Can China’s GDP growth be sustained while moving toward a free float? : an analysis of China’s exchange rate and economy

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Can China’s GDP growth be sustained while

moving toward a free float? An analysis of China’s

exchange rate and economy

Ryan Bond 10141758

Thesis monitor: Stephanie Chan

Working abstract: or my constantly changing thesis proposal.

China’s lasting current account surplus has had a lot of criticism, mostly critics urge China to

let it’s currency revaluate to the dollar. This article explains why critics argue that this is the way to go and then asks if China’s economy is able to sustain GDP growth whilst moving to release the exchange rate peg to a free float. This question will be answered by first focusing

on the exchange rate itself, is it still so strongly undervalued? After looking at different economic measures such as China’s financial system, trade, savings, current situation and employment. And the influence of those measures on GDP growth, the question whether the

Chinese economy is able sustain GDP growth whilst moving to a free floating exchange rate can be answered.

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Statement of Originality

This document is written by Student Ryan Bond who declares to take full responsibility for the contents of this document.

I declare that the text and the work presented in this document is original and that no sources other than those mentioned in the text and its references have been used in creating it.

The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents.

Table of Graphs and figures

1. Change in China’s International Reserves 4

2. Money Supply in Billions of Chinese yuan 5

3. Impossible trinity 6

4. Swan diagram 8

5. China’s Real GDP Growth 11

6. Current Account of China and USA 12

7. National Saving Rates 13

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Introduction

China’s gross domestic product (GDP) has been growing from 1978 on with an average of about 10%, which got more than 500 million people out of poverty (The World Bank, 2015). This was achieved with exchange rate policies. Specifically, China has had a peg to the US dollar from 1978 until 2005, which has enhanced China’s trade position because of the added exchange rate stability and made large growth possible.

In 2005 China’s currency, the yuan (Renminbi), was generally believed to be undervalued, studies estimates vary from 3-50% devaluation. Undervaluation has made a large current account surplus possible because it made Chinese export relatively cheap. Due to international pressure China released the peg in 2005 and continued with a managed floating exchange rate in which the currency was allowed to steadily appreciate to a basket of foreign currencies. This basket is dominated mostly by the US dollar, Euro, the Japanese yen en the South Korean won, and in a smaller proportion in some other currencies. The trading price of the US dollar against the Renminbi (RMB) was allowed to float within a band of 0.3% around the central parity. This went on until the financial subprime-crisis in 2008, when the float was kept steady to guard against a significant decrease in the demand for Chinese exports. In those 3 years the yuan appreciated by approximately 21% against the dollar. From 2010 on China started to let the currency float again and in 2013 the currency had appreciated by about an additional 12%. The band in which the float was managed extended slowly to 2% in 2014. China has a maximum purchase limit of 500 USD per day and one has to be present at the relevant bank and bring a passport or ID. This management tactic bottles up demand in both directions, effectively keeping the currency pegged and preventing the inflow of ‘hot money’, or speculative money flows.

China has already signaled wanting to free the exchange rate, the currency already appreciated by over 30% since 2005. Still there are mechanisms in place that effectively pegs the exchange rate in place. What is investigated in this paper is why China released the fixed exchange rate and if the process of moving towards a free float destroys GDP growth. After this we investigate if sustainable GDP growth is possible despite China’s moving to achieve a free float by appreciating the currency. First China’s historical actions will be explained. Then measures for economic well-being, such as current account (CA) surplus, savings and the unemployment rate will be examined and their relation to GDP growth explained. After which influences on those measures for economic well-being and therefore on GDP growth, such as the state of the Chinese financial institutions, monetary and fiscal policy and the 12th five year plan will be examined. Finally an answer will be found and discussed. The focus will lie on GDP growth, specifically on the question if GDP can keep growing after additional appreciations, which will happen when moving to a free float since the RMB is believed to be undervalued.

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Fixed exchange rates

China has chosen to keep the exchange rate fixed for a long time, and they did that by buying US dollars with their currency. This was needed because of a current account surplus generated by a larger export than import, which can clearly be seen in Figure 6, as it shows a surplus from 1995 on. Essentially this means that there was an excess supply of dollars and an excess demand of yuan, creating a pressure to appreciate for the yuan and depreciate for the dollar. Since the yuan was fixed it could not appreciate, therefore the people’s bank of China (PBOC) had to create an artificial demand for dollars. To achieve this they have printed enough yuan to buy dollars with in order to keep the exchange rate fixed. That means they had an excess amount of dollars at the PBOC as seen in Figure 1 by an increase in China’s international reserves, which they used to lend to the US government among others. This made it easier to borrow dollars so interest on dollar loans decreases, making dollar-debt cheaper. This should increase consumption in the US as saving becomes less attractive and consuming more attractive. Citizens of the US also consume from China and thus a cycle is created in which China’s export grows and China buys dollars with printed yuan.

