By Bo Peng*
C h i n e s e C o m m u n i t y F o r u m Saturday, June 13, 1997
Had Renminbi (RMB, the currency of mainland China) been freely convertible before the Asian financial crisis, as the rumor said the Chinese government had been seriously considering since 1996, the world would probably have looked suite different today. Sharing similar fundamental problems with neighboring tiger economies, China would have been hard to miss as the foreign exchange (FX) speculators circled around the pac-rim region like a flock of starving vultures. Due to its sheer geographic, demographic, and economic size (China's GDP was $820 billion in 1996 on the exchange-rate basis, ranking the 7th in the world, and in the $3 trillion range on the Purchasing-Power-Parity (PPP) basis, depending on the source), the relatively small external debt burden ("http://www.imf.org/external/pubs/ft/ar/97/pdf/file06.pdf") $116 billion by the end of 1996) and a large, primarily USD-denominated central bank reserve (about $100 billion by the end of 1996, ranking the second in the world after Japan), China would prob
ably have been able to avoid the near-devastation as its neighbors suffered. Nevertheless, the Hong Kong Dollar (HKD) would have been much more difficult to defend in the short term. If HKD is destabilized or economic/social/political problems break out at a large scale in China, the rest of the world would feel immediate, real pain.
How time has changed. A few short months later, it is now the best time for China to open up RMB in order to lay the financial foundation for its ambitious, historical project of privatizing the huge, struggling state-owned enterprises (SOE).
This seemingly preposterous thesis is based on two simple arguments: necessity and timing. First, it is impossible for China to carry out the SOE reform without a freely convertible currency. Secondly, the domestic and international environment for opening up RMB will not get any better until after the successful completion of the SOE reform.
The Necessity ***
The SOE reform is arguably the most critical, delicate, and difficult step in the Chinese economic reform process set in motion in late 70's. If China manages to pass this "critical point", the economy will go through a "phase transition" and change the entire global economic landscape. However, it is a painful path full of landmines, any one of which has the potential of triggering a chain reaction, leaving the country struggling in shambles for years and dragging down the whole world in the process.
The SOE reform in China is one of the biggest financing projects, if not the single biggest, in human history. According to ("http://www.worldbank.org/html/prddr/trans/marapr97/art1.htm") a Worldbank estimate in 1996, China will need about $700 billion investment in the next decade for infrastructure projects alone. This does not include many issues directly related to the SOE reform, such as the placement and retraining of the vast, largely inadequate SOE workforce, upgrade of its mostly outdated capital equipment and technology, modernization of the management system, and absorption of the nonperforming or unrecoverable debts owed by and passed through the SOE.
According to ("http://www.expressindia.com/fe/daily/19980330/08955204.html") a recent estimate by the Chinese central bank governor, Dai Xianglong, the
infrastructure investment need is about $1 trillion over the next three years, although no specific breakdown was given.
From a macroscopic viewpoint, the financing sources available to a society are productivity gain, inflation, real estate development, and foreign investment. The average productivity growth in China from 1978 to 1994 is estimated to be 4%, remarkable by any comparative standard. It is easy to see that productivity gain is not a solution for immediate, large-scale financing requirements. Furthermore, it is politically impossible in the post-cold-war era to follow the Japan and Asian Tigers model and accumulate capital primarily through export, especially for a country as big as China. Inflation is a quick and easy source of money, but also evil and unfair, and has many catastrophic implications. It should be the last resort as a short-term solution for emergency situations. Real estate development has great potential in China, due to the historical
underdevelopment and high savings rate ("http://www.expressindia.com/fe/daily/19980330/08955204.html") the total personal savings in China by the end of 1997 is $578 billion. However, overdevelopment in real estate may lead to debt problems throughout the society and weaken domestic consumption, thus undermining the ability to weather adverse economic conditions, as being demonstrated in Japan since late 80's. A healthy, stable real estate market must have a solid credit system and a credible legal system as its foundation. Unfortunately, neither is in place in China and both require some time to establish. Furthermore, due to the low per capita purchasing power in China, heavy government subsidy seems necessary to accelerate the development of the real estate market without going through severe boom-bust cycles in an entirely market-driven environment, due to the natural tendency of over-development at the high-margin high-value end, the intrinsic delayed feedback between supply and demand in the sector, an
d the speculative instinct of new, immature investors in China. Therefore, foreign
investment is a critically important resource for financing the SOE reform in the near term.
