China Staves off Devaluation Essay Example

remaining competitive in international exports (Song, 1998).

This paper examines the economic context of China, encompassing its capacity to devalue its currency and the preventative measures employed. Additionally, it delves into the correlation between currency and trade in China, emphasizing its dependence on exports and consequent impact on the economy during the crisis vis-a-vis neighboring countries. Moreover, it evaluates China's present state and illustrates how opting against currency devaluation has positively influenced neighboring economies.

The text discusses the impact of devaluing on China's economy and explores its positives and negatives. Additionally, it provides background information on the Chinese economy, which operated under a feudal system for over 2000 years. During this time, land was owned by a small group of landowners who relied on rents from peasant tenants. Peasant farmers also faced agricultural taxes imposed by the imperial government and were affected by unpredictable crop yields due to droughts and floods. The Opium War (1839-1842) marked the beginning of Western involvement in China through coastal treaty ports.

Railroads and highways were constructed, resulting in limited impact on the overall Chinese economy. However, rather than promoting trade, China was fragmented into different competing colonial spheres of influence. In the 20th century, China became politically and economically weak under foreign control. During a worsening economic crisis caused by foreign interference and increased power of rural landlords, the Chinese Communist party emerged in the 1920s.

In the past twenty years, the Chinese Communist party has extended its dominance over extensive rural regions by implementing a farming initiative focused on rent and imposing high interest rates. Additionally, power was bestowed upon peasant associations. On October 1, 1949, the Communist party

triumphantly achieved the establishment of a unified national government and economy on the mainland, marking the first time since 1912 following the end of the imperial era. The Four Modernizations program commenced in 1978, aiming to modernize agriculture, industry, national defense, and science and technology by the century's conclusion.

From 1976 to 1985, the focus was on making the economy a global leader by improving economic management and giving more importance to privately and collectively owned companies rather than state-owned enterprises. In October 1984, policies were implemented to further decentralize economic planning and rely on market forces for determining consumer goods prices. The five-year plan from 1986 to 1990 aimed for a yearly economic growth rate of 7%, but there was a temporary slowdown in 1989 due to cracking down on political dissent. However, in the early 1990s, the Chinese economy experienced strong expansion once again, with government planners expecting annual growth rates of 8-10% until the end of the decade.

China's economy saw a significant boost in the late 1990s, with GDP growth rates of 8.8% in 1997, 7.8% in 1998, and slightly lower at 7.1% in 1999 (State Statistics Bureau, 1999). In contrast, neighboring countries experienced negative growth during this period. The Chinese Central Bank took measures to encourage spending by households and businesses through frequent interest rate cuts from 1997 onwards; however, prices continued to decline. This deflationary trend began in October 1997 when the retail price index first turned negative and has persisted ever since.

(Chan, 1999). China's choice to not devalue its currency had a negative impact on the export industry. To increase exports, the government introduced measures like increasing the rebate rate

of value-added taxes for exports (which some economists view as a disguised form of currency devaluation). In 1998, there was a 0.5 percent growth in exports while imports decreased by 1.5 percent.

During the first five months of 1999, there was a decrease of 5.3% in exports, while imports showed a notable increase of 15.3%. These changes were directly attributed to the exchange rate policy. The decreased competitiveness of Chinese exports compared to crisis-affected nations led to more affordable imports. Therefore, export growth towards East Asian markets declined for most of 1998, although there was an increase in exports to the United States and European Union countries. This aligns with Huang and Yang's explanation (1998) of the income effect. The devaluation of currencies in crisis-impacted countries strengthened their export competitiveness, resulting in a significant contraction in China's export market.

Despite a decrease in growth rates of China's exports to the United States and European Union countries after mid-1998, the Chinese economy remained stable and unaffected by the financial crisis that affected other countries in the region. However, it did experience some consequences from the crisis-hit nations.

Currency and Trade

China's government mostly controls its banking and trade systems, although there have been some relaxations in regulations since the mid-1990s to allow more foreign and private participation in the financial sector. The Peoples Bank of China is the central financial institution with exclusive authority over currency issuance, while the Bank of China primarily handles international accounts and foreign currency arrangements for China.

Since the 1970s, China has undergone significant changes in its economic structure. In the past, it isolated itself from the international community but now focuses on modernization. Unlike Eastern

European transitional economies, China experienced rapid growth instead of a decline during its economic reforms. These reforms transformed China's economy from a centrally planned, Communist system to a more open and market-oriented one. After implementing important structural changes, China now conducts its foreign trade based on comparative advantage and international conventions rather than relying on administrative measures as in the past. In 1978, China decentralized power from state corporations and introduced the agency system into various levels of foreign trade institutions, effectively ending the government's monopoly on all foreign trade.

