China's Monetary Policy: Lessons for IndiaA commentary by Kalpana Kochar and Jahangir Aziz
Published in the Business Standard
July 5, 2007
There's no magical solution China has found that India needs to emulate.
For every complex problem there's a solution that is simple, neat and wrong.
China and India—two countries comprising a third of the world's population and more than half the world's poor—have grown at 9 per cent on average in the last five years. Both countries have experienced large foreign exchange inflows. But China—in contrast to India—has seemingly managed this remarkable achievement while limiting currency appreciation and interest rate increases and also keeping inflation low. This has prompted some commentators to state that the RBI "should...learn how the Chinese do their exchange rate management" (Surjit Bhalla, Business Standard, May 12, 2007). What explains the differences in the two countries' experiences and what lessons can India learn from monetary and exchange management in China?
We would argue that China has not found a magical solution to keeping inflation down, limiting interest rate increases, holding off faster currency appreciation and accumulating reserves, all at the same time. Its economy is paying a price in the form of widening economic imbalances, which increase the odds of an eventual painful adjustment. The lesson for India is that allowing the rupee to appreciate helps to cool an overextended economy without driving interest rates so high as to kill off much-needed investment. Resisting nominal exchange rate appreciation because of concerns over export competitiveness is counterproductive—the resulting higher liquidity and inflation will inevitably erode competitiveness by making domestic goods more expensive. A much more sustainable strategy would be to achieve cost efficiencies through urgent infrastructure upgrades and education and labour market reforms.
In the last five years, China's economy has grown by an average of 10 per cent and India's by around 8 per cent. Non-food, non-energy inflation in China is around 1 per cent, while India's inflation has jumped to well above 6 per cent. At the same time, the People's Bank of China (PBC) has limited renminbi appreciation to less than 7 per cent against the dollar since July 2005 and has raised interest rates by less than 100 basis points. On the other hand, the rupee has appreciated by around 14 per cent over the same period and interest rates have risen by over 200 basis points.
Why the difference? The short answer is that India's economy is supply constrained-rapid growth in consumption (and more recently investment) demand is pushing up prices because the economy is hitting capacity constraints caused by insufficient past investment. Meanwhile, China's economy is demand constrained: a torrid pace of investment in the past has created excess capacity that domestic consumption cannot absorb. The PBC needs to tighten monetary policy to curb investment growth to prevent this excess capacity from causing future price declines and eventual loan defaults. The RBI needs to tighten monetary policy to keep current inflation from getting out of hand, while ensuring that the investment that is badly needed to ease capacity constraints can be sustained.
The long answer requires an updated understanding of the situation in China today. Despite strong growth and low inflation, in March 2007, before the annual session of the National People's Congress, Premier Wen Jiabao cautioned, "China's economy is unstable, unbalanced, uncoordinated and unsustainable." Over the last few years, growth has been led by investment and exports. Investment rose from 38 per cent of GDP in 2002 to 43 per cent of GDP in 2006, while the current account surplus jumped from 2.5 per cent of GDP to nearly 9.5 per cent of GDP or $250 billion. In contrast, private consumption fell from 47 per cent of GDP to 36 per cent of GDP, almost entirely because of a similar decline in the share of household income. With consumption unable to keep pace with the increase in capacity created by the rise in investment, the excess has been sold abroad, raising the trade surplus.
Encouraging investment growth are a plethora of tax incentives; low costs of land, energy, water and—most important—capital; and the undervalued exchange rate. The low cost of capital, averaging around 2 per cent in real terms in the last five years, has skewed production toward capital-intensive techniques, and has dried up job creation; the 10 per cent growth in the past few years has created only 2 per cent employment growth.
The undervalued exchange rate has also encouraged import substitution. The caricature of China as an assembly line, processing imported inputs into cheap consumer goods, is fading into the recesses of history. Assembly-line exports make up less than 10 per cent of China's trade surplus. Instead, China's exports are predominantly capital-intensive goods with rising domestic content. As a result, the economy has become more dependent on exports and more vulnerable to fluctuations in external demand.
These imbalances raise concerns that China's rapid growth may not be sustainable. Continued expansion of capacity could eventually lead to price declines that would cut into profits, increase loan defaults and undermine investor confidence. The price declines could be worse if, at the same time, the global economy slows and protection by and/or competition from other countries makes it more difficult for China's firms to sell their products abroad.
Recognising this, China's government has embarked on an ambitious reform agenda to rebalance growth away from investment and exports and towards consumption. But the PBC's efforts to tighten monetary policy have been hampered by the management of the exchange rate. Specifically, more aggressive increases in interest rate are impossible, as they would encourage capital inflows adding to the already high liquidity in the banking system. Instead, the PBC has had to rely on administrative controls on credit to curb investment and credit growth. The resulting financial repression has directly conflicted with the need to develop the financial system and created further economic distortions. A sustainable solution to the problems that China faces requires more effective use of monetary policy, not more administrative measures. And the obvious way to do this is to let the renminbi appreciate more quickly.
To summarise then, the lesson for China is that relative prices—including the exchange rate—need to reflect underlying economic forces so that households and firms can make the right decisions. Distortions only serve to encourage decisions that sooner or later have to be readjusted, and often that readjustment is painful. And the lesson for India is that exchange rate flexibility combined with efforts to improve efficiency through urgent infrastructure upgrades, and education and labour market reforms will yield the most enduring gains in competitiveness.
Jahangir Aziz heads the China division at the IMF, and Kalpana Kochhar heads the IMF's India team