China Research

Just in tradition with its past policies, Chinese authorities have launched more recently another small, reversible but potentially significant step of reform towards a further opening of the economy. In the Pudong district of Shanghai, they opened a pilot free zone for hitherto highly regulated service sectors, in particular financial services. As services do not face tariff borders, the border between the Pudong area and the rest of China is determined by the extent of regulatory divergence: a foreign supplier of services is treated less favorably compared to a domestic supplier in the rest of China but not (or less) in the Pudong zone. So, in terms of so-called national treatment, that is non-discrimination between both suppliers in a domestic market, the Pudong zone in a nutshell would meet essential targets of the WTO in freeing international trade in services.

Beyond that trade policy aspect, from a macroeconomic point of view, this zone suggests the questions whether the authorities will allow the RMB to be traded freely without any interventions from the Central Bank and if so, under which assumptions a market rate different from the official rate would emerge and in which direction the market rate would differ. Finally, would the Central Bank accept such a market rate as a signal to adjust its interventions to that rate in order to keep differences between market and official rate small and thus contribute to gradually erode the border between a RMB rate in the rest of China and that in the zone?

Let us assume that a Chinese financial service supplier bets on continuing problems in the US to extend the debt break and perhaps even bets on a (temporary) default. He would offer a financial paper foreseeing a strong dollar depreciation and a stronger RMB.  Admittedly, this is an extreme assumption. But any other supplier seeing a weaker dollar in future for different reasons could bark upon the same tree. In the zone, he finds a partner taking the opposite position thus believing in a stronger dollar.

The result could be a sharp appreciation of the RMB market rate and a much lower RMB/$ rate than the official one. Other suppliers in the zone perhaps would follow suit and would trigger a herding effect.

My view is that for the time being, the Central Bank will not allow the Pudong RMB rate to differ widely from the official rate and that financial suppliers should be well-advised not to believe in a Pudong market rate exclusively determined by the markets rather than by the Central Bank. The reason for my assessment is that in the coming years, China will face two adverse effects in its current still export-driven industrial structure: an adverse price effect of trendwise real appreciation and an adverse income effect of lower demand in international markets.

This will make the transition in employment from exports to domestic demand-driven industries more difficult. Jobs in the export industry will be wiped out long before new jobs in the latter industries will be set up. In this situation, a further push in real appreciation triggered by financial service suppliers will be seen unwelcome. It would expose the already existing “currency mismatch” problem in China more sharply. China has returns in low-yield international currencies and commitments in local currency. An appreciation reduces the value of foreign reserves in local currency.

So, as in the past, the Pudong zone will not be a free market for foreign exchange. China will rely on its past policies. Steps must be reversible. Trials are welcome. So are errors once they can be corrected.

Rolf J. Langhammer
Professor & Former Vice President of the Kiel Institute for the World Economy

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