When Beijing relaxes the reins on one economic policy, it might tighten them on another. That could be what’s at work behind China’s efforts to rein in its external surpluses by reforming energy prices and liberalizing its currency.
Energy price reforms and exchange rate liberalization should go hand in hand, allowing market forces to play a greater role, because previous rigid controls on both have caused distortions harmful to sustainable economic growth. But Beijing has been reluctant to make sustained moves on either front because of ripple effects that increase export costs and hurt jobs growth.
Having raised domestic fuel prices last month to bring them closer to global market levels, China is now less likely to keep acting aggressively on the currency front. There is a growing recognition in Beijing that increased energy and environmental costs for businesses will raise export prices and could achieve the same objective as a stronger currency. Of course, how much the yuan will appreciate in the second half is subject to many factors over which Beijing has little control, such as the strength of the dollar on global markets.
Beijing has also already moved further on the exchange rate front, another factor that could mean officials are likely to favor energy price reforms over currency appreciation for now. The yuan has risen by 7% against the dollar this year and 21% since 2005. Meanwhile, despite an 18% jump in China’s domestic fuel prices on June 20, local prices are still about 18% below US levels. Market players anticipate another fuel price increase in the fall. But the futures market indicates investors believe the yuan will appreciate only 5% in the next 12 months because inflation is expected to moderate and China’s trade surplus could narrow further.
Authorities had initially taken a balanced approach with energy and currency reforms. But energy price reforms took a back seat to exchange rate reforms this year as international oil price rises and higher food costs stoked domestic inflation.
GROWTH TOP CONCERN
Now policy focus is changing. Growth has replaced inflation as the top concern for Chinese authorities. The trade surplus for the first half is down nearly 12% from a year earlier and is expected to moderate further in the next few months due to slower outside demand and higher domestic input prices. Government officials are becoming more worried about protecting jobs than the profit margins of a few energy industries. Higher input prices have weighed on commercial activity, with the official purchasing managers’ index slumping in June to its lowest level in nearly three years.
If officials allow the yuan to continue its rapid appreciation, that could exacerbate the narrowing of the trade surplus and hurt jobs in the export sector. Those concerns were highlighted by recent visits by top leaders to major exporting centres and state media reports that Beijing is planning to back-pedal on existing policies aimed at curbing some exports by raising tax rebates that it only recently cut on exports of goods such as textiles. “Against the backdrop of moderating economic growth, between currency appreciation and energy price normalization, we view the latter as the lesser of two evils,” said Qing Wang, Morgan Stanley’s chief Greater China economist.
Compared with the thorny policy of gradual exchange rate appreciation, energy price reforms have another benefit. They are unlikely to attract short-term capital inflows, which are becoming a major headache for Beijing. Such a policy shift could benefit the world and China. Continued increases in China’s domestic energy prices would reduce demand and take away some of the fuel driving international oil prices. This could help lower global inflation and promote greener growth in China.
But neither policy alone solves China’s structural problems. Exchange rate appreciation will narrow China’s trade surplus by increasing imports as well. In contrast, a possible contraction in oil imports as a result of rising fuel prices could widen the trade surplus imbalance. “Exchange rate appreciation is still needed despite increased energy prices,” China International Capital Corp Chief Economist Jiming Ha said. “The two policies cannot substitute each other, nor can they complement each other. They solve different problems of the Chinese economy.” (At the time of publication Wei Gu did not own any direct investments in securities mentioned in this article. She may be an owner indirectly as an investor in a fund.) (Reuters)