China's response to the problems of QE2 and the yuan

How does China view the problem of QE2? In a speech presented at the Caixin Summit in Beijing in November 2010, People's Bank of China governor Zhou Xiaochuan addressed this issue along with the thorny issue of the exchange rate of the yuan. The text of the speech is reproduced below.

I AM very glad to attend the Caixin Summit, and today I will focus on two issues.

The first is the RMB [renminbi, or yuan] exchange rate. Some journalists said that I used the concept of Western medicine and Chinese traditional medicine to differentiate the approaches in the study of the RMB exchange rate when I attended the IMF/World Bank 2010 Annual Meeting in Washington not long ago, and they wanted to know whether they got me right. First of all, I indeed said that a drug from Western medicine, which is based on theory and clinical trials, usually contains one ingredient and has a quick effect while a prescription of Chinese medicine includes various ingredients that work together to treat a disease. There may be 10 ingredients in a Chinese drug and it usually takes a slightly longer time to cure a disease. People may infer from what I have said as to whether we want to do it quickly or follow a gradual approach. This understanding is direct as well as right. In fact, there are two meanings, and I would like to take this opportunity to give some explanations.

Package of policies

First, a prescription of Chinese medicine is usually composed of various ingredients that have different functions and work together to treat a disease. In terms of alleviating the BOP [balance of payments] imbalance, China needs to shift its growth mode and restructure its economy, reduce reliance on exports, increase domestic consumption, and in particular, develop the services sector. All these measures are like the various components of a prescription of Chinese medicine, while the exchange rate is only one ingredient to play its role in treating the disease.

Expanding domestic demand is a very important ingredient of the medicine. As domestic demand expands, the balance of exports and domestic sales will witness a large change, imports will increase and the BOP surplus will shrink correspondingly. At the same time, wages will be adjusted upward, and the prices of energy and resources will further reflect market demand and supply and environmental costs. In the past, the pricing of the environmental costs was relatively low. With the environmental costs priced to the actual level, some manufacturing sectors will feel the rising comprehensive social and economic costs. The price mechanism includes the management of tax rebates of exports.

Overall, this package of policies is somewhat similar to a Chinese medicine prescription. We hope this combined treatment is effective, and it also reflects our judgment that no single ingredient is particularly effective and can cure the disease on its own. This represents another approach to analysing and solving problems.

Second, Chinese medicine includes one method, i.e., dynamic adjustment or trial-and-error. The so-called dynamic adjustment means that a Chinese medical doctor will adjust the composition of the prescription according to the patient's condition, removing herbs, adding new ones and adjusting the dosage of some ingredients. Overall, the adjustment is based on the feedback from the patient, and the feedback is also a process to observe the improvement of the physical condition of the patient.

As you can see, the dynamic adjustment is based on the patient's feedback. Chinese medicine, unlike Western medicine which has comprehensive and logical theories, relies on experiences in some respects. Experiences are built on the basis of experiments and statistics, and may not be very accurate in some respects, while its logic can be adjusted. Useless medicines or medicines with strong side-effects will be removed, or their dosage decreased, and this is the trial-and-error.

I think this is a way of learning from experience, which can be continuously adjusted in the process. For example, we used to rely heavily on the export tax rebate in adjusting the BOP accounts. Later on, however, we found that the adjustment of the export tax rebate may have side-effects, and it was inconsistent with the principle of equal competition. Thereafter, the strength and scope of this measure was adjusted on a dynamic basis, reflecting its continuous evolution and progress.

In short, the analogy of traditional Chinese medicine has three meanings: the first is a preference for a progressive approach to the radical approach of shock therapy; second, no single measure is expected to play a major role; third, dynamic adjustment is an ongoing process based on feedback and allowing for trial-and-error.

