October 19, 2007
My purpose in being here today is to explain the IMF’s approach to surveillance of China’s economy. I am not the IMF "truth squad", sent to correct factual errors made by Mike Mussa.
At the start, though, I must admit that I do not understand the basis for Mike Mussa’s assertion that essentially everyone, but him and possibly Tim Adams have been wrong in their approach to surveillance of China’s exchange rate. When I sort through Mike’s paper and pare his arguments down to their essence, I am not surprised to find that he is simply advocating the traditional IMF approach to surveillance—which is exactly what we have been doing for the last several years.
In looking at what the IMF has done, you have to keep in mind that the public record on our work is really just the tip of the iceberg. A significant part is done out of the public eye. It has to be that way if we are going to play a role as a trusted policy adviser—to have “a seat at the table” as Mike puts it—especially on a sensitive issue such as the exchange rate. As a consequence, the IMF at times makes a handy target and a convenient scapegoat.
In broad policy terms, the staff report on the Multilateral Consultation exemplifies where the IMF stands on surveillance of the economic policies of the major economies that participated in that exercise (China, the euro area, Japan, Saudi Arabia, and the United States). The policy plans laid out in that context were judged to meet the objective set by the IMFC of bringing about an orderly adjustment in global imbalances over time through policies that were in each individual countries’ own interest.
But those policy plans did not come out of thin air; to a significant extent, they reflect results from our regular bilateral and multilateral surveillance work.
In the case of China, since 1999—long before there were any questions about the value of the exchange rate—the IMF was pressing the Chinese authorities to increase the exchange rate’s flexibility.
The record on the IMF’s position is reflected in public statements by IMF management and senior staff in various venues. For instance, the current Managing Director has made several trips to China during his tenure, meeting with Premier Wen Jiabao on three occasions, and during each trip and in subsequent public statements and remarks, the MD has stressed the need for greater exchange rate flexibility and an appreciation in the renminbi.
A clearer view on the IMF’s position comes from the staff reports for the annual Article IV consultations with China, which became publicly available starting in 2004. These reports reflect how the staff’s position on the renminbi has evolved in line with economic developments in China. In the 2004 report, the staff said:
• The staff continued to stress that greater exchange rate flexibility would enhance China’s ability to pursue an independent monetary policy...
• The staff also maintained its view that it is difficult to find persuasive evidence that the renminbi is substantially undervalued... [The report in other parts, however, makes clear that the renminbi was undervalued and the exchange rate needed to be adjusted.]
• While recent strong capital inflows potentially complicate the introduction of flexibility, it is best for China to move from a position of strength, which should serve to limit adverse effects, and a move to greater exchange rate flexibility should not be unduly delayed.
With the current account widening further in 2005, the report said:
• Although it is difficult to reach firm conclusions about its extent, the continued strengthening of the external balance points to increased undervaluation of the renminbi, adding to the urgency of making a move...
• Greater exchange rate flexibility continues to be in China’s best interest, with an early move desirable....
• ...the continued strengthening of China’s external position has added to the urgency of making a move.
• The costs associated with a continued delay in moving toward greater exchange rate flexibility are growing...
This was written in June 2005; China’s new exchange rate regime was introduced in July 2005. At that time, IMF said that the change represented a move in the direction of greater exchange rate flexibility, and we encouraged the authorities to utilize fully the scope for flexibility in the new exchange arrangement.
In 2006, the staff report said:
• ...developments point to the currency as being undervalued and that this undervaluation has increased further since last year’s Article IV consultation...
• Now is the time to more fully utilize the flexibility afforded by the current exchange rate system and allow greater movement in the renminbi-U.S. dollar exchange rate and a further significant appreciation of the currency in nominal effective terms...
Given this record, I admit to being absolutely puzzled about how Mike Mussa comes to the conclusion that the IMF has not “pressed” China on the exchange rate issue and that the IMF “speaks only vaguely about the desirability of greater exchange rate flexibility”. His comments give the distinct impression that he is not completely familiar with what the IMF has publicly released on this subject.
Because China has persisted in heavily managing its exchange rate, it has created for itself a major problem with macroeconomic control. Trying to contain investment and credit growth has been the major preoccupation of macroeconomic policy over the past four years. It has not and will not be possible to solve this problem without a faster pace of renminbi appreciation to provide scope for monetary policy to operate.
Maybe part of what bothers Mike Mussa about the IMF’s performance on China or a potential source of his misunderstanding is the emphasis that we place on the fact that, while appreciation of the exchange rate is important, it alone will not be enough. Only by rebalancing its economy away from heavy reliance on investment and exports for growth toward consumption will China be able to sustain rapid growth and provide a permanent contribution to resolving global imbalances.
The exchange rate is only one of several key prices in China that are badly distorted. Energy, other utilities, land, and pollution are others. But above all the cost of capital in China is very low. We have laid out the impact of these price distortions on investment in a working paper (Aziz, 2005); we have looked at the effects on consumption in another working paper (Aziz and Cui, 2006); and the overall case for rebalancing the economy is laid out in a September 2007 Finance and Development article by Aziz and Dunaway.
The exchange rate and the cost of capital are linked. No meaningful increase in the cost of capital can take place without an appreciation of the exchange rate. If the cost of capital and the exchange rate are raised, credit and investment growth will be slowed and the composition of investment will shift away from the production of tradable goods.
If at the same time, bank intermediation is improved and the capital markets are permitted to develop further, there will be a better allocation of capital.
One key element in financial market reform is removing the ceiling on bank deposit rates in China, which—with appreciation of the currency—will raise household real incomes and boost consumption over time.
The government also has to play a major role in rebalancing the economy by removing uncertainties that have contributed to very high precautionary savings, particularly in the areas of education, health care and pensions.
The authorities recognize that China’s economy needs to be rebalanced along these lines, and this is reflected in the China’s policy plans put forth in the context of the Multilateral Consultation. IMF also has argued that it is critical to maintain focus on the appropriate primary objective which is rebalancing China’s economy. Reducing the current account surplus should not be the goal, however. Only by rebalancing the economy will a permanent reduction in the current account surplus be achieved.
So we agree on the basic policies. The key remaining difference between the IMF staff and the Chinese authorities is the speed of implementation. We continue to warn the Chinese that it is not costless to them to delay reform. Distortions in the economy grow day by day. By proceeding slowly, they also test the patience of the rest of the world. So we closely monitor the situation and continue to push for the speedy implementation of reforms.
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