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Three brilliant Chinese initiatives
This is a rerun of an article that was published in two parts on June 24 and 25 in the wrong order
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This is a rerun of an article that was published in two parts on June 24 and 25 in the wrong order. ' Editor
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President Xi Jinping of the People's Republic of China (PRC) recently introduced three brilliant initiatives that are interconnected to reshape a new international economic and political order. These indicate the readiness of the PRC to take a greater role in managing the global economy and assume leadership in a new international economic and political system.
The first initiative was proposed in September 2013 to reestablish the traditional land and maritime silk roads linking three continents: Asia, Africa and Europe. The 'Silk Road Economic Belt' will reopen the links between China and Europe through Middle Eastern, Central Asian and southern European countries. The maritime route passes through the South China Sea, ASEAN countries, the Malacca Strait and the Indian Ocean all the way to East and South Africa.
The second initiative is to create the Asia Infrastructure Investment Bank (AIIB). China pledges US$40 billion to build modern and high speed transportation systems to replace the old mule and camel caravans to save travel time and transportation costs.
For this initiative, China is building new harbors and ports in the Indian Ocean Rim, including in Kelantan, Malaysia, Myanmar, Sri Lanka and Pakistan. The three continents lined by silk routes are highly populated and rich in natural resources that are important markets for Chinese exports and sources of energy and raw materials for its manufacturing industry. The exports include services such as construction, railways and other engineering from China.
The third initiative is to internationalize its currency, the renminbi (RMB). The increasing trade and investment from the PRC with countries in the land and maritime silk routes will rapidly increase the role of RMB as an international currency.
The meeting of the 57 founding member countries of AIIB in Singapore in May 2015 agreed that the head office of the bank would be located in Beijing and use English as its operating language.
According to its Article of Incorporation, AIIB will be overseen by a nonresident and unpaid board of directors. This and the plan to maintain lean staff, will save operating costs and shorten the decision making process.
Voting members are distributed according to a complex formula. Each founding member receives equity plus 600 votes plus other factors such as its capital contribution and the size of its economy. At least 75 percent of share votes are reserved for members located in the Asia-Pacific region and the other 25 for members from rest of the world. At present 37 founding members of AIIB are in Asia-Pacific, 19 from Europe, two from Africa, namely Egypt and South Africa, and Brazil, representing Latin America.
Being the biggest shareholder, China has veto power over major decisions involving structure, membership, capital increases and other significant issues that require a 'super majority' of at least 75 percent of the votes.
Traditionally, ASEAN countries are suppliers of raw materials for manufacturing industries in the PRC as well as markets for its exports. The global supply change that breaks up the production process into geographically separated stages has increased the exportation of industrial spare parts and components from ASEAN to the PRC.
The increasing use of RMB as a store of value shows the trust that the international community puts on its stability as a safe asset and confidence in its future role in the international monetary system.
The PRC is now the second-largest economy, after the US, with a large share of global trade and huge foreign exchange reserves. Because of these factors, the RMB has been used by its trading partners as a medium of exchange and a unit of account for pricing and settlement of bilateral trade with the PRC.
The use of RMB in regional trade is rapidly increasing after the authority in the PRC allows a number of domestic enterprises in selected cities to settle trade in RMB. Imports are increasingly settled in renminbi but exports are still mainly settled in US dollars. Starting from a small amount, a number of countries such as Belarus, Cambodia, Malaysia, Nigeria, the Philippines, South Korea, Chile and Russia have been holding RMB in their international reserves as an insurance against balance of payments pressures.
Personal use of the RMB is encouraged by allowing financial institutions in Hong Kong to open renminbi denominated accounts and its use for cross-border settlements, including sending remittances to mainland China.
On a limited basis, the authority in the PRC allowed some domestic banks to issue renminbi-denominated bonds, popularly known as dim sum bonds and Panda bonds, in Hong Kong in June 2007.
This allowed Chinese banks and companies to tap low-cost financing in international markets without exchange-rate risks. The issuers were gradually expanded to non-bank companies and to other jurisdictions such as Singapore.
The PRC and Japan are now important providers of emergency swap facilities or liquidity support to central banks of many emerging economies in the ASEAN+3 region during the time of crisis. In addition, the PRC wants a greater role as a provider of development aid and finance.
Together with the other four BRICS countries (Brazil, India, Russia and South Africa), China recently established a new BRICS development bank headquartered in Shanghai.
An efficient legal system should protect property rights and enforce business contracts.
The establishment of the BRICS development bank and AIIB is a welcome initiative given the declining lending capabilities of the World Bank and Asian Development Bank (ADB) after the global financial crisis in 2008-2009. The building of infrastructure projects provide fiscal stimulus for the stagnated world economy.
Under the Chiang Mai Agreement (CMI) of 2000, the ASEAN+3 countries ' China, Japan and South Korea ' established emergency swap arrangements to provide liquidity support for the member countries that experienced a short-run balance of payment deficits. The objective of this initiative is to prevent crisis and systemic failure in a country and subsequent regional contagion as occurred in the Asian financial crisis in 1997. The CMI has two components, namely: (i) a network of bilateral swap and repurchase arrangements (BSA), which is an expansion of the ASEAN Swap Arrangement of 1977 and (ii) the multilateral swap arrangements of 2008.
The multilateralization of the CMI is a great leap forward in traditionally less politically cohesive ASEAN+3 countries as they transfer some of their national powers to a regional supranational authority, namely, the Chiang Mai Initiative Multilateralization (CMIM). The PRC makes a significant contribution to the pooled funds in the CMIM.
