China Growth Story 1

8/4/2019 China Growth Story 1

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China: Revolution to revaluation


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Beginning of the process (1978)..

Mao dies in 1978 leaving a legacy of disastrous attempts at socio-economic reform

Great Leap Forward (1958-61) during 2nd five year plan

Collectivism for agro development

Also promotes SOEs as a vehicle for growth along the lines of theSoviet model

Ended in famines, inefficient industrial sector and a fall in growth rates

A new model needed after Mao to usher in growth for the Chinese


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China ushers in reforms (1979)

Deng Xiaoping used the reforms bandwagon to attain leadership of the

Chinese Communist Party CCP

Frees up prices on some agro commodities: Dual pricing system in place

Allows farming households to retain surplus

Dismantles the commune system thereby allowing labor movement

Encourages TVEs


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The concurrent Open Policy initiative (1979)

This had 2 features: Increasing foreign trade of China and allowing foreign

Enterprises to invest in the local economy

The policy designated limited areas in China "as places with preferentialconditions for foreign investment and bases for the development ofexports: This was to later become the SEZ model for the world

This was of course accompanied by fierce resistance driven by the fear of againsuccumbing to imperial forces

By 1988, benefits of the policy were visible

A new Coastal Development Strategy announced in 1988 along lines of Taiwan

And other Asian tigers


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Shanghai in the Yangtze Delta Area, left out of the 1979 announcement wasDesignated under the 1988 program

The area that had received $ 3.3 bln in the 80s received the same amount in 1992Alone

Quickly became the financial capital of China; the new policy pumped lot of moneyInto infrastructure facilities to invite further K flows

Tax concessions, duty free imports of raw materials, and cheap labor droveInvestments into China at a tremendous rate

Big names such as Siemens, Hitachi, Boeing were some of the first to enterThe Chinese SEZs

In 1990, the Shenzen stock exchange was set up


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Accompanying problems

This phase had its own share of problems

The Chinese, with an entirely different set of norms for running enterprises, didNot fit the international bill on disclosure norms

Several companies listed on the Shenzen exchange for 3 years did not issueAnnual reports


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Chinas industrial setup (1979 to 1990)

SOEs were s.t. controlled input and output prices rendering many of them

Inefficient and unprofitable

This was handled by taking loans from a tightly controlled financial system,whose ballooning NPAs were to become a big issue later

Exposure to market led to some SOEs becoming unviable

In others, labor retrenchment drives labor to TVEs

Chinese policy of allowing NRCs to invest at home pays dividends

However, by 1986, picture not very encouraging despite 7 years of reforms


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TVEs- the new wave

As labor with experience and organization capacities shifted to TVEs, localadministrations started seeing merit in providing finance to these local outfits

Non Resident Chinese also saw a venture opportunity and pumped in capital

Regions started fiercely competing for capital: Competitive forces were now playingWithin the economy

Production was not the brand variety but rather standardized: toys, plastics,Chemicals etc.

The NRC venture capitalists were also buy back agents for these cheap butStandardized commodities

However, TVEs could not get capital infusion to become MNC giants

In 1988, with SOEs faltering, TVEs unable to grow, there was labor resentmentagainst the Government


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Inflation and corruption

By 1986, inflation, the biggest fear in China, starts creating problems

Prices that were freed jumped up unsustainably

Central bank seen to be riding the tiger: Growth was up but unsustainably so

Alongside inflation, inequality increased tremendously

Huge corruption was associated with sectors such as infrastructure, real estate,financial services etc. where Government involvement was high


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The Tiananmen Square 1989

Started as mourning by students for Hu Yaobang, a pro-market, anti- corruption

Official

Students who believed that the State had not gone far enough in reform terms wereJoined by workers who believed reforms had destroyed their livelihood

Corruption within Government ranks became common bone of contention within2 groups

From April to June, there were protests on the Square followed by a bloodiedmassacre by the Government


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Economic impact of the event

World Bank, ADB and several foreign Governments suspended developmentloans to China

FDI commitments were reversed; defense spending by China increased

Foreign investors skeptical about continuation of reforms

Trade off between political and financial outcomes becomes visible

Politically costly to allow free markets and financially costly to curtail them

But attempts by the Government to curtail free markets met with very stiff resistancefrom the local provincial administrations that had become relatively powerfulpolitically and financially

