Trying to determine the trajectory of economic policy in China is never easy, but last week we got some important insights into the financial bureaucracy's views when PBOC deputy governor and SAFE administrator Yi Gang spoke on April 18th at Indiana University's Indianapolis campus. Yi, a former economics professor at the awkwardly named Indiana University Purdue University Indianapolis, or IUPUI, was in town to receive an honorary doctorate of letters for his academic research and application of this knowledge through his contributions to Chinese economic policy during the past 15 years. Yi joined the PBOC in 1997, and has steadily risen up the ranks, becoming deputy governor in 2008 and SAFE administrator in 2009. In a very nice (and brief) ceremony, President Michael McRobbie ticked off Yi's accomplishments and then bestowed the honorary doctoral hood over Yi Gang's shoulders.
Yi Gang was visibly moved by the ceremony. It was clear he has a special place in his heart for IUPUI and Indianapolis, a city he called a second home to him and his family. He obviously really liked being a scholar, and like most academics, is not extremely comfortable being in the public eye.
It was fitting that Yi Gang then delivered a highly academic 40-minute lecture, "China's Economy -- Path of RMB Exchange Rate Converging to Equilibrium," followed by 10 minutes of Q&A. I'm not sure that everyone in the audience and the members of the Board of Trustees on the stage sitting behind him could follow the details of his graphs and, conversely, that experts on China's economy would find much new. However, I found his presentation and the discussion quite refreshing and insightful.
I haven't seen any media reports other than IU's own press release before the event occurred, but this was a public lecture presented to an audience of about 200 people, and so I'm sure it would not be seen as confidential. Hence, I feel comfortable summarizing his main points.
- China has depended heavily on exports for growth, but that era is ending. With substantial RMB appreciation and wages growing faster than productivity growth, China's terms of trade are systematically worsening, which will hamper Chinese competitiveness. Hence, growth must come from other sources.
- China's substantial increase in real estate prices does not represent a bubble waiting to pop. There may be a market correction, but he thinks an underappreciated reason for extended increase in prices is the strenghtening of property rights since housing reform in the late 1990's.
- The official 2012 target for growth is 7.5%, but growth will likely be just over 8%. He expects inflation to come in around 3%.
- China's trade surplus with the US is entirely based on processing trade, which is less sensitive to exchange rate flucutations. For trade in final goods, China actually runs a deficit with the US. He argued that if the US would have reduced barriers to exports of high-tech goods and kept the same market share it had in 2000, US exports would have grown by an additional $250 billion since then. (Of all the things he said, this was the least persuasive, as it assumes a highly unrealistic linear extrapolation. This is just an official talking point that others shouldn't take very seriously.)
- To help re-balance China's economy, key policy reforms include: 1. Increasing domestic demand; 2. Improving the social safety net; 3. Increasing environmental protection; 4. Reducing price distortions in oil, other energy products, and transportation (this means raising these prices); 5. Expanding Chinese outward direct investment; 6. Making the RMB exchange rate more flexible, which received a boost a few days before when the daily trading band was widened; and 7. Expand imports.
- Given the Euro sovereign debt crisis and the uncertainty surrounding US deficit reduction plans, it would not make sense for China to accumulate additional foreign exchange reserves. This does not mean, however, that China wants to reduce forex holdings.
- Interest rate reform is important, but forex reform and achieving capital account covertibility are higher priorities. These 3 reforms need to coordinated and sequenced correctly. Interest rate reform seems less pressing because: 1) Chinese interest rates are much lower than rates abroad, and reforming interest rates would mean raising them, inducing more capital inflows (hot money) into China, which the PBOC would like to avoid; and 2) Since inflation has come down, Chinese real interest rates are no longer negative as they were a few years ago.
What's this all mean? A couple things. First, this sounds like a roadmap for reform, and is consistent with the report, "China 2030," published in February by the World Bank and the State Council's Development Reform Center. How quickly China will move down this road or whether it will take another path is unclear, but at least we have a pretty good sense of the outlines of what we could potentially expect.
Second, I'm told by someone who closely follows the comments of China's financial bureaucracy that almost everything Yi Gang said in Indianapolis has already been said by others. The only thing that stood out is his last comment about the appropriate sequencing of reforms -- liberalizing the RMB exchange rate and opening the capital account before engaging in further interest rate liberalization. To be fair, that comment was made during the Q&A period and wasn't part of his prepared remarks. My source says Yi Gang's explanation isn't entirely persuasive. Since the RMB is not likely to appreciate much soon, raising interest rates -- the likely outcome of their liberalization -- isn't likely to spark a hot-money inflow. The more likely reason to not reform interest rates is to keep the cost of borrowing as low as possible for favored borrowers, that is, for state-owned enterprises. The implication is that if Yi Gang presented us with a roadmap for reform, it is a road that won't be traveled in a day, but, in fact, will take much longer.