China's financial conundrum and global imbalances

Abstract and executive summary:

China's financial conundrum arises from two sources: (1) its large trade (saving) surplus results in a currency mismatch because it is an immature creditor that cannot lend in its own currency. Instead foreign currency claims (largely dollars) build up within domestic financial institutions. And (2), economists - both American and Chinese - mistakenly attribute the surpluses to an undervalued renminbi. To placate the United States, the result is a gradual appreciation of the renminbi against the dollar of 6 percent or more per year. This predictable appreciation since 2004, and the fall in US interest rates since mid 2007, not only attracts hot money inflows but inhibits private capital outflows from financing (compensating?) China's huge trade surplus. This one-way bet in the foreign exchange markets can no longer be offset by relatively low interest rates in China compared to the United States, as had been the case in 2005-06. Thus, the People's Bank of China (PBC) now must intervene heavily to prevent the renminbi from ratcheting upwards - and so becomes the country's sole international financial intermediary.

Despite massive efforts by the PBC to sterilise the monetary consequences of the reserve buildup, inflation in China is increasing, with excess liquidity that spills over into the world economy. China has been transformed from a deflationary force on American and European price levels into an inflationary one. Because of the currency mismatch, floating the RMB is neither feasible nor desirable - and a higher RMB would not reduce China's trade surplus. Instead, monetary control and normal private-sector finance for the trade surplus require a return to a credibly fixed nominal yuan/dollar rate similar to that which existed between 1995 and 2004. But for any newly reset yuan/dollar rate to be credible as a monetary anchor, foreign "China bashing" to get the RMB up must end.

Currency stabilisation would allow the PBC to regain monetary control and quash inflation. Only then can the Chinese government take decisive steps to reduce the trade (saving) surplus by tax cuts, increased social expenditures, and higher dividend payouts. But as long as the economy remains overheated, the government hesitates to take these trade-surplus-reducing measures because of their near-term inflationary consequences.

This is part of a series of BIS Working Papers (273 to 278) collecting papers presented at the BIS's Seventh Annual Conference on "Whither monetary policy? Monetary policy challenges in the decade ahead" in Luzern, Switzerland, on 26-27 June 2008. The event brought together senior representatives of central banks and academic institutions to exchange views on this topic. BIS Paper 45 contains the opening address of William R White (BIS), the contributions of the policy panel on "Beyond price stability - the challenges ahead" and speeches by Edmund Phelps (Columbia University) and Martin Wolf (Financial Times). The participants in the policy panel discussion chaired by Malcolm D Knight (BIS) were Martin Feldstein (Harvard University), Stanley Fischer (Bank of Israel), Mark Carney (Bank of Canada) and Jean-Pierre Landau (Banque de France). This Working Paper includes comments by Michael Mussa.

JEL Classification Numbers: F21, F32

Keywords: Global Imbalances, Chinese Exchange Rate Regime