -1 -1 -1 -1 -1 -1 -1 -1 1- -1 -1 1 1 -1 0- -9 -8 -7 -6 -5 -4 -1 04 03 -2 -3 -1 03 03 03 03 03 03 20 20 20 20 20 20 20 20 03 03 03 -1 2- 1- 1 -1 -1 -1 -1 -1 -1 -1 F ig u r e 4 : O v e r a ll C o n s u m e r , F o o d a n d G r a in P r ic e 20 20 20 20 -1 -1 1 1 1 -1 0- -9 -8 -7 -6 -5 -4 -3 -1 03 02 02 -1 2- 1- -2 -1 02 02 02 02 02 02 02 02 02 20 20 20 20 20 20 20 20 20 20 20 20 -1 -1 02 01 01 -1 -1 -1 -1 -1 -1 -1 -1 -1 0- -9 -8 -7 -6 -5 -4 -3 -2 -1 -1 01 01 01 01 01 01 01 01 01 01 20 20 20 20 20 20 20 20 20 20 20 20 Percent from the same month in previous year Inflation rate accelerates In d e x e s 40 35 30 25 20 15 10 5 0 z z Food price, in particular, grain price increased sharply, largely due to reduced incentives to plant grains and consequently the land devoted to grain production. But the current inflation will not become a run-away one, unlike the previous ones. • Consumer goods supply still exceeds demand (473 out of 600 consumer products still face oversupply) • There is no sign of wage led inflation • Domestic demand still weak (consumption share in GDP is only 60%, compared with74% for LDCs and 80 for DCs). • Increased grain imports and increased acreage to grain production RIETI CONFERENCE-LIU 24 Does an “undervalued” currency cause rapid M2 growth? •Conventional wisdom links rapid M2 growth rate to the undervalued currency: An expectation of revaluation led to capital inflows, thus increase the central bank asset base and monetary supply if it becomes difficult to sterilize. RIETI CONFERENCE-LIU 25 Table 8: Current account balance, capital account balance, reserves accumulations and M2 Growth (Billions of US Dollars) 1998 Current Account 29.3 Capital Account -22.8 Foreign Direct Investment 43.8 Other capital flows -66.6 Change of Reserves 6.5 Total Reserves 146.3 Reserve Growth 4.6 M2 Growth 14.8 Credit Growth 15.5 Source: Calculated from data publised on PBOC's website. Note: a. Figure for 2004 is for January to March 2003. 1999 15.7 -7.1 38.8 -45.9 8.6 154.9 5.9 14.7 8.3 2000 20.5 -10 38.4 -48.4 10.5 165.4 6.8 12.3 6.0 2001 17.4 29.9 44.2 -14.3 47.3 212.7 28.6 17.6 13.0 RIETI CONFERENCE-LIU 2002 35.4 40.1 49.3 -9.2 75.5 288.2 35.5 16.9 16.9 a 2003 2004 29.5 90.5 54.7 35.8 120 408.2 41.6 19.6 21.1 26 -7.8 n.a. n.a. n.a. 113.5 439.8 39.2 19.1 18 Relations among reserve growth, M2 growth, and Total Loan Growth 160.0 140.0 120.0 Percent 100.0 80.0 60.0 40.0 20.0 0.0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 -20.0 M2 Grow th Reserve Grow th Loan grow th RIETI CONFERENCE-LIU 27 2003 But empirically, the linkage is weak Table 9: Granger Causality Test between M2 and Foreign Exchange Reserves Dependent Variable: M2 Variables M2 Foreign Exchange Reserves F-Statistics 10.53 0.67 Significance 0 0.75 Dependent Variable: Foreign Exchange Reserve Variables F-Statistics M2 2.57 Foreign Exchange Reserve 52.7 Significance 0.04 0 Source: Calculated by the author RIETI CONFERENCE-LIU 28 Rapid M2 growth has more to do with 1. 2. 3. Competition to get listed: Incentive to grow out of NPL problem by expanding the balance sheet (if loan growth is 10 a year, 7 years NPLs will be halved). Interest rate liberalization: lending rate first (at a range of --10 percent and 170 percent from 5.31) and deposit rates (1.98%) lead large interest rate margin. Thus it is profitable to lend. Local government influence on bank lending remains. RIETI CONFERENCE-LIU 29 Will China have a hard landing? • Other than the central bank efforts to use OMO and raise reserve