Four reasons why China will not revalue RMB
Aside from political pressures from the US, there's really no reason for China to appreciate its currency.
Four fundamental conditions that exist today will prevent China from floating the renminbi.
First, restrictions on the Chinese travelling to the US and other major countries restrict investment and spending opportunities. Second, the floating rate of housing mortgages and the lack of individual credit lending system reduce China's control on inflation and lending. Third, the high income tax rate has created near zero profit for export industries that can easily move factories to other countries when labour costs or the renminbi become too high. Lastly, and most importantly, the income gap between the roughly 900 million rural population and the 500 million urban population has widened to an unprecedented 1:4 level, with the average rural real income less than 1,900 yuan (US$230) per year. If not resolved or controlled, any of these four conditions can create disasters for the Chinese economy.
Restrictions on the Chinese travelling abroad give Chinese companies no means to sell products directly to end consumers, no means to find the latest technology necessary to stay competitive, and no means to invest excess money in other countries' markets. This unfair condition will put a massive demand on the renminbi if China floats its currency.
Everyone will buy renminbi to invest and spend in China while virtually no Chinese will be able to buy foreign currencies to spend abroad. This will artificially shoot up the value of the renminbi and stop investment in any new factories while there are still millions of people in China who can provide cheap labour. As long as foreign countries restrict entry to Chinese, China will not agree to float its currency.
In the years to come, we should expect to see a gradual opening of Chinese investment and spending abroad, but for now the pressure is still on foreign currencies to appreciate against the renminbi.
Perhaps not as apparent, but a much more serious problem exists within China's housing mortgage system. From steel to concrete to coal to other commodities, the real-estate boom in the past six years that has created huge demand on raw materials will continue to require massive imports of commodities that are lacking in China.
At the same time, real-estate pricing bubbles and illegal acquisitions of farm lands have created a phantom inflation problem that has actually put a constraint on the development of non-real-estate industries. The culprit is the floating mortgage interest rate.
To make new housing available to common people, China has been pushing a low floating rate mortgage lending system that allows people to borrow money to buy houses at an interest rate level much lower than the most favourable corporate lending rate. Developers and entrepreneurs have been able to finance their projects by hyping up property prices and borrowing from banks twice the amount than the real worth of previous projects. China will not be able to raise interest rates to regulate the housing industry simply because by doing so, common people will not be able to afford the monthly payments and will be forced to forfeit their homes while developers can walk away free leaving banks with all the mortgaged properties without a market.
We will see a crackdown from the government on illegal development of real estate, but without fixing the interest at market rate, China will not be able to stop the real-estate inflation problem, which will continue to force the renminbi to devalue.
In comparison to other countries' income-tax rates, China is considered one of the highest in the world. Foreigners have been investing heavily in China for the past 15 years to set up factories for the manufacturing of their products abroad, taking advantage of the cheap labour in China. Although China is a big market, imports have always been tough due to high VAT, sales, and import duty or quota taxes. With the high income-tax rate, there's no incentive for these exporting enterprises to leave any profit inside China. That means multinational corporations will buy from their Chinese factories at a price just enough to cover the cost and have all the profits assigned to their distribution companies elsewhere that have a much lower income-tax rate. That would then leave China very vulnerable to renminbi appreciation.
By not floating the renminbi, China is essentially asking foreign companies to use foreign currencies to pay for Chinese labour. This is also the reason why China is the second-largest holder of US dollars outside the United States. If China floats its currency, foreign investments would have the freedom to buy renminbi to set up Chinese ventures, which will create a huge demand for renminbi and artificially appreciate the currency.
Appreciation of the currency means Chinese labour is artificially more expensive, and factories will start to leave China for other cheap-labour countries, leaving millions of people without a job in China. We are likely to see the split of income tax to an income tax and a dividend tax to encourage corporate reinvestment.
The biggest problem China faces in terms of both political and economic stability is its 900 million rural population that is still living in poverty. This number represents 65 per cent of China's total population, much higher than a fully-industrialized country of about 25 per cent. At the same time, China has been behind in spending on rural education, infrastructure, technology, and medical systems. As a percentage of total spending, China has reduced its annual spending in rural areas from 13.4 per cent in 1978 to 7.7 per cent in 2001, a mere 146 billion yuan (US$17.6 billion). What that translates to is that there are still a lot of cheap labourers for the world to set up their factories in China. To industrialize, China will need to invest heavily in the rural areas and bring the rural population up to industrialization standards.
Already, China has committed to spend an additional 110 billion yuan (US$13.3 billion) just on the educational systems of rural areas this year. China will have to keep its labour cost or currency low to compete and generate new jobs for its people. Until China can successfully push at least half of its rural farming population into industrialial production, the currency is not likely to budge.
In conclusion, until the above four fundamental problems are solved in China, there's really no reason to appreciate the currency.