Printing currency is known to create inflation because that currency loses worth, this specifically is called price inflation. China has been printing yuan from 1978 on, increasing the amount of available yuan, as can be seen in Figure 2. Increasing the money supply also creates inflation. This is because GDP is relatively constant over the short-run, and an increase in money creates extra demand and therefore higher prices. This inflation is

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the exporters in China, as their products become more expensive. Which is the same thing that would have happened if the yuan would have appreciated.

Despite lending excess dollars China’s foreign reserves have increased a great deal. In Figure 1 the amount of international reserves are shown to grow significantly. Figure 1 also shows the growth of international reserves which seem to have been going up since 2001 and down since 2010.

Figure 1 additionally shows CA surplus and GDP growth, this will be discussed later on in the section on measures of economic performance. The effects of keeping the exchange rate fixed are in short, China’s reserves are growing, inflation is high and export is getting dampened by inflation. Keeping the exchange rate fixed could go on for a few more years but it is not optimal anymore. China has to change.

Policy options for China

Letting the exchange rate float

China has had to keep the Exchange rate fixed, and capital flows in China have historically been restricted. Economic theory suggest that China can have a sovereign monetary policy because their capital flows are not free. China can not have all three, this is also known as the impossible trinity (Pilbeam, 2013, p. 93). In Figure 3 China starts from a position of fixed exchange rates and monetary independence, thus it is situated on the upper left beam.

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Nowadays China is starting to ease up on the fixed exchange rate and also opening up a limited amount of free capital flow, suggesting that it is moving from the bottom side of the triangle to the right hand side. This would mean that China is planning on slowly letting the yuan float against a basket of currencies. So that their export would drop as well as their foreign currency reserves and inflation. In Figure 2 this means a move to the lower beam.

Letting go of capital restrictions

China could also go the other way and sacrifice independent monetary policy to release the capital flows. Keeping the exchange rate fixed as is logical since countries with significant foreign currency denominated liabilities and currency-mismatch problems tend to fear a float and like a hard peg (Yi, 2006. p. 310). This is because the value of their liabilities can change with the exchange rate. In the case of China letting go of capital restrictions would present problems. Speculative capital flows or ‘’hot money’’ could cause instant market instability since it can move in and out in an instant. This could be caused by two factors, by an exchange rate differential and by an interest differential. Since China’s exchange rate is undervalued this would cause speculators to buy RMB and sell when the RMB has appreciated because their money would be worth more then.

Likewise, there exists an interest differential. China’s interest rate is higher, around 6%, than many other countries (World interest rates, 2015). For instance, the EU, has an interest rate of around 0.75% and the US has an interest rate of around 0.25% (World interest rates, 2015). If capital could flow this could cause large inflows of hot money. There would be an inflow of capital since you could get more interest on your money in China than in the US or EU. Also since financial assets such as Chinese government bonds would get more demand, the price of those bonds would go up and cause asset price bubbles and therefore inflation. China has inflation of around 2% in 2014-2015 (Trading Economics (2), 2015) and therefore should not agree to take this chance since high inflation does not help the economy.

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Right now China also moves toward free capital movement as well as monetary independence. To counter the inflow of hot money, China is now keeping capital flow restricted until at least the exchange rate differential has become smaller. After that happens there is only need to counter the interest rate differential to put a stop to flows of hot money, which could be accomplished by monetary policy, which is autonomous on the lower beam, by lowering the interest rate. This would not be possible on the fixed exchange and free capital movement beam as the monetary policy would not be autonomous.

Effect of current policy on China’s economy

The Swan-diagram is a tool to see what a countries policies could do to achieve external as well as internal balance. China’s position is estimated to be above EB and IB because China has inflation and a surplus on the current account.

