Possibility for China to Devalue RMB under Reduced Capital Inflow
      	
                                           Comments on the recent Chinese Government Speeches

China occupies a unique position in the midst of Asia’s continuing economic turmoil. The brinkmanship of China against the temptation of depreciation is even regards as a heroic behaviour. However, as the Japanese yen weakened, the Chinese government repeatedly publicly expressed their concerns at the worsening regional environment, and the risks this posed for the stability of the RMB (see appendix 1). Before analysing the underlying rationale and  justification of this statement, the following table of the major arguments is produced in order for the concise.

Maintaining the Current Parity of RMB

Major Arguments	Rationale 	Comments	
real appreciation 	1. 	Demand of RMB > Supply
2. 	Balassa-Samuelson
3. 	 where   1992- 1996	It is an old story. 
 in 1997 and Q1 Q2 1998
…	
fear of inflation	1. PPP
2. Import-Driven	Why not to reflate this economy to some extent, facing with the current deflation	
threat of competitive devaluation of  TABE	sunspot mechanism?	Suicide for TABE with large import dependence and with the heavily-debited export enterprise; 
those ERs possibly around bottom	
long term cost 	1. 	Hong Kong Status
2. 	WTO Issue
3. 	Reputation for this Superpower-in-Waiting	Right, but only after surviving through the short term!

Devaluation of RMB

Major Arguments	Rationale 	Comments	
reduced foreign investment 	1. 	expectation of a crisis 
2. 	risk premium of investment
3. 	etc.	A Game in the following!	
reduced export	1.    relative competitiveness
2.    income effect of the Crisis	Reducing cost and decreasing price can work, instead of depreciation 	

Theoretically, negative shocks to one country can spread to other countries. The contagion channels of the Asian crisis to China are trade linkage, reassessment of fundamentals and perceptions of risks. Trades linkages work through both a price effect, —part of international trade shifts from China to the TABE—; and an income effect, —the TABE reduce import from China—. Re-assessment of fundamentals means that investors may reinterpret or downgrade the information that they have at hand, even if no new information is available, due to connect in their mind to similar scenarios. The same virus leading to the Asian crisis is in the Chinese organ, which is weaknesses in financial systems and governance. There may be some naïve speculation on a similar crisis. Following a negative shock to the Asian markets and then to the Chinese economy, investors may require a larger risk premium. Thus China can not totally immune itself from the Asian crisis. There is a contagion and then the question becomes whether China is robust enough to live with this contagion.

China has a large current surplus of US$ 25.7 billion, a foreign-exchange reserves of US$ 140.4 billion, while a relatively low ratio of debt-to-GDP as 16.9%, among which only US$ 41.7 billion is short-term foreign debt. Moreover, incoming capital are predominantly long-term foreign direct investment and the Chinese currency is not convertible for capital account transactions. A decision to devalue is not up to the market, but depends on the Chinese government. A currency crisis of China is not possible, since only the Chinese hold the gun of the RMB exchange rate. Chinese Premier has promised  to stick to the current parity more than two months ago, since it is coherent to the long-run interest of China. Thus most academic and governments believe that China can and will maintain its current RMB exchange rate.

However, the market seems to have a different opinion. Black market currency trading to sell RMB reappears on the mainland of China. Investors show hesitation. The actual foreign investment in April was only US$ 3.12 billion, down 19.4%. Speculators continue to go short HKD and to speculate against HKD asset, as a way to hedge exposure to the Chinese RMB. Observing the appendix 2, there is a strong pressure and tendency to depreciate recently. It is consistent with  the new signals of policy intentions of the Chinese government and international community need seriously consider it.

My interpretation for the recent disagreement of the market and the rationale of the worries of China’s government is a mental model of an emergency state of the Chinese emerging economy. This scenario develops from the above table and bases on my diagnose of China’s nowadays economy.

Two main features of China’s economy are capital-scarcity and input-driven growth. The boom in 1992 brings a two-digit inflation and then the government enforced a tight monetary policy and a tight fiscal one for the last five years, which brought a consumer price index 2.8% in 1997 and a shrunk domestic effective demand. A weak domestic consumption and over-capacity result in towering stockpile of low-quality goods almost everywhere in China. It implies that the Chinese market has turned from the seller-dominant to the buyer-side. Followed is the loss of low-efficient enterprises. At least 44% State-Owned Enterprises are in red, which heavily burdens China’s financial sectors under the same public ownership with serious moral hazard of the agentsmanagers and bankers. The total bad debt is estimated between 17% and 30% 

GDP. Thus the way-out for China is to engage in restructuring SOEs and in reducing their role in economy. It requires a massive reallocation of labour and capital. Macroeconomics literature suggests such a shift is costly. However, without fully understanding or predicting the effect of the Asian crisis on China, a massive laying-off to slim the SOEs has been being in the progress (see appendix 3). This brings down the expectation of future income and then further restricts the current consumption. In April, the CPI is -0.3% and the retail price index is -2.1% year on year. A deflation comes into being. It aggravates the loss of the low efficient SOEs and asks a further laying-off. The demand shock also comes from the external through the trade linkage. Export is estimated to grow only 6% this year, compared with the 20% in 1997. The weakness of Japanese is intensifying this problem, but which is not the focus of this essay. Massive laying-off in turn requires substantial investments in new firms to absorb the unemployed.  Foreign investment is a major source of financing the non-state sector. It implies that any decline in capital inflow means a rise of the unemployment rate, however, the once significant growth of FDI has became negative (-1.49%) during the last five months. This effect makes it meaningful to construct the following game.

