How might China win or lose the currency war?

(Tao Wang is the Managing Director, Head of China Economic Research, UBS Securities. The views expressed in this column are the author’s own and do not represent those of Reuters)

A Chinese museum guide explains different sets of yuan notes for visitors at the Shanghai Bank Museum July 22, 2005. REUTERS/Ming Ming/Files

By Tao Wang

The currency war is upon us, and China and the RMB are at the centre of it. China has rejected the notion that the RMB exchange rate is the culprit of the global imbalances and so far resisted increasingly loud calls for a large RMB appreciation.

The U.S. Congress is trying to force a larger RMB appreciation with protectionist trade legislation, but most experts believe that is unlikely and in any case would take a long time to be effective.

However, as the U.S. is worried about growth and plans to use quantitative easing to reduce the risk of deflation, it will be able to force (real) currency adjustments upon its trading partners by printing as much of its own currency as it desires. A few other advanced economies can follow suit, notably Japan.

What will QE do? While it is not clear how effective QE might be in boosting economic growth in the U.S. and the advanced economies, global interest rates will be kept low for a much longer time. It is all but certain that a flood of liquidity will be seeking lower risk and higher returns -- emerging markets, including China, have and will continue to be favoured destinations. As emerging currencies face appreciation pressure, some countries, notably Brazil and Thailand, have stepped up capital controls.

What can China do in the world of QE? How might it win or lose in this “currency war”? Martin Wolf, Financial Times’ famous columnist, argued convincingly why the U.S. would win the battle. Some in the Chinese community believe that since the U.S. cannot force currency appreciation on China, the latter will win.

While China may be able to hold on to the current exchange rate policy, to gradually adjust as it pleases, that in itself can not be the sole criterion for losing or winning in the world of QE. Can China escape the unwanted consequences of QE, limit the damage of large liquidity inflows, asset bubble, and potentially gross misallocation of resources while still tightly managing currency appreciation? That will be the real test.

First, QE in the U.S. will make China’s monetary policy decision even more difficult, increasing the risk of policy error. To the extent that QE is seen as a reflection of the weakness in the U.S. and global economy, some in China may be inclined to keep China’s monetary policy accommodative for longer, to further stimulate domestic growth to compensate for weak external demand.

Moreover, interest rates may be kept low to avoid drawing in more capital flows -- concerns about capital inflows have contributed to the delay in raising interest rates so far. QE and the wall of money potentially headed for emerging markets will further weaken the stance of those who favour rate hikes and a quicker exit of the expansionary credit policy.

Maintaining a loose monetary policy and low interest rates for too long in China will not only be misguided but also dangerous. The U.S. and other advanced economies have a lot of economic slack and may need to keep monetary policy expansionary for a prolonged period of time to help smooth their adjustments in private sector deleveraging, or fiscal consolidation, or both.

However, in China the cyclical position is very different: there is little or no slack. China should be able to sustain a relatively rapid growth of 8-9 percent even with a weak growth in advanced economies in the next couple of years.

There is no need for policy to be overly accommodative to keep growth at or close to double digit, especially as the changing demographics have reduced the pressure to create new jobs. Indeed in an economy with no slack, ample liquidity plus increasingly negative real interest (measured by nominal interest rate minus the expected inflation) could lead to misallocation of resources, inflation, and asset bubbles.

Second, China’s exchange rate policy will come under increasing pressures, political and speculative. The expected QE in the U.S. has already led to a rapid depreciation of the dollar against the euro and some other major or emerging currencies.

In this environment, China’s reluctance to allow for a faster RMB appreciation will draw even more criticism, even though some Asian countries may hide behind China for their own mercantilist reasons.

Increased political pressure will increase market expectations of RMB appreciation, in our view. As China provides relatively high returns to investment and its currency is expected to appreciate, more capital inflows, real or speculative, are expected in the coming months and years, putting further upward pressure on the currency.

A faster RMB appreciation now could invite more trouble if not managed well. A faster appreciation could help defuse some international pressure and reduce the threat of trade protectionism in the short run, and could help to reduce trade surplus and the adjustment of economic structure in the long run.

However, in the current environment, a faster appreciation could also raise expectations of further appreciation and invite more capital inflows, which may offset the liquidity tightening effect of the initial appreciation. While so far capital inflows have not been nearly as large as written about in the news, things may start to change soon if China does not tighten capital controls further.

We believe that China should do the following to have a good chance of success in winning the battle, or at least limit the damage in the ongoing currency war:

1. Tighten controls on capital inflows and ease controls on outflows. Capital controls are never the perfect solution but can be effective in deterring the most volatile short-term flows, and seriously reducing overall capital inflows over a short period of time. This can provide some breathing space for other policies to be more effective, whether it is the exchange rate appreciation, liquidity management, or interest rate hike.

In recent years, China’s capital controls have already kept out a lot of flows, judging by the relatively small size of capital movements (relative to market conviction and the size of the country). Controls on foreign exchange borrowing by domestic banks and companies should especially be tightened, including by setting a tougher quota and raising the costs of borrowing. Direct investment abroad and QDII should be further liberalised.

2. Allow for a quick and sudden appreciation that is more than expected to surprise the market (say 8-10 percent rather than 3-5 percent), followed by a widening of the trading band around a basket to inject more uncertainty about future direction of the exchange rate. This is best helped with tighter capital controls.

3. Build up multiple layers of defence to manage excess liquidity and prevent excessive credit expansion: Increase sterilisation by raising reserve requirements and issuing more central bank bills to mop up liquidity generated from the rising FX inflows; Impose a more strict credit quota, including FX lending quota, so as to control the increase of leverage in the economy; Raise both lending and deposit rates so as to manage inflation expectations, raising the cost of capital and help prevent asset bubbles (property included).

4. Aggressively push through structural reforms to foster a healthy growth in domestic demand in the cheap capital environment. The more healthy the growth is, the less likely that a given amount of liquidity is going to be inflationary. Key among the reforms would be to expand state-owned enterprise dividend reform to promote household income and consumption growth; deregulate services industry to encourage more investment and private competition; change the tax system -- to tax labour less and ‘bads’ (for example, environmental damage) and capital more; continue to beef up the role of the government in health, education and social security, and so on and on.

5. Take additional measures to reduce the risk of asset market and property bubbles. On the property sector, increasing land and property supply by reducing the monopoly power of local governments and distortions created by state-owned enterprise, using taxation to quell investment and speculative demand, and raising interest rates to limit leverage would be critical.

Accelerate the development of capital market by increasing the supply of shares listed in the stock market and expanding corporate bond market would also be important.

This is a long wish list and policy decision and careful implementation will not be easy. Will China lose or win in the current battle of currencies?

The criterion is not whether China can hold on to its current exchange rate policy and resist external pressures for a large appreciation. The real answer lies in whether China can manage an orderly exchange rate adjustment while resisting the easy monetary policy that advanced economies are imposing on the world, avoiding a big asset bubble, and limit asset misallocation in the process.