Friday, June 16, 2006

Accelerating Chinese Growth Strengthens Case For Yuan Revaluation

Numbers for May that have come out so far from China suggests that growth in the second quarter will be even higher than the 10.3% growth rate in the first quarter. The trade surplus rose to $13 billion from $9.5billion in May 2006, despite extremely fast increases in domestic demand. Retail sales rose 14% in nominal terms or 12.5% in real terms while urban fixed asset investments rose 30.3%. Industrial production growth therefore accelerated to 17.9%, the fastest in years.

This mainly reflects the impressive structural strength of the Chinese economy created by the extremely high savings rate and the abundance of workers coming in from rural areas. Yet it clearly also reflects a too high rate of monetary expansion, with M2 money supply increasing 19.1%.

The Chinese authorities are well aware of the risks that this poses and have tried to tighten somewhat. Yet because of the widespread expectation of continued yuan appreciation, interest rate hikes are of limited value as the reduction in loan demand it would create would be partly offset by increased capital inflow.

Another measure which the Chinese authorities could do and most likely will do is various administrative controls to limit credit to overheated sectors. This is exactly what they did today, when they ordered banks to increase their reserves. This will certainly do some good, yet experience shows that local authorities sabotage such measures to some extent and secure credit for such projects in defiance of Beijing.

Another thing which they could do and have actually said they will do to a limited extent is to reduce barriers for Chinese individuals to invest outside of China. But this is likely to have limited effect, particularly in the modest form so far proposed.

The best and most effective way, particularly if combined with the above measures, would be to significantly revalue the yuan. A higher current exchange rate for the yuan would reduce appreciation expectations and thus reduce the capital inflow that is the main reason for today's overheated economic conditions. Moreover, by reducing profitability in capital intensive export industries to more labor intensive domestic sectors, it would reduce loan demand. Unfortunately, the Chinese authorities don't seem to get that. While the yuan did rise above level of 1/8 dollar Wednesday, that is far too little.


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