The growth of China’s GDP is only 7.2% during the first quarter and it should continue to decline, since the expansive fiscal policy staged in the late of this March need time to take effect. IMF forecasts that China can only grow 7% this year. Excluding political consideration, the predictions by JP Morgan, ABN Amro, SBC Warburg and etc. are consistently the same 6.5%. However, the target of 8% simply means that the economy can generate nearly enough jobs to soak up the 6 million Chinese entering the workforce each year as well as the 12 million being laid off by restructuring state enterprises. It is useless to resort to the official statistics, since it excludes workers who have been sent home on partial pay and it does not include the presumably substantial unemployment among the “floating population” ranged between 30 million to 110 million, but which is unquestionably part of a causality of an emergency state. Moreover, growth is distributed unevenly across China and anything below 7% almost certainly means part of this economy are already in recession. Considering lack of social welfare system and of a channel to dilute the grumble about joblessness and corruption, a high unemployment in some contracted areas possibly means a social unrest. Thus the definition of an emergence state is a huge unemployment with the low GDP growth in China. Stability is the top priority for the communist leaders and thus they will try every kind of way to get out of the emergence, including depreciation of RMB. So the warn of the Chinese government speech is very realistic. A mental model of the above mechanism is presented here.

As emphasised above the significant importance of the capital inflow, an one-shot game with complete information is constructed. Players are China and the international capital market, abbreviated as the market in the following. The positive behaviour of the market is to continue investing in China and to stop speculating RMB and probably also HKD; the negative, vice versa. China has two choices whether maintaining the RMB current parity or devaluing it. 

		                                C H I N A

M
A
R
K
E
T

	        maintain	         devalue	

positive	                       a 

    e	                       b

   g	

negative	                        c

   f	                       d           

   h	

Assume that the emergency will not exist if excluding the consideration of capital inflow issue. It implies the positive behaviour of the market can gain some return if China maintains RMB and then China should pursue its long-run interest. Whereas, if the market is negative, China will meet with emergency and then short-run interest is prior. If China devalues its currency, the asset in China and their returns of the market will depreciate. The market prefers to the maintaining by China. Other implications are obvious. Then the utility hierarchy under the above assumption is a>b, c<d, e>f, g<h. One form of the game can be as following.

	                                   C H I N A

M
A
R
K
E
T

	        maintain	         devalue	

positive	                       1

    1	                       -1

  -2	

negative	                       -1

   0	                       0           

   0	

Now there are two Nash equilibrium: positive with maintaining and negative with devaluing. However, the market may tend to be negative. One main reason is the expectation of the depreciation. There is an effective circular logic to explain the mechanism as for the Chinese issue, which implies the expectation can become the reality with its own power.

Expect Devalue RMB

Negative Market

 Devalue RMB

Emergency State

It needs a beginning of this reinforcing vicious circle. China doesn’t have an obvious fundamental inconsistency between domestic policies until now, which fails the canonical model of currency crisis. Obstfeld (1994 & 1995) considering unemployment effect and Krugman (1998) considering a weak financial sector summarise and also provide a platform to generate the expectation of devaluation. However, as stated before, the depreciation of RMB can be actualised only by the Chinese government. With its amazing current account, China can and did once offset the conjecture of RMB devaluation through a firm political statement. However, the recent statements of the Chinese government to rethink its exchange rate policy have easily reincarnated this speculation. Then the vicious loop works on itself towards of the Nash equilibrium of the negative and devaluing. The way towards to a better off is for China to eliminate the possibility of depreciation and then stops the circle starting from the expectation. In an incomplete information world, China either need convince the market to play an infinite repeating game, which implies no emergency state exists, or need cheat the market to believe the dominant strategy of China is to maintain the parity. Put into another way, China has to make or simply pretend d<c. The Nash equilibrium of positive and maintaining will achieve. Then China is not going to meet with an emergency state derived by the negative action of the international capital market. 

Returning to the reality, this abstract model simply implies that China should not make any further public statement about devaluing the RMB, which aggravates the reduction of capital inflow and does harm China itself. On the contrary, addressing to the world about firmly sticking to the former international commitment is useful closing the Pandora’s box. The way to put pressure on the Federal Reserve and the Bank of Japan can reach through collusion —reveal this game and the related information only among them—, which means using tactic diplomacy to convince the Fed of the possibility for China to go for an emergency state and to devalue RMB, if Japanese yen continues to depreciate and pressures on the Chinese economy. Depreciation of RMB is not impossible, if China can not avoid an emergency state. Actually, this short essay has tried to show that China appears susceptible in the future. However, some skilful manoeuvres of policy-makers can help to deal with such a delicate situation.