RMB FLEXIBILITY: VIEWS OF INCOMING AND OUTGOING

C O N F I D E N T I A L SECTION 01 OF 02 BEIJING 017238

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E.O. 12958: DECL: 08/21/2016
TAGS: CH ECON EFIN ETRD PGOV
SUBJECT: RMB FLEXIBILITY: VIEWS OF INCOMING AND OUTGOING
ACADEMIC MEMBERS OF PBOC'S MONETARY COMMITTEE

Classified By: ACTING ECONOMIC MINISTER COUNSELOR, CHRISTOPHER BEEDE; R
EASON 1.4(B) AND (D).

-- SUMMARY/COMMENT


1. (C) Summary: People's Bank of China (PBOC) Monetary
Policy Committee (MPC) member Fan Gang told Finatt and
Econoff on August 3 that the Chinese government could reduce
the RMB's modest undervaluation while stemming speculative
inflows by signaling to financial markets that the RMB would
appreciate five percent per year over the next five years,
but no more. Fan was subsequently appointed August 11 to
replace Yu Yongding on the committee.


2. (C) Both noted in separate August 3 meetings that the
senior leadership now understands better the link between
exchange rate rigidity, excess liquidity, the growth of
investment and credit, and the constraints the exchange rate
policy imposes on monetary policy tightening. They saw this
as welcome, given that they have become more concerned about
the exchange rate's impact monetary conditions. According to
Yu, President Hu Jintao, Premier Wen Jiabao, and MOFCOM
Minister Bo Xilai have recently sought audiences with
reform-oriented Chinese economists to discuss the exchange
rate regime and its impact on investment and credit growth.
The economists said that the Chinese government will likely
allow for an accelerated pace of RMB appreciation, but did
not expect any large or discrete changes.


3. (C) Comment: Dr. Yu had been the MPC's, and one of
China's, most outspoken proponents of greater exchange rate
flexibility. Fan was reined in earlier in his career for
being too outspoken, and is likely to be more cautious
arguing for a gradual, albeit accelerated rate of
appreciation. Given future relative productivity increases,
a five percent annual crawl may not be enough to affect
materially China's external surplus, particularly if the USD
weakens. To avoid speculative inflows, such a crawl could
also lock China into excessively low interest rates. End
Summary/Comment.

-- FAN: CONVINCE MARKETS THAT RMB WILL RISE SLOWLY, STEADILY


4. (C) Fan, who is also the Director of the National
Economic Research Institute, told us that the Chinese
government should signal to financial markets that the RMB
would continue to appreciate gradually over an extended
period, and suggested a rate of five percent per year for the
next five years. He argued that the current yearly two to
three percent rate of appreciation is too low to reduce the
RMB's undervaluation, which he termed modest, given relative
productivity growth. A publicly announced annual
appreciation of five percent, but no more, with clear signal
that it would last for five years, would tackle the RMB's
undervaluation while dampening speculative inflows. This
would result from investors knowing that the government would
allow for a sufficiently large appreciation (28 percent on a
compounded basis) but, given interest rate differentials,
would not make RMB assets significantly more remunerative to
dollar assets to attract inflows. Fan termed five percent
annually to be large enough to press Chinese companies to
upgrade their operations yet gradual enough to avoid large
scale dislocation.

-- SPECULATIVE INFLOWS CONTINUE, BUT THROUGH CURRENT ACCOUNT


5. (SBU) Fan said that since 2005, when the State
Administration for Foreign Exchange (SAFE) began to enforce
controls on capital inflows, speculative inflows have been
entering by way of the under- and over-invoicing of current
account transactions. He estimated that one-third of the
current account surplus is actually disguised capital
inflows. This helps explain the counter-intuitive and
weakening link between investment and imports. (Note:
During the first half of 2006, the rate of growth of fixed
asset investment rose to a run-rate above 25 percent, while
the rate of import growth was a downward trend. End Note.)

-- CHINESE LEADERS CONCERNED ABOUT RMB EXCHANGE RATE


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6. (C) Fan said China's rapidly rising foreign reserves are
contributing to increased concerns among Chinese government
officials about an overheating economy. Chinese leaders now
understand better the link between exchange rate rigidity and
balance of payments surpluses, liquidity growth and excessive
investment and credit.

-- "BIGGER STEPS" FOR RMB, BUT BASIC POLICY WILL NOT CHANGE


7. (C) Fan noted that Chinese leaders have been recently
seeking economists' advice about the exchange rate regime.
He said that MOFCOM Minister Bo Xilai recently invited
reform-oriented economists to speak at a MOFCOM conference.
He suggested, however, that strong political pressures still
limit the scope for greater movement of the RMB. There
remains concern that RMB appreciation would harm low
value-added assembly operations, hurting migrant workers
whose remittances support rural areas. The Chinese
government will likely accept "bigger steps" in RMB
appreciation, but the basic policy of a managed float will
not change, in Fan's view.

-- THE POLICY MAKERS FOR THE EXCHANGE RATE


8. (C) Fan assessed that the key decision makers on the
foreign exchange rate are Vice Premier Wu Yi and Vice Premier
Zeng Peiyan. Zeng also plays a large role in day-to-day
economic policymaking and favors a gradual approach to RMB
appreciation. Fan described Premier Wen as one who seeks
consensus on key economic issues such as the exchange rate
before going ahead with a decision.

-- YU: LEADERS ENGAGE REFORM )ORIENTED ECONOMISTS ON
LIQUIDITY


9. (C) Yu, Director of the Institute of World Economics and
Politics, Chinese Academy of Social Sciences (CASS),
separately told Finatt and Econoff that it was notable that
President Hu Jintao, Premier Wen Jiabao, and MOFCOM Minister
Bo Xilai had all recently sought audiences with
reform-oriented Chinese economists to discuss the exchange
rate regime and its impact on overheating. Yu noted this
indicates greater awareness to the risks of exchange rate
rigidity. If senior officials continued to see signs of the
economy overheating, then the government would allow for a
more flexible exchange rate, though any changes would be
gradual, Yu suggested.


10. (SBU) Yu also said that higher interest rates have
limited effectiveness in constraining investment growth
because large enterprises are increasingly financing
investment through retained earnings.


SEDNEY