Economic reforms continued and growth rates became visiblyhigher in early 1990s


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Structural break in 1993

Most important year since it marks a change in Sino US relations

In 1993-4, China started relaxing curbs on sale of goods produced by enterpriseswith foreign stake in the domestic markets

US businessmen too seem to have overcome the mental barriers posed by theTiananmen Square protests and to start believing in continuation of Chinese reforms

FDI from US rose from an average of $0.22 bln per year before 1993 to more than$4 bln per year from 1993-99

At least till entry into WTO in 2001, Chinese exports into the USA did not largely

invoke sharp reactions since they were in sectors that were not strong in the USA:Thus Chinese exports were not yet leading to job loss in the USA

A new, more realistic peg to the dollar came into being in 1997


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Trends in RMB Yuan

Phase 1: 1979 to 1993

With reforms, the Central Bank allowed the Yuan to devalue to indicate itsmarket value: Emergence of dual rates

The exchange rate RMB/USD devalued from 1.5 in 1980 to 5.8 Yuan to $1 in1993

Phase 2: 1994- 97Managed float starts in 1994, with a real devaluation of 6.7%

Hurts S E Asian economies: One of the pre-cursors to the 1997 crisis

But strengthens by 4.8% against the $ in three years

As the S. E. Asian crisis spreads in 1997, a fixed exchange rate seen to be asource of stability


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Phase 3: 1997- 2005 (Fixed exchange rate system)

From 1997 to 2005, the Yuan was pegged at 8.27 to one dollar (perceived

as a huge undervaluation world over)

China used its FOREX build up in this period to stabilize its currency

Helped China successfully deal with a recession that had hit economiesacross the world

Also has been a key force in the Chinese belief that fixed exchange rateshelp in tiding over recessions: Is being mirrored today


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Phase 4: 2005 2008 (Back to the managed float)

In 2005, the rate was re-valued to 8.11 Yuan to a dollar under pressure from

many quarters, especially with the USA running huge current account deficitsand threatening tariff imposition

This phase has seen an approx. 5% appreciation every year as well asFOREX build up, signalling that the growth in BoP surpluses is greater thanthe appreciation allowed

Phase 5: 2008-2010 (Soft peg)In 2008, China pegged the Yuan at 6.83 Yuan to one USD and the era of thesoft peg began

For 23 months, the Yuan was held at 6.83 to a dollar for bringing stability in the

Face of a world wide recession


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Trends in FOREX

Stock of foreign exchange reserves crossed the astounding milestone of $2

trillion in April 2009 and stand at about $2.2 trillion today

China has accumulated a larger stockpile of reserves than any other country.

It accounts for nearly 30 percent of all reported foreign exchange reserves,almost quadruple its share of 8 percent in 2001

Largely contributed to the policy of keeping the exchange rate at an undervaluedlevel.


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Sources of the FOREX build up-

Chinas foreign exchange reserves increased by almost $1.8 trillion from

December 2000 to June 2009

Much of this increaseover $1.3 trillionhas occurred since the end of 2005

Where did the money come from?


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Where did the money come from?

1. Current account surpluses: From 2000 to 2008, CAS contributed 78 % of

Chinas reserve accumulation

Especially from 2004 to 2008, the current account surplus contributed 91%of the accumulation.

The goods trade surplus, which is a big component of the current account,

is responsible for 64 percent of the accumulation over the whole period.


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2. Capital account surpluses: From 2000 to 2008, the capital account surplusaccounted for 21 percent of Chinas reserve accumulation.

Capital account surpluses were far more important from 2000 to 2004,accounting for 51 percent of overall reserve accumulation.

From 2004 to 2008, the share of reserve accumulation accounted for bycapital account surpluses was only 11 percent.


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3. Valuation effects:

Reserves are reported in U.S. dollars

The dollar has experienced significant volatility against other major currenciessuch as the euro and the yen.

China does not report the currency composition of its foreign exchange

reserves, but is believed to hold about 70 to 75 percent in dollar-denominatedassets, with assets denominated in euros and yen accounting for most of theremainder.


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What is China doing with its reserves?

Treasury bonds and bills:

China has steadily increased its holdings of U.S. Treasuries.

At the end of March 2000, China held $71 billion of Treasuries.

By the end of March 2009, China held $768 billion.

2. Government agency bonds:

Until mid-2008, China had also been accumulating bonds issued by agencies suchas Fannie Mae and Freddie Mac.

In March 2000, China held just $19 billion in agency bonds.

