Crunch Time for China

By: Barry Eichengreen

Another year, another round of criticism of Chinese currency policy.  Once more Beijing is being faulted for tethering the renminbi to the dollar.  By keeping its exchange rate artificially low, China is enlarging its already enormous current account surplus.  This beggars the rest of the world.  It obstructs the process of global rebalancing.

            Here’s an easy prediction: the renminbi will move by more against the dollar in 2010 than in 2009.  After all, it could hardly move less.  But here’s a riskier prediction: it will move by a lot, and it could move either way.

            It’s crunch time for China.  If the authorities don’t let the renminbi appreciate substantially now, they risk a substantial depreciation later.   Appreciating now will help cool off China’s overheated asset markets. Otherwise China risks a crash and economic slowdown with a weaker currency, since exports will be the only game in town.

Chinese  markets display all the symptoms of bubble trouble.  Why is no mystery.  By preventing the exchange rate from moving, China imports accommodative foreign monetary conditions.  Zero interest rates may be appropriate for a still depressed United States and Europe, but they are not appropriate for a booming China – a booming China that increasingly looks like an overheated China.

            The excesses are visible to the naked eye.  I know; I was just there.  Apartment prices in Shanghai were up by 25 per cent last year.  In Beijing they were reportedly up by 35 per cent in the second half alone.  The main thing my dinner companions wanted to talk about was real estate.  (I know; they were economists.  But still…)  Construction companies are building left and right.  Housing starts nearly tripled in 2009.  With only limited supply of other assets, apartments are the main instrument for speculation, though now we hear of the speculative fever is spilling over into markets for garlic and dried chili peppers.

            These are the classic signs of an accident waiting to happen.   So far Chinese officials have settled for half measures.  They have encouraged lenders to tighten mortgage lending standards.  They have imposed a 5.5 per cent sales tax on residential property held for less than 5 years.  But this is like trying to hold back a flood with a finger. 

            What China needs is substantially tighter monetary conditions to prevent its already blazing housing market from overheating further.  The central bank finally raised interest rates modestly last Thursday, from 1.328 to 1.368 on 3-month bills.  Right – you have to look to the second decimal point to find the change.  The level is still dangerously low for a booming economy.  The authorities need to tighten further. 

But the only way of effectively tightening credit is by substantially appreciating the renminbi.   So long as the renminbi is linked to the dollar, higher interests will only attract more capital from overseas Chinese.  So long as investors think that the renminbi can only appreciate, they will be looking for more ways around China’s controls.  The siren song of the carry trade will be irresistible.  A one-shot revaluation is the only solution.

            If the authorities instead continue to rely on half measures, the housing market and the economy will overheat further.  Eventually the bubble will pop, and the construction sector will be hit.  Construction workers will be sent back to the farm.  Growth will slow substantially.  It may slow by more than is consistent with social stability.

            A Chinese crisis would, of course, be more a slow-motion crisis than the fast-forward experience of the U.S. after Lehman Bros.  The government has plenty of reserves with which to recapitalize the banks. It can instruct them to keep lending, as it did after Lehman Bros.  It can instruct state-owned enterprises to keep working.  But in the same way it can’t now entirely limit the frenzy, it won’t be able to entirely avoid the fallout from the correction when it comes. 

Consequently, it would be better to take preventive measures now than to have to cope with the consequences.  China has been exceptionally vigilant about the H1N1 flu, administering free vaccinations to children.  It needs to be equally vigilant financially.

            Why Chinese officialdom hesitates is clear.  The prevailing policy has influential supporters, not just exporters who benefit from the cheap currency but also the construction companies that are party to the real estate boom.  

The sharp rise in December exports announced last Sunday should give policy makers some cover.  Officials are reluctant to abandon policies that served the country well in the past.  They have a saying about crossing the river by feeling the stones beneath their feet.  In this case, however, if they don’t leap between the banks, they risk losing their footing. 

Predicting crises is easy.  I myself have predicted 11 of the last 7.  But preventing them is harder, especially when doing so means abandoning policies that, to all appearances, have worked so well in the recent past.

           

Barry Eichengreen is George C. Pardee and Helen N. Pardee Professor of Economics and Political Science at the University of California, Berkeley.

 

 

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