Zhou Xiaochuan, China’s central bank governor, has said the rate of growth in China’s foreign exchange reserves is unsustainable, but the country cannot significantly change its policy because of uncertainties in the global economy.
In an exclusive interview with Emerging Markets in Washington last weekend, Zhou ruled out a substantial one-off revaluation of the renminbi.
“I should say that [the current rate of foreign exchange accumulation] is not desirable because the government already admits that they want to have better balance of payments,” Zhou said.
“[The government] wants to reduce this and meanwhile encourage domestic demand.” But Zhou said that a rapidly changing external environment — including uncertainty over export demand from the US, Europe and Japan — ruled out a shift in policy at present. “The problem is sometimes you don’t know [all the variables] which can also have an impact,” Zhou said.
His comments came as China’s foreign currency holdings soar to new heights. Exports, foreign investment and the falling dollar pushed the nation’s foreign exchange reserves, the world’s largest, to $1.68tr at the end of March. A revaluation of the renminbi has long been desired, in particular by the US Congress, as a way to slam the brakes on China’s burgeoning trade surplus.
Critics say the currency remains undervalued, keeping Chinese exports artificially cheap and contributing to the country’s massive trade imbalance with the US. At the same time, the renminbi appreciated this month at its fastest rate since China’s introduced a new, more flexible currency regime in July 2005. That has fuelled talk that a more substantial revaluation is on the cards.
China’s currency rose past the mark of Rmb7/$ for the first time since the government unpegged it from the dollar nearly three years ago, allowing it to crawl upwards within a narrow trading band. Zhou admitted that the question of a large one-off revaluation had been discussed among members of China’s monetary policy committee, but he said policy remained the same — a gradual shift towards a more flexible exchange rate.
“We have a lot of policy discussion forums, we have public discussion and also internal discussions,” said Zhou. But he added that China would continue to increase exchange rate flexibility, in line with its long stated principles. “Going back to 2005, at the time we mentioned three principles for reform of the exchange rate,” Zhou said.
“One is that there is independent decision-making, the other is gradualism and the third is keeping it in a controlled range — not to allow it to get out of control.” The renminbi’s rise in recent months has attracted inflows of speculative capital — which has contributed to the massive growth in China’s currency reserves.
China’s currency gained 7% against the dollar last year and has surged another 4.3% already this year. Zhou said Chinese officials “work very hard in collecting the data and doing the analysis” on capital inflows, but refused to say whether such inflows could feed a domestic liquidity bubble.
“It’s still too early to talk about the outcome,” he said. He nevertheless rejected the term “hot money” to define the inflows. “To me there is no widely recognised definition of hot money. What’s being referred to? It’s difficult to measure that,” he argued.
Inflation a big concern
Chinese policymakers — including premier Wen Jiabao — have labelled inflation and economic overheating as the two biggest obstacles to growth that China faces this year. But Zhou said inflation would not be a primary reason for exchange rate reforms. A large revaluation could help to lower the price of imported goods, but it risks opening the floodgates to speculative inflows.
The government is scrambling for ways to keep the inward surge of capital from accelerating an inflation rate that is already at its highest for more than a decade. Consumer prices in China jumped 8.7% in February after the worst snowstorms for half a century disrupted transport and food deliveries. The central bank governor noted that efforts in recent years had already helped stem inflationary forces.
“Monetary policy, especially in the past two years, has been absorbing a very huge amount of liquidity in the system,” he said. The central bank’s actions over this period underlined “a tremendous role for maintaining the stability of the money supply in the economy,” Zhou said, adding that without the People’s Bank’s efforts over this period “inflation would have come much earlier and much stronger”. In an effort to tamp down on liquidity, China’s central bank has tightened the required reserve ratio for banks to a record 15.5%.
However, China has held off from raising interest rates after six increases last year, waiting to see if the rate-cutting campaign being waged by the US Federal Reserve has the desired, offsetting effect. “We have several policy choices [in fighting inflation],” Zhou said. “Our models show us not only the inflation outlook, but also we look at growth, employment and so on, and we determined that the interest rates were maybe not the best [policy] choice [at that time]. “Whether we should have additional [interest rate rises], I think that first we need a [better] understanding of the inflation mechanisms,” Zhou said.
He said consumer price rises were “mainly caused by food prices this time”. “It seems not a very classic case in which inflation is caused by too much aggregate demand,” he said.
World economy limits choices
Zhou also drew attention to the difficulties facing policymakers at a time of heightened uncertainty, especially about the US economy. “What we didn’t know [in January] was what the US Fed was going to do,” he said. “We needed to wait for that. We didn’t have good enough empirical analysis to know what the Fed — the extent to which the Fed — would lower interest rates, and what impact this would have on global capital flows.”
But Zhou cautioned that the rapidly changing global economic environment had constrained policy choices. “When you design the policies, even though you try to reduce [economic] imbalances — balance of payment imbalances, reduce the trade surplus, increase domestic demand — you do so with certain assumptions. But later on when you find that these assumptions are not as you thought, or that they are different from the reality — this has quite an effect. “It’s the dynamic process of decision-making which reflects the changing reality,” Zhou said.
The recent fall in the dollar, however, has yet to make the trade imbalance with the US worse. “For the past few years, the percentage of US dollar depreciation was not very significant to have a major impact on Chinese balance of payments,” Zhou said. Until now, he said, Chinese exports had remained resilient to a US economic slowdown.
“Up to now, the reality of a negative impact on Chinese exports has been less than predicted. So if we look at exports to the US from China we could see still them growing, though at a lower rate, but we have yet to find them declining,” he said. But dealing with a change in circumstances “is the major challenge,” Zhou said.
Although the central banker believes the impact of the US subprime mortgage crisis on China has so far been negligible, he suggested that further fallout from the turmoil could prompt closer scrutiny of the rapid rate of financial liberalisation in many emerging market economies. “Certainly along with the events we may have to start thinking about this,” he said. “But it is better to talk about that after we see how the turmoil is terminated.”