requirement, a coordinated administrative efforts, which are perhaps more effective, have been taken to cool down the economy. • Various indicators such as fixed asset investment growth, industry output, money supply and bank credit have all shown signs of slow down. • Capital inflows is likely to reverse because the high probability of interest rate hike by the Fed. • The end result of the overheating in some sectors will be more NPLs in the banking sector and deflation may also resume. RIETI CONFERENCE-LIU 30 IV: An optimal exchange regime for China Which exchange rate regime performs better in the long run? Table 11: Performance of Exchange Rate Regimes Classification Scheme Peg Annual Inflation Rate Standard 38.8 Dual Rates 20.7 Per-Capital GDP Growth Standard 1.4 Dual Rates 1.7 Source: IMF, World Economic Outlook. Limited Managed Freely Flexibility Floating Floating Dual or Multiple Exchange Rates 5.3 10.1 74.8 29.7 173.9 45.5 n.a 167.4 2.2 2.6 1.9 1.5 0.5 1.1 n.a 0.8 RIETI CONFERENCE-LIU 31 What exchange works better for China? Table 10: Exchange Rate Regimes I. Fixed Arragements a) Currency Unions b) Currency Boards (Dollarization) c) Truly Fiexed Exchange Rates II. Intermediate Arrangements a) Adjustable Pegs b) Crawling Pegs c) Basket Pegs d) Target Zone and Bands III. Floats a) Managed Floats b) Free Floats Source: Frankel (1999) RIETI CONFERENCE-LIU 32 As China’s capital account has become more porous, its objective of maintaining stable exchange rate and autonomous monetary policy simultaneous becomes increasingly untenable Figure 5: The Trilemma Stable Exchange Rate Capital Control Currency Board Floating Exchange Rate Autonomous Monetary Policy Free Capital Flows RIETI CONFERENCE-LIU 33 z z Indeed, in order to maintain stable exchange rate and conduct independent monetary policy, China should strengthen, rather than weaken, capital controls. The existing pegged exchange rate regime offers advantages: • To prevent time inconsistent policies because of the lack of credibility of domestic institutions • Leverage on better institutions for credibility • Allow time to build domestic institutions and convergence to center RIETI CONFERENCE-LIU 34 China’s institution quality is not up to handle domestic financial liberalization d o m e s ti c fi n a n c i a l l ib e ra li s a ti o n a n d c o r e i n s t it u t io n s i n th e l a t e 1990s 12 core ins titutio ns 10 H K 8 S IN M L C H TW ZA 6 C Z AR G C OL BR 4 IN D PE MX TK VEN KR PH ID PL 2 TH H U SA CN R U 0 0 10 20 30 40 50 60 70 80 90 100 d o m e s tic f in a n c ia l lib e r a l is a t io n RIETI CONFERENCE-LIU 35 China’s core institutions are not up to the job of capital account liberalization, either. c o r e i n s t it u t i o n s a n d c a p i t a l a c c o u n t o p e n i n g i n t h e l a t e 1 9 9 0 s 12 core institutions 10 HK ML 8 4 VE N CH ZA TW TH IN D ARG 6 COL KR BR PH TK PL 2 S IN PE CZ MX HU ID SA CN RU 0 0 0 ,5 1 1 ,5 2 2,5 3 3 ,5 4 4 ,5 c a p i ta l a c c o u n t o p e n in g RIETI CONFERENCE-LIU 36 China’s core institutions are generally weaker than some of the crisis economies. T a b le 1 : C r is is E c o n o m y P ro f ile s c ir c a 1 9 9 0 s C o re I n s tit u t io n s In d e x S c a le 0 – 1 0 I n t e r n a tio n a l L e v e ra g in g I n t 'l b o n d & b a n k d e b t/G D P % 1998 Q 2 E x te rn a l L iq u id it y C o n s tr a in ts S h o rt-te rm F u n c tio n a l d e b t/F X re s e rv e s % D F L % Sept 1998 S in c e 1 9 8 0 s KAO 1 9 9 8 -9 9 S c a le 0 – 4 A r g e n t in