There is little doubt that China’s exchange rate policy has emerged as a major global topic. During recent months, the governments of Japan, Korea, and the U.S. have called upon China to revalue the country’s currency. Many Americans blame China for the fact that manufacturing employment has been declining for a year after the economy bottomed. China is perceived as a threat because it has been enjoying export growth of 35% during recent months. As a result of booming foreign direct investment and the return of flight capital, China also has foreign exchange reserves of $355 billion or the second highest in the world after Japan.

China has been resisting pressure for exchange rate appreciation for a variety of reasons.

First, China maintained currency stability during the east Asian financial crisis of 1997-1998. China kept her exchange rate firm in order to lessen the risk of greater financial contagion in the region. Her policy was an act of financial statesmanship which she believes weakens the case for exchange rate appreciation today. Secondly, China has recently joined the WTO and slashed import barriers. Her import growth is now booming at a 40% annual rate and her trade surplus is likely to fall sharply this year despite robust exports. Thirdly, China is deeply concerned about rising unemployment because of layoffs at state owned companies. These firms have shed over 50 million jobs during recent years. As exports are now 28% of GDP, China regards the foreign trade sector as a growth locomotive for containing unemployment. Finally, China’s financial system is highly fragile. The big four state owned banks have $300-400 billion of non-performing loans (30-40% of the total) and also must prepare for greater foreign competition because of the WTO rules. China fears that currency volatility could bankrupt more state owned companies and undermine confidence in the country’s financial stability at a time when the WTO rules will be exposing the troubled state owned banks to foreign competition.

The decision by China to maintain a stable currency during the Asian financial crisis caused her real exchange rate to appreciate but it did not greatly damage her competitive position because of rapid productivity growth. As a result, China is now emerging as an important workshop in the global supply chain between Asia and the world. China is increasingly playing the role of an assembly shop for components produced by other Asian countries. Pan Asian exports to China rose from $72.1 billion in 1995 to $160.6 billion in 2002. The imports for domestic consumption grew from $42.2 billion to $78.7 billion while imports for reprocessing grew from $29.8 billion to $81.9 billion. Imports for reprocessing now account for 51% of China’s imports from east Asia compared to 41% in 1995. As a result, China is now running trade deficits with other east Asian countries because of imports of components and raw materials while running trade surpluses with North America and Europe because of rapidly growing exports of manufactured goods. On the basis of Chinese data, the country has trade deficits of $31.5 billion with Taiwan, $13.1 billion with Korea, $7.6 billion with Asean, $5.0 billion with Japan, and $1.3 billion with Australia. Taiwan’s exports to China now exceed 13% of the island’s GDP. China has displaced the U.S. as South Korea’s largest trade partner.

The changing role of China can be seen in the composition of U.S. imports. China now produces about 11% of U.S. imports compared to 5% in the late 1980s. But the east Asian share of U.S. imports has slumped from 40.1% during 1994 to 32.5% recently. Many of the goods formerly produced by Taiwan, Singapore, and Korea for the U.S. market now come from China. There has also been intense price competition which has reduced costs for American consumers. Morgan Stanley estimates this competition has saved American consumers $100 billion.

The major cause of China’s booming exports is not an undervalued currency. It is an upsurge of foreign direct investment which has significantly boosted China’s productive capacity and managerial competence. China now has over $400 billion of FDI compared to $1.3 trillion for the U.S., $497 billion for the United Kingdom, $482 billion for Belgium-Luxemburg, and $480 billion for Germany. As FDI is now expanding by $55-60 billion per annum, China will soon have the second largest stock of FDI in the world. Foreign companies produce over half of China’s exports and accounted for 65% of export growth during the past decade. China’s openness to FDI is also in striking contrast to the policies of Japan and Korea, which tried to restrict trade in the past by discouraging FDI. On the eve of the Asian financial crisis six years ago, Japan had only $17 billion of FDI while Korea had just $12 billion.