The agency system has resulted in an increase in the number of companies authorized to import and export products, reducing government control over foreign trade. This shift allows market forces to play a more significant role without intervention from the government, promoting competitiveness in an open market and enabling flexibility to respond to changing conditions. The previous bureaucratic system was rigid and time-consuming, hindering adaptability.

According to Fong (2002), exports and imports subject to central planning accounted for only 30 percent of the total by 1991, while those operating under the agency plan represented just 20 percent.

Despite the decline of central planning and the agency plan, there is still direct control over exports via a licensing system. According to Bell et al (1993), this system accounted for 55 percent of exports and 40 percent of imports in 1991. The relationship between exchange rate, trade balance, and price and quantity factors is continuously evolving. When a country devalues its currency, it initially leads to an increase in the value of imports denominated in local currency due to rising import prices.

Although there will be a temporary decrease in the

trade balance, the value of exports will remain the same. However, over time, both import and export volumes will be influenced by changes in relative prices due to devaluation. Import volume will decline while export volume will increase because export prices in dollars become more competitive. As a result, there will be an improvement in the country's trade balance (Fong, 2002). China consistently devalued its currency during the 1980s and early 1990s to boost exports and achieve a favorable trade balance. In 1991, China transitioned from large one-step currency devaluations to more frequent adjustments of the renminbi's value based on current economic conditions as part of its overall foreign trade system reform.

China implemented measures in the early 1990s to achieve full convertibility of its currency, including the unification of the two main currency rates in 1994 and the deregulation of foreign invested enterprises' ability to freely exchange funds at selected banks without approval from the State Administration for Exchange Control (SAEC) in 1996. The International Monetary Fund (IMF) acknowledged and formally classified the renminbi's exchange rate as a more flexible management system.

Moreover, China's reform of its foreign trade system had a significant impact on its rapid expansion of foreign trade. From 1978 to 1992, China witnessed an eight-fold increase in total international trade, with it growing from $20.6 billion USD to $165.6 billion USD. Export also experienced substantial growth during this period, rising from $9.75 billion USD in 1978 to $84.9 billion USD in 1992 (Zhang, 1995).

China's previous system involved stringent supervision of foreign exchange transactions and a set exchange rate for the renminbi. This inflexibility impeded the country's capacity to adjust to price disparities

with other countries and promptly react to fluctuations in supply and demand of foreign currency. The government adopted a centralized method that closely regulated China's international trade, allowing only authorized import and export corporations to engage in contracts with overseas companies.

By 1978, there were only ten national import and export corporations authorized by China's trade ministry to exclusively sign import and export contracts with foreign companies. As a result, individuals in this economic setting lacked motivation to adapt trade practices based on shifts in prices and exchange rate policies. In the initial phases of reform, different strategies were experimented with for overseeing foreign exchange in order to enhance export incentives. Eventually, a retention system was implemented.

The SAEC issued retention quotas to exporters, which were a portion of their actual foreign exchange earnings. Over time, the system became more complex, with regulations allocating foreign exchange based on industry and location. However, in 1991, a uniform retention rate for businesses was implemented nationwide. To further promote exports, various export subsidies were used, along with the establishment of trading units or foreign trade corporations. By 1989, the number of these corporations had exceeded six thousand (World Bank, 1990). The introduction of the agency system also expanded the capabilities and freedoms of those who were authorized to engage in importing and exporting.
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China implemented a dual exchange rate system in 1981, where one rate applied to non-trade transactions and a more beneficial rate was used for international trade settlements. This system was abandoned in 1985, but reestablished in 1996 with the creation of foreign exchange adjustment centers (FEACs). These FEACs were government-approved entities that had the authority to trade retention

quotas. Following the deregulation of trading in 1988, the premium on exchange rates within the FEACs reached approximately 80 percent. The number of participants and total demand steadily increased during this period.

The majority of China's foreign-currency transactions were conducted through the Foreign Exchange Adjustment Centers (FEACs), representing approximately 80 to 85 percent of all such activities. The exchange rate at FEACs was determined by a combination of government intervention and market factors, although governmental involvement was infrequent. By 1986, the official exchange rate had essentially been linked to the U.S. dollar's value.

In 1991, the exchange policy underwent changes, which included smaller and more frequent adjustments based on market conditions. On April 9 of that year, there was a devaluation of 0.95%, resulting in an exchange rate of 5.2935 renminbi per dollar. Another devaluation occurred on May 20, bringing the exchange rate to 5.4066 per dollar. Throughout the year, several additional minor adjustments were made. By April 1993, the real effective exchange rate had depreciated by a greater extent than both in 1986 (33%) and in 1980 (70%) (Bell et al.).

