Revaluation: A Double-Edged Sword for China

The effect of a renminbi appreciation on each Chinese industry and on the country's overall economy is intricate and difficult to accurately predict. Due to the costs and profits that vary with each industry, economists to a large extent have different estimates when it comes to whether or not the renminbi should be allowed to appreciate.

At the "2005 International Currency Conference of the Forum of the Central Bank" on June 7, Zhou Xiaochuan, governor of the People's Bank of China, expressed his thoughts on the issue. The reform of foreign exchange policy in China must take into account its responsibility to the Chinese people, he says, and so before all else its influence on domestic industries needs to be researched thoroughly.

Since no one can claim to be able to fully predict the effects of an appreciation, the best one can do to effect an orderly and predictable management of the upward pressure on the renminbi is to thoroughly consider every angle as much as possible. For individual industries, it will clearly favour some, and cause worry for others.

Textile: grim situation

Amid the current wave of speculation over the renminbi appreciation, it is the textile industry that is on the frontline of the debate. If the renminbi were to rise, this industry would find itself in a difficult situation more than any other.

First, according to initial estimates, for each 1 per cent the renminbi rises, each sub-sector of the textile industry will see its profits from exports reduced, including a drop of 12 per cent in the cotton sector, 8 per cent in wool, and 13 per cent in garments. Smaller segments of the garment industry that depend more highly on exports will face even higher losses.

Large corporations with margins that are already high would see a smaller decrease in profits. At the same time, if a company already has a fixed proportion of the international market, although there will be more talk of raising prices, the overall negative effect will be relatively small. However, if the extent of the revaluation is too large or if the prices of exports continue to rise, then a slide in profits will be unavoidable. In addition to a weakened ability to negotiate prices abroad, as the range of the revaluation expands, the potential for other negative consequences rises considerably.

Professor Wang Kangmao, the honorary president and doctoral adviser of the East China University for Law and Politics, recently told reporters that if the renminbi were to appreciate by 3 per cent the textile industry could face export losses of up to 30 per cent mainly due to a lack of value-added products.

Uncompetitive small-and-medium-sized companies would then likely face bankruptcy, causing possible job losses for several hundred thousand workers. Since most of the employees in the textile industry come from low or medium income families, the loss of jobs could possibly trigger even greater social problems.

Real estate: Flush with hot money; on the edge of a bubble

Real estate is another sensitive sector. A possible renminbi appreciation would cause a still-adjusting housing sector to confront the enormous pressures brought on by the massive influx of hot money.

Professor Yang Fan, a doctoral adviser in the China University of Law and Politics' Business School, recently explained to reporters that as a nation's or region's currency faces upward pressure or is on an extended rise, investors who exchange foreign currencies into the national currency will earn a profit proportional to the rise of the national currency. This will make capital in the country whose currency is being revalued attractive to investors, especially in stock and real estate. Thus investors will not only reap the benefits of the currency appreciation, but also see an increase in value of their corporate stock and real estate investments - something of a double return on their money. But since China's stock market continues to perform poorly it is likely that a large amount of hot money will be poured into real estate.

Professor Wang Kangmao also told reporters that it's possible that some 50 per cent of the Shanghai's housing market is currently being inflated by such foreign capital. For instance, he says, some Russian businessmen would buy 20 apartments at a time in some downtown or luxury districts. This clearly is a form of arbitrage and price manipulation, with an aim that endangers the economic health of the nation.

If China does pull off a revaluation, there are two possible ways they could implement it: incremental or in one step. If it is done in one step, the danger of floating capital in the real estate market is relatively small as the country can employ a variety of methods to restrict the outflow and inflow of the capital over a short period of time. However, because it is impossible to forecast the magnitude of a single move towards appreciation, if there is an overestimation the danger to the economy is still great.

Looking at the recent experiences of other nations, a number of financial crises occurred due to an overestimation of currency. But, if the readjustment is gradual, the pressures that arise from floating capital are magnified. Each small readjustment will cause the market to anticipate even greater changes, attracting more hot money to flow in through all channels, creating an even bigger bubble. It seems that regardless of the method, the health and continued development of the real estate sector will soon face an unprecedented challenge.

Banking: risks of bad credit and outflow of hot money

For China's banking industry, the greatest risk associated with a revaluation is the possibility of deflation.

Zhang Weiguo, an associate professor in the social sciences department of Fudan University, says that an increased risk in the real estate sector implies an increased risk in banks' real estate financing activities. Over 60 per cent of the capital used for purchasing or building houses is lent from the banking system, and at present, the estimated amount of loan for individual home purchases totals around Rmb1,400bn, with mortgages accounting for 70 per cent.

If the renminbi were to appreciate under these circumstances, it is fully possible that those who hold hot money will sell their property at a high price level, triggering an unavoidable price collapse, with the related loans, mortgages and properties possibly turning into bad debt. Professor Wang Kangmao points out that a banking crisis caused by growing real estate risks would be a threat to the stability of the overall national banking system and an obstacle to the reform of the state-owned banks - unfortunately, all in one chain reaction.