The role of FDI in China’s economy makes for a striking contrast with Japan and Korea. On the eve of the east Asian financial crisis six years ago, there was only $17 billion of FDI in Japan and $12 billion in Korea. Both countries effectively banned FDI for almost half a century to nurture domestic companies. Japanese companies also developed their own brand names and distribution channels to conquer global markets. As a result, both large and small American companies often felt that Japan was an unfair trade partner. China is totally different. More than half of China’s exports come from American, Japanese, and other foreign companies. China has no global brand names. It sells primarily under the names of foreign companies. As a result, most multinational companies are satisfied with Beijing’s trade and investment policies. The major complaints are coming from small or medium sized U.S. companies which don’t have the capital to invest in China or have not yet had time to penetrate the market there. If Beijing could improve market access for small companies, there would be fewer demands for trade protection or currency revaluation.

The major risk posed by China’s decision to retain a stable exchange rate lies in the area of monetary policy. The boom in forex reserves is encouraging rapid growth of money and credit. The growth rate of M1 and lending has accelerated from 10-12% during early 2002 to nearly 20% during recent months. The surge in money growth has not had a major impact on asset markets. The stock market is below its peak of two years ago. Real estate prices have been increasing at a 5% annual rate. But the central bank is very concerned about over investment in real estate and recently announced new regulatory controls on property lending. Property lending had been expanding at an annual rate of 25% while the volume of mortgage loans has shot up to 924 billion rmb from only 19 billion during 1998. What the central bank cannot fully regulate is the tendency for easy credit and surplus liquidity to promote an inefficient allocation of capital throughout the economy. China now has the highest rate of investment in the world. In 2002, investment averaged 42.2% of GDP compared to a previous peak of 41.3% during the boom of the mid-1990s. There is a danger that such a high level of investment could encourage the creation of so much excess capacity that firms will find it difficult to achieve profitability. In such a scenario, the investment boom could set the stage for corporate liquidity problems and an investment recession in two or three years. Korea experienced such a crisis during the late 1990s. If China wants to maintain a stable exchange rate without running a dangerously expansionary monetary policy, she will have to liberalize her controls on capital outflows. If Chinese people and companies could purchase foreign assets, there would be slower growth of foreign exchange reserves. There were large capital outflows by Chinese companies during the late 1990s because of concern about the Yuan being devalued. But this money has returned and swelled forex reserves recently because of the new confidence in China’s currency.

It is ironic that the U.S. government has joined the list of countries calling upon China to revalue her currency. The U.S. is now able to finance its large fiscal deficits and current account deficits only because of currency intervention by Asian central banks, especially Japan and China. The central banks of China and Hong Kong have purchased nearly $100 billion of U.S. government securities during the past eighteen months. The east Asian central banks now have 70% of the world’s foreign exchange reserves compared to only 30% in 1990 and 21% in 1970. They keep their $1.7 trillion of reserves 80-90% invested in U.S. government securities. In the 1960s, France sold U.S. dollars for gold in order to protest the role which the dollar played promoting America’s super power status but continential Europe is now irrelevant to the dollar’s direction because it has only 8.6% of global foreign exchange reserves compared to 40% in 1972. If China were to protest U.S. foreign policy by selling the dollar for Euros or gold, it could set the stage for a large correction which would drive up U.S. bond yields, weaken the housing market, depress American domestic consumption, and jeopardize the President’s reelection. But China has a $105 billion trade surplus with the U.S. and is anxious to promote American consumption, so it will do nothing to challenge Bush policies through the currency market.

There is no simple answer to the debate about China’s currency policy. There are increasing fears in the U.S., east Asia and Europe about China’s competitive challenge. China is naturally reluctant to alter her currency policy because of concerns about high unemployment, the weak banking system and the legacy of the east Asian financial crisis, and the competence of Chinese firms at hedging currency risk. These concerns will cause China to change policy gradually. But as the recent upsurge of monetary growth will testify, China cannot totally insulate herself from the burgeoning foreign exchange reserves resulting from speculation about her currency policy. The most sensible policy is to introduce a wider target bank of 3-5% for the currency and let the market begin to reflect the factors which have caused forex reserves to increase so dramatically.