China & World Economy / 11-20, Vol. 12, No.

1, 2004 11

A Structural and Macroeconomic

Approach to RMB’s Valuation

Liu Ligang *

Abstract
This paper argues that a nominal appreciation of renminbi should be eschewed because of
China’s existing trade structure, financial fragility and macroeconomic imbalance. Instead,
the renminbi’s valuation issue can be dealt with effectively using a structural and
macroeconomic approach by first reducing distortionary export subsidies and gradually
removing excessive fiscal incentives granted to FDI-founded firms in the short term. In the
medium term, the renminbi’s valuation issue can be addressed via reflation: expansionary
fiscal policy with a focus on rural infrastructure investment accommodated by supportive
monetary policy. Finally, the paper emphasizes that such investment has to be incentive
compatible by involving local government and private initiatives aided by the development
of China’s local government or municipal bond market.

I. Introduction

Calls for renminbi (RMB) – the Chinese currency, yuan – to revalue, first advocated by a
former senior official of the Japanese Ministry of Finance in December of 2002, have gained
prominent converts in the government of the United States since the second half of 2003.
Treasury Secretary John Snow, Federal Reserve Chairman Allen Greenspan, and Commerce
Secretary Don Evans have since joined the campaign to egg on Beijing to revalue RMB.
This high-profiled campaign has also gained intellectual backing from an influential
Washington DC based think-tank, the Institute for International Economics. 1 Unfortunately,
these insistences for a nominal RMB appreciation may be inappropriate at this stage given

* Liu Ligang, formerly was a senior research fellow at the Asian Development Bank Institute in Tokyo
and an economist at the World Bank in Washington DC. He is now an assistant professor of public policy
and finance at the School of Public Policy, George Mason University. E-mail: lliu@gmu.edu.
1
See Morris Goldstein and Nicholas Lardy, 2003 and John Williamson, 2003.
12 Liu Ligang / 11-20, Vol. 12, No. 1, 2004

China’s fragile banking system and its ill-developed capital markets. In addition, a nominal
RMB revaluation would not lead to trade balance between China and the US, let alone
bringing to an end of large job losses in the US manufacturing sector as the current
Administration seeks to address. The simple reason is that the large US trade deficit with
the rest of the world is fundamentally determined by its own large imbalances of savings
and investment. An appreciated yuan may only change the geographic distribution of the
US trade deficit, rather than eliminate it. However, the unintended consequence of the
RMB appreciation would be to fulfill the current market expectation of the RMB appreciation,
which in turn would attract more speculative and short-term capital inflows into China and
entice the expectation of further RMB appreciation, thus setting off a major financial bubble
in China up to the 2008 Beijing Olympics.

II. Four Underlying Factors on RMB’s Real Valuation

Why is it that by simply manipulating the nominal exchange rate of RMB, the US is not
going to resolve the structural trade deficit with China? Other than the US savings and
investment imbalances, from the Chinese perspective, four underlying factors that determine
the existing Sino-US trade balance would also help to understand the argument. The first is
related to China’s trade structure. At present, more than 50 percent of the Chinese exports
are conducted in the form of processing trade: China imports intermediate components,
mainly from Japan, South Korea, and Taiwan province, and then assembles them for exports.
The final products after assembly are then disproportionately exported to the US market.
This pattern of trade has allowed China’s powerful exporting neighbors, South Korea,
Taiwan province, and to some extent, Japan, to divert their previously US-bound exports to
China, thereby reducing their trade surplus with the US. If this triangular feature of the
Sino-US trade were to be taken into consideration, the adjusted real trade balance between
China and the US would be far smaller than the current number since China’s value added
in the processing trade has been rather minimal, mostly in the form of low wages of the
assembly workers. Indeed, this feature is evidenced by the fact that although China has a
large trade surplus with the US, it runs a similarly large size of trade deficit with South
Korea, Taiwan province and Japan (see Figure 1). Therefore, China’s global trade surplus is
small, accounting for only 2 percent of its GDP per year (IMF, 2002). As the US-China trade
deficit ballooned, it will not be surprising that China has become an obvious target. An
appreciation of RMB may appear to make the Chinese exports more expensive, but it will
also make its imports cheaper. This is because that as long as exporters can internalize this
exchange rate effect, the net impact for exports in the processing trade sector will not be
 A Structural and Macroeconomic Approach to RMB’s Valuation 13