a B r a z il P e ru M e x ic o I n d o n e s ia K o re a M a la y s ia P h ilip p in e s T h a ila n d T u rk e y R u s s ia 5 ,0 4 ,6 5 ,2 4 ,7 3 ,4 5 ,1 8 ,0 4 ,1 5 ,4 3 ,7 1 ,1 2 3 ,1 1 7 ,3 1 3 ,2 2 6 ,0 4 2 ,2 2 9 ,9 3 6 ,5 2 8 ,3 4 0 ,8 2 4 ,3 1 6 ,1 1 5 9 ,0 1 1 4 ,0 7 4 ,0 8 2 ,0 7 5 ,0 1 7 3 ,0 2 7 ,0 6 4 ,0 4 8 0 ,0 1 0 1 ,0 1 4 0 ,0 2 4 ,2 0 ,0 2 7 ,6 2 8 ,1 4 0 ,2 6 7 ,5 8 6 ,2 6 7 ,3 5 6 ,5 2 5 ,5 1 0 ,3 2 ,5 3 ,0 3 ,5 4 ,0 3 ,5 3 ,5 3 ,0 3 ,0 2 ,5 3 ,0 4 ,0 C r is is E c o n o m ie s O th e r E M E s O f w h ic h C h in a 4 ,6 3 ,8 1 .6 2 7 ,1 1 6 ,0 1 0 .2 1 3 5 ,4 3 1 ,1 1 3 .0 3 9 ,4 3 2 ,2 3 4 .0 3 ,2 2 ,8 1 .5 C o n tro l G ro u p 7 ,5 1 1 ,8 5 9 ,7 6 8 ,5 3 ,3 C o u n try N o te : O th e r E M E s in c lu d e th e P R C , I n d ia , C o lo m b ia , th e C z e c h R e p u b lic , P o la n d , S a u d i A r a b ia a n d V e n e z u e la . T h e C o n tr o l g r o u p in c lu d e s H o n g K o n g ( C h in a ) , S in g a p o r e , T a i p e i ( C h in a ) , C h i le , S o u th A fr ic a a n d H u n g a r y . S o u rce: C h a n-L ee 2 0 02 . RIETI CONFERENCE-LIU 37 z If China opts for a flexible exchange rate regime, it would have to build domestic institutions that can act as credible nominal anchors. •Central bank independence •Inflation targeting •Risk management skills of its financial institutions •Efficient financial markets RIETI CONFERENCE-LIU 38 Some sequencing is still needed! T a b le 1 : A R o a d m a p f o r F in a n c ia l R e f o r m I m p le m e n t a t i o n Issu es T im e -F r a m e fo r I m p le m e n t a t io n I. R e sto r e B a n k in g S e c to r S o lv e n c y a n d R e d u c e B a n k in g S e c to r R isk s H yb rid A p p ro a c h : C a r v in g o u t a p o r tio n o f N P L s a n d g r o w in g o u t th e r e s t; c o n tin g e n t lia b ilitie s a r e n o t fu lly rec o g n iz ed a n d n e ed h ig h g r o w th to m a in ta in fis c a l su s ta in a b ility U n d erm in in g s u s ta in a b le e c o n o m ic g r o w th a n d p o s s ib le m e d iu m -te r m fis c a l s tr e ss Q u ic k r e s o lu tio n o f N P L s v ia la r g e -s c a le o w n e r s h ip d iv e r s ific a tio n . S u sta in in g h ig h , m e d iu m -te r m g r o w th v ia v ia b le b a n k s a n d S O E r e s tr u c tu r in g F isc a l co sts, m o ra l h a z a r d w ith o u t o w n e r s h ip c h a n g e s a n d w ea k c o rp o ra te g overn an ce; N P L r e s o lu tio n w ill e n ta il s h o r t-te r m h ig h d e b t to G D P r a tio B e tte r fu n c tio n in g g overn m en t bon d m a r k e ts a n d b e tte r e q u ity m a r k e t fo r p r iv a tiz a tio n ; tra n sp a re n t b u d g et in stitu tio n s a n d s tr e n g th e n in g ta x a d m in is tr a tio n S O E o w n e r s h ip d iv e r s ific a tio n a n d r e s tr u c tu r in g m u s t a c c e le r a te . R a tio n a liz in g c e n tr a l a n d lo c a l fis c a l a rra n g m en ts; w id e n in g ta x b a s e . S ta r t n o w a n d a c c e le r a te e x istin g p r o g r a m s to m a in ta in fis c a l s u s ta in a b ility in th e m e d iu m te r m . II. C h a n g e In c e n tiv e S tr u c tu r e s A tte m p t to b u ild a n in c e n tiv e str u c tu r e w ith o u t c le a r p r o p e r ty r ig h ts S evere agen cy p r o b le m s; in c r e a s e d s ta te a s s e ts s tr ip p in g a n d r e la te d c o r r u p tio n C le a r p r o p e r ty r ig h ts th r o u g h o w n e r sh ip d iv e r s ific a tio n P o ss ib ility o f tr a n s itio n a l u n em p lo ym e n t a n d s o c ia l d islo c a