(Reprinted from HKCER Letters, Vol. 51, July 1998)
China's Export Growth: Its past and Future
Since the introduction of economic reform in 1978 the size of China's export trade has increased by 1,450 percent. In 1978 exports made up only 5.3 percent of China's GDP, while in 1997 the figure had increased to 20.2 percent. This rapid rise took place despite the fact that China inherited from the old regime a highly centralized foreign trade system and an overvalued exchange rate. As will soon be shown, one of the important factors driving China's export growth during the past two decades has been the reform of the foreign exchange regime. With the establishment of the national inter-bank foreign exchange market in 1994 and the introduction of conditional current account convertibility in 1996, China now has less latitude with which to employ foreign exchange policies to promote export. China's future export performance will depend on the progress of reform in other sectors, especially in the foreign trade regime, banking and state enterprises, and on the country's ability to obtain a higher level of market access abroad.
A short review of history will serve to put into perspective the relationship between foreign exchange reform and the increase in the level of exports in China during the past two decades. Before China's economy opened up, all foreign trade in the country was monopolized by a handful of foreign trade corporations and was conducted strictly according to mandatory import and export plans drawn by the central planning authority. In determining these plans, the State Planning Commission first came up with a list of necessary imports. Exports that could generate the required foreign exchange needed to pay for these imports were then identified. As the foreign exchange rate at that time had very little influence on the level and the pattern of foreign trade, the exchange rate was set according to its influence on a few non-trade items, such as tourism and remittances from overseas Chinese. It was fixed mainly on the basis of the relative prices of a basket of consumer goods in China and in other major cities in the world. Because many consumer goods in China were under-priced, this led to a substantial overvaluation of China's domestic currency.
In 1978 China decided to open up the economy and to promote exports. New policies centered around the delegation of foreign trade power, and the diversification of trade channels was adopted. After China decentralized foreign trade authority to localities and enterprises, the exchange rate was no longer an accounting device used in the formulation of foreign trade plans. Rather, it began to act as a signal to motivate import and export decisions. To counteract the disincentive effects of currency overvaluation, China began to reform the foreign exchange system. The major modifications that occurred were as follows.
First, official exchange rates were steadily devalued so as to offset the rising costs of exports. Second, the foreign exchange retention scheme, whereby exporting enterprises and local governments were allowed to retain a certain portion of their foreign exchange earnings to finance their own imports, was introduced. Third, foreign exchange swap markets, which allowed exporters to convert their retained foreign exchange earnings at more favorable exchange rates, were established. These reform measures have been effective at making exports more profitable, even though the domestic prices of exportables have continued to rise during the past two decades. They are the primary reasons behind the astonishing export growth that China has been experiencing.
One of the measures China has undertaken to alleviate the disincentive effects of currency overvaluation on exports has been devaluation. The first round of devaluation took place in January 1981 with the introduction of an internal settlement rate of 2.8 yuan per U.S. dollar. The internal settlement rate was determined on the basis of the average cost of generating one U.S. dollar of foreign exchange earnings plus a 10 percent margin. That devaluation marked a turning point for China's foreign exchange rate policy. From 1981 to 1993 the official exchange rate in China was determined largely on the basis of the costs of generating foreign exchange earnings rather than on the relative prices of a basket of consumer goods in China and in other major cities in the world. In line with the rising average costs of generating foreign exchange earnings, the exchange rates were being adjusted downward gradually so as to make exporting profitable.
From 1981 to 1993 there were six major devaluations in China. Their amounts ranged from 9.6 percent to 44.9 percent, and the official exchange rate went from 2.8 yuan per U.S. dollar to 5.32 yuan per U.S. dollar. On January 1, 1994, China unified the two-tier exchange rates by devaluing the official rate to the prevailing swap rate of 8.7 yuan per U.S. dollar. Export, tourism, and foreign direct investment grew briskly at rates of 31.9 percent, 56.4 percent, and 22.7 percent, respectively, in 1994. Foreign exchange reserves increased by 114.5 percent in 1994 and by 42.6 percent in 1995. By the end of May 1998 the foreign exchange reserve of China had reached US$140.91 billion. Due to the increase in foreign exchange supply, the official exchange rate has continued to appreciate slightly. By the end of May 1998 the official exchange rate was around 8.28 yuan per U.S. dollar.