Figure 1. China’s Trade Surplus with Key Trading Partners

00 00 00 00 00 00 00 00 00 00 00 00 0 00 00 00 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 00
40,000
00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 0 0 0 Taiwan, China 00
00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 0 0 0 South Korea 00
30,000
00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 000 00 00 00 00 00 00 00 000 000 000 00 0 0 0 0 0 0 0 00 00 00 00 0 0 0 0 0 0 0 00 00 00 0 0 0 0 Japan 0
00 00 00 00 00 00 00 00 0 0 0 0 00 00 00 00 00 00 00 00 00 00
00 000 000 000 000 000 000 000 00 00 00 00 000 000 000 000 000 000 000 00 00 00 00 000 000 000 000 000 000 000 00 00 00
00 00 00 00 EU 00
0 00 00 00 00 00 00 00 00 00 00 00 0 0 0 0 0 0 0 0 0 0
20,000
00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 0 0 0 0 0 0 0 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00
00 0 00 00 00 United States 0
0000000000000000000000
00 00 00 00 00 00 00 00 00 00 00 00000000000
Millions of US dollas

00 00 00 00 00 00 00 00 0 0 0 000 000 000 000 000 000 000 000 000 000 000 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 000 000 000 000 000 000 000 000 000 000 000 00 00 00 00 00 00 00 00 00 00 00
10,000

00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 000 000 000 00 00 00 00 00 00 00 00 00 00 00

00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 000 000 000 000 000 000 000 000 00 00 00 000 000 000 000 000 000 000 000 000 000 000
00 00 00 00 00 00 00 00 00 00 00
0

00 00 00 00 00 00 00 00 0 0 0 00 00 00 00 00 00 00 00 00 00 00 00 0 0 0 0 0 0 0 0 0 0 00 00 00 00 00 00 00 00 00 00 00 000 00 00 00 00 00 00 00 00 0 0 0
000 00000000000 00 00 00 00 00 00 00 00 00 00 00 0 0 0 0 0 0 0 0 000 000 000
0 00 00 00 00 00 00 00 00 00 00
-10,000
00000000000 0 0 0 0 0 0 0 0 00 00 00
00000000000 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 0 0 0 00 00 00 00 00 00 00 00 0 0 0
-20,000
00000000000 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00
-30,000 00000000000 00 00 00 00 00 00 00 00 00 00 00
-40,000
1995 1996 1997 1998 1999 2000 2001

Source: IMF, Directions of Trade, 2002.

affected much. However, an appreciated yuan will disproportionately hit the exporters in
the non-processing trade export sector primarily dominated by Chinese domestic firms,
further exacerbating the painful restructuring and the wage depression process.
The second factor that has much influence on RMB’s real valuation is value-added
export tax rebate implemented in 1998. By addressing export subsidy issue first, China still
has ample room to maneuver before any consideration of the exchange rate appreciation. In
the midst of the 1997-1998 Asian financial crises, former Chinese premier Zhu Rongji, while
pledging not to devalue the RMB, also sought to placate Chinese exporters by offering
them a 17 percent value-added export tax rebate. This policy, still in effect today, has
certainly contributed to an imbedded real depreciation of RMB. The export tax rebates,
which have contributed to maintain China’s export growth over the turbulent period of the
Asian financial crisis, are no longer needed at a time when China’s export growth is robust
and its FDI inflows reach a record number, even surpassing the United States for the first
time in history. To be sure, China’s rapid export growth since the 1998 has made the export
tax rebate too expensive to maintain. The export tax rebate, currently stands at US$ 24 billion
or a quarter of China’s trade surplus with the US, also runs the risk of impairing the credibility
of the government as the Ministry of Finance would have to backlog the payments to
exporters for at least a couple of years. Not only is the export tax rebate too expensive, but
it has also led to distorted incentives and increased corruption as some exporters round-
trip their products in order to qualify for tax rebates. From the income distribution point of
view, the export tax rebate has a biased impact: tax payers in other sectors of the economy
are subsidizing the exporting sector, which by far is the most profitable and fastest-growing
14 Liu Ligang / 11-20, Vol. 12, No. 1, 2004

sector of the Chinese economy.

