Eswar Prasad: China’s exchange rate policy isn’t working

The headline is mine.   Don’t blame Dr. Prasad.  

But that is the conclusion I took away from Eswar Prasad’s most recent paper.     I usually write about how China’s exchange rate policy distorts the global flow of capital, and impedes effective balance of payments adjusmtent.  Eswar Prasad – now at Cornell, but formerly one of the IMF’s leading China hands – focuses instead on how China’s peg has distorted China’s domestic economy. 

Maintaining the peg, in Dr. Prasad’s view, impedes China’s ability to achieve many of the Chinese government’s stated goals – jobs, an efficient financial sector and a more balanced economy.       Moreover, incremental reform no longer works – especially not when the de facto peg effectively constraints a host of other policies.  

“There are inherent limits to the incremental reform strategy that has worked well in the past.   At a certain level of development and complexity of an economy, the connections among different reforms become difficult to ignore. …   Ignoring these linkages – for example, trying to push ahead with banking reforms while holding monetary policy hostage to an exchange rate objective – makes an already difficult reform process harder.” 

The right answer is to do more, not less – and to so now, when strong growth makes reforms easier.  Dropping the peg is key.    Why?   Because a host of other policies in China are now directed at reinforcing the peg, and those policies cannot easily be changed if the paramount goal of Chinese policy is a weak RMB.

“The … inflexible exchange rate, while not the root cause of imbalances in the economy, requires a large set of distortionary policies for its maintenance over long periods.  It is these distortions that – though multiple channels – hurt economic welfare and could, over time, shift the balance of risks in the economy.”

“China has held the exchange rate of the renminbi relative to the US dollar within a narrow range despite enormous pressure for a substantial appreciation in recent years.    … This has been accomplished without the typical rising quasi-fiscal costs of sterilizing the liquidity generated by large capital inflows.  … Sterilization has been facilitated by financial repression and relatively closed capital account.  This has, among other things, meant very low real rates of returns for households who save a lot and have few investment opportunities other than domestic bank deposits.   These policies have also curtailed financial sector development, leading to inefficient intermediation of domestic capital.”

Eswar, drawing on work by Jahangir Aziz (more here, with Li Cui), notes that Chinese job creation has been very weak.   The low real interest rates associated with China’s exchange rate policy – along with the absence of any dividend payments by now profitable SOEs -- has encouraged the substitution of capital for labor, and thus inhibited job creation.

“Cheap capital has played a big part in skewing the capital labor ratio and holding down employment growth (Aziz, 2006) …  The result has been slow employment growth, that is hardly at a pace sufficient to keep with the growth in the labor force, absorb workers laid off from state enterprises that are retrenching and to absorb excess rural labor ….  During the period 2000-05, growth in non agricultural employment averaged less than 3% per annum, compared to average non-agricultural GDP growth of about 9.5%. 

One of the most remarkable features of China’s boom is that it has been accompanied by a very strong fall in household income as a share of GDP.     Household income – to be sure – has increased.   But it has grown more slowly than the overall economy.   That is a key reason why consumption is shrinking as a share of GDP.

Holding nominal interest rates down to support the peg keeps the real returns on Chinese savings low.    It it also means that demand for borrowing – at least at current interest rates– is quite strong.   But the government doesn’t want the banks to meet this demand.   A burst of lending would add to inflationary pressures – and it would make it a lot harder for the government to sterilize ongoing reserve growth.  

The solution: administrative controls.  The problem: the controls work against meaningful financial sector reform.   Prasad:

“One of the principle concerns is that the lack of exchange rate flexibility not only reduces monetary policy independent it also hampers banking sector reforms.   The inability to of the PBC to use interest rates as the primary tool of monetary policy implies that credit growth is often controlled by much blunter and non-market oriented tools, including targets/ ceilings for credit growth and as well as “non-prudential administrative measures.”   Prasad and Rajan (2006) argue that this vitiates the process of banking reform by keeping banks’ lending growth under the administrative guidance of the PBC …  this constraint has also perpetuated large efficiency costs via provision of cheap subsidized credit to inefficient state enterprises.  [The resulting costs] are probably ultimately born by deposits in the form of low real returns on their savings.”

Throw in Yu Yongding’s point -- the banks increasingly are stuffed with low-yielding sterilization bills – and it is hard not to conclude that the Chinese government has held down the costs of using the central bank’s balance sheet to support Chinese exports by shifting a lot of the costs to Chinese savers.   Chinese savers are subsidizing the Chinese state – and indirectly American and European consumers – by accepting very low real returns on their savings. 

China’s taxpayers also will ultimately absorb – one way or another – large losses on the central banks balance sheet.  Buying a depreciating asset is a good way to loose money.  Buying ever large amounts of a depreciating asset is good way to loose a very large amount of money.

And that is what happens if everything goes well.  It things go badly, Chinese savers will get a low real return on their deposits and get hit with an additional tax bill to bailout the banks for making another round of bad loans … 

Dr. Prasad shows why the fragility of the domestic banks isn’t a good reason to avoid more exchange rate flexibility – the banks fragility doesn’t stem from currency exposure.   And the risk of a large capital outflow from the banks is an argument for going slow on capital account liberalization, not to go slow on the exchange rate.   I agree on both points.    China simply doesn’t have the currency mismatches that made Asian banks vulnerable ten years ago.    Bad banks aren’t the problem per se.   Banks that have lots of foreign currency exposure are.

Eswar is implicitly critical of China’s decision to try to substitute a relaxation of controls on capital outflows for RMB appreciation.      “This [encouraging institutional investors to move funds abroad and relating restructions on the amount of financial capital that can be taken out of the country by households] poses a significant risk because deposits in the banking system now stand at 160% of GDP whil foreign exchange reserves now amount to less than 50% of GDP.   The risk of massive flight out of bank deposits is small, but let’s consider a more plausible scenario.   What if depositors become concerned enough to move say 10% of their deposits out of the banking system into foreign assets.” 

Good question. 

The banks ,in Dr. Prasad's view, would cut back on their lending – creating a credit crunch.    Nervous households would increase their savings, “setting off a deflationary spiral.” 

That seems right to me.     I would just note that if a booming China has a current account surplus that now looks to be close to 12% of GDP, a slumping China – one with less investment and more household savings – would have an even bigger current account surplus.   China likely would come close to being able to finance a 16% of GDP capital outflow from its current account surplus.  It wouldn’t need to dip into its reserves at all.

My summary of Eswar’s argument – itself a summary of the insights he has gleaned from watching China’s economy closely over the past few years – doesn’t do it justice.   Read it all.   And don’t forget to look at the charts and tables at the end.  Eswar may have left the IMF, but he hasn’t forgotten the value of a set of charts and tables summarizing a country’s key economic data.

Update: a bit more from Richard McGregor of the Financial Times.   He notes:

Chinese leaders publicly stress the priority of employment creation, but economic incentives continue to favour capital intensive industries, not the job-generating service sector. The huge profits these industries have made in recent years have flowed back to state investors and officials, not the workforce. The other winners have been foreign multinationals, often in local joint ventures, using China as an export base.

Claims that China's current policy mix are necessary to create the jobs China needs should -- in my view -- be subject to more critical scrutiny, particularly in light of the strong fall in labor's share of total Chinese national income.