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China's Financial Policies Upon Accession to the WTO Ronald
MCKINNON China's accession to the World Trade Organization (WTO) is a big step forward toward increasing the efficiency of China's increasingly market-oriented economy. However, my discussion will focus on exchange rate management and the problem of maintaining macroeconomic control as China's financial system becomes more open. Exchange Rate Policy With the passing of the Asian crisis and the end of the undervaluation of the currencies of China's East Asian competitors, China's industrial exports are once more growing very rapidly. So the discussions have revolved around exchange rate policy: whether the currency should go up or go down, and what should the government's policy be toward the exchange rate. As long as China maintains controls over international flows of portfolio capital, the market cannot decide the exchange rate; the government does. Moreover, I will argue that China's government should continue with strict prudential controls over short-term capital flows. Then, a pure float is impossible because banks and private financial institutions are not free to take open positions in foreign exchange. The government must "make" the foreign exchange market and also decide on what the exchange rate should be. The question is whether the government has been correct in keeping the exchange rate close to 8.3 Yuan to the dollar for more than five years. Contrary to the views of many economists, the exchange rate should not be manipulated to secure some particular target for the trade balance; nor should it vary with the ebb and flow of imports and exports. Instead, a stable exchange rate against the currency of the center country, i.e., the U.S. dollar in the Asian case, preserves confidence in the currency as the economy becomes more open. A stable exchange rate is a natural anchor for domestic monetary policy in a high-growth economy whose long-term capital market is not yet well developed -- and where almost all of its imports and exports are invoiced in dollars. For example, Japan's currency remained firmly fixed at 360 yen to the dollar from 1949 to 1971; during this period Japan had a great spurt in economic growth, between 6 and 12 percent per year. This fixed rate securely anchored Japan's wholesale price level while monetary aggregates, such as M2, increased very rapidly relative to GDP -- and Japan's long-term bond market remained underdeveloped. The Japanese government did not restore current-account convertibility until 1964, and it maintained capital controls for long after that. As such, "hot" money flows, rapid movements of short-term capital through the foreign exchanges, were not a problem throughout Japan's high-growth era. Even with capital controls in place, Japanese businesses competed very successfully in the global market. Fortunately, the old Bretton Woods agreement of fixed exchange parities against the dollar created a common worldwide monetary standard that contributed to the success of Japan's fixed exchange rate system. Therefore, China's policy of fixing the exchange rate, with prudential capital controls to offset the (latent) moral hazard from the bad loan positions and resulting under-capitalization of state-owned banks, is correct. But a fixed exchange rate can be more easily sustained if China's East Asian trading partners, which are also its mercantile competitors, are on the same monetary standard. Before the great currency crisis of 1997-98, all the other East Asian economies, with the important exception of Japan, kept their currencies more or less pegged to the dollar. On a daily basis, they were all quite tightly pegged -- though with some drift in the medium and longer terms. The Indonesian rupiah drifted gently down, while the Singapore dollar drifted gently up, with the others showing little or no drift at all. The fact that all the East Asian countries except Japan were on a common monetary standard protected them from (inadvertent) beggar-thy-neighbor devaluations. During the 1997-98 crisis, the debtor countries -- Indonesia, Korea, Malaysia, Philippines and Thailand -- had to devalue quite massively, albeit temporarily, against the dollar; and even the creditor countries of Singapore and Taiwan devalued to a more moderate extent. For China and Hong Kong, the upshot of this series of devaluations by trading partners was a loss of external competitiveness, as shown by the fall in export growth, and quite severe deflationary pressure lasting through 1999. Fortunately, there was long-term confidence in China's currency and exchange rate. Thus, under the tutelage of Premier Zhu Rongji, China could engage in a quite massive Keynesian-type stimulus of public sector spending from 1998 into 2000 to successfully counter the deflationary pressure without provoking a run on the currency. By contrast, in Latin America where there is so little long-term confidence, increased fiscal deficits would provoke currency runs almost immediately. What are the lessons? It is to China's advantage if its neighbors maintain stable exchange rates against the dollar. Conveniently, it appears as if all the other East Asian economies, except possibly Indonesia, are converging back to more or less stable dollar exchange rates in year 2000. So in international forums, APEC and elsewhere, mutual exchange rate stability should be a prime objective. Because China now has the largest economy in East Asia after Japan's, and the yen is not properly tethered against the dollar, the smaller economies are much more likely to converge back to exchange rate stability if China (along with Hong Kong) engenders confidence in the fixed rate system. Limits to Financial Liberalization Accession to the WTO, requiring further liberalization of foreign trade both in industry and agriculture, will be of enormous benefits to China, especially if exchange rate stability is maintained. Even so, China is inherently limited in the amount of financial liberalization it should undertake. Among other things, the government should restrain foreign banks from accepting RMB deposits in order to compete with domestic banks, and also restrain foreign financial institutions from undermining the capital controls by transacting freely between foreign and domestic currencies. What is the underlying problem? For more than twenty years, the Chinese government has covered its large implicit fiscal deficits by borrowing from the state-owned banking system -- whether it be in the form of policy loans for infrastructure investments or loans to prop up loss-making state-owned enterprises. For the most part, these loans cannot, or will not, be repaid. Thus, domestic Chinese banks are encumbered with a portfolio of nonperforming loans which are the implicit debts of the government in a long run sense -- but don't bear true interest in the short and medium terms. Thus the state-owned Chinese banks are encumbered or handicapped with substantial holdings of non-interest-bearing assets. Admitting foreign banks, which are not so encumbered, to bid for RMB deposits would not be fair competition. In the interbank market (and even at retail if deposit interest ceilings are abolished), foreign banks could bid away deposits from even well-behaved domestic banks that are encumbered. Most importantly, this would undermine the government's fiscal position as its ability to extract policy loans from the banks at low interest rates erodes. And the cost of carrying the large domestically held government debt could rise sharply if the government are forced to convert all its domestic debt into bonds traded on an open market. Before having more competition in domestic financial markets, it is best to substantially improve the government's ability to collect taxes, which are now only about 13 percent of GDP. The conversion of existing government debt (largely in the form of loans from state-owned banks) into higher-interest, open-market bonds should also proceed gradually over several years before full liberalization. In the interim, if foreign banks or other financial institutions enter China's RMB market, the government should impose high capital and non-interest-bearing reserve requirements on them so as to create a "level playing field." For example, if it is estimated that 35 percent the loan portfolios of domestic banks is nonperforming, the People's Bank of China could impose a 35 percent reserve requirement on foreign banks and financial institutions accepting RMB deposits. Finally, there is the major problem of maintaining prudential controls over "hot" money flows. If foreign banks are allowed to move freely between dollars and RMB, then domestic banks will clamor for the same privilege. But because of their bad loan portfolios and eroded capital positions, domestic banks have a more serious problem of moral hazard, i.e., more of a proclivity to gamble by taking exposed positions in foreign exchange. As such, like domestic banks, foreign banks may have to be restricted in foreign exchange transactions. In conclusion, China should be congratulated on its accession to the WTO, which I think will be a wonderful benefit to the economy. But the liberalization of trade in financial services best proceeds much more slowly than the liberalization of trade in goods and non-financial services. (The author is Professor of Economics at Stanford University.) References: 1. McKinnon, Ronald I. The Order of Economic Liberalization: Financial Control in the Transition to a Market Economy, 2nd ed 1993, Johns Hopkins University Press, Baltimore. Chinese Translation, 1997, People's Press, Shanghai. |