The Travails of Current Macroeconomic and Exchange Rate Management in China: The Complications of Switching to a New Growth Engine

Just when China’s leaders receive conflicting signals of “overheating” and “below-potential growth”, they encounter tremendous external pressure to revalue the Renminbi (RMB) substantially. Our conclusion is that the major macroeconomic challenges have their roots in China’s inadequate marketization and continued discrimination against the domestic private sector. The monopoly state banks intermediate the large volume of savings not only inefficiently but also inadequately. The latter results in aggregate demand expanding slower than supply-side growth, imparting a deflationary tendency to the economy. The present remedy of increased public-directed investments can be a satisfactory solution in the short run, but they are a disaster in the long run because they would follow an increasingly rent-seeking path that is wasteful as in Japan (e.g. wasteful projects that benefit politically- connected companies), and the increased state enterprise investments would convert themselves into nonperforming loans. In partially-reformed China, public-directed investments via the state enterprises tend to veer out of control frequently and overheat the economy. China’s persistent trade surplus is fundamentally linked to the deflation phenomenon because a chronic trade surplus means that national savings is larger than domestic investments, the result of inadequate financial intermediation. China should now expand its investment program to incorporate large import-intensive infrastructure projects as the alternative to the appreciation the RMB, or as an important complement to limited RMB appreciation. The additional construction would create jobs, relieve production bottlenecks, and preserve employment in China's export-oriented sectors. The long-run solution to eradicating the deflation bias and the tendency toward current account surplus lies in establishing an efficient financial intermediation mechanism. Frequent bank recapitalization is the biggest threat to China’s fiscal solvency and macroeconomic stability. Our calculations conclude that the forthcoming second recapitalization since 1997 is the last one that China can afford. Even then, fiscal solvency and macroeconomic management requires that the state continues keeping interest rates artificially low in order to avoid reducing the present fiscal stimulus to accommodate the servicing of the bonds issued for the bank bailout. In short, China faces a difficult tradeoff between the maintenance of fiscal stimulus to keep growth on track and the promotion of financial market development via recapitalizing the state banks, splitting them up and privatising some of them, liberalising the establishment of private financial institutions, improving prudential monitoring and enforcement, and deregulating interest rates. The entry of Western banks into China’s financial markets is not the same thing as the opening of the capital account. China would not be well served by a rapid opening of the capital account because foreign banks could suddenly become conduits for large-scale capital flight, or for rapid swings in short-term lending and repayments, or facilitators of bank runs (in which depositors do not merely switch banks, or switch from domestic banks to domestic currency, but actually switch from domestic deposits to foreign assets). Just as in financial market liberalization, capital account opening should also proceed in stages, because it must be accompanied by sophisticated financial market regulation, something that is clearly not in place at this time. The state-owned sector and state-controlled companies are still a serious threat to sustained high growth, banking sector solvency, and price stability. Worse, yet, the corruption within state enterprises undermine social stability. The transformation to a private market economy should be accelerated by faster privatization of state enterprises, and the reduction in legal discrimination against private sector activities.