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Interesting Analysis by UPI Courtesy of Brett:
Analysis: China, today's Creditanstalt?

Analysis: China, today's Creditanstalt?
Thursday, 16-Oct-2003 4:01PM PDT Story from United Press International
Copyright 2003 by United Press International (via ClariNet)
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WASHINGTON, Oct. 16 (UPI) -- Wednesday, the American Enterprise Institute held a seminar to discuss whether China will revalue the renminbi. The bottom line was: economically, they should, but it would be very difficult and so they won't. The seminar's analysis, however, was more interesting than the conclusion.

The general view was that the Chinese authorities would prefer to keep the renminbi at around 8.3 to the dollar, because their principal concerns are unemployment and the agricultural sector, rather than the country's balance of payments. In any case, China's balance of trade as a whole is far less positive than its balance of trade with the United States; the $100 billion per annum surplus with the United States is offset by a $70 billion per annum deficit with the rest of the world, primarily other countries in emerging Asia. Approximately two thirds of China's exports are processed goods, with substantial amounts of the inputs coming from other Asian countries, and China supplying primarily the labor factor. Thus the net surplus on current account, 3 percent of gross domestic product in 2002, will be less than 2 percent of GDP in 2003.

At the time of the Asian crisis of 1998, there was considerable expectation that the renminbi might decline against the dollar (it has been pegged at its current exchange rate for a decade.) However, the continued high level of foreign investment in China (currently around $50 billion per annum by official figures, although half or more of that may be "round-tripping" of domestic money exported illegally) and the consequent rise in China's foreign exchange reserves has since made the renminbi strong rather than weak. In the past year, the decline of the dollar against the euro and to a lesser extent the yen has been tracked by the renminbi, and by a number of other Asian currencies that also track the dollar, and whose economies are intimately bound up with that of China. Currently, the top 5 Asian holders of foreign reserves own around $1.8 trillion of U.S. Treasury bonds, of which China owns $350 billion.

China's capital account is also an upward force on the renminbi. According to Nicholas Lardy, of the Institute for International Economics, China's capital account was positive by about $30 billion in 2002, a similar amount to the previous year. However, its foreign exchange reserves are building more rapidly than the surplus on capital account, having risen above $350 billion in the first half of 2003. The errors and omissions item in the balance of payments, which generally represents unreported private capital transfers, having fluctuated around $10 billion negative (transfers out) in the years from 1994-2002, was nearly $10 billion positive (unrecorded transfers in) in 2002, and is likely to be larger in 2003 as Chinese savers speculate on a possible revaluation of the renminbi.

Harvey Chen, of Shanghai Jiao Tong University, pointed out that the major political pressure on China to revalue comes from those U.S. multinationals which have not relocated part of their production to China, and from the European Union, against whose currency the renminbi has of course substantially declined, in line with the dollar. U.S. multinationals manufacturing in China would suffer from any substantial revaluation.

Because of the high foreign content in much of the Chinese export volume, it is likely that a revaluation of the renminbi will affect the balance of payments much less than might at first be expected; Lardy estimated that a revaluation of 15-25 percent would be necessary to remove the Chinese payments surplus of only 3 percent of GDP.

Yusuke Horiguchi, of the Institute for International Finance, suggested that rather than a single revaluation, China might widen the trading bands of the renminbi against its current central rate, so that the currency appreciated gradually; repeated such steps, and re-peggings of the central rate, could be undertaken over a period, so that Chinese exporters, and more particularly China's weak banking system, would have time to adjust.

The most difficult problem facing the Chinese government if it wished to revalue the renminbi is in the banking system. This is funded by the very high savings of the Chinese people, who are not allowed to take money out of China, except in very limited circumstances, or to hold non-renminbi deposits with Chinese banks, unless they earned the foreign currency abroad. As Randal Quarles, U.S. Treasury's Assistant Secretary for international affairs pointed out, since only about a third of the increase in foreign exchange reserves has been sterilized, the result has been a huge increase in the Chinese money supply, by 22 percent in the 8 months to August 2003.

