Is China's Exchange Rate Undervalued?

Recently China has come under increasing pressure to revalue its currency, the Renmbini (RMB) from US policy makers. Indeed, in July 2005 China succumbed to the pressure with a revaluation of roughly two percent. This quieted the objections for a few months; however US politicians are again applying pressure on China to further revalue the RMB. Concern relating to the ballooning US current account deficit is the major motivation for the political posturing. The US's current account balance is, as of 2005, in deficit by more than $800 billion . Compare that with China's situation of a positive $129 billion current account position for the same period and you can see why there is concern over the issue.

US politicians point to the rapidly accumulating foreign reserves held by China, now amounting to over $850 million, as evidence of currency manipulation. (The Times, 28Mar06). They make the case that maintaining the artificially low position of the RMB through foreign reserve accumulation deteriorates the US current account balance with China because it reduces the competitiveness of US industries with respect to price. Thus, they argue that an appreciation of the RMB would help to level the playing field for US companies and increase output which would, in turn, decrease the imbalance in the current account.

China on the other hand is hesitant to revalue. China has been going through an amazing bout of growth over the last couple of decades which they are cautious to undermine. Since 1978 China has averaged over 8 percent growth annually (Shane and Gale, p-02). In achieving this growth, China has gone through a series of structural changes with respect to the governing of their economy, most notably a transition from a centrally planned economic allocation of resources to a more socialized market influenced system of governance. While this transition has provided the impetus for their growth, their transition is far from complete and is beset by significant internal imbalances. Many Chinese officials remain cautious in transitioning their exchange rate regime to a fully market influenced mechanism too quickly, given these internal imbalances. China's central bank governor Zhou Xiaochuan stated in a summarized speech on the People's Bank of China (POB) website, "China will only consider to take the gradualist reform approach." (WSJ, 29Mar06).

What are these internal imbalances that are causing hesitation in the Chinese government to fully transition to a more market influenced exchange rate mechanism when there are such obvious external imbalances in the trade situation? This paper will discuss the differing issues concerning the internal imbalances faced by China and how these imbalances are related to the external imbalances that are pressuring the Chinese currency to revalue. Moreover, this paper will examine the various methods employed by the Chinese monetary authority in maintaining their external imbalances.

The internal imbalances present in China's economy that may make a revaluation of its currency and move toward greater flexibility inadvisable mainly arise from its immature financial system. Among these imbalances are the underdeveloped banking sector and the ineffective capital account regulations.

China's banking system can be characterized by many problems, the most notable of which is a lack of a credit culture. Years of government-led investment coupled with weak contract enforcement have created a credit culture where banks have limited incentives to maintain strict lending practices and enforce loan contracts. (Pigott, p-19). This defunct credit culture has lead to the massive accumulation of non-performing loans (NPLs) by banks.

In 2003 the NPLs of the banking sector, including state owned banks, policy banks and joint stock banks, amounted to 2,532 billion yuan measured according to the five-category supervisory loan classification system, and the NPL ratio is 18.7 percent (Ping, p-3).

The actual ratio is expected to be higher due to weaknesses in the classification system. Weaknesses include, "a relatively large share of loans are classified as special mention and doubtful, the lack of proper treatment of restructured loans and foreclosed assets, and losses from non-credit activities." (Ping, p-3) One can only imagine the disruption that a call on these NPLs would cause in the Chinese economy.

The Chinese government realizes this threat. In order to help alleviate this hazard China has recently injected more than $60 billion to recapitalize four of its five largest banks and has transferred some $200 billion worth of nonperforming loans out of these banks into specialized asset-management companies (WSJ, 17Oct05). Comparatively, Korea spent half this amount to restructure its banks during the 1997-98 financial crises (WSJ, 17Oct05). In addition to the recapitalization efforts of the Chinese government, China is attempting to cut down on the easy access to credit that has led to the misallocation of resources. The formation of the China Banking Regulatory Commission (CBRC), an organization aimed at the supervision of banking administration, has provided a boost to its banking reforms (Prasad). Conversely, some argue that this regulatory strategy is inherently flawed. Tung and Baker (2004) contend that any policy of reform that relies on administration fiat to ensure commercialized lending will result in another round of bad loans and excess capacity (Tung and Baker, p-333). While the establishment of the CBRC may not be the most favorable manner for which to regulate the management of China's banking industry, it does add some degree of accountability to the system.

The most promising reform of China's banking sector is the recent entrance of foreign banking institutions.

ING has recently invested $215 million in the Bank of Beijing, HSBC bought a 19.9% stake in Bank of Communications for $1.7 billion and Bank of America announced its intention to pay $3 billion for approximately 9% of China Construction Bank. Furthermore, press reports describe ongoing negotiations for similarly sized sales to foreign interests of two of the remaining big four banks, Bank of China and Industrial and Commercial Bank of China (Fineman and Lung).

The expertise and solid business fundamentals that these companies will bring to the Chinese banking system are sorely needed to correct the unsound credit culture of years past. However, do to their minority holdings of the banks, one wonders how much authority foreign bankers will be given to make changes (Fineman and Lung). It may be some time until the expertise that foreign bankers provide take hold in China's transitioning financial environment.

The opening of the financial system