The Chinese government has taken several initiatives recently to boost the role of the RMB in international trade and finance. These include (i) agreeing currency swaps worth 650 billion yuan ($ 95 billion) with several economies (including Argentina, Malaysia, South Korea, Hong Kong, Belarus, and Indonesia) that will allow foreign importers to pay with RMB for imports from China; (ii) allowing two foreign banks to launch international bonds denominated in RMB; and (iii) allowing exporters and importers in five Chinese cities to settle cross-border trade deals in RMB. The government is also studying a proposal to extend financial aid to developing countries in RMB instead of in U.S. dollars and then allow beneficiary nations to trade RMB reserves in Hong Kong.

It may take time before the RMB becomes a major reserve currency. International experience suggests that several conditions need to be in place, including open capital markets; deep, liquid foreign exchange markets; well developed bond markets; and a more or less flexible exchange rate. It will take time before China has achieved these benchmarks.

Special Focus: Global Prices—the Risks of Short-Term Deflation and Medium-Term Policy-Induced Inflation

The steep global economic contraction has raised fears of deflation. Headline prices are under downward pressure now because of falling raw material prices. On balance, though, the risk of deflation is low, in large part because of a forceful policy response in most major economies. At the same time, the uncommonly forceful response of fiscal and monetary policy in major industrialized countries is raising concerns, including among China's policymakers, that inflation may emerge in those countries once their economies recover, and that this may weaken their currencies. The risk of such policy-induced inflation depends on the ability of central banks in major industrialized countries to reverse the recent liquidity injections, balance sheet expansions, and monetary policy loosening. So far, most experts and the financial markets expect the major central banks to be able to do this, although it cannot be ruled out that central banks err on the side of supporting a recovery at the risk of higher inflation.

With headline prices lower than a year ago in the U.S. and Japan amidst a global recession, there are fears of deflation. Real, malign deflation is a persistent and generalized decline in prices across a wide array of products and services, with the price declines generating expectations that prices will continue to fall. The current situation does not constitute global deflation, as headline prices are down because of lower raw commodity prices, especially energy (Figure 10); core inflation is on course to remain positive in the U.S. and the euro zone, although perhaps not in Japan. Nonetheless, vigilance is required. A key reason why real deflation can be dangerous is that, with prices falling persistently, central banks cannot stimulate the economy by pushing interest rates below inflation. In fact, the more deflation, the higher real interest rates are, further hampering economic activity.

The global policy response to the recession makes sustained deflation unlikely, although it cannot be ruled out. Decressin and Laxton (2009), in an IMF "staff position note", find that spare capacity world wide has historically led to downward pressure on inflation.15 Thus, in the short term, the severe recession and large amount of unused capacity will create deflationary pressures. However, the global policy reaction to the financial crisis has been so aggressive and determined that it is likely that deflation is avoided. Current consensus forecasts for inflation in the U.S. and the Euro zone show that experts do not expect prices to continue to fall (Figure 11).16 They do expect prices to fall in Japan, but that has happened frequently in the last decade. Current 10 year government bond yields in the U.S. and Germany (3.7 and 3.5 percent) show the same for financial markets. Decressin and Laxton conclude that, while the risks for sustained deflation are appreciably larger than in 2002-3, the previous period with downward pressure on inflation, the most likely outcome is that sustained deflation will be avoided. Their model based analysis also suggested that, on the assumption that the financial distress is gradually resolved, the most likely outcome is that the global economy will stay clear of sustained deflation. However, they note that if financial sector problems are not remedied or further shocks add to current stresses, there is a significant probability of more negative deflationary outcomes, with a deeper and more prolonged recession.

In fact, the aggressive policy response in key industrialized countries has led some to worry about inflation in the medium term. There is a reasonably widespread consensus among economists that lowering interest rates alongside substantial fiscal expansion was the right response to the current downturn in the short term. Indeed, there are few who expect inflation any time soon. However, the response of several key central banks to the crisis has been aggressive compared to historical benchmarks and it has included additional unorthodox measures that could potentially lead to inflation in the medium and long term. Many worry about the large fiscal deficits that will result from the forceful fiscal policy response in major industrialized countries, notably the U.S. In a country such as the U.S., where the government can issue interest bearing debt, whether large fiscal deficits lead to inflation depends on monetary policy. If the central bank "accommodates" the fiscal deficits by letting them lead to higher money supply, higher total demand and inflation may follow. If the central bank prevents the money supply from rising, higher short term interest rates will contain the rise in total demand and inflation. This puts the onus on monetary policy. Several prominent economists have expressed worries about the ability and willingness of policymakers to successfully reduce the size of central banks' balance sheets and tighten monetary policy more generally.17