Floating the RMB would cause appreciation and a worsening current account (CA). In a Swan-diagram this would mean China moves down because the appreciation decreases export more than it increases import, however this is only true if Marshall-Lerner can be assumed. Marshall-Lerner condition, which states that, when the sum of the long run export and import demand elasticities is equal to, or greater than 1, an depreciation would cause a

balance of trade improvement, can be assumed for China despite not beginning in equilibrium

because the condition has been confirmed by Gozgor (2014, p. 7). Gozgor’s research was just published in 2014 so throughout this text the Marshall-Lerner condition is assumed to hold. The appreciation will worsen the balance of trade, which is good for external balance (EB). Swan does not take into account the capital streams but just takes CA as EB.

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𝑆_𝑟 Real exchange rate = 𝑆 ∙ 𝑃∗/𝑃 𝑆 Nominal exchange rate

𝑃 and 𝑃∗_{Price level and foreign price level}

𝐴 Absorption = C + I + G

𝐶(𝑌,𝑟) Consumption, dependent on income y and interest r

𝐼(𝑟) Investment, dependent on interest r

EB: CA=0 External Balance when Current account equals 0

IB: Y=Yfe Internal Balance when income equals income under full employment

The effect on absorption is uncertain as its factors are influenced in different ways. 𝑌 is growing but will grow less because of decreasing demand caused by the appreciation and the worsening 𝐶𝐴. 𝐴 decrease in growth of 𝑌 means a decrease in growth of 𝐶 and thus a decrease in growth of 𝐴. 𝑟 depends on capital flows. As seen in the impossible trinity China is moving toward free capital flows but capital is still mostly restricted. Interest in China can be set by the PBOC. The interest rate 𝑟 can be set by The PBOC in a situation of autonomous monetary policy, which is where China is going. The PBOC should want to stimulate spending and investments because it would stimulate the economy in a situation of decreasing world demand. This could be done by decreasing interest rate 𝑟. This increases investment I so absorption 𝐴 goes up as well. Also this makes consuming more appealing, as saving pays less, increasing 𝐶 and thus 𝐴. Taken together we can expect a move downward because of the appreciation and a move to the right as 𝐴 goes up. It is reasonable to assume this

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position in the Swan-diagram as we know that China is experiencing a surplus as well as inflation. We can predict the future actions of the PBOC but not exactly so there is no predicting if this would help getting to a situation of internal balance or if it would

‘overshoot’. This is represented in the Swan-diagram in Figure 3 by the two situations from which the red lines go to the right. In the left situation China would be moving toward internal balance and equilibrium in general, shown as a red point 1. In the right hand

situation China would be moving away from internal balance IB and toward external balance EB, shown as a red point 2. It would help getting the current account to zero but it would mean additional overheating of the economy. The overall effect cannot be predicted with certainty as is shown in the diagram. Further it cannot be influenced because the downward motion is the appreciation of the RMB, and going to a free floating RMB means that the appreciation is equal to the undervaluation and that can only be imprecisely estimated. Although no definite conclusions can be made about the outcome, the effects of moving to a free float are in the right direction so this would probably have an overall effect that is conducive to reaching equilibrium.

Appreciation to a free float

Now we know what China is going to do and why, we can focus on the speed of the process. I have found existing literature hardly ever mentions a time frame, except in a passing

remark. Why is it difficult to let the currency go into a free float? Because the undervaluation has always been expected to be significant (3-50%). This would mean China’s export prices would inflate by about the same percentage, and that would mean a subsequent worsening of the current account.

Research undervaluation

The research pertaining to the yuan’s undervaluation does not have clear answers. Cheung, Chinn and Fujii (2007, p. 770), used a 2004 dataset and conventional empirical methods of interference, such as pooled OLS, to measure PPP misalignment. They used conventional methods to avoid measurement errors associated with frequently used models such as fundamental equilibrium exchange rate (FEER) and behavioral equilibrium exchange rate (BEER) estimations. They tell us that although point estimates often point toward 50% misalignment or even more, this is within two standard deviations in most cases, so using a significance level of 5%, these results are not significant to actually prove undervaluation (Cheung, Chinn & Fujii, 2007, p. 770). Why these statistics are not significant can have a number of causes such as: corruption, country grouping, data reliability and serial

correlation. The last could be important as procedures controlling for these serial correlation effects substantially weaken the evidence for RMB undervaluation (Cheung, Chinn & Fujii, 2007, p. 783). In new research of Cheung et al. (2008, p. 16), again using the same

conventional empirical methods of interference, they find that with a new dataset, that of 2008 instead of 2004, the estimated misalignment disappears entirely. These incongruities highlight the fact that statistical uncertainty of model outputs should be taken seriously in

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policy debates (Cheung, Chinn & Fujii, 2008, p. 17).