This money in turn has been recycled by the state owned Chinese banking system into loans, which according to Lardy are likely to increase by a staggering 33 percent of Chinese GDP, 3.6 trillion renminbi ($435 billion) in 2003. Non-performing loans, which were already around $500 billion, have risen significantly in 2003 and are of course likely to rise even more rapidly as 2003's new loans go sour. Much of the money has been lent to real estate and industrial park developers, to the benefit of U.S. multinationals seeking to manufacture in China, but with a high probability of producing a huge space glut in the near future. China's increase in loans in 2003 is a larger relative increase than in any of the Asian bubble economies of the middle 1990s; as John Makin of AEI pointed out, China has the potential to be the "third bubble" after 1990 Japan and 2000 Wall Street.

In Lardy's words, the Chinese banking system is currently insolvent, in that its liabilities exceed its assets by a substantial margin, but it is not illiquid, as Chinese savers have nowhere else to put their money. This does however mean that for China to remove exchange controls would be highly dangerous; Chinese savers, to whom the parlous condition of the domestic banks cannot entirely be a secret, would instantly move their savings out of the system and into foreign banks. The foreign exchange effect of this would probably be bearable, given China's huge volume of dollar reserves, but the banking system effect, by making the domestic banks both insolvent and illiquid, would almost certainly cause a collapse, the immediate effect of which would however be felt primarily by the Chinese savers with deposits in the banks, rather than by foreign multinationals in China or by the international banking system which (unlike in other Asian countries) does not have a huge exposure to China.)

Of course, if China does not remove exchange controls, it is impossible for a true market rate for the renminbi to be determined. Nevertheless, as a number of participants pointed out, an exchange rate system of either fixed or floating exchange rates can in practice be combined with capital controls relatively easily; this was done in Europe until the middle 1980s.

The principal beneficiaries of a revaluation of the renminbi would be the Chinese middle classes, who would also be the principal beneficiaries from a relaxation of exchange controls, that would allow them to move their money to safer, more lucrative environments abroad. If the Chinese government was motivated purely by the welfare of its people, it would in my view revalue the renminbi by around 10 percent, and at the same time engage in a substantial relaxation of exchange controls that was heavily weighted towards the small saver, rather than to business, as is currently contemplated, or towards the rich (who can mostly get their money out anyway.) For example, if each family was allowed to convert $10,000 worth of renminbi into foreign currency deposits, of which $2,000 could be removed from the Chinese banking system altogether -- in cash or by wire transfer to a foreign bank -- the adverse liquidity effect on the Chinese banking system could be moderated, and the small saver in particular granted that most precious of economic freedoms, the right to remove his money from the system if he wishes. Since transfers would be made through domestic Chinese banks, policing the "once a year" requirement would in principle be straightforward.

The collapse of the Chinese banking system is in the long run inevitable; by 2007 foreign banks must be allowed to enter China, under China's World Trade Organization obligations, and the poor quality of the current tsunami of loans will presumably become apparent well before then. Much more important than prolonging the lives of the Chinese banks, however, is preserving as much as possible of Chinese middle class savings from the collapse. Such savings are the only way in which small businesses can be funded, and if they are allowed to be expropriated by the collapsing banking system, the result will be a recession lasting a decade or more, as new business formation drops catastrophically and unemployment soars.

In 1929, a huge U.S. stock market boom burst. In 1930, the stock market began to recover, at a lower level, and the U.S. economy was also only moderately affected by the collapse. In May 1931, the Austrian bank Creditanstalt failed, causing a knock-on liquidity crisis throughout Europe, the insolvency of many European countries, a collapse in world trade, and a downward spiral into the Great Depression.

It is unlikely that China will revalue the renminbi, or free up exchange controls for its unfortunate citizens; the short term political and economic costs are too great. Doing so, however, would at least mitigate the cost of a Chinese banking system collapse, since it would prevent that collapse from destroying the Chinese domestic savings base. In such a case, the Chinese banking system could indeed prove today's Creditanstalt, causing a collapse of world trade, and a re-run of the Great Depression.