The balance sheets of key central banks have expanded sharply. They have done this by boosting base money (the liabilities of the central bank) via standard injections of liquidity; pursuing quantitative easing by buying long maturity government bonds; and, in the case of the FED, providing direct credit to private borrowers. As a result, the balance sheets of central banks are now much larger than they normally are (Figure 12). If things go wrong, this potentially could threaten monetary stability. To date, these liquidity injections have led to a much more moderate increase in overall monetary aggregates in the U.S. and, especially, Europe (Figure 13). So far, banks in the developed countries have used the additional base money to restore their required reserves and built up excess reserves (some $700 billion the case of the U.S.). In the face of the global recession and very weak demand for loans, banks have actually slowed lending (the "money multiplier" has dropped dramatically in the U.S. and Europe) (Figure 14).18 Once the financial system stabilizes and bank lending eventually comes on stream again, banks could lend out multiples of the hoarded reserves (the money multiplier could rise). What will happen to monetary aggregates depends on the "exit strategy" of central banks.

While there are no disagreements over what needs to be done to avoid inflation in the medium and long term, some fear that central banks are not able to do this. To avoid inflation in the medium and long term, central banks need to eventually withdraw much of the high powered money they created and bring the size of their balance sheets back to normal. In principle, there are no disagreements over the need to do this. However, there are some concerns over how easy this is going to be, technically and politically. On the technical side, for instance, many of the new assets on the balances sheets of central banks are illiquid. In the case of the U.S., Feldstein notes that commercial banks may not want to exchange their reserves for the "mountain of debt" that the FED is holding and the FED lacks enough treasury bonds to conduct ordinary open market operations. These technical concerns are countered by FED president Bernanke (2009).19 He argues the FED has sufficient ability to soak up the liquidity, including because (i) much of the FED lending (up to $ 1 trillion) is short-term and thus could be wound down relatively quickly; (ii) the FED can conduct reverse repo agreements against its long-term securities holdings to drain bank reserves.

There may also be political constraints in soaking up the liquidity and tightening monetary policy swiftly. It may be politically difficult to tighten monetary policy at a time when the economic recovery is not yet in full swing. Moreover, government debt is set to rise substantially in the coming years in several countries. Some fear that this may lead to political pressure on central banks to keep interest rates low. This may lead to weakening of currencies. In addition, "when the time comes to sell its large holdings of mortgage debt, the FED may face resistance from the housing lobby of the U.S." (the Economist, April 25). Indeed, some say that the real risk is not "uncontrollabe" inflation, but rather a preference for inflation over deflation.

Policy makers should be able to manage these challenges—this is also what financial markets think—but risks remain. It is not clear that the technical difficulties are really problematic. However, there is a risk that central banks err on the side of supporting a recovery at the risk of higher inflation. Given that monetary policy has lost some credibility, independent central banks may feel the need to show independence and strengthen their credentials, thus erring on the side of caution, and policy makers have some time to develop instruments and mechanisms to deal with possible problems. The potential risks may be more significant. So far, judging from inflation forecasts and bond yields, experts and investors do not expect significant post crisis inflation. But this cannot be ruled out. n

Notes:

1. Our government-influenced investment covers utilities, transport, scientific research, water and environmental conservation, education, health care, social security, culture, sport, and public administration.

2. Besides including asset sales, there seem to be additional reasons why China's monthly data on urban FAI is not a good proxy for (national accounts type) gross fixed capital formation. The discrepancies are likely to be larger when the pace of investment is changing significantly, as is the case now. Interpreting the data is also more complicated when the rate of price rises is changing rapidly, as was the case in the first quarter (the rate of price rises changed from 8.9 percent (yoy) in 2008 to -1.2 percent (yoy) in the first quarter).

3. Wages of migrants have felt much more downward pressure than those of people in the formal sector, because migrants tend to work more in the private sector and in export oriented firms.

4. The petroleum extraction sector, which saw its output price falling by 55 percent (yoy) in February, contributed the lion's share of the overall industrial profit decline.

5. This residual category is sometimes called "hot money" in China, but it comprises various types of financial flows, as well as earnings on inward FDI, divesture of inward FDI, outward FDI and losses on foreign assets. Moreover, data on headline foreign exchange reserves has been subject to undisclosed one-off transactions, for instance between the PBC and other financial institutions. As a result, the estimation of underlying financial capital flows is subject to a lot of uncertainty.

6. Markit's global "order to inventories ratio" index rose sharply in March.

7. Incomes and consumption (as in the household expenditure data] have benefited from a low base effect in the first quarter. They are likely to slow down later in the year.

8. Our March Quarterly Update discusses the various elements of and considerations on China's fiscal policy, including under the stimulus package (pp 17-21).

9. While some of the stimulus-related spending will show up immediately on the government's balance sheet, some is likely to show up only later, such as in the case of government commitments to co-finance the repayment of bank lending or subsidies to cover operating costs of projects that are otherwise not financially sustainable.

