Potential financial-stability issues associated with changes to the renminbi exchange rate must be considered with great care.
There has recently been intensifying political pressure on the Mainland authorities on the exchange rate front. This is despite the significant appreciation in the real effective exchange rate of the renminbi since the beginning of 2005, amounting to about 8%, although the appreciation against the US dollar, including the step adjustment in July last year, is just over 3% in nominal terms. The pressure, understandably, has come largely from the United States, where the external imbalance has been growing, reaching almost 6.5% of GDP.
The relationship between the trade balance and the exchange rate is a complex one, as economists readily appreciate. Whether on a multi-lateral or a bilateral basis, the trade balance is not always sensitive to changes in the relevant exchange rate and may indeed not even move in the desired direction. But the view that an exchange rate appreciation will make imports cheaper and exports more expensive to trading partners often prevails to such an extent that the price elasticity of demand and supply of imports and exports, and their interaction, are ignored. That view cannot be ignored by policy makers, because it may be the legitimate view of the many voters who are exporters and workers employed by exporters, and who are capable of influencing national trade and other policies. Indeed, there is now a real threat of resurging trade protectionism or even a trade war, which obviously would not be good for the global economy.
It is a pity that the focus of political attention has shifted to the renminbi exchange rate as a solution to the global imbalance. This is I think partly a reflection of the lack of a global consensus on a problem, measured by the current account deficit of the United States, that has been getting bigger and bigger, although there is consensus that the problem is an unsustainable one. Many economists would agree, however, that exchange rate changes generally, and appreciation in the renminbi exchange rate specifically, are not the solution to the global imbalance, at least not the orderly solution that all policy makers are hoping for. There are those who think that, if the exchange rate changes are large enough, the insensitivity of the trade balance to exchange rate changes notwithstanding, the necessary adjustment would eventually come and the size of the global imbalance decrease. The problem with this argument is that it ignores the financial stability issues associated with large exchange rate changes.
The globalisation of financial markets and the advancement of information technology have changed market dynamics to such an extent that they may be beyond the comprehension of many participants operating in individual financial systems and the policy makers responsible for them. The Asian financial crisis in 1997-98 was a clear manifestation of this. We may have learnt something from that crisis, but I fear that the level of appreciation of financial market dynamics and the related level of risk-management skills, in both the public and private sectors, are still fairly inadequate.
It may be useful just to think through what the market dynamics might be like, if an appreciation of the renminbi exchange rate against the US dollar of the size that has been called for were to take place. There would certainly be a large impact on the exchange rates of developing economies, particularly those in Asia. The appreciation of these currencies might be as large as that of the renminbi, or even larger given the prevalent use of these markets or currencies as proxies for taking a position on the renminbi. There would certainly be much volatility associated with this, which might be magnified through derivative products. It is doubtful whether institutions inside and outside the financial system would be in a position to manage the exchange rate risks arising from the large appreciation and the volatility that would inevitably surround it.
Further, the sharp increase in the US's current account deficit implies a rapid rise in claims against the US assets, possibly by both the official and private sectors of its trading partners. As their domestic currencies appreciate sharply, there would inevitably be shifts, in both the official and private sectors, in the allocation of assets back into domestic assets or assets denominated in currencies that are appreciating. There is a chance that this might be disorderly, as many attempt to rush through the door, albeit a fairly large door, given the size of the US financial markets. This might have implications for long-term interest rates in the US, which might in turn affect the rather stretched housing market and consequently the consumption of those who have been relying on the extraction of housing equity in a hitherto rising market.
Although I do not claim to be an expert on politics, one thing should be quite obvious; if political pressure must be applied on the exchange rate of the renminbi, however legitimate it may be from the perspective of those applying it, it is in the interests of the US and everyone else in the global economy that it should be applied with great care.
Joseph Yam
27 April 2006
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