The RMB’s undervaluation is mostly insignificant with current models, meaning that although point-estimates indicate undervaluation, hypotheses predicting undervaluation are found not significant. There was no point-estimated misalignment at all with a 2008 dataset. There are few more recent peer-reviewed articles discussing this and after the latest Cheung et al. research, there has even been an additional 12% appreciation of the yuan to the dollar. Expecting that the misalignment is in all probability less than expected could shorten the time period in which the RMB enters a free float. In fact, the IMF made a report in 2014, in which they individually asses countries and among those was China. That report was prepared by the research department of the IMF and it concluded with an expectation of 5-10% undervaluation for the RMB (IMF, 2014). Considering the RMB appreciated 21% in 2005-2008, an appreciation of about 7% a year, meaning 5-10% could be remedied in one to two years using a managed float like before. Although this is by no means certain as many factors play a role and ceteris paribus cannot be assumed.

These appreciations are expected to lower GDP growth, now we will check what influences GDP growth and if the growth can be sustained by other sources. Ahead the focus will lie on checking what these revaluations have done to measures of economic

performance such as employment, savings and trade do to the growth of GDP. After, research needs to be done to check how the Chinese financial systems and Chinese and world politics will influence GDP growth and how, since this is a good indicator of economic durability. Then we can answer the question if China’s economy could sustain GDP growth whilst handling a final round of revaluations. The factors influencing GDP growth are important for the economies health. We need to know about these because floating the exchange rate would decrease growth, due to a decreased exchange rate stability and lowered exports which are caused by appreciations.

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Measures of economic performance on Growth of GDP

GDP Growth

As seen in Figure 5, GDP growth from 2005-2015 is never below 5% and averages at about 9% annually. Drop in GDP in 1989-1990 was because the government put the break on an overheating economy (Chinability (2), 2015). The peak in 1992 comes from an increase in Foreign Direct Investment, FDI, and government investment. More recently, the growing peak that forms until 2007 is because of joining the WTO in 2001 and the subprime-crisis in 2008 dropped growth again due to lower world demand (Chinability (2), 2015).

GDP growth is proving to be difficult to sustain, not only because of the appreciations and the subprime-crisis, but also for different reasons. Growth of capital formation

(investing) is expected to decrease, the amount of people moving from agriculture to other jobs is expected to decrease, the working force (age 15-59) will shrink and total factor productivity growth is expected to decrease (Cai & Lu, 2013, pp. 4-6). Cai & Lu use least squares estimating to model expected GDP growth for different periods. They find that for 2011-2015 the potential output growth is 7.19% and 6.08% for 2016-2020 (2013, p. 6). These are low estimates but Cai and Lu don’t think them to be unreasonable because they did not even factor in the slowdown of mass labor-force migration from agricultural jobs to non-agricultural sectors (2013, p. 6). Leaving that out matters because it is an important contributor to total factor productivity growth.

Floating the exchange rate would mean the exports would drop more than imports would rise and that would cause a slowing in GDP growth. Looking at Figure 6 would suggest that the effect is quite small, because GDP growth slows less than the decrease in CA surplus relative to GDP but that may be because of other reasons like for instance saving and the subprime crisis.

The simple textbook formula to calculate GDP is 𝐺𝐷𝑃 = 𝐶 + 𝐼 + 𝐺 + (𝑋 − 𝑀). Thus GDP is influenced by 𝐶𝐴 = 𝑋 − 𝑀, by private saving, which is defined as 𝑆_𝑃 = 𝑌 − 𝐶 − 𝐺

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and by Unemployment because that influences all those variables in one way or another (Pilbeam, 2013, p. 47). These economic measures all influence GDP so now we will look at those.

Current Account Surplus and Exports

Firstly look at Figure 6 to the China’s Current Account or CA in relation to GDP. In the period from 2005-2008 when the RMB appreciated 21% there was a growth of China’s CA surplus relative to its GDP and that of the world. After this period the subprime-crisis started and world demand generally dropped, lowering China’s CA surplus. But from 2011 there was even a small growth, while from 2010-2013 the RMB appreciated 12%. This suggests that China’s export has not declined as much as could be expected with the subprime-crisis and 30% appreciation according to the Marshall-Lerner condition. China’s CA surplus is still at about the same level as in 2005 before the controlled floats and the subprime-crisis. But this is current account surplus relative to the GDP. In Figure 5 it becomes clear that China’s GDP growth is averaging 9% annually, that might explain why exports haven’t declined as much as would be expected considering revaluations of >30% and the subprime-crisis that both decreased export demand.