Given China’s large reserves of productive labor force, one could never ignore the
wage rate issue in the calculation of China’s trade competitiveness. This is the third factor
that is affecting RMB’s real valuation. China’s export structure in terms of technology
content and valuation has improved markedly over the past years. However, it is puzzling
that the wage rates in the labor-intensive exporting sector have not changed much over the
last ten years, roughly staying at around US$100 a month (Cheong and Xiao, 2003). This
rather stagnant wage pattern can be connected directly to the on-going restructuring in the
state-owned enterprise sector and the fact that China has an unlimited supply of labor from
its vast rural area. Because of these two factors, the wages in the export sector have not led
to an overall domestic wage growth, usually observed in a country with large inflows of
FDI where an uplifting effect through the relative higher wages in the export sector will tend
to pull up the overall wage rate of the economy.
The fourth factor is related to China’s FDI investment regime. Although China is the
largest recipient of FDI in the world, close to 60 percent of its inflows are from Taiwan
province and Hong Kong SAR, as well as its own round-tripped capital via Hong Kong
SAR and more recently and increasingly, from offshore banking centers such as the
British Virgin Islands and Bermuda. These firms are mainly small- and medium-sized ones
with a short investment horizon and low technology content. Their main motives are to
take advantage of China’s cheap labor, generous fiscal incentives offered by both central
and local governments, and securer property rights protection not usually offered to
domestic investors. To attract FDI and create jobs, local governments are often eager to
offer more fiscal incentives than that already granted by the central government. The
income tax of foreign-funded firms is a case in point. At present, the income tax rate is
only 15 percent for foreign-funded and joint venture firms in special economic zones, less
than half of the 33 percent levied on domestic firms. In addition, foreign-funded enterprises
can enjoy an income tax exemption in the first 2 years after making profits and an income
tax reduction by half in the following 3 years. For so called FDI-funded high-tech firms,
income tax reduction by half will be extended further to 6 years. These tax incentives are
further sweetened by concessions that stipulate favorite treatment of land, raw materials,
energy and labor usage. Fiscal subsidies have made the real costs of capital of FDI-
funded firms, especially of those export-oriented ones, considerably below the world
market price.
As long as these four underlying structural factors of China’s export competitiveness
are still in place, a simple revaluation of RMB, in spite of its expediency, can not adequately
address the concerns of the policy makers in the US: trade competitiveness and halting job
 A Structural and Macroeconomic Approach to RMB’s Valuation 15

losses in the manufacturing sector. Even if China were to appreciate its currency by 15 to 25
percent in nominal terms as suggested by Morris Goldstein and Nicolas Lardy of the
Institute for International Economics, the nominal appreciation could easily be offset if
exporters in China were to be given additional concessions in kind by local governments
for local economic growth reasons and other types of export incentives by the central
government for reasons to continue to maintain China’s exports growth.
Apparently, Chinese policy makers are fully aware of these structural factors behind
China’s real export competitiveness. Because of the RMB appreciation pressure, on
the trade side, they are in discussion to reduce the value-added tax rebate rate to 11
percent from a previous 17 percent.2 To lessen market pressures, they are in the process
of relaxing foreign exchange controls imposed on Chinese firms and citizens to bring
foreign exchange overseas so as to alleviate the pressures of RMB appreciation because
of capital inflows. Obviously, to reduce the value-added tax rebate is a policy in the
right direction. However, the ad-hoc and piecemeal approach to capital account
liberalization could potentially lead China to repeat what the crisis countries in Asia
erred before the 1997-1998 crisis, thus casting aside the valuable lessons learned.
Given China’s existing institution quality and limited capacity to monitor capital flows,
the current inflows can be quickly reversed once the market sentiment on China sours.
The experiences from countries that have successfully liberalized the capital account
indicate that there must be an overall policy framework to sequence the capital account
opening through speedy building up of core institutions that are related to capital
account transactions such as clear property rights, efficient legal system, prudential
oversight, sound banking system, enhanced transparency and disclosure rules, and
foreign participation in the domestic financial sector. By various measures, China still
trails far behind in each of these areas mentioned. It is only wise for China to take a
cautious and risk-based approach toward its capital account liberalization.
Notwithstanding, it does not mean that China should not proceed with its financial
liberalization. Its liberalization policy has to be sequenced carefully with its domestic
sector liberalized first before contemplating the capital account liberalization and its
exchange rate regime (for detailed argument see Chan-Lee, et al., 2002). The current
dollar pegged system has served China well as its domestic capital market is still nascent
and its international transactions are all denominated in dollars. Given its institutional
capacity, it is a system that allows great flexibility and less complexity.

