On May 12, the Peoples’ Bank of China raised reserve requirements for the fifth time this year, by 50 basis points. This move, which will be effective from May 18, comes amidst a broad sell off in the global commodity markets. With Crude Oil settling around the $99 mark last week and a sell-off in gas and copper, the policy move seems to be lagging behind the markets. The increases in margin requirements across various commodities including more than three recent margin hikes in silver, and the announcement of hikes across various Crude Oil contracts earlier last week, has led to a cooling-off in the recent speculative bull run in commodities.
The Chinese demand for commodities like copper has shown a decline in April, although imports of Crude Oil still continue to grow. Given that the economy is projected to grow at over nine percent by the World Bank, it is unlikely that the overall pace of Chinese commodity demand is going to slow down in the longer term, which should continue to fuel energy and raw material inflation globally. Inflation is indeed economic priority number one for China these days, and the Chinese Premier Wen Jiabao confirmed this in his State of the Union Address last month. He said the government must “make it our top priority in macroeconomic control to keep overall price levels stable”. The quest for battling inflation is likely to spur a debate within the economic community in China, while they try to decide which limiting measure is best. With expectations regarding the medium term appreciation of the Yuan being strong, and some relaxation of commodity prices, their continued hawkish stance on monetary policy might be counterproductive.
In international finance, there is a trilemma, which is to say there is a policy choice between three particular goals of economic governance, and nations (open economies) can only choose to control two goals as a necessary constraint imposed by the laws of economics. The goals are: to have open international flows of capital, effective monetary policy (in the sense that the central banks can actively control money supply using only monetary tools), and stable exchange rates. China has chosen to have a stable exchange rate by managing it actively, and an active monetary policy, while imposing capital controls, especially on exporter’s foreign currency earnings. However, with the massive build ups of foreign currency reserves as a consequence, the Chinese government has been relaxing controls on foreign exchange earnings off late. This means that Chinese exporters are going to increasingly be able to retain their foreign exchange without converting them to the Yuan.
The result of easing capital controls is that Chinese policy makers have to consider letting the Yuan appreciate according to market expectations, or continue to face strong inflationary pressures, even with aggressive monetary tightening. In a way, the interest rate and reserve rate hikes have reached a plateau, and there cannot be many more without severely undermining economic growth and the efficient allocation of capital in the economy. April’s CPI reading of 5.3% year on year was just 0.1% below the reading in March, which was a 32 month high for the figures. While authorities maintain that their 2011 inflation target is 4%, there are few options left to achieve such a drastic pull back, given that there have already been four interest rate hikes since October, and import growth slumped to 21.8% from 32.6% in March.
It is certainly not unusual for a country, which has now arguably become the biggest manufacturer and exporter in the world, to want its currency to stay depressed. Given that China’s top exports both to the US and to the world are electrical machinery and equipment and power generation equipment, the appreciation of the Yuan might lead to the US searching for more competitive bargains from other countries, especially the export oriented ASEAN nations and Japan. However, even with the ongoing rises in wages, Chinese exports will be able to stay competitive in the medium term since there has been a veritable shift in the manufacturing base from countries like Japan and Taiwan. Industrial output in April rose 13.4 percent year on year, while the Yuan has been allowed to appreciate by about 5% against the dollar during the same time.
Although Yuan appreciation is warranted, and there has been a marked change in Chinese policy off late with policymakers increasingly recognizing this fact, politicians in the US should be aware that this is not a panacea for global imbalances and especially their huge trade deficit. Appreciation of the Yuan will not change the import needs of the US, and the widening of the trade deficit to $48.1 billion in March, while the Yuan is at multi year highs relative to the dollar is indicative of this fact.
From the Chinese point of view, persistent inflation, especially food inflation, is not good for the Communist government, since inflation erodes the value of money and is particularly harsh on the poor. Chinese policy makers are unequivocally united in their pursuit to tame inflation, and rightly so. At the same time, there is also an understandable instinctive dislike for being told what to do by the West. This internal conflict needs to be sorted out as soon as possible, and the West needs to recognize that this conflict exists and is not a projection of economic hubris. Increases in the value of the Yuan will increase the purchasing power of the people, and will give domestic demand a much needed boost, in an imminent shift away from a purely export driven economy to one driven by domestic consumption.
Negative interest rates are common in emerging markets these days, but countries like China and India cannot afford to get carried away by their own growth stories. The narrow output gaps in both countries suggest that both the economies are working at almost optimal capacities, and fighting inflation should remain top national priorities, not just economic ones. In this regard, keeping in mind the policy trilemma for China, there is definitely more room for the Yuan to appreciate.
(Vivan Sharan is an Associate Fellow at Observer Research Foundation)