In March 2009, China held $424 billion of agency bonds, accounting for 6 percentof the total outstanding amount of these bonds.


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3. Other uses:

China has used some of its reserves to recapitalize state-owned banks ($60 bln)

and create a sovereign wealth fund ($ 70 bln recently to capitalize the ChinaInvestment Corporation)

4. Building oil stocks

China is in the process of building oil reserves equal to 30 days of imported oil

Requirements by 2010 i.e. about 120 million barrels


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What are the global implications of this kind of reserve accumulation?

1. Diversification of reserve holdings threat to the global system:

A shift from $ denominated holdings to Euro denominated holdings couldseriously impact value of the dollar, leading to ramifications for the worldeconomy as we know it today

2. Foreign policy implications:

If used for goals of foreign policy, it could change the power balance in LDCs.

When China purchased $300 mln of Costa Rican bonds, Costa Rica shifteddiplomatic preferences from Taiwan to China


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3. Implications for the World Bank and the IMF:

These international FIs want to increase their capital base.

China has already agreed to purchase up to $50 billion worth of SDR-denominatedIMF bonds.

Over time, China will look to explicitly tying its contributions to permanent increasesin the IMFs resource pool to an increase in its voting rights and greater influence in

policies of these institutions

4. Implications on the oil demand

By 2010, China will stock a seventh of USs oil reserves, putting further pressureon already high oil prices


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Revaluation of the Yuan: The dynamics

2009-10 saw a major stand off between the US and China

US alleges China to be a currency manipulator: BoT deficits in the US seento be largely due to the Chinese policy of keeping their exchange ratepurposely undervalued

The Obama Govt. finds it convenient to nominate China to be a scapegoat forUS exports not picking up: Nov 2010 is the mid-term US congress election

World-wide feeling that China needs to revaluate: And quickly

But the US postpones its 15th April currency report : China not named amanipulator

President Hu visits Washington on 12th April

Some thawing is visible: Stage is set for China to take action on its own


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Possible repurcussions of a trade war:

The Sino-US trade supports about 3 mln jobs in China and around 3 mln in

the US as well

Any trade sanction by the US and possible reaction from the dragon thus couldland about 6 mln jobs in trouble

In June 2009, China held about $1.4 trln US assets, amounting to 16% of totalforeign portfolio holdings of the US financial assets

Even a rumor of a sell-off would lead to huge shocks in the US capital markets,at least in the short run

Paul Krugmans passionate speech on the strength of the US markets to absorbThese shocks further took the pressure on China to new levels


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G20 @ Toronto

Currency revaluation was to be a major point of discussion at Toronto on

26th

June

Between April and June, the US had issued several statements regardingThe issue

Chinese backlash focused on why steady exchange rates are important in

Turbulent times

Went so far as to say that the steady (read undervalued) Yuan allowed theAmericans to over consume even in the face of a recession!

Also spoke of the Plaza Accord and how it did Japan in


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The Surprise Announcement on 21st June

Beijing announced ahead of the G20 summit that it would allow more flexibilityInto managing the Yuan, thereby making the issue null and void

Has however ruled out the possibility of a one-off revaluation

Allowed around 0.47% appreciation in a single day, signaling end of the peg

Says that the level of about 6.56 Yuan is fair, but that it will allow the Yuan toClimb gradually to reflect market sentiments


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Markets caught unawares with the announcement.

Nearly every move that was expected did not happen

The dollar was supposed to go down. It went up

The Dow was supposed to go up. It went down

Treasuries were supposed to suffer. Prices picked up.

Gold was supposed to rise. It fell.

Silver did not know what to do and zigzagged throughout the day


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Reasons for China softening up

A revaluation helps China to get imports such as oil at more competitive rates

But what about exports?

Exports will slow down, thereby helping the economy to apply brakes on growthAnd cool down a bit

The need to cool down has been evident from yet one more feature: A hike inWage rates across the board

Allowing wages to rise (very recently done) is a masterstroke: Takes care ofLabor issues and at the same time, makes goods little more expensive abroad

In fact, this almost worked like a revaluation before it was announced!

Secondly, puts more disposable income in Chinese hands, thereby increasingthe internal market


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China is thus, now moving differently

It will attempt to allow its currency to play on the markets

From an investment destination, it will be viewed as one of the biggest markets

Remains to be seen whether the world disequilibrium will stand corrected

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