In 1993, the Chinese currency was highly over-valued, making products more expensive abroad. This made them less attractive to importers and consumers. A key reason for the devaluation was to reduce price distortion and promote exports. According to Wang (1993), there was a positive relationship between the real exchange rate and exports. Brada, Kutan, and Zhou (1993) also found that devaluation of the renminbi improved the balance of trade in both the short and long run. In the early 1990s, a significant step in foreign exchange reform occurred when the two main currency rates (the trade

rate and the official rate) were joined. This allowed for a limited amount of flexibility for the renminbi to freely float starting in 1994. This resulted in a significant devaluation, and since then, the exchange rate has remained stable.

During this period, China experienced a significant increase in its exports, which brought up concerns about the connection between the real exchange rate and the trade balance in China's transitional and emerging economy. Nevertheless, according to the World Bank reports (1990), the manipulation of the exchange rate has had a significant impact on the volume and types of imports and exports in the Chinese economy. It is anticipated that China will eventually adopt a floating exchange rate system, but this is contingent upon meeting certain prerequisites. A crucial condition would involve substantial enhancements in the operational methods of the banking industry.

Before the crisis, the ratio of non-performing loans to total bank assets was around 25 percent, which is actually higher than the crisis-affected economies. Some state-owned banks were even technically insolvent. If the loss of depositor confidence were to trigger bank runs, these banks could face major problems. The major role of these banks could cause widespread instability in the economy (Lardy, 1998). Hence, the banking sector cannot be reformed separately; it is interconnected with state-owned enterprises and public finance policy. Although China is consistently reforming state-owned enterprises to become competitive both domestically and internationally, they still fall behind in efficiency compared to Western standards.

Since 1996, these companies have consistently incurred a net loss of 38 billion renminbi (SSB 1997). The majority of fiscal resources are allocated towards personnel and administrative operations. The presence of approximately 30

million excess government employees further burdens the economy, leading to increased inefficiency and expenses. Problems like social security, infrastructure development, and regional disparities remain largely unaddressed. These factors are interconnected; inefficient state-owned enterprises require budgetary subsidies and contribute to non-performing loans, thereby exacerbating the already dire financial and fiscal circumstances.

Due to revenue shortages, the government often transfers its financial responsibilities to state-owned banks through policy loans with low interest rates that are rarely repaid. These and other factors create a complex web of relationships that hinder the government's ability to address the situation on a sector-by-sector basis. These problems also contribute to other challenges in China, including unemployment pressures and regional inequality. The financial system has become more vulnerable due to the abundance of non-performing loans, and there is widespread presence of real estate bubbles and excess production capacity.

Current Situation

China's renminbi trades within a narrow range of approximately 8.2760 to 8.2800 against the dollar. The Central People's Bank of China uses foreign-exchange reserves to intervene and maintain the currency within this range.

According to experts at Reuters News Service (5 May, 2002), China's main focus is to maintain stability in its currency during the turbulent period of joining the World Trade Organization and before a leadership reshuffling later this year. The International Monetary Fund has been urging China to gradually replace the virtual peg of its currency, the RMB, to the dollar with a peg to a more flexible basket of currencies. Chinese authorities have stated that they are studying the proposal but have no immediate plans for changes. Chinese Premier Zhu Rongji announced last month that there are no plans to devalue the renminbi or

shift its peg to the dollar to a basket of currencies in the near future. "China insisted on not devaluing its own currency out of consideration for the region's interests and its own needs. We will continue to follow this policy," Zhu said (Reuters, 2002). Concerns have arisen in the region due to weakness in the Japanese yen this year, raising the fear of China devaluing its currency and triggering competitive devaluations by Southeast Asian nations.

American manufacturers are worried about a potential devaluation of the Chinese currency. They believe that this could lead to an influx of low-cost goods from Asia, causing a negative impact on the exports of American products. They also feel that the strength of the U.S. dollar is already putting pressure on their exports.

Beijing may be hesitant to allow the renminbi to depreciate significantly as it could negatively impact the currency of Hong Kong, which is already under attack. If Hong Kong's currency were to devalue shortly after the power transfer, China's reputation would suffer. Additionally, a decrease in the value of the renminbi could worsen trade tensions with the United States. China is projected to have a trade surplus of $50 billion USD with the US this year, and Chinese officials have expressed concerns about this imbalance (Reuters, 2002). Although Chinese leaders have maintained their commitment not to devalue the currency in 2022, the government has intervened to prevent illegal outflows of capital through loopholes in China's foreign exchange controls. Recognizing that Chinese companies anticipate a possible devaluation, central regulatory authorities have taken aggressive measures to counter perceived capital flight.

China's foreign exchange authorities have implemented over 20 notices

and regulations since mid-September. These measures aim to enhance supervision of foreign exchange transactions, impose stricter requirements for official documentation, and regulate conversion and remittance of hard currency transactions. The tightening of foreign exchange controls reflects China's concerns about the stability of their currency, illegal outflows of hard currency, and hidden exposure to foreign exchange debt. This demonstrates their perception of the currency's stability and ongoing worries about the impact of the Asian disease. Prime Minister Zhu Rongji and central bank governor Dai Xianglong are committed to maintaining the value of the reminbi, not only for international economic stability but also for the benefit of China's own economy.