Foreign Exchange Retention
Although China's exchange rate prior to 1994 was set to make exports profitable, the official exchange rate usually lagged behind the costs of generating foreign exchange earnings. In 1983 the official exchange rate was 2.8 yuan per U.S. dollar, but the average cost of generating foreign exchange earnings was 3.03 yuan per U.S. dollar. In 1993 the official exchange rate was 5.32 yuan per U.S. dollar, while the average cost of generating foreign exchange earnings had reached 6.32 yuan per U.S. dollar. Why did exporting enterprises have an incentive to export when the costs of generating exchange earnings were higher than the official exchange rates?
In China, the difference between the average cost of generating foreign exchange earnings and the official exchange rate does not reflect the true profitability of exporting. This is because of the foreign exchange retention scheme. The foreign exchange retention system was introduced in 1978 to enhance exporting enterprises' incentive to export. After exporting enterprises had sold all their foreign exchange earnings to the government at the official rate, the government allowed these enterprises as well as local governments to keep a certain amount of foreign exchange. If they wanted to use the retained foreign exchange, they could use renminbi to buy it back from the government according to the prevailing exchange rate, as long as the use of the foreign exchange fell within the confines of regulation. As the official exchange rates were overvalued, the right to buy back foreign exchange at the official rates in effect further devalued the domestic currency. Foreign trade corporations thus had an incentive to expand their exports, even though the average cost of generating foreign exchange earnings was higher than the official exchange rate.
The permitted rates of foreign exchange retention in China have increased considerably since 1978. In 1979 the retention rate for exports handled by local government was only 40 percent of earnings above the level of exports achieved in 1978. In 1985 the retention rate was raised to a minimum of 25 percent of total export revenues. In 1991 it was possible to retain 80 percent of total export revenues, while the central government reserved the right to purchase at the swap rate of 30 percent of the foreign exchange earnings. In 1994 the foreign exchange retention scheme was abolished when China unified the exchange rates.
Foreign Exchange Swapping
Shortly after the foreign exchange retention system was introduced, exporting enterprises and local governments were allowed to sell foreign exchange quotas to units that sought access to foreign exchange to purchase imports. The possibility of swapping foreign exchange further enhanced export incentive, because it gave holders of foreign exchange quotas another opportunity to capture the value of retained earnings. In addition to purchasing imports, they could convert retained earnings at rates that were more favorable than were the official rates. Similar to the foreign exchange retention system, foreign exchange swapping, in effect, permitted further devaluation of the domestic currency.
The foreign exchange swapping service was established by the Guangdong Branch of the Bank of China in 1980, and it was soon extended to twelve major cities. The price of early transactions was 3.08 yuan per U.S. dollar. The first official foreign exchange swap center opened in 1985 in Shenzhen. Centers then opened in Shanghai and Beijing in 1986 and in Tianjin in 1987. From 1985 to 1987 the foreign exchange swap centers provided swapping services to Sino-foreign joint ventures only. Domestic enterprises were not allowed to participate. In 1987 domestic enterprises in light industry, arts and crafts, and garments were also allowed to sell their retained foreign exchange in the foreign exchange swap market. In April 1988 all domestic enterprises were also allowed to sell their retained earnings in foreign exchange swap centers. The relaxation of exchange controls gave further impetus to the expansion of the number of swap centers as well as to the transaction volume. By the end of December 1992 there were over 100 swap centers, and the transaction volume had reached US$25 billion. In the 1994 reform, foreign exchange swap markets were replaced by a national inter-bank foreign exchange market, and a foreign exchange selling and buying system was introduced. All foreign exchange income derived from all sources by all Chinese enterprises and institutions had to be sold to designated banks. In exchange for the compulsory selling of foreign exchange, enterprises were granted more freedom to buy back foreign exchange from banks. For general imports, enterprises could buy foreign exchange at authorized banks by presenting import contracts and payment notices issued by financial institutions abroad.
Foreign Exchange Reform and Export Performance
The effects of foreign exchange reform on export performance from 1981 to 1996 are summarized in Figure 1, which shows that export growth from 1981 to 1996 was quite closely related to the difference between the effective exchange rates and the costs of generating foreign exchange earnings, expressed as the percentage of the latter. The effective exchange rate is the weighted average of the official and swap rates, with the foreign exchange retention rate as the weight.
