The Nikkei Financial Daily (Market Eye Column), 31st July 2006
China’s trade surplus rose again in June and has amounted over the past year to US$ 133 bn. Although there are signs that growth is slowing, the Chinese government has needed to intervene massively in the foreign exchange market to prevent their currency appreciating in value.
This intervention has been widely attacked, but it has had one beneficial impact, in that it has contributed to restraining inflation in the rest of the world.
Rapidly growing economies naturally have rising real exchange rates. Japan has provided an excellent illustration of this in the past. During the 1960s and 1970s, when its economy was growing particularly fast, its exchange rate appreciated around 3% p.a. against the US dollar.
A country’s exchange rate can appreciate in real terms either because the nominal exchange rate rises or because it has a faster rate of inflation than the rest of the world.
For the past decade or more, China has had neither above average inflation nor a rising nominal exchange rate. This has had two results. One is that the prices of its exports have been kept down and the other is that the undervaluation of its exchange rate has steadily increased.
By keeping down the price of its imports, China has made an important contribution to restraining inflation in the rest of the world. It seems unlikely, however, that this process can continue for much longer. If China keeps intervening in the currency market to prevent its exchange rate from appreciating, then it will have increasing difficulty in preventing a rise in its domestic inflation.
When countries increase their foreign exchange reserves, they need to borrow at home to finance the purchases of foreign currency and it is very difficult to prevent this borrowing from increasing domestic liquidity.
How much and how soon this matters depends on many different factors, but a key one is the scale on which it is carried out. If the currency intervention makes only a small difference to the rise in domestic liquidity, then the process can continue almost indefinitely. But this is not the situation in China today. Its foreign exchange reserves already amounted to US$ 720 bn. at the end of 2005, equivalent to 31.8% of GDP, and have recently been growing at over 40% p.a.
So far, the attention of financial markets has been concentrated on whether China will reduce its intervention and allow its currency to appreciate in nominal terms. This is likely to change. If the world does not suffer a recession within the next year or two, and China continues to intervene in the foreign exchange markets, it seems likely that the build up in domestic liquidity will start to show up in a rise in Chinese inflation.
It would probably be better for the world economy if China allowed its currency to appreciate in nominal terms, rather than to have its real exchange rate rise through a pick up in inflation. This is because the former process would be easier to control.
China has shown that it can peg successfully its nominal exchange rate. It should not, therefore, have great difficulty in allowing it to appreciate at a few percentage points a year. On the other hand, experience shows that, once inflation starts to pick up, the expectations to which this gives rise lead quickly to an acceleration of the rate of inflation which can then only be brought back by a sharp slowdown in economic growth.
Whatever route is chosen, it seems unlikely that the downward pressure on world inflation that has come from China’s increasingly undervalued exchange rate will last for much longer. This need not push up world inflation, however, provided that other deflationary pressures rise to offset it.
It seems likely that the pegging of China’s nominal exchange rate has had a useful impact on offsetting the inflationary pressures arising from the rapid rise in the price of oil. If the oil price were to stabilise at its current high level, these pressures might again balance out. A weakening of the deflationary impact of China will, however, increase the vulnerability of the world economy to the price of oil.