Cover, issue 339, Oct 29, 2007
Translated by Liu Peng
Original article: [Chinese]

That China's economy slowed down in the third quarter is certainly good news. What is not good news is that the liquidity surplus has yet to be definitively dealt with. Regarding this persistent problem, the government should give more room to monetary policy in its macroeconomic toolkit.

Figures released by the National Statistics Bureau show that GDP growth in the third quarter was 11.5 percent, slightly lower than the second quarter's 11.7 percent. This clearly illustrates the slowdown in investment, export and consumption China has witnessed. And although inflation pressure remains high, most economists expect that it will ease in the coming months. This signifies that China will maintain sound growth.
 
Nevertheless, excess liquidity still persists, as does the government's intent to solve it, embodied by its raising of the reserve ratio nine times, interest rates five times, and the issuing of notes and special treasury bonds.

Since exchange rate reform began two years ago, the yuan appreciation followed a metered pace that helped ease domestic firms into new competitive environments. Meanwhile, financial enterprises were able to take advantage of this opportunity to create new products to providing domestic clients risk management tools. In the past two years, the trade surplus has continued to sail (by the end of this year it will amount to ＄270 billion), and hot money from overseas has continued to flood into China. In order to stabilize the exchange rate, the central bank has had to buy dollars and free up more yuan in the process. But with the insufficient potency of these new measures, few policy options remain open to the central bank.
 
We are afraid that this will only drag on. After the Federal Reserve cut interest rates, China's continued bumping of interest rates will only attract more investment from overseas. And although the Chinese government established a special body to manage the investment of ＄200 billion in foreign exchange reserves, it is powerless to actually reduce them. Finally, despite the government's implementation of a slew of measures to encourage outward investments, they will take time to reveal their effectiveness.
 
As some investment bank economists say, the core challenge China faces is how to control the pace and window of appreciation. In the past two years, China chose prolonging the period of appreciation in order to allow domestic firms time to adapt to the pressure. But how long it will last, or where the ceiling is, is still unknown.
 
What is certain is that the US, EU, IMF and other international bodies will continue to push for more appreciation in the long term. While many in China say it should not succumb to their prodding, we think China should pause to rationally analyze what are in its best interests.
 
Every policy requires making a sacrifice. Monetary policy is a critical tool that can be used to alleviate the liquidity surplus. To this end, the exchange rate debate should make way for discussion on how China should best utilize monetary policy.