However, setting aside these real estate issues, we can see that there are yet other factors arising from a renminbi adjustment.

In an analysis done by Sun Lijian, associate professor of the international finance department of Fudan University, the initial effects of a renminbi revaluation on the banking system will not be large, and will be mainly centerd on two aspects: a contraction of bank's core capital, and a possible increase in bad debt of trade companies. For example, the core capital of Bank of China and China Construction Bank include $45bn in foreign exchange reserves, which will take a hit from a renminbi appreciation. Both banks are actively seeking strategic overseas investors, and a renminbi revaluation would directly affect the process, influence their listing schedule and finally affect the ability of the entire banking industry. Of course, the proportion of foreign exchange reserves of other banks is not very large, so the overall effect that this issue would have on the banking system is not entirely clear.

Trade companies will also be affected by a revaluation. When the renminbi weakens together with the US dollar, local labor will become cheaper and can achieve an advantage on the international market.

However, 60 per cent of the Chinese economy is dependent on foreign countries, meaning it will continue relying on the outside world to drive the economic development. If the renminbi were to appreciate, the competitiveness of trade companies would decrease, causing a squeeze in the margins, and the ability to repay loans would weaken, resulting in an increase in bad debt.

Furthermore, exports point out once the renminbi appreciates a large amount of the "hot money" would flow out, increasing downward pressure on the renminbi. This would result in another tough blow to the country's banking industry.

In 2004 alone over Rmb20bn of foreign assets that had no discernable background flew into the country, and according to the latest statistics of the central bank, these individual accounts actively engaged in currency trade in the past six months. In the battle around renminbi revaluation it is this steady stream of foreign hot money that poses the greatest risk to damage China's economy. As foreign capital withdraws the bubble of prosperity will rapidly burst, causing bankruptcy of many investor. This will bring about a huge risk of bad debt as some mortgages will default, bringing considerable losses to the banking sector.

As a result of these predictions, experts in related fields suggest that trade companies should strive to shift toward self-sufficiency and more value-added products from dependence on price superiority in foreign markets.

On the other hand, the banking industry needs to develop more banking derivative products to avoid the risks of a changing exchange rate. At the same time, to avoid increasing amount of bad debt after a revaluation, national banks should be on guard against the irrational speculation of foreign capital, including those that use property as collateral for loans.

One other potential countermeasure is to speed up the development of channels of direct funding. Professor Sun says that a banking systems using direct funding is far less affected than those using mainly secondary channels based on the lessons from the multinational financial crises of recent years. Direct channels for funding, he says, better distribute the risks that emerge when hot money is withdrawn from a market, thus resulting in a less serious challenge for the banking system.

Energy industry: enormous effect in the medium and long term

According to analysts, if the renminbi appreciates within the range of 5-10 per cent, the effect on the electricity and coal industries would be minimal. However, there would be an obvious effect on the oil industry, which would be more noticeably over the medium and long-term. More importantly, the livelihood of the country rests on the energy industry, and must be treated with the utmost caution.

China's electricity industry has been financed partially through foreign debt, primarily in US dollar and Japanese yen, and in the form of long-term loans. According to China's current system of national accounting, discrepancies created by a changing exchange rate will translate directly into losses for the current financial period. This will, however, only show up on the industry's financial reports before repayment of the loan begins and not the corporation's cash flow. The electricity industry which suffers from big foreign exchange losses would benefit greatly from a renminbi revaluation.

As for the investments in new facilities in the electricity industry, an appreciating renminbi is of limited usefulness in lowering costs. This is because thermo-electric generators that have below 300,000 kilowatts of capacity are all produced domestically, and the fuels they use are procured domestically.

On the other hand, this would mean a drop in costs for oil industries, which rely more heavily on imports. Take Shennan Electric as an example. It has imported over 600,000 tonnes of heavy oil and 60,000 tonnes of light oil each year. If the renminbi were to rise 5 per cent, this company could reduce its costs by over Rmb60m.

Overall, experts recommend that the electricity industry should try to pursue the opportunities of an appreciating renminbi by readjusting their financing mechanisms. Under one possible scenario, these corporations should delay the construction or purchase of new investments, to take advantage of cost savings after a future appreciation.

The influence on the coal industry is considerably smaller. Because exports currently account for a relatively small proportion of the domestic coal industry – only 4.5 per cent - there would not be much of an effect on the industry's overall profits. Moreover, China's major listed coalmakers don't hold any foreign currency debt and so would not be influenced by a fluctuating exchange rate. However, international coal prices could become more competitive with a revaluation, and coastal areas may take the lead in choosing import coal fuels. Experts conclude that an appreciation of less than 10 per cent would have a negligible effect on domestic coal price competition.

