All that cash is causing China's money supply to mushroom -- a worrisome possible precursor to higher inflation and real estate bubbles. BusinessWeek International Finance Editor Chester Dawson discussed China's ballooning surpluses -- and their implications for the Chinese economy -- with Nicholas Lardy, a senior fellow and China watcher of the Institute for International Economics in Washington, D.C. Here are edited excerpts of their conversation:
Q: China has been running a surplus with the U.S. for years. So what's new about the current situation?
A: We used to point out that although [China's] surplus with the U.S. was big, globally its current account surplus is pretty small. But particularly as of last year, that's no longer an accurate picture. China still has a deficit with the rest of Asia. But its global surplus is no longer trivial. We don't have a final number for 2004, but I believe it may be as much as 4.1% of GDP. It could easily be over 5% this year because the Chinese economy is starting to slow and exports remain strong. By comparison, for Japan it was running at 3.8 to 3.9% [of GDP as of November.] China is now right up there with Japan in a way that it has never been before.
Q: How much of the growth in China's surplus is short-term "hot money" from overseas investors?
A: The big increase in the capital account is not at all explained by foreign direct investment. The term [hot money] is over-used and somehow implies that most of this increase is in unrecorded foreign capital inflows. In fact, it's mostly coming from Chinese companies that are borrowing from foreign banks offshore. So you can say it's hot money, but it's not foreign capital. It's the Chinese companies that are borrowing abroad and stand to make out [if the yuan appreciates against the dollar.] Short term debt increased by $27.3 billion in 2004.
You scratch your head wondering: if China has all these [foreign currency] reserves, why are Chinese companies borrowing money abroad? [The answer is that] they are hoping to take out a loan [in dollars] and then by the time they have to pay it off, they'll get windfall because they can repay with [dollars bought with] stronger yuan. Every CFO at every Chinese company is trying to find a way to borrow dollars.
Q: Why are these mounting surpluses a problem for China?
A: When you've got this huge capital inflow, you have a hard time controlling base money [supply]. The government is buying up more than $130 billion a month in foreign currency. That basically means [the central bank is] selling the Chinese currency for dollars. So in the morning, they buy up foreign exchange [from Chinese banks] to get the dollars for yuan and then in the afternoon they sell central bank notes -- short-term paper -- to soak up the excess yuan. But the volume is getting larger. The increase in reserves as a percentage of GDP is 12.5%. So the interest rates [the central bank] has to pay to get the banks to buy this paper are going up. It increases the challenge that the authorities face in controlling money supply and credit growth. In some regions, there's plenty of evidence that [with so much loose cash floating around] property prices are going up too rapidly.
Q: What are the implications of a rising money supply on overall growth rates in China?
A: The domestic economy is probably growing too rapidly -- unsustainably rapidly. Last year, the official numbers were 9.4%--that's the fourth consecutive year it's been higher than the year before. They're trying to slow the rate of growth but haven't had much success. A higher currency [against the dollar] would slow exports and increase the growth of imports."
Q: How close is China to allowing its currency to appreciate against the dollar?
A: I certainly think you're getting signs of it. When the man who runs the central bank and is in charge of reserves says the reserves are too large, that's all but saying the reserves should be reduced. It's the most explicit statement made so far that supports the idea that the currency is undervalued. [But Chinese authorities are] very reluctant to change in the face of foreign pressure. It makes them look weak. Every time [U.S. Treasury Secretary John] Snow rails at them, it delays it by another 90 days at least.
Q: Does China risk tipping the economy into recession by allowing the yuan to appreciate?
A: No. Domestic economic growth would slow down a bit. [And] they might not create as many jobs, of course. But China doesn't face the [twin] problems of a domestic recession and high surplus. Revaluation helps on both fronts: You don't have the tradeoff problem common in other economies. EDITED BY Edited by Thane Peterson