Devaluation would have an impact on China's ability to raise hard currency as they are prioritizing strengthening state enterprises and relying on Hong Kong capital markets for cash. If the Hong Kong dollar is no longer securely pegged to the U.S. dollar, international investors would avoid investing in new Chinese securities, leading to a loss in their value. Moreover, a weaker currency could erode confidence within China. The collective savings deposits of ordinary Chinese people in local banks total around 8 trillion renminbi (equivalent to approximately $1 trillion USD). However, many individuals may consider withdrawing their funds and purchasing black market U.S. dollars.

China cannot afford a run on its banks, as it would destroy Beijing's credibility and ability to extend credit to businesses and projects that support economic growth. Devaluing the renminbi could prevent China from being undercut by other Asian countries in the market, especially as drops in their currencies have reduced local costs like labor.

Undermining the efforts of other Asian countries to restore their economies and

setting off another cycle of devaluations, devaluing the currency would also increase the attractiveness for foreigners to invest in China. Known to draw more than half of its foreign investment from elsewhere in Asia (Mufson, 1998), China possesses several advantages over other East Asian and Southeast Asian countries. One such advantage is that its currency is supported by a trade surplus, which contributes to its strength.

In 1997, China had an impressive export value of $182 billion, exceeding its import value by $40 billion. Furthermore, China possessed foreign currency reserves amounting to $140 billion, which was sufficient to cover its foreign debt of $119 billion. China maintained a current account surplus of approximately $30 billion USD during the crisis in 1998, which differed significantly from the consistent current account deficits observed in Thailand and Indonesia prior to the crisis. (Refer to the table below for comparison). Additionally, although China was the largest recipient of capital in East Asia, over 60 percent of the capital inflow consisted of foreign direct investment. This mainly involved multinational corporations establishing businesses, commerce, and infrastructure to support their presence in China, as well as direct international investment in Chinese firms by Western institutions and private individuals.

China maintained low levels of debt due to not borrowing as much as other companies. In contrast, other countries borrowed short-term money and were at a disadvantage when their currencies were devalued, as they had to repay more in their own currency. China, however, maintained strict controls over the capital account and achieved the goal of full convertibility of the renminbi in accordance with IMF's Article VII stipulations.

The controls acted as a form of protection from

the volatility of the local capital markets in the region (Huang and Yang, 1998). These stringent controls, coupled with deep integration into global commodity markets, increased flexibility in structural adjustments, and current account surpluses, were key factors in China's ability to withstand the Asian crisis. The controls also deterred attacks on the Chinese currency by international speculators in foreign capital markets, and evidence suggests that they have effectively prevented significant capital flight through periodic tightening. However, these controls have had negative consequences, such as hindering trade and impeding efficient transactions. They require close monitoring of transactions, extra paperwork, and thorough examination of business practices, all of which are time-consuming and non-productive. Nonetheless, the Chinese have demonstrated their willingness to sacrifice short-term profits in order to safeguard the long-term strength and stability of their economy.

Conclusions

According to international observation, China has successfully prevented a currency crisis in recent years, which has positively impacted regional economic stability. It is worth noting that China's ability to maintain the value of the renminbi, despite potential negative trade effects, sets it apart from crisis-affected countries. The key factor contributing to China's success is the level of liberalization it had achieved before the crisis. By enforcing capital account controls, China has incurred some efficiency costs, but it has effectively safeguarded its vulnerable financial sector from the instabilities of the international capital market. Furthermore, these capital controls have played a significant role in creating favorable conditions such as substantial foreign exchange reserves and the dominance of foreign direct investment as a source of capital inflows, ultimately helping China avoid a currency crisis.

References

(1999). The Chinese Economy in the Asian Financial Crisis: The Prospect of the Stability of the RMB. HIID Development Discussion Papers No. 669, Harvard Institute for International Development, Cambridge.

(1997). A Thai-Mexico Primer, The International Economy, September/October: 20-3, 55.
Fong, Y. (2002). Personal interview with former UCLA International Economy Student, April 13, 2002.
Huang, Y. (1999).

The Last Steps Crossing the River: Chinese Reforms in the Middle of the East Asian Financial Crisis. New York: Graduate School of Business, Columbia University.

(1998) China not Going to Devalue Currency , U.S. Official Says, Washington Post, A17.

McLeod and R. Garnaut (eds), East Asia in Crisis: From Being a Miracle to Needing One? New York: Routledge: 105-109.

New York: St. Martins Press.

World Bank (1990). China: Between Plan and Market. Washington: World Bank.

Zhang, Z.Y. (1995) Chinas Foreign Trade Reform and Export Performance, Singapore: National University of Singapore.

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