The coal industry is advised to closely follow developments in supply and demand, and carefully adjust the proportions of foreign sales accordingly. Under a possible change in coal prices, they should be careful to expand production capacity.

In contrast to the coal industry, the domestic oil products industry still lacks the capacity to set prices, with a relatively large dependence on imports. The market follows price changes abroad and is influenced by changes in the US dollar. Should the renminbi appreciate it would directly cause domestic crude oil prices to fall, and exert downward pressure on the once high profits in the industry.

In the refined-oil industry the price of crude oil is subject to international forces but the sale price of the end product of refined oil is controlled by China's government. An appreciation of the renminbi will lower the cost of international crude imports for the refinery industry and thereby lend some help to raising profits. Since the prices of finished oil-products are determined with a fixed mechanism, and selling prices are interrelated with international prices, if the price of refined oil products drops lower than the price of the drop in crude it would engender a substantial benefit to China's refined oil industry.

China's main petrochemical imports are synthetic rubber and synthetic resin, while the chief exports are more basic industrial chemicals. If the renminbi appreciates, the profits of chemically engineered products will be squeezed, with the only products avoiding influence being those that are under non-tariff protections such as import quotas. The present imports for synthetic rubbers, resins, fibres and other intermediate products are larger than the exports. A renminbi revaluation would lower import prices for these items, creating more competition in the domestic market, resulting in price pressures at home.

A Classification of Industry Influences

When asked how she thought an appreciating renminbi would influence domestic industries, Professor Hu Jian, chair of the Beijing University Center for Chinese Finance, replied,"this problem is too big to be answered in one or two sentences." Indeed. To discuss this issue first requires that we set up a classification of various industries and businesses that could be affected, and identify a range of specially designated circumstances under which we can observe the diverse responses to a renminbi revaluation.

First of all, those businesses that engage in foreign trade or hold foreign capital will certainly feel a much stronger influence that those that are not involved. Those with foreign trade or foreign capital will also experience a more direct effect from a revaluation, while those without must consider that a revaluation would affect the entire state of the economy, changing the environment of outside competition, which is an influence in itself.

As for foreign trade, says Harvest Fund Management analyst Dr Li Ji, the influence of a revaluation works both ways. For industries like textiles, TVs, electronics and others, a renminbi appreciation would mean a reduction in exports, but at the same time would reduce import costs on components and machine equipment. Because the need of intermediate products for industry will be lessened, imports like machinery, transportation facilities, textiles, chemical products and others that influence key domestic import and export industries will be decreasing along with the exports.

But for the oil and natural gas, steel, aluminium, copper and other staple raw materials a large effect would be felt in the short- and medium-term as prices for these are fixed in US dollars. In the short-term this means these materials and products would be priced lower due to a rise in the renminbi, bringing along with it two major effects: a fall in the sales of companies that produce these raw materials and lower costs for those industries that require purchase of these raw material for use in production. At the same time we must consider the effect that the international price of raw materials will have on China's national demand. Lower prices bring with it increased demand, which could cause an increase in the price of some parts of the international raw material trade, ultimately offsetting the negative influence of a rising renminbi.

However trade companies can be further separated according to whether they engage in general trade or in processing trade, with a decidedly different effect on each. A rising renminbi will cause a consequent rise in the prices of export products and a drop in international price competitiveness which would bring about a crisis especially for small and medium businesses that engage in general international trade.

Dr He Fan, assistant to the director of the World Economic and Political Research Institute at the China Academy of Social Sciences, says that the influence of appreciation on finished products must be analysed in more specific detail. The processing trade can first be further divided by whether the imported components are paid by foreign investors or local companies. Currently, these two forms together account for 55 per cent of China's exports, while added by the import of machine equipment from abroad, they account for nearly 60 per cent of imports.

Looking even closer at the imports of raw materials and investment products among these trade enterprises, the ratio still has room to rise. The profits of companies that engage in the assembly of products from imported materials is mostly fixed, and would not be fundamentally influenced by a change in the exchange rate. However, their purchasing power will rise, allowing them to purchase a greater amount of imports. In Professor He's estimation, the positive and negative sides should be given equal weight, but the net effect remains to be fully determined.

Professor He also says that there is still a relationship between the influence of an appreciating renminbi and the corporations' ability to set prices abroad. China has a set of export products that make up a large share of the international market, leading many to rely on the competitiveness of their manufacturing costs. This group of manufacturers has a very strong ability to set prices abroad, and the revenues from exports will actually rise with the stronger renminbi.

In other words, Chinese industries and companies which have the ability to set prices abroad stand to gain from a rise in the renminbi's value. However, this is only true if their ability to set prices stems from their own advantage, such as through competitiveness or product superiority, and not based on a reliance on low prices to make a tiny profit. It is only by following this path can they truly strengthen their ability to face the risks of a changing exchange rate.