International | Oct 13 2010
By Julien Guillaume, GaveKal
In a little reported news item, the PBoC's deputy governor Yi Gang came out and said the central bank will focus on foreign-exchange reform that will help China cut its current account surplus. This was announced at a panel at the IMF in Washington, and marks the first time that China has made a specific commitment to current account surplus reduction.
Tactically, this shift in attitude from the PBoC is smart at a time when the level of 'China bashing' in the media, and in the US congressional campaigns, is starting to reach fever-pitch. Moreover, it also makes sense for China to try and focus the discussion on the size of the current account surplus rather than the nominal exchange rate. After all, this is what the discussion ought to be about, since the nominal exchange rate is only relevant as a tool toward current account adjustment. It also helps put the spotlight on other large current account surplus countries (Germany, Japan, Middle-East…). Mr Yi said China's aim is to reduce the CA surplus to 4% of GDP in the next three to five years, from 5.8% in 2009 (Dragonomics estimates the '09 ratio is slightly higher, at 6%).
Nevertheless, it is very likely that China's new proposed policy will not prove aggressive enough to alleviate concerns about global imbalances. If, as Beijing proposes, it takes the country about four years to get the current account surplus back down below 4% of GDP (where it last was in 2004), then assuming nominal GDP growth of +11%, a further $100bn will actually be added to the surplus. That brings it to US$400bn by 2014, higher than the peak level of 2007 and six times the level of 2004. Now of course, when China states that it aims to run a US$400bn surplus in 2014, China is de facto asking the rest of the world to provide US$400bn in extra demand. And needless to say, this is not a proposition that goes down remarkably well today in the finance ministries of most OECD countries.
China's latest remarks also bring us back to Milton Friedman's 'impossible trinity', or the fact that a government can control its monetary policy, its capital movements or its exchange rates… but it can rarely control all three for long periods of time. From 1997 through 2005, China, whose capital account was much more closed then, simultaneously controlled its exchange rate (at a fixed rate), interest rates (at a fixed rate) and money supply/inflation. But starting in 2005, inflationary pressures built up and the government was forced to allow the exchange rate and interest rates to rise, as well as to increasingly liberalize outward capital flows to take pressure off the internal build-up of liquidity. Clearly, we are now back in a similar environment with the PBoC raising reserve requirements and the RMB making a fresh high yesterday. As the extreme deflationary shock of late 2008 fades away, China will have to confront important policy choices: it will have to pick either a higher RMB (and a lower current account surplus), higher interest rates or higher inflation. Politically, the first option would be the savviest.
The above expressed views are GaveKal's, not FNArena's (see our disclaimer). All copyright GaveKal.
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