Tough choices for PBOC

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 Would Trade Organization (WTO). A closer look at China's national accounts suggests 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 intervention. 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 performance 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 from 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' represent? The deliberate evasion of capital controls is only one source of error in the national 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 overstatement of exports. Both types of economic 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 diminish (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 economy and sparked an influx of capital. But so far, at least, the influx hasn't consisted primarily 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 percent). The time lags involved in planning FDI projects are probably too low for the effects of WTO membership in December 2001 to have appeared in the full-year 2002 statistics. However, the figures do suggest that Chinese ?flight capital' – which departed the country during most of the 1990s 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 improvement in the merchandise trade balance China's deficit in services rose slightly during the year. The increased surplus in merchandise trade, combined with the change in net errors and omissions, improved China's 2002 balance of payments by US$32bn 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 latter 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 structural 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 consumer 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 commitments 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 outbreak, utilised foreign direct investment rose by 34 percent in the first half of 2003 to US$30.3bn. 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 period. 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 capital. China's exchange controls are apparently 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 purchase 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 bringing forward the cuts in import duties pledged in China's WTO accession package may be the only way to check the explosive growth of the central bank's reserves.