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because in 2001 China had joined the World Trading Organization (Chinability (1), 2015) in December 2001 (WTO, 2015). The WTO deals with global trade rules, ensuring that trade flows smoothly, predictably and freely. After 2007 the subprime-crisis dropped exports.

Figure 6 also shows the relevance of exports to the GDP. In 2006 it almost reached 40% of GDP and now it is about 30%. This is a large portion and an drop in export demand could therefore have great impact on the economy.

Floating the exchange rate would cause an additional round of appreciation and would decrease demand for exports whilst increasing demand for imports. Yet we know not with how much those exports would drop and imports rise. This will be discussed in the section on saving.

Savings

This Figure 7 tells us that China is nationally saving more than the world average. From 2004 on even more than double. It also shows that households save about 20% of their earnings, which is high relative to the rest of the world. For example US household savings rates are about 5% in the last five years (Ycharts, 2015)

Figure 3 shows high GDP growth, import should grow because of that, but China’s savings are high and that dampens import growth (Yang, Zhang, Zhou, 2011, p. 1). Looking at Figure 2 and Figure 3 for the time period of 2000-2007, an increasing CA surplus coincides with high GDP growth. This indicates high saving, because when GDP grows, import should grow as well, and it does not. This means that the high savings of the Chinese population helps sustain a CA surplus, even through times of crisis and appreciation of the RMB. Yang, Zang and Zhou (2011) argue that because more consuming would be a substitute in the situation of lower world demand, the high saving means that China’s population is holding China back by not consuming (p. 31). Yang, Zang & Zhou, do emphasize that the reasons of China’s high savings are complex and cannot be remedied fast (2011, p. 31). This might mean that lowering the interest rates by the PBOC won’t be enough to inspire additional spending in order to get spending and investment up.

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However, a few factors make it likely that household savings will drop. Pensions are improving, income inequality is dropping, growth of earnings is slowing and the percentage of pensioners is rising (Yang, Zhang, Zhou, 2011, p. 31). This will effectively decrease saving percentages among households.

If savings drop, what will people invest in? The urbanization happening in China makes millions of people go from rural to urban areas, these cities are still being built. These areas all need new infrastructure, which is what the government is investing in together with private investors (Zhang, 2014, p. 477). Also there is a need for new jobs, new businesses are created to accomplish those jobs and the investment for that comes mostly from the people themselves, often entrepreneurs also take out loans to finance this. These investments will cause growth, in fact urbanization has always been highly correlated to economic growth. A recent study by Golley and Wei (2015) found that 18.7% of GDP growth has been because of the move of people from rural to urban areas (p. 15).

Unemployment rate

Figure 8 shows China’s official unemployment rate with a trendline. Although it needs to be said that these figures might not be accurate. Firstly unemployment rates differ substantially across urban and rural environments. Data used for official figures is mostly gathered from urban environments and might not be representative for China as a whole (Liu, 2012, p. 20). Secondly, Liu also finds the age range too small, as it does not include men over 50 or

woman over 45, whilst retirement ages are higher than this (2012, p. 20). Thirdly, those who are unemployed but do not register are not counted as unemployed. Lastly, XiaGang

workers, or laid-off workers, do not register because they still have ties to their last employment. They are unemployed but are not counted as such (Liu, 2012, p. 20).

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and prices determine demand. So when the RMB appreciates their prices go up and exports go down. The same way an appreciation of the RMB also makes importing cheaper. Figure 8 shows that despite of appreciations and the subprime-crisis which caused decreased

demand due to higher prices and lower exports, China’s unemployment is still decreasing on average. The growing GDP could account for this as the growth is a substitute for the

decreasing world demand. Exchange rates have not mattered much in China’s past since they were fixed but it might matter more now when the exchange rate is moving toward a free float.

China’s CA surplus, saving and unemployment rates all affect GDP growth and that growth was somewhat diminished by the recent developments from 2005-2013.