China has yet to tap into the vast resource of international capital market on a scale appropriate for the size of its economy. In 1995, ("http://www.imf.org/external/pubs/ft/icm/97icm/pdf/file18.pdf") the aggregate size of the combined capital markets, including bonds, equities, and bank assets, in EU-11, Canada, US, and Japan was about $62 trillion. For China, the placement of sovereign debts in international markets was $4 billion, while the international equity placement was negligible in comparison and corporate debt placement was a mathematically perfect zero.
So far, the lack of participation in the open market has been supplemented by the successful campaign of attracting foreign direct investment (FDI), mostly in the form of private debt placement, joint ventures, and foreign-owned venture projects. From 1978 till the end of 1994, ("http://www.imf.org/external/pubs/ft/issues8/issue8.pdf") China had attracted an accumulative FDI of about $100 billion. The figure is estimated to be nearly $200 billion by the end of 1997.
However, the current model of attracting foreign investment is clearly insufficient for meeting the needs of the SOE reform, in terms of both capacity and speed. From the debtor's point of view, the best advantage of direct investment, as compared to capital in the open market, is its reliability. It is usually impossible to exit from a direct investment position quickly without suffering significant losses, especially under adverse conditions. Unfortunately, the very same feature is also the source for its limits. The lack of liquidity is a primary source of risk in direct investment. The results are higher effective cost to the debtor, access to high risk-tolerance capital only, and usually long, tedious, and costly negotiation process. The FDI in China in 1997 is estimated to be about $40 billion, an impressive achievement but a far cry from the required amount. In addition, it will be difficult to repeat the number in the near future as the world is still traumatized by the Asian financial crisis.
An open capital market, on the other hand, is the flip side of the coin in reliability, cost, capacity, and speed. Whereas domestic private debt placement can easily take months to finish even in a well-developed, intermediated financial society, it is common to finish bond issuance in days, with a minimal fee. The streamlined, institutionalized mechanism of an open, efficient market maximizes capacity and speed of the capital flow while minimizing the cost. The lack of reliability in theory is a necessary price to pay for the benefits. However, historical experiences show that only changes in the economic fundamentals can cause large-scale shifts or long-term trends in an open, efficient financial market.
In terms of attracting international capital, the potential benefit of an open market can be realized only through the liquidity provided by a freely convertible currency. While FX risks (risks due to volatility in FX rates) have long been recognized and considered in modern finance, the currency convertibility risk, or the FX liquidity risk, began to attract attention only after the Asian financial crisis. We can expect to see in the near future financial products explicitly tied to the FX liquidity risk. These products will show, with painful clarity, how various non-convertible or controlled currencies are penalized by the market.
The difference between obtaining capital through direct investment and on an open market is quite similar to that between obtaining groceries through negotiations with various individual farmers, paid for by exchange of goods and services, and in a modern-day supermarket paid for by credit cards. And, as any rational person as well as not-so-rational but experienced ones know, one has better be careful using credit cards. Watching neighbors going bankrupt on mounting credit card debts, it is tempting to congratulate oneself on having been so wise as to stick with cold cash or to throw away the half filled application. The best approach in a world with only cash and credit cards, of course, is to use credit cards with discipline, controlling the total debt based on the total asset and scheduling the payments according to incoming cashflows, in order to enjoy leveraged buying power while building a better credit history, which in turn results in a higher line of credit and lower interest rates.
The above analogy has a notable flaw, though. The highly saving-oriented traditional Chinese mind always remembers the eventual total cost. This concrete argument on individuals, however, is completely irrelevant to countries. The finite time line for individuals produces the notion of eventuality, based on which one can compare the total cost. The time line for a country, on the other hand, is infinite for all practical purposes.
