China Staves off Devaluation

China Staves Off Devaluation

Introduction

China has come to the forefront of the international finance scene following the East Asian financial crisis for two reasons. First, the post reform Chinese economy closely resembles the other East Asian countries. China experienced significant levels of growth led by exports, with a rapid expansion in labor-intensive exports in its early stage of development. Rapid growth was accompanied by a rapid increase in domestic savings and massive inflows of foreign capital (Perkins, 1986). The banking sector dominated financial intermediation and the ratio of non-performing loans was high. Estimates put non-performing loans at China's four leading banks at 25 per cent -- far higher than in South Korea or Thailand before they fell prey to the Asian contagion. Would China be the next victim of the crisis? (Dornbusch, 1997).

The second reason why China came to the forefront of the international finance scene following the East Asian financial crisis is China's economic performance became the key to the current economic stability of East Asia. During 1997 - 1998, China was the only country in the region to sustain significant growth. In particular, maintaining the stability of the renminbi, was seen as the last hope of achieving equilibrium in the regional currency system and facilitating recovery (Garnaut, 1998). The Chinese government took up the challenge and made a firm commitment not to devalue the renminbi in the short term. China's decision not to devalue in the face of internal pressures has been credited for stabilizing Asia's economic situation.

Most economists predicted that a currency crisis was unlikely to damage China's economy or trade; its macroeconomic fundamentals were healthy and it had the extra insurance of capital account controls. However, surrounded by neighbors in trouble, China could help but be somewhat effected by the larger, regional situation. The rest of the world continued to watch and worry about how much longer China would be able to defend its overvalued currency and still remain internationally competitive on an export basis (Song, 1998).

This paper will begin by examining the economic background of China. We will see how China came to be in the position to devalue its currency as well as address some controls that were used to inhibit the devaluation. The paper will continue by examining the currency and trade noting how China's reliance upon export allowed them to move through the crisis with fewer difficulties than its neighbors. Lastly we will examine the current situation China is in and how not devaluing their currency helped neighboring economies. Also, we will project how devaluing may have provided positives and negatives to China's own economy.

Background

For more than 2000 years the Chinese economy operated under a type of feudal system. Land was concentrated in the hands of a relatively small group of landowners whose livelihood depended on rents from their peasant tenants. Adding to the peasant farmers' burden were agricultural taxes levied by the imperial government and crop yields subject to drought and floods. Under these conditions agriculture remained essentially underdeveloped. The conclusion of the Opium War (1839-42) formally began a period of Western entrance into China from the coastal treaty ports. Railroads and highways were constructed, and some industrial development was begun. Such activity had little impact, however, on the overall Chinese economy. In fact, rather than coming together through trade, China was carved up into a number of competing colonial spheres of influence.

By the 20th century China had become a politically and economically weak nation, dominated by foreign powers. The Chinese Communist party emerged in the 1920s in the midst of a mounting economic crisis caused by foreign intervention and increased landlord influence in the countryside. For more than two decades, the Chinese Communist party expanded its control over large rural areas by introducing an agricultural program based on the control of rent and high interest rates, and by giving power to peasant associations. On Oct. 1, 1949, the Communist party successfully established a unified national government and economy on the mainland for the first time since the end of the imperial period in 1912.

In 1978, the Four Modernizations program was launched. It called for the modernization of the agriculture, industry, national defense and science and technology by the end of the century. This was so that the economy can take its place in the front ranks of the world. A 10-year plan from 1976 - 85 stressed improvement in economic management and a larger role for private and collectively owned (as opposed to state-owned) enterprises.

The policies introduced in October 1984 called for further decentralization of economic planning and for increased reliance on market forces to determine the prices of consumer goods. The 5-year plan from 1986-90 anticipated an annual economic growth rate of 7%, but the economy slowed temporarily after a political crackdown in 1989. In the early 1990s the Chinese economy resumed its robust expansion, and government planners forecasted average annual growth rates of 8-10% through the end of the decade.

China's GDP grew at 8.8% in 1997 and 7.8 percent in 1998. Strong growth momentum was sustained in 1999, with a slightly reduced GDP growth rate of 7.1% (State Statistics Bureau, 1999). This is remarkable, considering the negative growth rates experienced by most of China's neighbors for the same time period.

The monetary environment, measured by the growth rate of the money supply, was tight in 1998 and early 1999. See table below:

Table 1: China: Macroeconomic Indicators, 1995-9

1995 1996 1997 1998 1999

Real GDP (% real change) 10.5 9.5 8.8 7.8 7.1

Gross industrial output (%real change) 20.3 16.6 13.1 8.9 9.6

Inflation (CPI % change) 17.1 8.3 2.8 -0.8 -1.4

Growth of M2 Broad Money supply (%) 29.5 25.3 19.6 14.8 14.7

Exchange Rate (RMB/US$) 8.32 8.30 8.28 8.28 8.28

Fixed Asset Investment (% nominal change 13.3 10.6 9.0 14.1 8.9

Retail Sales (% nominal change) 26.8 20.1 10.2 6.8 6.7

Exports (% changes in US$) 23.0 1.5 21.0 0.5 6.1

Imports (% change in US$) 14.2 5.1 2.5 -1.5 18.2