Big Risks in China's Yuan Policy

November 10, 2009

Inside Asia
Big Risks in China's Yuan Policy

By ALAN WHEATLEY

BEIJING — Exactly a year after it unveiled a stimulus package worth 4 trillion yuan and switched to an easy monetary policy, China is basking in the success of its aggressive response to the global financial crisis.

The government’s 8 percent growth target for the year — derided by some prominent economists as fanciful well into 2009 — is in the bag. And the solid consensus is that growth will be stronger, possibly a lot stronger, in 2010, when China is set to overtake Japan as the world’s second-largest economy.

China is contributing more to global growth than is the United States, the euro zone or Japan, and its surging imports have limited the slide in global trade, the World Bank says.

“There’s an inexorable shift toward East Asia, particularly toward China,” said Vikram Nehru, the bank’s chief economist for the region. “China is becoming a central part of the global economy.”

China, in short, is riding high. But could it also be riding for a fall?

After all, the imbalances at the heart of China’s mode of development — too much investment, too much saving, too little consumption — seem to fit the dictum of the late American economist Herbert Stein to a T. “If something cannot go on forever, it will stop,” Stein’s Law says.

Exhibit 1: the prolonged U.S. credit binge that begat the crisis.

As was the case with the United States, the overarching risk for China is that it keeps policy too loose for too long. Yet Finance Minister Xie Xuren again signaled over the weekend that China was in no hurry to shift gears.

“There are still many uncertain factors in the current global economic recovery, so all countries should maintain the continuity and stability of macroeconomic policy,” Mr. Xie said at a Group of 20 meeting in Scotland.

Another huge wave of bank-financed investment is guaranteed for 2010 because the government is only halfway through its two-year stimulus package. You do not start building a railroad and leave it half-finished.

The boom in capital spending has worked as intended. Investment contributed 7.3 percentage points to the 7.7 percent increase in gross domestic product over the first nine months.

China has vast infrastructure needs, but there can be too much of a good thing. Bank lending has grown by a third in the past year to finance the investment spree. Mr. Stein would be raising his eyebrows.

“It is now time to begin slowing the pace of rapid credit growth,” said Tarhan Feyzioglu of the International Monetary Fund’s office in Beijing.

Central banks usually apply the brakes to ward off inflation. Not in this case. China’s underlying price pressures are mild.

“In China the potential risk is that excess investment and excess credit growth could lead to excess capacity and eventually nonperforming loans, which would weaken the financial system,” Mr. Feyzioglu said at a conference in Beijing.

The related danger in China — and in much of Asia, incidentally — is that plentiful credit will bring a scramble for assets, especially property and equities.

“We see a high risk that policy makers may be unable to tighten aggressively, making an asset price bubble likely in our opinion — and magnifying any negative consequences a few years down the road,” said Mingchun Sun, Nomura’s chief China economist.

That prospect highlights Beijing’s dilemma. While China can steer the housing market by tweaking down payment and mortgage rules, its hands are largely tied on monetary policy: Because it insists on holding down the value of the yuan — $1 brings about 6.8 yuan today — China in effect takes its cue from America’s zero interest rate policy, even though its economy is much stronger.

So the way China manages its exchange rate is shaping up as the most decisive — and divisive — policy issue in the year ahead.

“It’s a difficult subject, I know, but one must ask the question at any rate as to whether or not China has grown up sufficiently to let its currency find its own level against the international currencies, particularly the dollar,” said Simon Linnett, vice chairman of the investment bank NM Rothschild & Sons.

U.S. officials have resumed their campaign for a stronger yuan. The protectionist drums are beating louder in America about underpriced Chinese imports of everything from steel to tires.

And significantly, Brazil broke ranks over the weekend by declaring China’s quasi-fixed exchange rate to be a problem.

China retorts that it cannot risk allowing the yuan to climb as long as its exports are fragile. And raising Chinese interest rates before U.S. rates go up would be to suck in speculative money, making it even harder to soak up excess liquidity, officials contend.

Their argument is understandable but unconvincing. For the longer China waits, the more capital inflows it will attract in any case because of its strong economic fundamentals and in anticipation of an eventual rise in the exchange rate.

“There’s still a lot of money to come from Western investors into markets like China,” said Anthony Bolton, president of investments at Fidelity International.

So how will it play out?

Alicia Garcia-Herrero, chief economist for emerging markets at the Spanish bank BBVA, reflects a widespread view that China might let the yuan resume its climb from the middle of next year.

But she envisages only a minimal rate of climb. And with inflation under control, the central bank will not be under pressure to tighten significantly.

“That means policy will be too expansionary,” said Ms. Garcia-Herrero, who is based in Hong Kong. “2010 will be a year of good news, but you will be building up problems for 2011.”

Alan Wheatley is a Reuters columnist.