RENMINBI REFORM IS JUST THE START FOR CHINA / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( VERY HIGHLY RECOMMENDED READING - A MUST READ )

Renminbi reform is just the start for China

By George Magnus

Published: March 22 2010 20:18

The friction between Washington and Beijing over exchange rates is about to get a lot worse. On April 15, the US Treasury will issue the first of two semi-annual currency reports, mandated by law since 1988, in which China may be deemed to be manipulating its currency “for the purposes of preventing effective balance of payments adjustments or gaining unfair competitive advantage in international trade”. The Treasury and the Congress have been deliberating inconclusively on China’s exchange rate policy since 2003, when the country’s balance of payments surplus was a tenth of what it is now and its foreign exchange reserves were a sixth of the current stock of $2,500bn (€1,840bn, £1,660bn). This time, events may play out quite differently.

If China continues to stand firm in the face of US pressure for policy change, the case will almost certainly go to the World Trade Organisation. More to the point, it will become the most prominent of several bilateral spats, in which the US could threaten to impose across-the-board tariffs on Chinese imports and China could threaten to dump holdings of US Treasury bonds. A major economic dispute between the US and China would be in no one’s interest, least of all China’s, but it looks unavoidable for three reasons.

First, the financial crisis has shocked the US and Europe into a major change in behaviour and exposed China’s economic model as being in conflict with the global system. America, the world’s biggest debtor, is going to save more and borrow less. The change has started in the private sector, and the public sector will follow. But this will only work if China, as the world’s major creditor, saves less . If we all end up trying to be savers, the global economy will tilt more heavily towards protectionism and recession. The US will not watch as this happens and is right to demand stronger action from China.

Second, the heart of the issue is not China’s exchange rate, per se, but the inflexibility of the exchange rate regime. Indeed, the State Council may yet give its blessing to an adjustment in due course, despite the recent protestations by Wen Jiabao, China’s premier, that the renminbi is not undervalued. But an undervalued exchange rate is at the centre of a development model built around exports and capital investment. The currency regime is a tax on consumption, which accounts for a mere 36 per cent of gross domestic product and represents a considerable subsidy to exports. The excess savings that sustain this model will not decline without extensive political reform that includes but goes beyond the exchange rate system.

Excess savings are locked, for example, in an economy that has left a rural population of 800m behind in terms of incomes and economic security; in the hukou system of urban citizen registration, which forces millions of migrant workers to save; in the inadequacy of the social security system; in the large profits of state-owned enterprises that cannot be distributed in the form of dividends; and in the social consequences of the one-child policy. Changing the exchange rate will not have any effect on these structural phenomena.

Third, the status quo in China is leading the country down a potentially dangerous credit and monetary policy path. True, some recent warnings about a China bubble seem overdone, neglecting to note that China is a lot bigger and more populous than the coastal provinces where most of the “evidence” on overbuilding is collated. Centrally controlled China still has the capacity to lean on credit creation and to address the growing non-performing loan problem in the banking system.

Nevertheless, China’s monetary policy is complicated by the exchange rate regime, which is under-pricing capital and moving the country inexorably towards negative real interest rates. Commitment to the current development model weds China to a credit system that is incompatible with stable goods and asset prices, not unlike the US in the 1920s and Japan in the 1980s.

With 1.3bn people, China is going to be a large power with a big GDP. But unless it somehow finds in its institutions the capacity to change pre-emptively in the ways suggested, the march to greatness is by no mean assured, and, in any event, very long.

The writer is senior economic adviser at UBS. He is the author of the ‘Age of Aging and Uprising: Will Emerging Markets Shape or Shake the World?’, to be published later this year

Copyright The Financial Times Limited 2010.