The currency swap facilities together with the BRICS development bank and the AIIB will further promote the use of RMB in international trade and financial transactions. The availability of BSA and CMIM minimized systemic liquidity disruptions and helped reduce the cost of borrowing foreign exchange in particular currencies.
There are several benefits and costs to the internationalization of renminbi to the Chinese economy. The benefits include lower transaction costs because foreign trade and investment are done in domestic currency, therefore eliminating exchange rate risk. The country enjoys international seigniorage, which is the difference between the face or nominal value of the currency with its cost of production. The issuing country enjoys inflationary tax as the inflation rate erodes the real value of the currency.
Internationalization of the RMB allows the PRC to provide low-cost financing in international markets with liabilities denominated in that currency without exchange rate risk. The issuing country can live beyond its means as it can finance both fiscal and current account deficits by its own currency. Issuing international bonds makes domestic interest rates more dependent on interest rates in the international market.
Issuing international money enhances the political leverage of the issuer throughout the world. The cost of internationalization of RMB includes greater global policy responsibility to maintain stability in the international monetary system. The issuing country cannot devalue its currency to improve its trade balance and promote investment.
The domestic economy becomes more prone to international shocks with the more open current and capital account, and also domestic monetary policy will be influenced by external constraints.
In my opinion, making the RMB a reserve currency or an international store of value should be a long term goal.
A number of policies should be taken to make it happen.
First, end rigid capital controls and make the RMB tradable in international financial markets. At present, the RMB is not a convertible currency. To make the RMB convertible, the Chinese government needs to remove restrictions on capital flows to open capital accounts. Government interventions should be reduced in the thin foreign exchange and financial markets. Limited capital restrictions can only be used as a macro prudential policy to deter speculative attacks.
Second, adopt a flexible exchange rate system and allow market forces to determine the external value of the RMB. This requires the end of the current fixed exchange rate policy and the use of it to promote exports, restrict imports and to reallocate resources from the non-traded sector to a traded one within the domestic economy.
The exchange rate system, however, does not necessarily mean that the central bank cannot intervene in the relatively thin foreign exchange market to prevent exchange rate volatility, which could severely affect balance sheets of financial institutions and the corporate sector. In particular, the central bank should be aware of speculative attacks.
To promote export and external competitiveness the authorities should replace mercantilist policies with internal devaluation or a wide range of policies that raise efficiency and reduce costs. These include improvements in business climates and better logistic and trade facilitation and labor reforms. On exchange rate policy, the International Monetary Fund (IMF) recently announced that China had made significant progress in ending mercantilist policies by allowing the RMB exchange rate to reach its market value. The recent IMF report indicates that the PRC had ended its mercantilist exchange rate policy.
Third, liberalize the currently repressed monetary and credit policies and move toward market-based policies. At present, in terms of asset and branch networks, the financial system of the PRC is still dominated by state-owned banks with limited competition.
The system needs to be privatized because it is still relatively closed and repressed as the government sets both the interest rate and the allocation of bank credit by economic sector and class of customers.
Fourth, improve the legal system and rule of law as a way to improve market efficiency and hence reduce the cost of market transaction. An efficient legal system should protect property rights and enforce business contracts.
The system eliminates market failures by upgrading the rule of law. It should also eliminate public sector failures and upgrade productivity of state-owned enterprises to allow them to compete with privately owned institutions in international markets.
Fifth, give independent status to the central bank so that it can achieve its short-run stabilization objective of controlling the inflation rate. This is supported by flexible exchange rate policy and sustainable fiscal and debt rules in the public sector.
The stabilization policy should be accompanied by supply-side measures to raise efficiency and competitiveness in the economy in the medium and long-term. Following Taylor's rule (1993), the central bank, in the market-based system, uses interest rates as the operating target of monetary policy.
The central bank sets the real interest rate level neutral if the monetary policy is neither expansionary nor contractionary. The neutral or equilibrium interest rate depicts stable inflation with a closed output gap over the medium term. The central bank sets the interest rate lower than the neutral rate to stimulate the economy to full employment levels.
On the other hand, the central bank sets the real interest rate above the neutral rate to dampen economic growth. The difference between the actual policy rate and the neutral real interest rate is called the interest rate gap that can be used to evaluate the monetary stance to close the output gap.
Sixth, develop liquid, deregulated and open financial markets with a wide range and large volume of financial assets and high level of turnover. With a limited private equity market in the socialist PRC, the financial instrument is dominated by a government debt market either issued by the central government or provincial and local governments or state-owned banks and enterprises.
There is no incentive for state-owned enterprises to issue equities and bonds because of the availability of loans from state-owned banks with low interest rates and minimal risks. Sale of state land is an important source of revenue for local governments.
Are there institutional investors, such as the insurance industry, pension funds and postal-savings banks, strong enough to absorb the government debt? The trust of the international community in the government debt of the PRC is depended on its macroeconomic policies in maintaining low inflation, sustainable public debt and stability of the RMB.
Under the fixed exchange rate system, the sole objective of monetary policy is to maintain stability of the exchange rate. Sustainability of the public debt is affected by the fiscal and debt rules of various levels of the government.
The Maastricht Treaty of the European Union sets rigid fiscal and debt rules. The government budget deficit is not higher than three percent of its gross domestic product (GDP) and the government debt should not exceed 60 percent of GDP (De Grauwe, 2003).
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The writer is emeritus professor of economics and was the dean of the School of Economics, University of Indonesia (1998-2001), the senior deputy governor of Bank Indonesia (1999-2004) and head of the State Audit Agency (2004-2009).
