Much has been said, including in FinanceAsia, about the inevitability of the revaluation of the peg. However, new research by Stephen Green, author of a forthcoming book on the mainland privatization process, indicates that the PBOC (People's Bank of China) is managing to balance the competing pressures bearing upon it to an extent that that the pressure for a big revaluation is not as great as many think.
Green estimates that despite the huge accumulation of China's foreign reserves, the central bank is not in fact sterilizing all the forex which is pouring into the country, on the back of a strong current account surplus (from the weaker Yuan), foreign direct investment running at $60.6 billion in 2004, and hot money from investors betting on a revaluation.
Green estimates the central bank only sterilized 32% of forex inflows in 2004 and only 26% in 2003.
That is surprising. Most observers have assumed the bank has carried out a much higher level of sterilization, the expense of which will eventually become unsustainable, leading to a change in the peg.
Normally, a country defends a deliberately weak currency by taking the forex inflows out of the system - the 'sterilization' process. If the forex inflows stay in the system, they are eventually converted into local currency, thereby decreasing the availability of the local currency, driving up its value and making exports more expensive - precisely the effect Asia's export tigers want to avoid.
Unless forex inflows are sterilized, they also have an inflationary impact, since the forex inflows eventually translate into huge deposits of local currency, which the banks naturally aim to lend.
In order to prevent these outcomes, the government sucks the money out of the system by borrowing the money from the banks in order to re-convert it into the foreign exchange - thus nullifying the effect on the local currency.
Unfortunately, this leads to an unwelcome side effect: Interest rates may rise on the back of the central bank's demand for the funds deposited in the commercial banks. After all, by taking this money away from the banks, the central bank is attacking their capacity to lend to corporate and consumer borrower, thus affecting their bottom line. The banks normally want to be compensated for this through higher rates.
A further cost occurs after the government switches the funds back into US dollar, since the latter is apparently in the grip of a secular downward spiral.
Yet instead of being sucked into this game, the central bank, under the leadership of Zhou Xiaochuan has simply negated all the pressure by keeping the bulk of the forex inflows, converted into local currency, with the banks, Oddly enough, this more passive approach has kept rates low, protected the peg and put the lid on inflation.
China scholars will be irresistibly drawn to making a parallel with the Daoist practice of 'Wu Wei' - the concept of inaction leading to the desired outcome.
What's the evidence that the central bank's policy is actually working?
Green's idea is based on study of the money markets, where interest rates have been trending down - not upwards as they would normally do during a major sterilization programme.
"We know that money market rates in the last quarter of 2004 - when forex inflows apparently were rising at US$30 billion a month - were actually lower than in the second and third quarters. That's contrary to what you'd expect if a full scale sterilization program was underway," he points out.
How has this miracle occurred?
Instead of sucking money out of the system through expensive bond issuance, the central bank, under the leadership of Zhou Xiaochuan, has left the money with the commercial banks. But he has prevented them from using these huge inflows through hiking the reserve requirements, ie the amount of money the banks have to hold on deposit at the central bank. In addition, the central bank has used its considerable administrative muscle - 'moral suasion'- to limit bank lending.
The result: lower costs for the central bank and inflation contained through non-lending.
"As part of China's macroeconomic adjustment programme, bank lending has been constrained," adds Green. "Thanks to the lending slow down, related to overheating crackdown starting last year, the money market is now full of banks more than willing to buy central bank bills. That has kept market interest rates low - allowing the sterilization that has taken place to remain pretty cheap."
That means the peg is protected since it greatly reduces the cost of maintaining it.
The Chinese solution has therefore been to apply the useful tools of the command economy to result is an innovative and so-far successful response by China's central bank to the numerous pressures weighing upon it.
Green points out however, that costs are involved as well.
"Since banks have been constrained from making loans, the result will be a hit to their earnings, given their main source of income is the spread between the cost of their deposits and their loan income," he points out. That's a thorny issue, in view of the ambitions restructuring and listing plans of the four state banks.
Another aspect is that the 'moral suasion' involved in limiting bank lending goes against the central bank's own desire to move towards a financial system where interest rates are used to determine the cost and flows of capital, as opposed to pronouncements by the central government.
In the meantime, however, the PBOC is doing a rather successful job in confounding classical Western economic theory.
The big question is what could happen in 2005. Green is cautious. "So far, this approach to dealing with the inflows has worked pretty well. Inflation is just about being managed. But if the inflows continue, then the existing pressure for change will just grow", he concludes. "There will be a need to increase bill issuance and that could lead to interest rate rises."
In the meantime, observers will continue to debate the ever-changing ratio of market versus command characteristics the Chinese economy exhibits.
