Why the Chinese Government Should Not
Devalue the Yuan
By Satya J. Gabriel
"We Chinese have backbone." Lu
Xun.
I am honored to have the opportunity to speak before the
governor of Jiangsu Province, my many colleagues here at Nanjing
University, and the many other distinquished members of this audience.
China is facing many challenges during this period of transition. These
challenges have been made all the more serious given the current economic
crisis sweeping through Asia and beginning to touch other continents, as
well. The future success of China, as a world economic power, depends upon
the myriad choices that will be made by the Chinese leadership during this
period. Despite the difficulties currently encountered, there is a great
deal of reason for optimism. China's leadership has been quite skillful
at managing the macro economy over the past twenty years of economic
transformation. Inflation has been tamed, even as the economy has grown
at rates thought unattainable by most development economists and others
schooled in traditional thinking. This leadership has proven capable of
experimentation, of finding creative non-traditional solutions to
problems, to combining lessons learned in Marxian economic theory and
functional relationships posited by mainstream economic theories. We would
do well in the so-called Western world to have as much openness to novel
and eclectic ways of thinking about economic concepts and relationships.
And much of the so-called Third World, the world of less developed
nations, could use leaders as focused on improving the economic well-being
of their citizenry. It is a good starting point, then, that China's
leadership has proven itself capable of dealing with economic problems and
finding creative, non-traditional, and often unexpected solutions time and
time again. Particularly at times such as we are now experiencing on the
global economic stage, it may be necessary to seek such creative and
non-traditional solutions, rather than follow conventional thinking.
For instance, many have argued that China will be forced to
devalue its currency to maintain competitiveness with other Asian
economies where devaluations have already taken place. This is a very
traditional economic response to a crisis of competitive devaluations. If
country X devalues and it competes in the same markets as country Y, then
country Y will be forced to devalue. But the competitive devaluations
that have rocked Asia provide an unusual opportunity for China. If China
does not devalue, what can be gained? This is a critical question. What
are the advantages of maintaining a stable yuan? Firstly, China gains
in regional and international stature by acting as a stabilizing force in
an environment of global crisis. The Chinese monetary authorities gain
credibility that will serve the national economy well for many years to
come. Credibility is hard to gain but can be enormously valuable in
making monetary policy an effective tool in overall economic management.
Remember always that psychology is one of the most important catalysts for
shifts in economic trends, for better or for worse. When investors,
whether of the portfolio or the direct type, BELIEVE in the credibility of
monetary authorities, then these investors are less likely to panic and
more likely to accept the currency of the country as of long-term, stable
value. This perception can help to create the very stability that is
necessary to sustained long-term growth and economic development.
Secondly, the relatively strong yuan can serve as a tool for
further "modernization" of the Chinese economy and infrastructure. The
current economic crisis has caused a drop in global input prices, raw
materials and technological inputs. China faces lowered imported input
costs as a result. This is particularly important in terms of imported
technology. The backbone of China's future prosperity is the nation's
ability to acquire more efficient technology for generating economic
growth and higher per worker productivity. This is also the key to
competitiveness in the long run. If Chinese workers produce at a lower
unit cost, due to improved technology, then China gains a strong advantage
over rivals focusing on the short-term (fleeting) benefits of lower unit
cost for tradable goods due to a devalued domestic currency. Indeed,
achieving lower unit cost of tradables by the mechanism of devaluation
may, in many instances, be an illusion. Often devaluation raises imported
goods prices to such an extent as to wipe out any potential competitive
advantage. Only the most labor intensive goods are likely to gain
competitive advantage and only then if domestic laborers can be forced to
accept the lower real wages that result from the devaluation. If laborers
are organized and resistant to such a depreciation in their real wages,
then they may force wage increases that wipe out all the possible
competitive gains of a devaluation.
