IMF Harps on PRC Yuan Undervaluation (Again)

Here we go again: with China being the country with the world's largest external surplus, its role in the resolution of global economic imbalances is always going to loom large. Given the past and continuing Western dominance of international financial institutions alike the IMF-witness the Christine Lagarde appointment to replace Dominique Strauss-Kahn--it is no real surprise that China's economic practices have been in its crosshairs. Namely, the IMF has done next to everything but declare the yuan undervalued. This together with many other attempts to use the IMF for clubbing China over currency valuation and sovereign wealth fund governance.

However, IMF hypocrisy aside, the obvious thing is that the institution has limited leverage on China. Having witnessed how troubled countries were treated in the aftermath of the Asian financial crisis, China famously embarked on an unprecedented export / reserve-building complex that has taken its holdings to well over a previously unimaginable $3 trillion. With so much cash accumulated, it's actually worked the other way around with the IMF asking the IMF to contribute to its firefighting efforts in Europe and elsewhere.

It is in this context that The IMF recently completed its regular Article IV surveillance of the PRC and made the usual suggestions of currency revaluation to staunch inflationary pressures at home. This being the IMF, it is no surprise that release from "financial supression" is what it prescribes to ward off trouble while putting the country on its professed path of domestic-led growth. What follows is the IMF blurb (you can also download the full report):

Financial liberalization will be essential in transforming China’s economic model to one of more inclusive growth, raising household incomes, boosting domestic consumption, and reducing the reliance on exports as an engine of growth, say IMF economists.

In their regular Article IV assessment of the country’s economy, IMF economists called for a revamp of China’s financial system with a comprehensive set of reforms that strengthen the conduct of monetary policy, improve the financial stability framework, develop financial markets and savings vehicles, and move toward more market-determined loan and deposit interest rates.

The assessment follows a visit by a team of economists led by Nigel Chalk, the IMF’s mission chief for China. This year, for the first time in China, the IMF, in collaboration with the World Bank, also conducted an assessment of the health of the Chinese financial system under the Fund’s Financial Sector Assessment Program (FSAP). The FSAP marked the culmination of more than a year of work by IMF, World Bank, and outside financial sector exports. “In our surveillance work, we have taken up this financial theme and focused on laying out a clear, strategic roadmap to manage the process of financial liberalization in the coming years, in a way that both reduces the risks and delivers the full benefits of a more market-based financial system,” said Chalk. “Financial reform will be of great help in rebalancing China’s economy,” he added.

The report notes that China’s system currently leaves many depositors short changed, with deposit rates well below the rate of inflation. While this helps to sustain high levels of corporate investment and foreign currency intervention, it conflicts with many of the objectives of the government’s 12th Five Year Plan.

The IMF team visited Beijing, Shanghai, and Chengdu from May 23 to June 9 to conduct the annual review and presented their findings to the Executive Board of the IMF on July 15. Both the FSAP and a separate report on the spillovers to the global economy from China’s policies were also discussed by the Executive Board. At the conclusion of his visit to China in June the IMF’s then Acting Managing Director, John Lipsky, paid tribute to the authorities for their adept handling of the economy during the recent global crisis. He said the country’s economy was a “bright spot” of global growth.

In moving ahead with financial liberalization, the staff team highlighted the importance of allowing the renminbi to appreciate to give greater monetary policy autonomy to the People’s Bank of China and to reduce the pace of foreign reserve accumulation. “A stronger renminbi would increase household income, boost consumption, make China’s manufacturing products more affordable for the Chinese people, and help build a stronger service economy,” said Chalk.

The report also recognized that financial liberalization was likely to be a complex and lengthy process, which would need to be carefully sequenced. “Continuing to delay could mean that the financial system, instead, evolves in an uncoordinated and disorderly fashion, outpacing supervisory capabilities, and revealing regulatory gaps,” says the report. This would risk change “proceeding on a timetable driven not by careful, pre-emptive, and concerted policy planning, but rather by the pace of market disintermediation and innovation.”

The report also discussed the main near-term risks to the Chinese economy, including the danger of rising inflation. IMF economists expect inflation to decline in the second half of this year—it rose above 6.4 percent June—as the impact of higher food prices eases. “Barring further food price shocks, and assuming the ongoing tightening of monetary policy is maintained, there was general agreement that inflation should soon peak,” says the report. This monetary tightening should rely more on higher interest rates and an appreciation of the exchange rate, and less on credit controls, it suggests.

In recent years, many China watchers have also been concerned about the threat of a property price bubble in Asia’s largest economy, where the property sector directly makes up 12 percent of GDP. In their report, IMF economists said they did not see imminent risks of a major downturn in the sector, but they warned that as long as the cost of financing continued to be low, and other investment options remained limited, “the propensity for property bubbles will remain.”

The FSAP report concluded that China had made “remarkable progress” in its transition to a more market-based and financially sound system. Consequently the banking sector had entered the global financial crisis from a position of relative strength. But it also noted that the country’s financial sector was confronting several risks, not only from rising real estate prices and economic imbalances, but also from a likely worsening of credit quality following the enormous injection of stimulus in response to the global financial crisis.

IMF staff believe the potential risks in the financial system are manageable given the capitalization of banks, strong economic growth, and proactive approach being taken by the regulators in dealing with these credit risks. But they recommended improving supervision and regulation, and further enhancements to financial institutions’ risk management systems, as China moves toward a more commercially orientated financial system.

The curious thing is that I do not disagree much with any of this--nor do the Chinese authorities, I think. It makes sense. However, I am not hardly convinced that the IMF represents the ideal messenger given reasonable perceptions that it continues to serve Western interests. How can this same message be sugar-coated? After all, the IMF has been urging China to do so at least since 2006. I believe the Chinese are already taking heed, but the messenger needs to be someone more congenial to the PRC leadership.