The measures discussed are important indicators of economic performance. These factors are all interrelated with GDP and GDP growth. They are influenced by numerous situations and policies. The influences of policies on GDP growth through China’s surplus, China’s savings and China’s unemployment rates are therefore important determinants of

sustainable growth. The focus lies on Chinese financial institutions with respect to banking and government workings and the usage of monetary and fiscal policies of the PBOC to reach goals set in the five-year plans.

Changes in Chinese financial institutions

Financial institutions such as banks and mutual funds directly influence economic measures such as saving and unemployment so it is important keep track of changes in their policy. China’s financial institutions such as commercial banks give out loans and make investment possible for enterprises with financial needs. These enterprises employ more people and create growth. This makes financial institutions an important driver of the economy. China as an emerging economy needed to monitor financial institutions. This happened primarily through government-controlled large banks. This was needed to appropriately monitor Chinese financial institutions, since the banking sector plays the more important role relative to that of financial markets in most countries for supporting economic growth (Allen, Qian, Shan & Zhao, 2014, p. 599).

China’s Big Four banks control about 75% of national banking assets and are mostly government controlled (Berger, Hasan & Zhou, 2009, p. 113). This has had a significant impact on China’s economic performance. But having four banks with that much control is not efficient. Lack of competition diminishes the need to change and improve, and the significant government influence is not conducive to change either. According to Berger, Hasan & Zhou, the big four were the least efficient Chinese banks by far (2009, p. 115).

Nowadays China is partially privatizing those Big Four banks by selling shares to minority foreign ownerships. These foreign ownerships bring new ideas and according to empirical research they seem to have significantly improved efficiency (Berger, Hasan & Zhou, 2009, p. 128). They even found that minority foreign ownership non big-four banks had a profit efficiency of almost 20% higher than the big-four banks, meaning that under the

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same circumstances they earn 20% more profit. Also those non-big four banks got an almost 30% higher profit efficiency rank, meaning they are more efficient than an extra of 30% of the banks in the sample (Berger, Hasan & Zhou, p. 123). Minority foreign ownerships could support economic growth through more efficient lending because banks would be more willing to lend and this would create GDP growth as entrepreneurs could get access to capital.

Another characteristic of China’s bank financing is ‘political’ capital. Political capital refers to capital that is only accessible when an entrepreneur is politically active and continues to be so (Zhou, 2009, p. 797). Zhou also argues that this is particularly useful for small- and medium-sized enterprises (SMEs), because those are usually capital restrained and need to loan. However, the need to invest in political capital leaves less time for productive work that needs doing (2009). Lending to SMEs can be made easier through other means as well. Bai & Xu found that carefully invented incentive schemes, more competition and increasing lawfulness, through a stronger law enforcement and by giving local lenders more authority, all have a positive influence on SME lending (2009, p. 800). Since joining the world trade organization (WTO) in 2001 and particularly since the

amendment in 2004 in the Chinese constitution, the Chinese government has contributed to alleviating differences between state owned and privately owned enterprises. If these measures succeed in making the gap between private- and state owned enterprises, it will mean a faster and healthier growth of the private sector and GDP (Zhou, 2009, p. 797). Wang, Wang & Zhang already called the financial reforms instituted after joining the WTO in 2001 a step in the right direction according to their research (2012, p. 393).

Having government influence sometimes means that there are agency problems due to differing motives of principals, in this case minority shareholders and the controlling government. Specifically, these problems are called free-rider problems, these are fairly common in China (Yuan, Xiao & Zhou, 2008, p. 1552). However, there has been a rapid emergence of mutual funds, which pools minority interests of shareholders and solves some of those free-rider problems. The government has taken recent regulatory efforts that make mutual funds more powerful (Yuan, Xiao & Zhou, 2008, p. 1564). Research by Yuan, Xiao and Zhou suggest that mutual funds could have a positive impact on corporate governance and firm performance (2008, p. 1564). Which would have a positive impact on GDP growth.

State ownership is often associated with vaguely defined property rights, corruption, informal payments, and offers greater chance of political intervention (Lin, Lin & Song, 2010, p. 50). Lin, Lin and Song focus on property rights because of its direct link to GDP growth (2010, p. 49). This is because property rights are directly linked to R&D and if those rights are not protected China’s growth slows because firm development slows. In their research they found that property rights protection is positively related to corporate R&D activity. Also government services or ‘helping hand’ are conducive to R&D while informal payments to government officials are not (Lin, Lin & Song, 2010, p. 50). This implies that governments should not overly involve themselves with enterprises and should protect property rights. China is already decreasing government involvement and taking steps to protect property

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rights so this has been noticed.