Thirdly, devaluations typically generate capital flight. Hard currency
is siphoned out of the country in question to safer havens. Thus, a
devaluation has the paradoxical result of worsening the capital account
and fostering hard currency illiquidity in domestic financial institutions
and firms. The difficulty in stabilizing the exchange rate (which is as
much a result of psychological, as economic, factors), coupled with the
collapse in securities markets, makes it increasingly difficult for firms
to raise funds, in both equity and bond markets (as well as from other
sources of loans), and thus places these firms at a competitive
disadvantage vis-a-vis firms in more stable markets. More seriously, many
firms carrying heavy hard currency debt loads are faced with insolvency.
Defaults and worsening capitalization ratios among banks produces a credit
squeeze, worsening sentiment among investors and others, falls in
government revenues from taxes, and so on in a chain reaction of negative
consequences. Fortunately for China, most of the debt held by domestic
firms, particularly state-owned enterprises, is in renminbi. This allows
for the possibility of a more orderly solution to the debt problems faced
by the banking system. Nevertheless, a devaluation of the yuan runs
the risk of setting many of the aspects of this aforementioned chain
reaction into effect. Clearly, such a financial collapse is not desirable
and not conducive to solving the structural problems that must be solved
if China is to remain on its current and impressive growth path.
We must also note that the most serious problem facing Chinese
exporters is the drop in aggregate demand from other Asian economies.
Sixty percent of China's exports were going to other Asian economies prior
to the region-wide economic crisis. The fall in demand from these Asian
economies is the most serious impediment to maintaining export growth. A
devaluation in the yuan would only push back the recovery of the
region and thus make matters worse for China, not better. China must act
in the
interest of restoring economic stability and growth to the entire Asian
region. By doing so, China gains politically and economically.
In the future, economic growth in China will be far more dependent upon
the growth in domestic demand than upon export growth. Rising
incomes can stimultate a boom in consumer spending that will provide
the foundation for increased sales by state-owned enterprises,
town-village enterprises, joint ventures, and private
enterprises. The growth in domestic demand will make China
even more attractive for foreign direct investment. The growth in
foreign direct investment plus the growth in capital spending by
Chinese firms will further stimulate demand growth, creating a
virtuous cycle.
But can the state-owned enterprise sector play its part in this
virtuous
cycle? The ability to foster the successful restructuring of Chinese
state-owned enterprises is a key element in both stimulating domestic
capital spending and in making sure that Chinese firms can fully benefit
from the demand-side growth. By taking advantage of the current
environment to import
key technologies, state-owned enterprises can replace older technologies,
improve production processes, improve the quality of products, innovate
new products and new production techniques, and close down factories that
are too expensive to retrofit with appropriate technology.
In addition, this
period of difficulty represents an excellent opportunity to restructure
the finances of state-owned enterprises. Rather than putting financial
restructuring on hold until the regional crisis ends, the Chinese
government can take important steps to improve the balance sheets of
state-owned enterprises and to bring new partners into the process of
improving the management of these enterprises. This can be done by
replacing debt with equity, which would also greatly help the banking
sector and free up more loanable funds for productive investment at a time
when there is a high risk of overly tight credit. Less debt on the
balance sheets of state-owned enterprises would also reduce debt related
claims to surplus value, freeing more surplus value for new technologies
and new workspaces, and reduce bankruptcy risks from hardening budget
constraints. More equity would provide the potential for the government
sharing the ownership burden with other parties, including other firms,
even foreign firms, who might participate in finding creative ways to
improve the performance of these firms and to reduce agency costs.
The current crisis in regional economies provides an
excellent backdrop for bringing about these changes. If productivity in
the state-owned enterprises can be increased and management motivated to
focus on value creation, then China's state-owned enterprise sector can
become competitive with the transnational firms of the OECD nations,
creating a context for successful entrance into WTO. If this moment is
missed, it may be more difficult to bring about the necessary changes in
future periods.
Copyright © 1999 Satya J. Gabriel, Mount Holyoke
College.
All Rights Reserved.
Permission is granted to use this text, with proper
credit to its author, for non-commercial educational purposes, provided
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