FRBSF Economic Letter
2007-06; March 9, 2007
Update on China: A Monetary Policymaker's Report
Pacific Basin Notes. This series
appears on an occasional basis. It is prepared under the auspices
of the Center for Pacific
Basin Studies within the FRBSF's Economic Research Department.
Each year, the President of the San Francisco Fed
joins the Federal Reserve Board Governor responsible
for liaison
with Asia on a "fact-finding" trip to the region.
These trips advance the Bank's broad objectives of serving
as a repository of expertise on economic, banking, and
financial issues relating to the Pacific Basin and of building
ties with policymakers and economic officials there. The
knowledge gained and the contacts developed are critical
in understanding trends affecting the Twelfth District,
in carrying out responsibilities in banking supervision,
and in ensuring that policymakers have the understanding
of global economic developments necessary to conduct policy
and promote the stability of financial markets. This Economic
Letter summarizes President Yellen's report to the
Head Office Board of Directors on her trip to China in
November
2006.
Our agenda took us to the two largest cities in China—Beijing,
with about 15 million people, and Shanghai, with over
20 million—as well as to Chengdu, a "small" city
(only 10 to 12 million people!) that is in Western China
and that is the focus of intensive government development
efforts. We met with senior government staff, including
our counterparts at the People's Bank of China (PBOC)
and the China Bank Regulatory Commission, bankers, representatives
of U.S. and Chinese businesses, academics, representatives
of the U.S. Embassy, and experts from a number of multilateral
institutions. Our focus was the economy, with particular
emphasis on banking and finance, developments in the
information
technology (IT) sector, and energy and the environment.
(For a discussion of findings from the trip regarding
the banking and financial sectors, please see the March
2007
issue of the Bank's publication, Asia
Focus.)
Rapid growth and the monetary policy response
In the nearly 30 years since China's economic reform
process began, the economy averaged an annual growth
rate of about
10%, a performance that is probably unrivaled in human
history and that has lifted hundreds of millions of
people out of poverty. This growth has been facilitated
by China's
abundant labor supply, which has been massively reallocated
out of agriculture, where productivity is very low,
and into the manufacturing and service sectors, where
it
is much higher. In addition, the pace of investment
has been
extraordinarily high, which has kept capacity growing.
The efficiency with which the Chinese economy transforms
inputs into output—what economists refer to as "total
factor productivity"—has also improved.
Although rapid growth has propelled living standards
higher, the Chinese government has tried to slow growth
somewhat
during the past few years, using for the most part
the traditional tools of monetary policy, such as raising
lending rates and increasing reserve requirements.
Though
these
measures were expected to produce a mild slowdown in
early 2006, the economy instead grew almost 11% in
the first
half of the year, the fastest pace since 1995.
Some analysts believe that the traditional tools are
not terribly efficacious in the Chinese context, and,
indeed,
in the last six months, the government also has employed
administrative measures to curb loan growth, local
government investment, and property speculation, such
as mandating
that local authorities postpone or cancel investment
projects failing to meet land use limits and other
approval rules.
These efforts, together with the more traditional monetary
policy actions, did finally produce some slowing of
real GDP growth in the latter half of 2006.
Given that consumer price inflation has remained low
in the past year—1.9% year-over-year in November—it
is natural
to ask why Chinese policymakers perceive a need to
slow growth (update March 2007: the average inflation
rate
from January to October 2006 was only 1.3%; in December,
it
ticked up to 2.8% and then fell to 2.0% in January
2007). A primary rationale relates to concerns about
the quantity
and quality of investment. According to commonly cited
figures, fixed investment in recent years has amounted
to over 40% of GDP, and it actually accelerated during
2006. Policymakers are worried that this level of investment
is too high, fearing that the overinvestment in the
cement, steel, and aluminum sectors, as well as in
real estate,
could lead to excess capacity and a destabilizing boom-bust
cycle. Policymakers are also worried that investment
spending is not being efficiently allocated across
sectors, reflecting
concerns that banks still do not operate on a fully
efficient and commercial basis; poor lending decisions
could saddle
banks with new rounds of bad loans just when real progress
has finally been made in cleaning up the banking system.
Economists with whom we met at some multilateral institutions
have observed that a substantial share of investment
is financed not by banks but by firms from their own
internal
funds; in other words, enterprise saving is very high.
This suggests that the high pace of investment poses
fewer risks to the banking sector than it might otherwise.
The
Chinese government, with endorsement from the International
Monetary Fund, has suggested that state-owned enterprises
should distribute a larger share of their profits to
the government via dividends, thus raising government
revenue,
which, in turn, could be used to fund social expenditures,
particularly to strengthen the social safety net.
Trade and foreign exchange policy
China has long enjoyed an overall current account surplus,
and recently it has grown enormously—from 2.4% of
GDP in 2002 to 7.2% in 2005, with even higher prospects
for
2006. This, combined with a sizable capital account
surplus, has put upward pressure on the value of
China's currency,
the renminbi (RMB). Beginning in July 2005, the Chinese
government officially unpegged the RMB from the dollar,
and, since then, the currency has appreciated by
about 6%. Chinese policymakers seem likely to allow
this
process of gradual RMB appreciation to continue,
so long as it
is slow and orderly. Few people, however, believe
that even a more substantial RMB appreciation would
have
much effect on China's overall trade balance. For
one thing,
to the extent that China imports many components
used in producing its export goods, an appreciation
lowers
the
cost of those imports, offsetting somewhat the effect
on export prices. For another, demand for many Chinese
exports
tends to be fairly strong, regardless of price, which
implies a limited trade response to an appreciation.