Figure 1 suggests that devaluation, the foreign exchange retention scheme, and foreign exchange swapping were effective in raising the profitability of exports. The foreign exchange reform was one of the main causes of China's export growth. It should be noted that from 1988 to 1993, when the swap markets were in operation, export growth was less closely related to the difference between the effective exchange rates and the average costs of generating foreign exchange earnings. The main reason for this is that the swap markets provided exporters with the opportunity to hoard retained foreign exchange quotas for speculative purposes. With the abolition of the swap markets and the introduction of the foreign exchange buying and selling system in 1994, export performance once again corresponds closely to the difference between the effective exchange rate and the average costs of generating foreign exchange earnings.
The prospects of China's Export Industry
Perhaps the most fundamental change to take place after 1993 was the abolition of swap markets and the establishment of a unified inter-bank foreign exchange market for domestic enterprises. Under the new system, exchange rate stability and current account balance have to be maintained through monetary policies of the People's Bank of China (PBOC) and administrative controls of the Ministry of Foreign Economic Relations and Trade (MOFERT) rather than through foreign exchange controls on the current account transactions. Exchange rate determination has effects that extend beyond imports and exports to other sectors of the economy through the inter-linkages of various markets and bureaucracies. Consequently, exchange rate determination is no longer simply a trade or current account issue. Broader economic concerns relating to macroeconomic stability and monetary and fiscal policy have been brought into the picture, as have different political and economic constituencies. Such interrelations between the internal and external sectors of the Chinese economy imply that exchange rates in China cannot be set with an eye simply towards promoting exports. In fact, after the 1994 reform, exchange rates in China can no longer be determined on the basis of the costs of generating foreign exchange earnings. From 1994 to 1997 the general price level in China rose 50 percent, and there was a substantial increase in the cost of generating foreign exchange earnings. The renminbi, however, appreciated slightly as the result of an increase in the foreign exchange supply. The currency appreciation and rising export costs reduced the profitability of exports. Exports grew at a rate of only 1.5 percent in 1996. Despite the strong voice from the exporting sector to devalue the renminbi so as to promote exports, the PBOC maintained a stable renminbi because of its concern over controlling domestic inflation. The strengthened link between the internal and external sectors of the Chinese economy has enhanced the influence of exchange rate policy beyond the foreign trade sector. China has now less freedom to use the foreign exchange rate policy to promote exports.
China is determined to maintain a stable exchange rate for a reasonable period of time in order to achieve macroeconomic stability. The profitability of exporting under a fixed or stable exchange rate depends essentially on the level of domestic inflation. A high level of domestic inflation means that the exchange rate will easily become overvalued again, which will create an export disincentive. To eliminate inflation pressure, it is necessary to speed up state enterprise reform and banking reform. It is only when state-owned enterprises will be able to match their own assets and liabilities without subsidies from the banking system that China will be free from the pressure of high inflation. Since early 1995 inflation has been falling due to tight monetary control through limiting the total amount of loans in the state-controlled banking system. Inflation in 1997 was only 2.8 percent. Due to falling inflation and speeded-up tax reimbursement, China's exports grew by 22 percent in 1997.
In face of the Asian financial crisis, China has reiterated again and again that the value of the renminbi will be kept stable to avoid any devaluation. The crisis, however, has taken its toll on export performance. In May China's exports dropped a year-on-year 1.5 percent in value, the frst negative growth in 22 months. Although exports were able to grow at 4.3 percent in June, foreign exchange reserves showed its first decline since the unification in of exchange rates at the end of 1993. In May, the foreign exchange reserves were 140.91 billion US dollars. But in June, reserves were only 140.51 billion.
Given the current situation as a result of the crisis, China speeded up its reform in the foreign trade regime. One major step is to replace the long-term practice of administrative approval and examination system with a registration system for granting foreign trade rights. Such rights are now being extended to more enterprises, including foreign-funded and private firms. On the other hand, China also attempts to boost exports by increasing tax reimbursement rates. As early as February the tax reimbursement rate for textile products has increased by 2 percent. As from 1 July, six major kinds of exports including textile, machinery, ships, iron and steel, cement and coal, are to enjoy increases in tax rebates ranging from 2 percent to 8 percent.
The future of China's export growth depends on the continued reform of the foreign trade system itself and on China's ability to obtain a more favorable international trading environment. The successful transformation of state-owned foreign trade corporations into business entities truly responsible for their own losses and profits and the joining of the World Trade Organization will definitely expand China's export potential and allow the country to reap more gains from trade.
Sonia Wong is Ph.D. candidate at the School of Economics and Finance, the University of Hong Kong.