The debate to chart China’s economic strategy

The recent downgrading of the US credit rating was received with shock in numerous capitals including Beijing. Amidst reports of a likely global economic downturn, China’s leadership is additionally confronted with growing inflation and rising food prices. Inflation accelerated last month to its fastest pace in three years, with consumer prices rising by 6.5%. Rising food prices were a prime contributor, adding to the leadership’s concern.

There is speculation in Beijing that, prompted by these concerns, China’s top leadership revived a practice suspended since 2003 and met over one and half months this June at the northern seaside resort of Beidaihe. The economy and economic strategy were at the top of their agenda.

China’s leadership is very sensitive to any threat to ‘social stability’. Premier Wen Jiabao bluntly warned in March this year that rising prices, gap between the rich and poor, and corruption could ‘even hit the government’s control of power.’ While it is felt that an annual GDP growth of 7% would generate adequate employment, rising food prices are a more immediate worry. The effort is to keep the Consumer Price Index (CPI) under 4%.

Recent official Chinese reports reveal an increase in prices of consumer items. The price of eggs rose by 16.1% over last year while edible oil prices had risen by 21% in 50 cities across China. Ministry of Commerce data revealed a 38% increase in pork prices from the beginning of the year in 36 major Chinese cities. Chinese authorities were compelled to release stocks from 2,00,000 tons of State-held reserves of frozen pork into markets in eleven provinces. The price rise had another deleterious effect. Farmers producing grain are reluctant to sell crops at current prices and grain buyers report that purchases dropped by 90% this year. The drought of past months has adversely affected rice and cereal crops, compounding problems. Intervening to curb the trend, the People’s Bank of China informed banks that it will begin applying reserve requirements to some of the money that has been channeled into off-balance sheet lending.

The economic situation has, however, sparked a larger debate inside China, including advocating internationalisation or rapid appreciation of the Renminbi (RMB) though that could mean seriously slowing down GDP growth. Late this August, former Director General of the prestigious Institute of World Economics and Politics of the Chinese Academy of Social Sciences, Yu Yongding, criticised China’s large scale purchases of US Treasury Bills.

He observed that between June 2009-10 China’s holdings of US government debt had increased by US$351 billion! He recommended that the central bank not intervene in the global foreign exchange market and allow the RMB to float freely, despite the considerable impact on the trade balance since the RMB is ‘significantly undervalued’. China would have to accept reduced exports and increased unemployment, but its good current financial position, he said, will enable it to help businesses and workers get through difficult times.

Ding Zhijie, Dean of the School of Banking and Finance, University of International Business and Economics, Beijing, later recommended appreciation of the RMB. Recalling that since 2005, China has adjusted the RMB exchange rate upward twice without causing economic concussion, he asserted this will have positive long-term structural and speculative influences on the Chinese economy. He suggested reform of the RMB exchange rate be accelerated now.

Yao Yang, Director of the China Centre for Economic Research (CCER), Beijing, wrote (August 18) that China ‘should be very worried’ at the recent downgrading of US government debt since more than 60% of its US$ 3.2 trillion foreign exchange reserves are in US Dollars including US$1.1 trillion in US Treasury Bonds. He said if the US doesn’t default, the losses in the balance sheets of the People’s Bank of China (PBoC) will be small. A falling dollar will also make US goods cheaper for Chinese consumers and gains from these purchases will offset the PBoC’s losses. Yao Yang asserted that allowing appreciation of the RMB could be ‘suicidal’ as a CCER study had pointed out that a 20% appreciation against the US Dollar would mean a 3% drop in employment, or 20 million jobs.

Instead, he recommended ‘internationalisation’ of the RMB.

Significantly, on August 24, China’s Ministry of Commerce released a draft regulation on cross-border direct investment in RMB to be made effective by September. If implemented, the rules will expand channels for overseas-acquired RMB funds to flow back into the country and is expected to give a push to the RMB’s internationalisation drive. It will allow foreign investors to make direct investments in China with RMB legally obtained overseas.

While the debate will intensify, the trend seems to favour internationalisation of the RMB accompanied by gradual appreciation.