China devalued the reference rate for the yuan against the U.S. dollar by 1.9 percent on August 11, a seemingly innocuous step. Yet the devaluation “jolted global markets,” according to a Bloomberg story. The jolt was not so much a result of the devaluation itself, but rather as of few expecting it. After all, as financial market gurus kept expounding, China was determined to internationalize the yuan and make it a reserve currency. The central bank, the People’s Bank of China (PBoC), may not let the yuan appreciate, but there was no way it would devalue, the argument went. This would derail attempts to include the yuan in the IMF’s special drawing rights (SDR) basket and lead to capital outflows, and so on. Besides, China had $4 trillion in reserves—plenty to deal with any contingency.
So the fact that China has now actually devalued has opened a can of worms. Will this really be just a one-off, as PboC claims? What is it saying about China’s growth prospects, a topic of global concern? How will corporates exposed to dollar-denominated debt cope? Will currency wars be ignited? Or, as some China watchers have suggested, is the devaluation the first step to more flexible exchange rates in an attempt to ward off the macropolicy trilemma and ensure independent monetary policy as China opens up its capital account? My interpretation is that the devaluation is a reluctant acknowledgement by policymakers that internationalizing the yuan and liberalizing the capital account may be premature. There are more pressing policy issues on the agenda.
Time to take stock of economic reality and meet Carlos Diaz-Alejandro. The results uncovered by his research on the Southern Cone were published in 1985. The salient finding was that premature capital account liberalization fueled a sovereign debt crisis and contributed to Latin America’s lost 1980s. The policy prescription: Do not liberalize the capital account unless the domestic financial system is ready, or you will set the economy up for a crisis: goodbye financial repression, hello financial crash.
Even a cursory review shows China’s domestic financial system is not ready. The cornerstone of any financial system, be it a developed or emerging market, is confidence and transparency. China is deficient on both counts. Few believe the official non-performing loans ratio of 1.4 percent. Total social financing, a broad measure of credit, went parabolic, rising by 73 percentage points of GDP from 2008 to 2014, according to the IMF 2015 Article IV Consultation, with the increase worryingly concentrated in “real estate firms, SOEs, and overcapacity sectors.” Local government debt is about 35 percent of GDP, much of it short-term, yet invested in infrastructure and social housing with long paybacks. Genuine concerns about a housing price bubble abound, especially away from the four major cities. And about half of corporate credit, which stands at around 115 percent of GDP, is collateralized by land or property.
At the same time, the failure to fully liberalize bank deposit rates has fueled the growth of “wealth management products” in the shadow banking system. These “WMPs” offer higher returns but are poorly regulated and more risky. Not surprisingly, WMPs are entangled with the booming real estate market, a major engine of growth, yet increasingly regarded as the center of a “web of vulnerabilities” (to quote the IMF 2014 Article IV Consultation). This web ensnares banks, shadow banks, and local government finances. A real estate shock would ripple through the system, lowering growth and forcing bailouts.
Financial vulnerability has spiraled even as growth has fallen victim to diminishing marginal returns to capital. China has passed the so-called Lewis Turning Point, meaning it can no longer rely on an army of cheap surplus rural labor to keep real wages and the capital-to-labor ratio low. Total factor productivity growth, which took off after China joined the World Trade Organization in 2001, has slowed down dramatically. To rejuvenate growth, China’s leadership needs to decisively address weakness in its fiscal, financial, social, and state-owned enterprise (SOE) sectors. Hukou reform, whereby social benefits received by rural migrants will be placed on par with urban residents, could easily cost 3 percent of GDP a year for the next seven years as some 150 million additional people gain access to such benefits. Many SOEs are in heavy industry and metallurgy, sectors whose prospects have dimmed along with China’s growth.
The lesson from Diaz-Alejandro is that the domestic financial system must be fixed and market-determined interest rates adopted before entertaining hopes of internationalizing the currency. Instead of cleaning up the domestic financial system, PBoC has been preoccupied for at least a year with loosening financial conditions to meet increasingly unrealistic official growth targets, easing mortgage loan requirements to prop up house prices, and, more recently, taking steps to shore up the collapsing stock market.
The growth slowdown and formidable remaining agenda in the fiscal, financial, social, and SOE sectors are reminders that China’s transition to a full-fledged market economy remains incomplete. Rejuvenating growth requires hard budgets and competition to improve resource allocation and stimulate innovation, counterbalanced with a more competitive real exchange rate (China’s real effective exchange rate appreciated 31 percent between end-2009 and end-2014). This is the main insight from the transition in Central and Eastern Europe, which was far simpler than anything China faces.
Putting Diaz-Alejandro and the remaining economic agenda together, any reasonable economist would conclude that making the internationalization of the yuan the centerpiece of economic policy would be pure insanity. PBoC’s decision to devalue is hopefully proof that China’s leadership is beginning to get its economic policy priorities right. But this is only the first step of another journey of at least a thousand miles.
The author is a former senior adviser at the World Bank and former chief economist for emerging markets at GLG in London. His second book, “
How Does My Country Grow? Economic Advice Through Story-Telling
,” was published by Oxford University Press in 2014.