The Timing -- Why It Is the Sooner, the Better ***
An open FX market, as any other types of open market, carries some inherent volatility. The uncertainty is especially large when a currency first becomes convertible, since there is no market-established framework of reference for judging the relative value. As to RMB, the disparity between the exchange-rate based and PPP based GDP figures suggest it is currently undervalued. On the other hand, there are legitimate arguments for devaluing RMB in light of the worsened competition in export after the crisis. Efforts in predicting the direction in RMB FX rates immediately following the opening up may quite possibly be futile and pointless.
Ironically, the Asian financial turmoil has created a rare opportunity for China to absorb the first shock when opening up RMB, due to the relatively healthy and stable economy, the criticality of China's stability to the rest of the world, and the unlikelihood of a replay of the recent currency turmoil in southeast Asia.
As illustrated by Prof. Zongsheng Chen with concrete data (LINK TO ZCHEN'S ART) and concluded by many other experts, China's economy is relatively strong and stable compared to the neighboring tigers. In addition, the total size of the economy and the strong FX reserve of the Chinese central bank make the catastrophe scenario very unlikely even if RMB came under attack. The world saw with 20/20 hindsight at the height of the turmoil that the international capital had to share part of the blame as it was overtaken by greed and overlooked rational risk assessment. A few months later, the world again sees with 20/20 hindsight that it over reacted at the height of panic.
In terms of timing for making RMB convertible, a few factors suggest that it is the sooner, the better. Regardless of one's assessment of the current economic status in China, there is little doubt that more and more problems will surface as the SOE reform pushes forward. Unemployment, inflation, and social tension will inevitably rise. Bad debt problems will gradually become transparent as the SOEs are converted into private or public ownership, some of which will fail. Things will look uglier before becoming better, even if the underlying foundation improves steadily. The initial shock of opening up RMB would be much more severe then. In addition, early access to foreign investment through an open FX market can help lessening inflation and unemployment pressure.
China played a critical role in preventing the further spread of the Asian currency turmoil, first by resolvedly helping defending HKD, then by contributing a significant sum to the IMF rescue package to South Korea, and by not devaluing RMB. If the world had placed high hopes on Japan to act as a global economic leader and a regional anchorage at the height of chaos and panic, it has become clear now that the most contribution the world could expect from Japan is not to cause more trouble. Japan has been suffering from chronicle problems of the aging population and ignorance of the importance of a strong domestic consumption(LINK TO GREG'S ART). In fact, it is questionable whether Japan is willing to lend a helping hand even if it is able to do so. At this point, it is too early to declare the passing of the crisis, especially with the looming problems in Japan. Under these circumstances, the world cannot afford another breakout of large-scale problems. If there were severe problems in the infant RMB FX mar
ket, it would be in the self-interest of the governments and central banks of industrialized countries to intervene and help stabilizing with
concerted efforts. On the other hand, as the crisis fades away, South Korea revitalizes its economy, and Latin America learns from the lessons and strengthens their economic and financial fundamentals, the criticality of China's economic health to the world will be reduced, at least until the economy becomes a prominent world power. Should problems emerge then, international help would come only with a higher price and greater hesitation.
In addition, most of the industrialized countries, with the notable exception of Japan, have been experiencing sustained economic growth with high productivity, low inflation, and low unemployment over the last few years. The underlying reasons are the massive, direct application of information technology to various business sectors, and the babyboomer generation entering the age of high productivity and savings rate. The worldwide financial resources are at unprecedented levels. However, the current scenario will begin to deteriorate in five to fifteen years in various industrialized countries. It is unlikely that the international financial climate will further improve in the foreseeable future.
If anybody had any doubt on the international co-dependence in modern economic life, the Asian financial crisis has been an unmistakable wake-up call. Unfortunately, such doubt was apparently quite deep and widespread. In fact, the world stood by idly as the currency crisis became evident in Thailand in July of 1997. It was only after South Korea's balance sheets started to bleed that the rest of the world began to feel the sword of Damocles hanging over their own collective head. Even George Soros, the spiritual leader of the FX speculator bandit, openly admitted in a CNN interview that he had not expected the impact to be so grave and spread so fast. If people learned to be careful playing with nuclear bombs after witnessing Hiroshima, they ought to learn to be careful playing with large-scale FX speculations after witnessing the Asian financial crisis. Although greed is (rightfully) one of the founding stones for modern
financial systems, and will most likely prevail, many factors will help preventing it from causing catastrophe again, now that the world has learned the lesson. The containment force is the strongest while the memory is still fresh.