2
China announced on October 15, 2003 that there will be 3 percentage reduction of the export tax rebate
starting on January 1, 2004.
16 Liu Ligang / 11-20, Vol. 12, No. 1, 2004

III. Policy Responses

Then what should be China’s proper response to RMB’s appreciation pressured by both
financial markets and the U.S.? In fact, if properly framed, the RMB valuation policy
could have a natural connection with China’s short- and medium-term policy objectives
as stated by the new leadership in Beijing: reducing regional disparity and income gap
through eliminating distortions and raising rural income, continuing institutional
convergence as committed by China’s WTO obligations, and further developing its
nascent but inefficient capital market. Indeed, the RMB issue offers a rare opportunity
for the new leadership in Beijing to put into practice of their visions of development
agenda for the next five years.
In the near term, to deflect immediate pressures to revalue its currency, China should
consider reducing or even revoking the 17 percent value-added export tax rebate
implemented in 1998 in the near future. By phasing out the export tax rebate, China would
effectively allow yuan’s real appreciation against the US dollar, thus mitigating protectionist
pressure from the US and Japan. This policy initiative will show that China is a responsible
partner in the global economic adjustment process. In fact, the most significant part of
this policy is that it suits China’s own interests well as the export tax rebate program has
become outdated and too expensive to maintain. As a technical note, since nobody,
including the prominent economists from the Institute for International Economics, knows
the equilibrium exchange rate of renminbi, the yuan’s valuation issue could be further
studied through joint academic research and international conferences. This will show
that the new leadership is not only willing to listen to the domestic needs of its own
people as they have done so since coming to power but also willing to play a constructive
role in the world economy, as indicated by President Hu’s first attendance of the G-8
meeting in France.
In the medium term, the leadership could use this opportunity to take steps of
making its FDI policies in line with China’s WTO commitments. Despite China’s large
inflows of FDI, China is in fact an underachiever to attract FDI from large multinational
companies of the OECD economies. There are reasons why multinational companies
are still reluctant to relocate to China. For Instance, a recent survey conducted by the
Japan Bank for International Cooperation (JBIC, 2002) shows, despite the fact that
China has become a favorite place for Japanese investors, its FDI policies and regulations
still lack maturity, transparency and predictability. China’s scores in those areas have
been the worst among countries that Japanese firms have invested. Even with extensive
incentives in place, the current FDI-related tax system remains opaque and is subject
 A Structural and Macroeconomic Approach to RMB’s Valuation 17