tio n E ffe c tiv e le g a l s y s te m to e n fo r c e p r o p e r ty r ig h ts C o n v e r tin g p r iv a te s a v in g s in to o w n e r sh ip c la im s v ia s h a r e h o ld in g s S ta r t n o w a s it m a y ta k e d e c a d e s III. In d e p e n d e n c e o f th e C e n tr a l B a n k a n d S u p e r v is o r y A g e n c ie s U n d e r c o n tr o l o f th e S ta te C o u n c il; m u ltip le s u p e r v is o r y a g e n c i e s s u b je c t t o p o litic a l in te r fe r e n c e s P e r p e tu a te s govern m en t in te fe r e n c e a n d p o o r s ta n d a r d s ; p o litic iz e d e x it p o lic ie s F u ll in d e p e n d e n c e D iffic u ltie s in c o o r d in a tin g fis c a l a n d m o n e ta r y p o lic y a n d a c c o u n ta b ilitie s C o m p eten t te c h n o c r a ts a n d reg u la to rs; e n fo r c e m e n t o f r u le s b a s e d s u p e r v is io n ; b e tte r a c c o u n ta n c y , tra n sp a re n cy a n d d is c lo s u r e s ta n d a r d s A p p o in t in d e p e n d e n t c e n tr a l b a n k e r a n d reg u la to rs a n d im p r o v e th e c o u r t s y s te m ; d e v e lo p in d ir e c t m o n e ta r y p o lic y in s tr u m e n t v ia b e tte r in te r b a n k a n d m on ey m ark et S h o r t to M e d iu m te r m IV . S ta g e d In te r e st R a te L ib e r a liz a tio n A d m in s tr a tiv e ly c o n tr o lle d in te r e s t r a te s Im p r o p e r p r ic in g o f risk s P h a se d in te r e s t r a te d e r e g u la tio n w ith a b a la n c e o n c o m p e titio n a n d b a n k s ' fr a n c h is e v a lu e T ip s s tr u c o w in y ie ld F u n c tio n in g in te r ban k an d m on ey m a r k e ts; c a p a c ity to a c tiv e ly m o n ito r c re d it g ro w th to s p e c u la tiv e s e c to r s L e n d in g r a te s fir s t fo llo w e d b y d e p o s it r a te s S ta r t n o w V . N e w D o m e s tic a n d F o r e ig n B a n k E n tr y A d m in is tr a tiv e r e q u ir e m e n ts fo r e n tr y a n d r e str ic te d fo r e ig n e n tr y M a in ta in o lig o p o ly r e n ts , b u t lim it fin a n c ia l in n o v a tio n a n d c o m p e titio n E n c o u r a g e e n tr y o f r e p u ta b le fo r e ig n fin a n c ia l in s titu tio n s th r o u g h jo in t v e n t u r e s or M & A , as a part of W T O c o m m itm e n t W e a k e r c o m p e titio n m a in ta in s d o m e s tic m o n o p o ly p o w e r ; d e fa c to a c c e le r a tio n o f K A O v ia r e la b e lin g o f c a p ita l flo w s L e v e l p la y in g fie ld fo r r e g u la to r y c o n tr o l; " F it a n d p r o p e r " c r ite r ia fo r e n tr y . H ig h e r p r u d e n tia l o v ersig h t a n d tra n sp a re n cy s ta n d a r d s ; m o n ito r n e t p o sitio n s o f b a n k s a n d b e a w a r e o f o ffb a la n c e sh ee t risk s E n c o u r a g e fo r e ig n fin a n c ia l in s titu tio n s e n tr y to im p r o v e in fo r m a tio n p r o c e s s in g a n d e n h a n c e risk m a n a g e m e n t s k ills ; N a tio n a l tr e a tm e n t fo r fo r e ig n b a n k s S ta r t n o w V I. O p e n th e C a p ita l A ccou n t R e la tiv e ly r e s tr ic te d A p p r o p r ia te in th e s h o r t r u n b u t w ith d isto r tin g c a p ita l co sts R isk -b a sed s e q u e n c in g C u rren cy an d m a tu r ity m is m a tc h e s B e tte r lo n g -te r m d e b t m a r k e ts a n d c a p a c ity to m o n ito r s h o r t-te r m c a p ita l in flo w s F D I, tr a d e c r e d its , fo llo w e d b y p o r tfo lio in v e s tm e n t a n d b a n k lo a n s d e p e n d in g o n in stitu tio n