China’s forex control

China’s impressive trade surplus and foreign exchange reserves of 2005 were achieved against a backdrop of world economic imbalance. The Chinese Government has attached great significance to curbing runaway increases and to maintaining the international balance of payments at a responsible status through gradual reform of its forex control system.

For example, China has introduced more advanced financial products, including forward interest rate agreements and currency derivatives, to hedge the risks that it may encounter in an increasingly free interest and exchange rate market.

A key point is that China should take measures to bulk up domestic demand, especially consumption, to improve the trade imbalance scenario by increasing imports. But instead of placing more importance on importing primary commodities, China should boost its imports of advanced technologies, turnkey equipment and resources the country badly needs.

As far as the foreign exchange control system is concerned, China’s long-practiced compulsory forex settlements and floating system pegged to the U.S. dollar have been linked to the accelerated accumulation of forex reserves. To prepare for a more flexible convertibility of the renminbi, foreign exchange control authorities have introduced new market makers, and drafted new forex regulations governing overseas investment by Chinese enterprises to give them greater flexibility in using settlement funds by a system of voluntary settlement of foreign exchange.

As a developing country, China expects a diversified but balanced economic structure, yet also one where conflicts and disputes may exist. The macro-control mainly targets economic growth, full employment and trade balance. Controlling the trade surplus and explosive foreign exchange growth comes arm in arm with stabilizing market prices, but may conflict with the goals of full employment, an improved industrial structure and further economic development.

Net exports were a driving force of China’s economy last year. However, continued development depends more on an increase in domestic demand. China still needs time to narrow its income gap and improve the social security system.

In terms of investment, it has been clarified that anti-deflation would be the central task to circumvent the risk of stalled development.

The United States and European countries are China’s biggest surplus trading partners. If their economy looks good this year, their imports and trade deficits with China won’t fall sharply.

Another proposal has been to adjust the structure of China’s economy to cool down the extraordinary foreign trade. From an analysis of processing and general trade growth tendencies, the value-added processing trade is playing a more active role in China’s foreign trade, reflected in three aspects.

First, the general trade revival is more obvious. Second, processing of imported material far exceeds processing of material supplied by clients. Third, value-added processing is on the rise, in particular the processing trade aimed at goods that will ultimately become exports. Rough estimates indicate that, including imported equipment and not including onshore purchases in China, China’s processing trade has increased its added value by 45, 47 and 46 percent from 2002 to 2004, respectively, and even jumped to 50 percent in the first 11 months of 2005.

In the long run, it is beneficial to improve China’s division of labor in the international market, and to push national economic development onto a more sustained and stable track.

For 2006, China is pursuing a trade balance by cutting the surplus under the capital accounts and reforming the forex control system.

The authorities will strengthen surveillance to control the influx of hot money, and a more flexible capital outflow will be implemented to encourage direct investment by Chinese enterprises abroad, as well as to create a new system of voluntary settlement on foreign exchange.