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Summary of Nanjing University Speech
May 1998 

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.

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