a l c a p a c ity ; b e a w a r e o f la b e lin g o f c a p ita l flo w s v ia d e r iv a tiv e s M e d iu m V E A R A P e g g e d to th e U S d o lla r . C h in a h a s s ig n e d b ila te r a l s w a p a r r a n g e m e n ts w ith k e y c o u n tr ie s in th e r e g io n b a s e d o n th e C h ia n g -M a i In itia tiv e s Illu s io n o f F X g u a r a n te e d isc o u r a g e s h e d g in g p r a c tic e s C urren cy B asket S y s te m a n d fo r m a liz e d m u ltila te r a l m o n e ta r y arran g em en t G r e a te r v o la tility; m an ag em en t of e x p e c ta tio n ; D iffic u ltie s o f m o n ito r in g a n d m o r a l h azard G r e a te r tr a n s p a r e n c y a n d c o n s is te n c y o f e c o n o m ic p o lic y ; R e g io n a l m o n e ta r y arran gem en t U se D o lla r /Y e n /E u r o a s k ey ba sk et c u r r e n c ie s; A c tiv e ly p a r tic ip a te in r e g io n a l m o n e ta r y c o o p e r a tio n S h o r t- te r m fo r th e e x c h a n g e r a te r e g im e a n d m e d iu m te r m fo r th e fo r m a l r e g io n a l le n d e r o f la s t r e s o r t a r r a n g e m e n t. P o li c y G o a ls II. M o r e F le x ib le x c h a n g e R a te a n d c tiv e P a r tic ip a tio n in e g io n a l F in a n c ia l rran gem en t E x is tin g S tr a te g y P r o b le m s a n d L im ita tio n s P r o p o s a ls I n stit u tio n a l R e q u ir e m e n ts P o s s ib le N e w R is k s m a tu r ity tu r e to sh o r t te r m g to d isto r te d curve RIETI CONFERENCE-LIU 39 term z Sequencing steps 1. Resolving the banking sector risks 2. Change domestic incentive system 3. Building credible domestic institutions 4. Staged interest rate liberalization 5. Allow domestic and foreign entry 6. Staged capital account liberalization 7. Flexible exchange rate regime and participating the regional financial arrangement RIETI CONFERENCE-LIU 40 What is an optimal exchange rate regime for China? • The current exchange rate regime is not bad as long as capital control can be strengthened • China’s capital control is still likely to remain for some time • But flexible exchange rate regime is inconsistent with capital controls • BBC (band, basket peg, and crawling peg) are susceptible to big shocks, stabilizing speculation, and furnishing credible nominal anchors. • Managed floating with close monitoring of currency mismatches? (Goldstein, 2002, Bordo, 2003) • It remains a theoretical and empirical issue! RIETI CONFERENCE-LIU 41 V. China’s Role in the World Economic Imbalance China is not yet a world locomotive. A drop of Chinese growth has limited impact on the rest of world (WEO, 2004). E x p o r ts o f S e le c te d C o u n tr ie s to C h in a (I n p e r c e n t o f th e ir to ta l e x p o r ts ) Jap an K o rea S in g a p o r e In d o n e s ia M a la y sia P h i l ip p i n e s T h a ila n d In d ia 2000 2002 2003 6 .3 1 0 .7 3 .9 4 .5 3 .1 1 .7 4 .1 1 .8 9 .6 1 4 .7 5 .5 5 .1 5 .6 3 .9 5 .2 4 .1 1 3 .6 2 0 .5 7 .0 7 .4 1 0 .8 1 2 .0 7 .1 6 .4 S o u r c e : I M F D i r e c t io n o f T r a d e S t a t i s t i c s . RIETI CONFERENCE-LIU 42 z China’s policy priorities are still within its domestic sector and its continued structural reform will make it normal economy. • Reduce the urban-rural inequality and speed up urbanization process. • Unify its domestic market and remove non-tariff barriers • Reduce the tyranny of distance to facilitate market integration • Need domestic long-term bond market for these funding needs and foreign capital! RIETI CONFERENCE-LIU 43