Most observers
do not see China's trade surplus coming down until
it ramps up government spending and domestic consumption,
increasing
its own demand for foreign imports.
To exert some control on slow and orderly movements
in the RMB, the PBOC intervenes in the foreign exchange
market, buying dollars with RMB that it issues. This
intervention
has resulted in the PBOC's accumulation of over $1
trillion
in foreign reserve assets. Moreover, such intervention
also swells the domestic supply of bank reserves.
Therefore, to avoid inflation, the PBOC must offset
the associated
liquidity increase by sterilizing reserve inflows.
It has accomplished this by issuing low-yield PBOC
bills
in open
market operations and by progressively raising the
reserve requirements of domestic banks. However,
the policy of
forcing low-yield PBOC bills on the banking sector
works at cross-purposes with banking sector reforms,
which
are ultimately aimed at creating a banking sector
that operates
on a sound commercial basis.
A fundamental law of macroeconomics, which is well
appreciated by our colleagues at the PBOC, holds
that an independent
monetary policy, free capital flows, and a fixed
exchange rate cannot all mutually coexist. Thus,
greater exchange
rate flexibility will eventually be required for
China to manage the economy via an independent monetary
policy.
In the short run, however, the authorities are concerned
that the country's banks and firms are not yet fully
prepared to cope with a free-floating currency. We
discussed with
the PBOC in Shanghai the progress that is being made
in introducing hedging instruments, such as foreign
exchange forward and swap contracts and the experience
of banks
and other domestic financial institutions in managing
exchange
rate variability. Of course, Chinese policymakers
are also concerned that a large currency appreciation
could
have
a deleterious effect on exports, particularly in
sectors with low profit margins, such as textiles.
Energy and the environment
We spent some time learning more about issues relating
to energy and the environment, which are of increasing
concern to policymakers. China's current pattern
of growth is highly energy-intensive, and energy
use has
been expanding
proportionately faster than output. Oil accounts
for only about 20% of energy use, but almost half
is supplied
from
imports; thus, China's rapid growth in oil demand
has worked to push up global prices. The main source
of
energy (almost
70%) is domestic coal, and a very worrisome consequence
of coal use is that it produces air pollution,
which, in many Chinese cities, is among the worst in
the
world. Water
shortages have also become more serious as a result
of rapid urbanization, underpriced water costs,
and water
pollution. There is now much discussion of the
need for sustainable development, and government officials
discussed
efforts to boost energy conservation and reduce
environmental
damage, including tightening controls on power
plant emissions and implementing more market-based
pricing
of fuel and
water use. One overall goal is to reduce the ratio
of fuel to GDP by 20% over the next five years.
Business conditions
We met with U.S. businesspeople involved in a wide
range of sectors, including banking and finance,
IT, research
and development, and retail and service-oriented
firms. Overall, they continue to see huge opportunities
associated
with China's market size and low-cost labor.
China's coastal regions have traditionally attracted
the lion's share of foreign direct investment.
But a high priority
of the Chinese government is to promote the development
of inland areas, particularly Western China,
out of concern with growing income inequality,
poverty,
and
associated
social and political unrest in these areas. This
was our main focus in Chengdu. We saw some evidence
of
the city's
success in the form of a large international
retail chain store and a brand new assembly plant
for
a U.S. maker
of computer chips. Logistics are a key problem
for firms operating
in this region. For export-oriented manufacturing
firms, rail or river transport costs to the coast
offset much
of the advantage of the lower labor costs in
this area. But firms that are able to use air
transport
find it
profitable to operate, and the government is
highly cooperative in
minimizing obstacles.
Chinese policymakers are eager to see China move
up the value chain and promote indigenous innovation.
They are
pushing foreign firms to contribute by shifting
higher value-added activity to China. The executives
at
some
high-tech firms with whom we met shared the view
that Chinese-educated
engineers and other professionals are technically
very competent. But they regard their training
as narrow
and perceive a shortage of broader problem-solving
and management
skills. To address this issue, Chinese policymakers
are now trying to encourage creativity in the
educational system as well as entrepreneurship
and risk-taking
in
the workplace.
Some of those we talked to also regard protection
of intellectual property rights as an ongoing
concern.
Looking forward
As I have indicated, China's recent development
path has been characterized not only by high
investment and rapid
growth, but also by concerns about income disparities,
investment efficiency, and environmental problems.
According to the 11th Five-Year Plan (for 2006-2010),
China's top
political leadership agreed to pursue structural
policies that would emphasize more consumption
over
investment
and exports as well as the growth of the service
sector instead
of industry, improve the efficiency of investment,
and reduce income inequality and establish
a more "harmonious
society" through more social spending.
These are ambitious goals, and a number of
policies are under discussion to achieve them.
These include
better
pricing of energy, resources, land, and environmental
damage, reducing implicit and explicit subsidies
for manufactures
and exports, establishing a dividend policy
for state-owned enterprises to reduce corporate
funds
available for
investment, and dampening local government
incentives to pursue higher
growth single-mindedly.
If such policies are put in place, a number
of benefits may accrue. For example, raising
domestic
consumption
demand would help to lower China's external
surplus imbalance, thereby reducing current
trade frictions
and the risks
of protectionism. In addition, focusing on
the "quality" rather
than the quantity of investment could generate
productivity gains. Finally, greater government
spending, particularly
on pensions and health care, would reduce government
saving and precautionary household saving.
Janet L. Yellen
President and Chief Executive Office
Opinions expressed in this newsletter
do not necessarily reflect the views of the management
of the Federal Reserve Bank of San Francisco or of the
Board of Governors of the Federal Reserve System. Comments?
Questions? Contact
us via e-mail or write us at:
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