Many economists and financial market players wrongly blame the relatively
fixed RMB exchange rate for China's "runaway" economic growth and for attracting
"hot money" in anticipation of what they think is inevitable RMB appreciation.
That's because they think the only way for China to control economic growth is
by tightening credit, reflected in higher interest rates. They assume higher
interest rates mean greater foreign-exchange demand for RMB for investment and
thus the impossibility of a fixed RMB. This view was expressed recently by
Nicholas Lardy, senior fellow at Washington's Institute for International
Economics and a leading US expert on China's economy, in an appearance on
CCTV9's Dialogue programme just over a month ago. This thinking may stem from
The first may be the danger of identifying the real economy with the
financial or monetary economy, or of looking at monetary policy as the be-all
and end-all anchor of all economic policy. Money and credit are a commodity like
others, not a proxy for the entire economy which uses money as a medium for
valuation and exchange. Interest rates are the price for credit but it's the
level of all prices (reflecting their rate of change), not just of credit, that
drives the economy.
Rising price levels in China reduce foreign-exchange demand for RMB for
investment because they lower the "purchasing power" of the RMB in terms of the
amount of goods one unit of the currency can buy. Higher interest rates are the
exception but higher goods prices neutralize the ability of interest rates to
cause appreciation of the RMB. Think of the negative effect of higher prices on
the ability to export, resulting in less foreign demand for RMB.
A second reason for the erroneous thinking relates to China's economic rise's
still being in its early stages. In this period, the contribution to economic
growth by construction of infrastructure and buildings is disproportionately
high compared to the contribution made by the use of those facilities. This
attracts real-estate investment fed by credit availability, and that is
investment which seeks to profit from price appreciation, not from income from
use. So, higher real-estate prices, like high interest rates and the price of
other investments, wind up serving to appreciate the RMB rather than acting as
But there are a lot of other prices driving China's economy, and their rise
has the effect of depreciating the RMB. Furthermore a price rise by a company
makes it more profitable and this serves to attract market investment away from
real estate into other sectors of the economy where it is not financed by the
mortgage credit that would otherwise be made more available by ever higher
real-estate prices, or away from other "fixed-asset" over-investment that has
been driven by artificially-low input prices.
Foremost among those prices are the prices of energy, the economy's most
important single input. If any industrial policy needs to be consistent with the
rest of economic policy, it's energy policy. But few economists understand
energy because of its nature as a bulk-market commodity and many get distracted
by its nature as an essential commodity. Economists typically understand best
the retail markets they deal with in their everyday lives.
China has recognized the need to bring energy into the competitive market
economy by being the only Asian country besides Japan and the Philippines not to
cancel the marketization of at least the supply side of the electricity sector
after the US's abysmally-designed California electricity market collapsed in
2001. China broke State-owned oil, gas and petrochemical exploration, production
and marketing into four competing companies. Just over a month ago the National
Development and Reform Commission continued its policy of letting energy prices
rise to a level more consistent with energy markets, as I have supported in
previous China Daily articles.
In particular, NDRC allowed an approximate 7 per cent rise in the
still-regulated electricity price to consumers to cover 70 per cent of the cost
increase experienced by the electricity suppliers. This came a month after the
7th in a recent series of refined oil-product price increases.
Higher prices alone automatically solve much of the energy conservation and
energy efficiency issues China faces. Just this week NDRC's latest 1st-half-year
statistics show that low administratively-set prices have caused the nation's
energy efficiency to continue declining, especially in energy-intensive
industries (except for construction and steel where higher world steel prices
have reduced demand growth).
Hopefully the NDRC will next move toward "demand-side management" or
market-price-driven reduction in electricity, gasoline and natural gas demand
growth that enables producers to recover 100 per cent of their costs. NDRC can
do this by marketizing retail gasoline pricing and the demand side of
electricity, and by marketizing natural gas distribution and encouraging the
building and opening of an intercity natural gas pipeline grid that is operated
independently of production just like the electricity grid. An intercity gas
grid is needed to support a market for natural gas trading. It would also
deliver clean energy to all China's cities, including the gas from coastal
Liquified Natural Gas terminals, and the gas from coal mines, whose extraction
makes the mines safer and more profitable.
The third reason for ignoring prices and blaming the fixed RMB for
contradicting tighter monetary policy is the common misidentification of
inflation with price increases and ignoring that price increases are in fact
non-inflationary, especially when they prompt productivity or efficiency
improvements which raise both incomes and the supply of goods. Price increases
are actually counter-inflationary: they increase the demand for money, not the
money supply whose increase is defined as inflation.
It is what the People's Bank does or does not do in response to increased
money demand that is inflationary or not: It can expand credit or let interest
rates rise. And that is a very complicated judgment, informed by the fact that
any upward-biased effect on the RMB is neutralized by the higher goods prices.
If prices ever began increasing in anticipation of an inflationary monetary
policy, we would enter the bottomless pit of hyperinflation, which China's sound
monetary policy is nowhere near.
Accordingly, higher prices, not just of credit, can have the effect of
controlling economic growth. Allowing prices to adjust, ideally through market
mechanisms, precisely makes the policy of a fixed RMB exchange rate consistent
with any credit-tightening. The temptation, in a system of regulated prices, may
be to attempt to use a single blunt instrument, like credit-policy through the
People's Bank, to achieve an objective that is very complicated to co-ordinate.
Moreover, compared to markets, government regulation of prices or supply carries
the added burden of secrecy and a temptation of corruption, suggested by the
modest gas-pump queues seen on the eve of a gas price increase, or by the rise
in the stock-market price of energy producers when a price-increase is
The author is a Canadian and American investment
banker, economist and energy expert currently in Beijing.
(China Daily 08/04/2006 page4)