Tough choices for PBOC

Despite pressure from abroad, the Chinese government has so far taken only a few steps to mitigate upward
pressure on the yuan. However, it may be forced to take more drastic measures to check
the explosive growth in central bank reserves.

The People's Bank of China (PBOC) is under increasing pressure to allow a revaluation of the yuan, as senior
officials in Europe, Japan, South Korea and the US have criticized the rapid growth of
Beijing's foreign exchange reserves since China joined the World Trade Organization
(WTO). A closer look at China's national accounts sug-gests that the need for aggressive
exchange rate management to maintain the yuan at its current level may continue through
the end of the year. Trends in the real economy show no sign of reducing pressures for
revaluation, and the widespread anticipation of a rise in the yuan's value may well become
a self-fulfilling prophecy, as speculative capital flows into the country illegally.
Until this year, at least, it seemed possible that the existing dollar peg would remain sustainable
without massive central bank inter-vention. Part of the rapid growth in the PBOC's reserves
during 2002 may have stemmed from a one-time improvement in investor confidence after
WTO entry, while much of the rest reflected a strong perfor-mance in China's
merchandise trade balance that is unlikely to be repeated in 2003.
The table
overpage illustrates several dramatic swings in the components of China's national
accounts in 2002. Perhaps the most striking is the change in the sign of the net errors and
omissions entry, which went fmm negative (an unmeasured outflow of capital from China)
to positive (an unmeasured inflow to China) with an absolute shift of just under
US$12.7bn.
What do errors and omissions' repre-sent? The deliberate evasion of
capital con-trols is only one source of error in the nation-al accounts; others include
smuggling. which leads to the under-recording of imports, and the fraudulent claiming of
VAT rebates on exported goods. which leads to the overstate-ment of exports. Both types of
eco-nomic crime are likely to have diminished in recent years. when tougher customs
enforcement was applied to the more lawless provinces of southern China. Other things
being equal. better customs enforcement would tend to dimin-ish (negative) errors and
omissions in the balance of payments. But since these crackdowns have been underway
since the late 1900s, it seems unlikely that they contributed much to the shift last
year.
A more likely explanation is that the shift represents a change in the direction
of unrecorded capital movements. rather than errors in the current account figures. Just as
the supporters of WTO entry predicted. China's integration into the global trading order
seems to have improved investor confidence in the econo-my and sparked an influx of
capital. But so far. at least, the influx hasn't consisted pri-marily of foreign direct investment,
which grew rapidly but not spectacularly during the year (from US$37.4bn to US$46.8bn, an
increase of 25 per cent). The time lags involved in planning FDI projects are proba-bly too
lone for the effects of WTO member-ship in December 2001 to have appeared in the full-
year 2002 statistics. However the fig-ures do suggest that Chinese flight capital', which
departed the country during most of the I 990s just as foreign capital was flowing in. began
returning in sizeable amounts almost immediately after WTO entry. forcing the PBOC to
accumulate hard currency reserves to keep the yuan stable.
A second notable
trend is the sharp improvement in the current account, which is more than fully explained by
an improve-ment in the merchandise trade balance China's deficit in services rose slightly
dur-ing the year). The increased surplus in mer-chandise trade, combined with the change
in net errors and omissions, improved China's 2002 balance of payments by US$32.~bn
over the previous year slightly more than the US$25.2bn increase in the PBOC's rate of
forex reserve accumulation.
Growth in FDI. by contrast. had little effect on the overall
balance of payments in 2002. It appears to have been more than fully offset by other
changes in the capital account, particularly a large swing in the growth of 'other holdings'.
Most of this lat-ter shift represents a change in borrowing patterns: Chinese entities
accumulated some US$15.7bn in short-term forex debt in 2001. but just over US$0.3bn in
2002 – perhaps reflecting a crackdown on borrowing by state enterprises.
This
year, however, there are signs that Beijing's 'weak yuan' policy may have become
unsustainable unless deeper struc-tural reforms are put in place. Ironically. the pressure
on the peg has intensified just as China's merchandise trade balance has been
dramatically undermined by a surge in imports. As Table 2 indicates, growth in imports
destined for the processing sector -which typically entered China duty-free even before
WTO accession has lagged overall import growth. suggesting that much of the increase
reflects tariff cuts on imported con-sumer goods. Since China's trade barriers are still
substantially higher than those of its trading partners for most products, further
implementation of Beijing's WTO commit-ments is likely to extend this deterioration of the
trade balance.
But trends in the legal capital account appear to have offset those in
the current account. In spite of delays caused by the Sars out-break. utilised foreign direct
investment rose by 34 per cent in the first half of 2003. to US$30.3hn. This increase, of
roughly US$7.7bn in absolute terms, almost exactly cancelled the effects of China's
worsening trade balance. which deteriorated by US$.7.9bn over the same peri-od. Due to
the Sars scare, China's hard currency tourism revenues in the first half also declined by
roughly US$4bn year-on-year. exacerbating the deterioration of the current
account.
All this implies that the rapid acceleration of growth in the PBOC's forex
reserves (which rose by US$60.lbn in the first half, compared with only U5575.5bn for the
whole of 2002) has been driven almost entirely by heavy inflows of speculative cap-ital.
China's exchange controls are apparent-ly too weak to prevent disruptive movements of
'hot money'. most likely through the mis-pricing of legitimate trade
transactions.
Beijing has so far taken only a few steps to mitigate upward pressure
on the yuan. The PBOC recently ended the compulsory pur-chase of Chinese exporters'
hard currency revenues. although this may have little effect if firms continue to swap their
earnings for yuan for speculative reasons.. Restrictions on tourist travel to Hong Kong have
also been lifted. a move that should benefit the city's depressed economy while
encouraging mainland residents to spend money overseas. But although Chinese officials
have indicated that they will not adjust the dollar peg this year more drastic measures such
as bring-ing forward the cuts in import duties pledged in China's WTO accession package
may be the only way to cheek the explosive growth of the central bank's
reserves.