- What problems it is confronted with, how did such problems arise,
and what is the government doing to solve them?
Biggest problem is non-performing loans. Some estimates reach as high
as 50% of assets. In other words, half of the assets on the banks'
balance sheets are fictional. This will wipe out all of the banks'
equity and large proportions of customers' deposits. China has made
several massive infusions of hard cash into the banking sector, but
much of that money was immediately lent out rather than used to
compensate for loan write-offs. Banks have tried to "loan their way"
out of trouble by increasing new loan activity. However, many of these
new loans will likely become non-performing in time, thus worsening
the overall problem. The bad loan problem originates from the nature
of Chinese banking; it has always been state-directed rather than
profit-oriented. Local bureaucrats have used their influence to
channel lending towards state-owned or politically important
businesses, rather than to businesses that would likely repay the
loan. Thus, the banks have minimal experience in assessing credit
risk.
- China?s exchange rate system. How can China, operating in a
quasi-free market system, continue to maintain a fixed exchange rate
with the U.S. dollar?
I assume you use the term "free-market system" to mean the broader
economy, rather than the exchange rate regime, since maintaining a
fixed exchange rate is the opposite of a market (or floating) exchange
rate. The easiest way to maintain a fixed exchange rate is to limit
capital flows. If foreign capital is not allowed to enter the country,
there will be no foreign exchange demand for the Chinese currency. The
same holds true for preventing domestic capital from fleeing the
country. In this case, the Chinese central bank needs only engage in
minor foreign currency interventions (buying foreign currency with
newly-printed domestic currency, or selling foreign currency from its
reserves to reclaim Chinese currency). If capital flows are permitted
(China now allows INWARD capital flows), the bank must make additional
foreign exchange transactions to cancel out the effect of private
capital flowing into the country. The private capital passes through
the foreign exchange rate, pushing up the value of the Yuan. The
Chinese central bank prints additional Yuan and sells them on the
forex market (against the dollar) in order to maintain the peg.
- What are the positive and negative aspects on the Chinese economy of
such foreign exchange system?
Positive Effects: An artificially cheap currency gives China an
advantage in its export industries. Its goods are artificially cheaper
to foreign buyers, boosting exports. A fixed exchange rate regime
(when the rate is fixed below market value) also adds stability to the
banking system by reducing the risk of dangerous currency flucuations
that could lead to capital flight. Since the banking system in China
is very fragile (see earlier answer), this stability helps prevent
possible banking collapse.
Negative Effects: Maintaining the currency peg requires China to print
more and more Yuan. This is an increase in their money supply, which
will ultimately lead to inflation. So far, the Bank of China has
somewhat controlled inflationary pressure by 'mopping up' the excess
liquidity. The Bank of China issues government bonds that pay
guaranteed rates of return. This takes liquid Yuan back out of the
banking system, reducing inflationary pressure. Since the commercial
banking system is considered highly risky, the Bank of China can offer
relatively low interest rates on the government bonds, which are
perceived as a safer investment.
- What are some of the major implications of a change to a floating
system for both China and the U.S. economies?
China: experts believe the effects would be mostly negative, which is
why China has resisted moving to a more flexible exchange rate regime.
Two scenarios are possible: 1) Yuan rises to the current (implicit)
market value- China loses a degree of its export competitiveness.
Export earnings fall, leading to increased unemployment and social
unrest. 2) Yuan initially rises as in first scenario, but outward
capital flight from China takes over. Experts believe a large
proportion of private savings in China is hidden in mattresses and
buried in backyards, due to fear of the unstable domestic banking
system. If capital controls are loosened, Chinese households and
businesses may try to transfer their savings to safer, non-Chinese
banks. This rush of capital out of China will pull the Yuan sharply
down.
US Economy:
Right now, Chinese intervention to keep the Yuan pegged benefits the
US's fiscal situation. China uses its newly-printed Yuan to buy US
government bonds. This helps keep long-term US interst rates
artificially low (witness Greenspan's complaints of an artificially
flat yield curve). At the same time, Chinese buying also finances the
US government's fiscal deficit. Were this to stop, US long-term rates
would likely rise. At the same time, the US dollar would likely fall
as it lost Chinese support. The falling dollar and rising interest
rates would combine to produce an inflationary scenario in the US. |