The Timing -- Why It Has to Wait ***
Some preparation must be performed before making RMB convertible, nevertheless. Otherwise it would be opening for the sake of opening, thus taking risks with no potential return. Unfortunately, the financial infrastructure is arguably among the most outdated and inefficient aspects of the economic framework in China, even after the significant reform in the banking sector over the past few years. Financial reform has also become a taboo in Chinese politics since the Asian financial turmoil. To a large degree, however, the new phase of Chinese economic reform is financial reform.
Being of service industry in nature, the financial industry is more about the quality of people than anything else. Without a sophisticated, professional workforce, a financial market would be no different from a high-stake gambling casino. It is essential for China to draw from external experiences and upgrade its financial workforce, through both direct hiring and the indirect training and transfer during participation of foreign firms in the Chinese market. Special attention should be paid to risk management education in the financial industry as well as the business sector in general. Furthermore, the general public must be educated on the danger of short-term, speculative trading, which has been dangerously apparent in the infant Chinese stock market.
There should be a relatively complete, sizable domestic capital market in order to realize the potential benefit of an open currency in attracting foreign capital. It would also help absorbing the initial shock and minimizing the possibility of short-term inverse conversion by providing viable alternative investment channels. Various futures markets, especially bank deposits and currency futures, must be established or expanded. They are essential for risk management and rational pricing of various financial products, without which the entire capital market would be intrinsically speculative. Both the domestic and international secondary markets for the central government bonds should be expanded. An open secondary market for central government agency and municipal
government debts should be established, paving the way for corporate debt market and various fixed-income derivatives markets. The open market for mortgage and its securitization needs urgent development. The IPO quota system should be replaced by regulated, professional underwriting to increase the volume and rationality of the equities market.
It is of strategic importance to gain support, or at least understanding, on the issue of making RMB convertible from the central banks of major hard currencies. Such support or understanding is especially important for minimizing the initial shock. In addition, it may be prudent to take advantage of the current low gold price and properly increase the strategic gold reserve before opening up. However, the proper level of FX and gold reserve is a complicated and delicate problem. It should be carefully debated and quantified by experts with adequate access to relevant information and resources.
Last but certainly not the least, an effective legal and regulatory system is vital for preventing large-scale speculation and other abuses. The immature investor mentality, the speculative tendency, the uneven access to information and large capital resources, and the lack of proper relation between profit sharing and responsibility among institutional investors in China today all make it vulnerable to various abuses. Without monitoring and control, these abuses are capable of causing macroscopic damages to the economic health and rapidly amplifying the economic disparity and social tension. International politics may further complicate the problem. Again, there is no logical reason not to learn
from the vast pool of experiences and lessons from developed countries, although no one has a perfect system.
In a way, opening up a currency is like letting a child leave home alone for the first time. It always has risks, and initial, short-term shocks are almost inevitable. However, it has to be done, and should be done as soon as the bond and futures markets as well as an adequate legal and regulatory system are established. Other, longer-term, and less direct issues can be resolved in parallel. The advantages and opportunities created by the Asian financial crisis will likely disappear within two years. The time is either now or too late.
April 12, 1998
Bo Peng, Vice President
Structured Credit Research
Lehman Brothers, Inc.
New York, NY, USA
"mailto:bpeng@lehman.com"
*(Dr. Peng currently carries out research and development on structured credit derivative products and risk management. Before joining Lehman Brothers in 1995, he had been Assistant Professor in computer science at Michigan State University. A theoretical chemist by training, he earned his PhD degree in West Virginia University in 1992, MS degree in the Beijing Institute of Chemistry, Chinese Academy of Science, in 1986, and BS degree in Nankai University in 1983. He is a former editor for ("http://www.china-net.org") Chinese Community Forum, and a co-founder of ("http://www.china-net.org/chihome.htm") China Hub, Inc.)