Current effect on GDP growth through changes in financial institutions

The research used to analyze the Chinese financial institutions originates mostly from 2008-2012 and generally finds that China’s actions are conducive to solving problems and creating GDP growth. This happens through improving the conditions for enterprises big and small. China is going in the right direction and it seems reasonable to expect that since 2012 there have been more improvements.

Changes in Chinese policies

China’s government does not give concrete plans for fiscal and monetary policy. What the government does is publish a five year plan that aims at economic and social growth and uses fiscal and monetary policy to achieve this.

Monetary policy in China has never been clear-cut. The five year plans only state the goals that are to be achieved. There is a section on the promotion of spending so the PBOC is expected to lower the interest rate r to promote spending and investment since world demand has decreased and China has to stimulate their own economy (Morgan, 2012, p. 20). This could also be done by creating safety nets with better job security or better pensions, but since those are more long term we expect the interest rate to be lowered (Morgan, 2012, p. 20).

Fiscal policy

China’s fiscal policy has been decentralizing since 1980 (He, Sun, 2014, p. 362). Fiscal decentralization has been a clear trend over the last 30 years going around the developing world (Han, Kun, 2015, p. 89). There has been a lot of literature devoted to the

understanding of its impact on economic development. It is considered beneficial to have fiscal arrangements that allow local governments to capture a larger portion of the local taxes, since this seems to be correlated with faster economic growth in the post-Mao era, which started after 1978 (Han, Kung, 2015, p. 89). As is logical since local governments get a larger share of the new profits generated by growth, which creates incentives for local governments to foster local economic prosperity (Han, Kung, 2015, p. 89). Fiscal incentives influence policy actions on a regional level. China’s fiscal incentives have changed after 1994, particularly allocating more revenues to local governments (He, Sun, 2014, p. 362).

Brehm (2013) investigated this with the use of panel data for the Zhejiang Province during 1995-2005. The results indicate that revenue and expenditure decentralization have both increased allocative efficiency (p. 92). Efficiency in the allocation of the funds which improve investment conditions. Investment which create economic growth which is taxed and

profited from by local governments (Brehm, 2013, p. 101). So indirectly decentralization creates economical growth.

In spite of that, the impact of fiscal incentives decreases with higher degrees of income inequality among regional governments. Other studies find little to support the

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relationship between decentralization and economic development (Brehm, 2013, p. 92). This might be because of income inequality differentials and large variation in production

patterns and revenue structures in China’s regions (Brehm, 2013, p. 101). So if

decentralization is going to help Chinese economic growth China has to put in effort to decrease these differentials, which they are working towards, as seen in the current 5 year plan outline section next.

Furthermore, fiscal decentralization seems to be facilitation the flow of inward FDI, foreign direct investment, which creates growth through diffusion of advanced technologies from leading countries. Testing in the period 1995-2002 in both least squares dummy variables (LSDV) regression and generalized method of moments (GMM) estimation gave clear indication that this is true (He, Sun, 2014, p. 361).

China’s five year plans have traditionally outlined economic plans for the entire country on both the fiscal as well as the monetary level. In the next section the current plan will be explained.

Current 5 year plan outline

China has had 5 year plans since 1953. These are plans made on a national level that aim at economic and social growth using fiscal as well as monetary policy. The last 5 year plan is the one from 2011-2015 and it is the 12th plan. This plan aims at creating: sustainable growth, moving up the value chain, reducing disparities, scientific development, environmental protection, energy efficiency and domestic consumption (KPMG China, 2015, p. 2).

Sustainable growth is needed as current GDP growth is slowing down as was explained in the section on GDP growth. Moving up the value chain means they plan at making more high-end products and increasing the complexity of their products, this will help create new value. Reducing disparities is an especially beneficial aim since this would help get income disparities down and increase effectiveness of the fiscal policies overall, as well as making people less poor. Scientific development is part of the need to create sustainable growth and also of moving up the value chain, this will create new growth opportunities that should be sustainable. Environmental protection and energy efficiency has little to do with the economic situation. That leaves domestic consumption, which China is planning to increase to create demand which has dropped due to appreciation and the subprime crisis.