10. The new fuel pricing mechanism announced in May is a welcome step in this regard. Under this mechanism, prices would be adjusted if global crude prices fluctuate more than 4 % over 22 straight working days, although the NDRC noted that "to prevent speculative trading, we will not adjust oil prices exactly in line with the benchmarks set in the regulation." In any case, benchmark prices of gasoline and diesel were raised by 7-8 percent on June 1. In a step in the opposite direction, the government recently lowered the cost of converting land for industrial use. Rebalancing considerations had earlier led the government to an increase in the minimum price of land for such conversion.

11. Our November 2008 Quarterly has a more comprehensive overview of the policies needed to rebalance the pattern of growth (in Box 3).

12. As an example, some pilot programs currently aim at extending the urban public pension plan to rural citizens. The pilots typically include a fairly generous subsidy, with contributions from the municipal government and required matching funds from the lower level government. However, often only in the relatively well-off areas do the lower level governments have the capacity to contribute. In the poorer areas, where the local government cannot contribute, rural people do not have access to the scheme and the subsidy. This makes the schemes regressive.

13. See Table 5 (p. 18) of our March 2009 Quarterly Update for the composition.

14. The relationship between monetary aggregates and inflation is complex. That is why central banks in mature market economies have largely abandoned using money as a guiding variable for inflation projections, giving priority to output gaps.

15. Gauging Risks for Deflation, IMF Staff Position Note, January 2009 (SPN/09/01).

16. Headline consumer price inflation is expected to be negative this year in the U.S. but not in the Euro zone because of the larger impact that oil price fluctuations have in the U.S. than in Europe (where gasoline taxes are much higher).

17. Martin Feldstein (Financial Times (FT), April 19) and John Taylor, quoted by Martin Wolf (FT, May 6).

18. Monetary aggregates such as M2 can be seen as a function of the monetary base and the money multiplier.

19. The Federal Reserve's Balance Sheet, Ben Bernanke (2009).

Medium-Term Growth Trends

—An Illustrative Scenario

More subdued exports are likely to lower GDP growth, although not dramatically. From 1998 to 2008, world imports grew 6.6 percent on average and China's exports 19.7 percent, in real terms. In the coming decade, exports will grow less. How rapidly depends on world import growth, China's competitiveness, and possible limits to its global market share. In an illustrative scenario, on the basis of mainstream projections for world imports and assuming a continued increase in market share reflecting strong competitiveness, the growth rate of China's exports could average 9 percent in the coming decade—10 percentage points (pps) less than in the previous decade.1/ China's global market share would be 12 percent in 2018. As a comparison, the U.S. share peaked at 14 percent in the early 1990s. The value added contribution of exports to GDP now is estimated at almost 20 percent.2/ Thus, as a rough, illustrative estimate, GDP growth could be (0.1*0.2=) 2 pps lower in the coming decade because of lower export growth. This is significant, but not dramatic, compared to average GDP growth of 10 percent in the previous decade.

A slowdown in potential output is likely to largely reflect lower capital stock growth. China's potential output has grown fast in the previous decades, driven by rapid capital accumulation and TFP growth (Figure). Several factors will contain potential output growth in the coming years, largely affecting the capital stock. First, most importantly, investment is likely to be subdued in the coming years, especially in manufacturing, given the outlook for exports, spare capacity, and profits. Second, the composition of investment is changing now, with more government influenced investment (GII) and less market based investment (MBI). GII is likely to contribute less to narrow GDP growth than MBI in the medium term, largely because the economic returns of investment in infrastructure are spread out over a longer period than those of investment in equipment. GII is also likely to be less efficient.3/ Third, some of the current capital stock in sectors facing particularly large spare capacity will have to be written off. In all, on reasonable assumptions, China's capital stock would rise by 10 percent in the coming five years, compared to 13.3 percent in the previous five years. Potential output growth would be about 2 pps lower in the coming five years than in the previous 5 years.

Successful rebalancing could help boost growth. In the transition to a new setting, TFP growth may be lower because of less migration out of agriculture and policies that channel resources to less efficient activities and firms. More progress with rebalancing would help offsetting this by generating more reallocation of labor from agriculture, more education, and more service sector productivity.

1/ We believe that, reflecting strong competitiveness, China will continue to gain market share, but at a slower pace, assuming that exports outpace world trade by 4 percentage points (pps), compared to 13 pps in the previous decade.

2/ He and Zhang (2008) (HKMA Working Paper 14/2008) use input output tables and estimate that the share in value added was 17.5 percent in 2007. In gross terms, exports of goods were 20 percent of gross industrial output in 2008.

3/ Assuming that GII is 40 percent less efficient in the medium term, potential growth would be 0.2 pp lower.