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Mr. Chairman, thank you for the opportunity to testify before this committee on the important issue of China's exchange rate regime and its effects on the US economy. My Institute colleague, Nicholas Lardy, and I have recently been analyzing China's currency regime and this afternoon, I would like to share with the committee five of our main conclusions.1 First, so long as China maintains controls on capital outflows, runs surpluses on both the overall current and capital accounts in its balance of payments, and accumulates international reserves in large amounts, there is a compelling case that the Chinese currency, the renminbi (RMB), is significantly undervalued. Our preliminary estimates suggest that the undervaluation of the RMB is on the order of 15 to 25 percent. These estimates of RMB misalignment can be obtained either by solving a trade model for the appreciation of the RMB that would produce equilibrium in China's overall balance of payments, or by gauging the appreciation of the RMB that would make a fair contribution to the reduction in global payment imbalances, especially the reduction of the US current-account deficit to a more "sustainable" level. Both approaches produce similar answers. Those who argue that the under-valuation of the RMB is much larger-30 to 40 percent or more—often confuse China's large bilateral trade surplus vis a vis the United States ($100 billion in 2002) with its much smaller overall current-account surplus ($35 billion). Adjusting for the overheating of the economy and other factors, China's "underlying" current account surplus in the first half of this year was probably about 2½ or 3 percent of GDP. Equally relevant, China's surplus on foreign direct investment (4 percent of GDP on average during the 1999-2002 period) has been considerably larger than the surplus on the overall capital account (1½ percent of GDP). It is the overall current and capital-account positions that matter for judging the extent of exchange rate misalignment—not bilateral trade balances or components of the current and capital accounts. In a similar vein, those who conclude that the degree of under-valuation of the RMB is small—10 percent or less—often ignore the fact that China makes extensive use of imported inputs to produce exports. China's role as a regional processing center means that it takes a larger revaluation to change the trade balance in China than it does in economies where imported inputs figure less prominently in exports. Admittedly, when China does decide to liberalize significantly capital outflows, it won't take a huge degree of international diversification of household savings deposits to put strong downward pressure on the RMB—but that doesn't alter the conclusion that right now the RMB is undervalued. Second, a revaluation of the RMB is in China's own interest as well as in the interest of the global economy. If China does not revalue the RMB, net capital inflows and the large accumulation of international reserves (about $135 billion over the past 18 months alone) will continue. With its mountain of bad loans, China should not permit capital inflows and reserve accumulation to exacerbate the already excessive expansion in bank lending, money supply growth, and investment. In the first half of 2003, the increase in bank loans outstanding relative to GDP rose to 38 percent—an all time high, while the investment share of GDP rose to 42 percent—also an all time high. Although the process of "sterilizing" the effects of reserve increases on the base money supply has so far been less onerous in China than in many other emerging economies, experience shows that sterilization typically becomes more costly and less effective the larger it is and the longer it goes on. The primary domestic risk of an undervalued exchange rate is that it will handicap China's efforts to rein-in the pace of credit expansion and to improve the quality of bank lending decisions.
Approximate Word count = 2463
Approximate Pages = 9.9
(250 words per page double spaced)
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