Impact of QE2

The second [issue] is the QE2 [second round of quantitative easing] of the US Federal Reserve and its potential effects on China. Since this topic is being hotly debated, I would rather not say too much, and not comment on which is right or which is not. The Federal Reserve has contemplated on QE2 for some time, and the PBC [People's Bank of China] and the Fed had communications on a number of occasions, including the regular bimonthly BIS [Bank for International Settlements] meeting. In most cases, [Fed] Chairman Ben Bernanke would attend the BIS meetings himself, while on other occasions other board members would attend. They have made a lot of explanations on the US monetary policy. In the communication process, we felt that many of their comments were actually understandable. The US Fed has the mandate to create jobs and maintain low inflation in the US. Given the fragile economic recovery, relatively high unemployment rate, low inflation rate and a US federal funds rate that is close to zero, it is understandable that the Fed has adopted the quantitative easing monetary policy.

However, a key issue widely discussed is that the US dollar is an international currency and a major international reserve currency. It is used in the pricing and trading of goods, especially commodities, and to a large extent, capital flows, foreign direct investments and financial market transactions are denominated in the US dollar. Therefore, the US dollar has global impacts.

If the QE2 is an optimal choice or a second-best choice for the US itself, it may not necessarily be optimal for the world, and may have some side-effects. This reflects the importance of the US dollar as the major international reserve currency. If we have any opinions, it may boil down to whether there are any problems in the current international monetary system, and whether it is necessary to resolve the issue from this perspective. As for international reserve currencies such as the US dollar, if its international role conflicts with its domestic one, how should we explain and analyse such an issue?

As far as the QE2's impact on China is concerned, the problem is: will there be a larger inflow of hot money? What measures should China take in response? As many people have offered their solutions, I just want to make two additional comments. First, China's current foreign exchange management still controls the capital account. Abnormal capital can choose to either stay away or take a detour. In the latter case, we can take regulatory measures to prevent hot money from coming. Second, I want to emphasise a significant measure, the sterilisation operation at the aggregate level. When speculative capital comes in, we want to keep it in a pool rather than let it flood into China's real economy. At the time when it retreats, we just let it flow out of the pool. We expect that this measure will largely neutralise the impact of abnormal capital flows on China's macroeconomy.

Indeed, another problem may arise: the capital inflows would make speculative profits from interest or exchange rate arbitrage. No one is happy about this except profiteers. On this I would like to say, on the one hand, we need to keep in mind the importance of sterilisation; on the other hand, we should understand that arbitrage always exists if there is such a chance and is almost unpreventable.

In the late 1970s and early 1980s, the price difference across cities and across regions in China was so conspicuous that it gave birth to daoye, namely profiteers who made profits from trafficking and speculation. If chances exist in the goods market, it's almost impossible to stop arbitrage. As much as we do not like it, we still have to admit that it is an inevitable phenomenon of taking advantage of a money-making opportunity and is in accordance with the logic of the market economy. When trying to stop it, we have to first consider whether or not there are effective measures. It makes no sense to stop railroad transportation in order to eliminate profiteering, because the benefit of the measure is dwarfed by the huge cost to the national economy. Therefore, the key lies in measuring the cost.

Similar problems also exist in the global financial market, such as the 'carry trade', which was a hot topic several years ago. At that time, the Japanese yen was mostly used in arbitrage due to its low interest rate, and many arbitrage transactions were yen/Australian dollar and yen/New Zealand dollar carry trade. Who was doing the carry trade then? If we could identify the major speculators or recognise the problems in the government's policies, we could find a solution. However, it was found that the speculation was mostly done by Japanese housewives, and it was difficult to prevent them from doing it.

For China, therefore, it is most important to keep the macroeconomy balanced, prevent risks, and conduct necessary sterilisation operations. Besides, we will try our best to prevent arbitrage and shut down those channels of arbitrage. However, it is impossible to root out all the chances for arbitrage.

To sum up, multiple angles are needed in the comprehensive analysis of the QE2's global impacts. I have provided some of my perspectives and you are welcome to give your comments and critiques. Going forward, more studies will be done on this topic.                                       

*Third World Resurgence No. 245/246, January/February 2011, pp 20-21