1 • 2012
China has recently taken several steps towards more liberal capital flows and wider international use of the renminbi. As with previous economic reforms in China, the liberalisation of capital movements is relatively slow and gradual. China's current growth model is largely based on a high savings ratio and the channelling of savings via state-owned banks to various investment projects. Liberalisation of capital movements is almost inevitably linked with substantial liberalisation of China's financial markets, which could pose a risk to the current growth model. But without such liberalisation, it will be virtually impossible for the Chinese currency to attain an internationally important position. Even though the renminbi is now somewhat more widely used as an invoicing currency in foreign trade, foreign companies must be able to invest their renminbis in something before they are needed again. There is also a clear need to hedge against exchange rate fluctuations.
A number of studies have been published in the BOFIT Discussion Paper series analysing changes in Chinese financial markets, eg from the perspective of capital-flow liberalisation. Two papers (He and Wang: 'Dual-track Interest Rates and the Conduct of Monetary Policy in China', BOFIT DP 21/2011 and Ma, Xiandong and Xi: 'China’s evolving reserve requirements', BOFIT DP 30/2011) examine China's current monetary policy tools. The role of policy interest rates is relatively small, but for example reserve requirements are widely used for steering bank lending. However, the use of reserve requirements is a form of tax on banks, and its steering effect differs from that of a policy interest rate. If liberalisation of capital flows continues, monetary policy tools also need to developed further.
In the past few months the growth of China's foreign reserves has moderated or even come to a halt. Appreciation pressures on the renminbi have therefore abated at least temporarily. However, liberalisation of capital flows also means increased volatility of exchange rates. Market-based determination of the exchange rate might lead to large changes in the renminbi's external value for example if the currency is substantially undervalued at the moment. Some estimates suggest that the renminbi is as much as several tens of per cent undervaluated relative to the equilibrium value. It is however not self-evident that the Chinese currency is currently substantially undervalued. He, Qin and Liu ('Exchange rate misalignments: A comparison of China today against recent historical experiences of Japan, Germany, Singapore and Taiwan', BOFIT DP 22/2011) show that the renminbi has developed much in line with currencies of four other rapidly developed countries at peak growth stages. Furthermore, Cheung and Fujii ('Exchange rate misalignment estimates - Sources of difference', BOFIT DP 25/2011) show that estimates of the equilibrium value of any given currency are highly sensitive to the quality of the data. For this reason older estimates for emerging economies in particular may be very inaccurate, as in many countries comparison eg of price levels has been genuinely possible only in recent times.
China's economic upsurge and ongoing integration into the world economy will almost inevitably lead to liberalisation of its capital flows. For this to take place without severe problems, China must eg renew its financial system and monetary policy tools. Even though work towards this end has already begun, the list of required actions is long. Reforms are nevertheless necessary to guarantee sustainable long-term economic growth for China.
Iikka Korhonen