Key economic targets of these plans are: 1. Annual GDP growth of 7%,

2. Increase urbanization from 47.5% to 51.5%,

3. Increase service sector contribution to GDP from 43% to 47%, 4. Increase spending on R&D to 2.2% of GDP and

5. Hold inflation (CPI) at or below 4% per year (KPMG China, 2015, p. 3).

These are plans that contain detailed plans for all regions of China. And are almost all of an economic nature aiming at GDP growth, particularly wanting to change the pattern of growth to one of scientific development. Such a plan would be carried out through fiscal

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policy on a national and on a regional level. Assuming the 13th 5 year plan follows the same path, this means China’s government focuses on creating sustainable GDP growth. In light of the slowing growth that is expected to come from a appreciation due to the move towards a free floating exchange rate, this would be a good policy.

Conclusions

China’s GDP growth is already slowing down due to factors like the amount of people moving from agricultural jobs to non-agricultural jobs are expected to decrease and capital formation growth is expected to decrease. Along with that, the move toward a free floating exchange rate will involve appreciations and declining exports. This decrease in Chinese output needs to be offset by growth from other sources. Mostly GDP growth has kept the Chinese economy going strong and this helped to take the sting out of more than 30% of appreciation by the Renminbi. These revaluations combined with the subprime-crisis less than halved GDP growth. Also China is creating other ways of growth by improving the efficiency of financial institutions and through five year policy plans aimed at growth. Factors that are expected to increase growth of GDP are due to 4 factors:

1. Moving toward a consumption economy: making a self-stimulating economy which make GDP growth possible. This will be achieved by many factors. For example, the PBOC is expected to lower interest rates increasing investment and consumption. This will decrease the high rate of household saving which are already lowering due to factors such as

improving pensions, decreasing income inequality, growth of earning is slowing, job security rises (less unemployment) and the percentage of pensioners is growing. The 12th five year plan also plans on making this happen and the 13th plan is expected to.

2. Chinese financial institutes are becoming more efficient due to: new FDI in the big four commercial banks, a decreasing gap between state owned and commercial firms, the

emergence of mutual funds, decreasing government influence and by the increasing steps to protect property rights and to better corporate law, which make it more efficient to do R&D, which stimulates growth. This increased efficiency also leads to an increase in lending to small and medium size enterprises, also stimulating growth.

3. Fiscal decentralization: creates GDP growth because of increased efficiencies. Fiscal decentralization also leads to an increase in FDI creating additional efficiencies. Differentials in fiscal incentives and incomes decrease the effect of fiscal decentralization but the five year plans plan on decreasing those factors.

4. Five year plans: using fiscal and monetary policy to achieve plans such as making incomes more equal, increasing consumption and create GDP growth that is sustainable.

Current belief in the literature about the undervaluation of the RMB is now in the area of 5-10%. The earlier appreciations of more than 30% together with the effect of the subprime crisis decreased GDP growth about 4%. China’s GDP current growth is about 7% this should mean that China could release the RMB to float right now and not suffer a great decrease in GDP growth from it, assuming there won’t be another crisis. Despite of this, China will probably take 2-3 years to get there with a managed float which they have used

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this far. Policies have been aiming not only at growth but particularly on sustainable growth. The policies seem to be in the good direction and will continue improving economic

conditions in China. Therefore I conclude that yes, China can achieve sustainable GDP growth whilst moving toward a free floating exchange rate.

Discussion

There are some possible dangers that threaten Chinese demand. From the Eurozone some risk comes from their quantitative easing measures and more seriously from a possible Grexit, which would create a permanent fall in demand. Of course policy actions from all over the world could influence China but there is no way to factor all this in without pure speculation.

An assumption in writing this paper was that China would move toward a free float as soon as possible. With the recent macroeconomic difficulties of the Eurozone and with the world still recovering from the subprime crisis, it might be better to wait a few years before starting the managed float, so that it would be another 4 years, or even 10 years until the float was achieved. This could alter the conclusion of this paper. Maybe it would be

interesting to investigate when the appreciation would be more efficient. The international pressure that pushed China in 2005 to manage a float and revaluate the currency by over 20% is much less nowadays. It could mean China is going to wait for more favorable world demand before floating their currency.

The 12th five year plan also ends this year. Another assumption was that the 13th plan would feature mostly the same key goals. If this is not the case, it could render the

conclusion invalid.

There was a line of thought were I assumed job security would go up which was partly because of the decreasing unemployment rates. This could very well be wrong because the way the unemployment rate is measured leaves room for error.

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Can China’s GDP growth be sustained while moving toward a free float? : an analysis of China’s exchange rate and economy