to frequent changes. The current FDI regime, despite its quantity success, needs to be
improved further through greater transparency and predictability to reach a quality
success by attracting large investments from multinational companies, for they tend to
offer high technology content that will demand a large amount of high-skilled labor
paid with higher wages, thus elevating the relative wage rate between the FDI sector
and the domestic sector so that the overall wage rate in the economy can be allowed to
rise to stimulate domestic demand.
China’s fiscal pump priming, initiated in the midst of the Asian financial crisis to
uphold growth target, have run out of steam over time as it has not been effective in
generating self-sustaining growth of domestic demand. Measured by its contribution
to GDP growth, domestic demand has been rather flat over the last five years. The
explanation of a low multiplier effect of these fiscal stimulus packages lies in the fact
that the current fiscal stimulus packages have a biased focus on urban areas by building
non-productive but symbolic infrastructure projects such as magnificent city halls and
monumental sky scrapers. Their economic returns may take years to recover. What is
worse is that these infrastructure investments are not incentive compatible as the local
governments benefit the spending and the central government picks up the tabs, thus
giving rise to pervasive moral hazard and soft budget constraint problems. Recognizing
these existing problems, the Ministry of Finance, which carries out most of the programs,
is lobbying to end such programs as they may jeopardize its long-term fiscal health.
Indeed, they have good reasons to fear so. Although China’s current domestic debt
level on book is still manageable at about 20 percent of GDP, if counting its potential
costs of clearing up mountains of non-performing loans (NPLs) in its state-owned
banking system, its liability in unpaid pensions, as well as external debt guarantees,
China’s national debt as a percent of GDP could easily climb above 100 percent (Chan-
Lee, et al,. 2002). Given its small revenue to GDP ratio at 16 percent currently, the fiscal
stance is clearly not sustainable.
Another reason the fiscal stimulus packages have been ineffective may have to do
with where they have been placed. While over 70 percent of the Chinese population still
lives in the rural area, the infrastructure needs in the rural sector have been largely ignored
since China’s economic reform. At present, the rural sector suffers from inadequate roads,
dilapidated irrigation systems, poor education facilities, and a non-existent rural health
system. China is now haunted by these inadequacies as evidenced by more frequent
floods, large scale of unskilled peasants roaming into the urban area in search of jobs, and
more recently, the occurrence of the highly contagious severe acute respiratory syndrome
(SARS). It is the depressed rural sector that should be given priority for the government’s
18 Liu Ligang / 11-20, Vol. 12, No. 1, 2004

fiscal pump priming since the investment in this sector can help reduce large regional
disparity and income gap. Empirical evidences (Barro, 1999) have shown that by focusing
on income gap and regional disparity issues, the formidable force of economic convergence
at both individual and regional level would unleash large productivity gains and bear long-
term benefits.
Then the question is how to fund these potentially large infrastructure needs in the
rural sector in the medium term? Obviously what the central government can do is rather
limited given its revenue to GDP ratio and its inadequate ability to conduct effective fiscal
transfers to shrink large regional income gap. Thus private capital must be allowed to
participate in this endeavor. After twenty years of economic reform, China is no longer a
capital-deprived country. Its stock of savings has exceeded 100 percent of GDP, in addition
to its large foreign exchange reserves. Indeed, the Chinese collectively are second largest
savers in the world, next to the Japanese. How to effectively utilize this stock of wealth is
what the government will need to address urgently. Inefficient capital allocation can be
better addressed if China can rethink its capital market development strategy by giving
priority to its government and municipal bond market development. This market will help to
meet the physical infrastructure need in the rural sector because of its large amount of
domestic savings. If long-term bonds can be issued by local government with some credit
enhancement from the central government for certain provinces in need, in addition to
measures such as enforcing the already existing balanced budget law for Chinese provinces
to constrain excessive local spending, credit ratings to assess local government financial
health, and an authorization procedure by the central government at the early stage of the
market development, the rural investment needs can be met as China has a surplus of
capital and it has been funding the rich consumers in the US. Of course, this does not
exclude the roles of foreign participation. These initiatives will certainly stimulate the
development of China’s municipal government bond market.
The fixed income market, once allowed to be developed, will offer viable investment
vehicles for China’s pension funds and for small investors who fear the stock market is too
risky and volatile to put their life long savings. This segment of capital market could also
offer hedging instruments for banks and securities firms to manage risks, thus contributing
to the improvement of their profit margin and the overall efficiency of China’s capital
market. In fact, these local government bond issuances are another form of fiscal
expansionary policies, and if accommodated by monetary policies, will raise productivity of
rural sector and the rural income. Higher rural income will substantially raise domestic
demand, thus putting an upward pressure on the existing price level of the economy. As
China is still lingering with the effect of deflation, the combined expansionary fiscal and
 A Structural and Macroeconomic Approach to RMB’s Valuation 19

monetary policies will effectively stimulate domestic demand by shoring up the overall
price level. This reflation effect will thus give rise to a real appreciation of renminbi. With
robust domestic demand, China will then be reckoned as an important economic power to
help resurrect the sputtering world economy over the next 5 years.
Another compelling reason to invest in the rural sector through infrastructure
spending is that it would raise productivities of the rural laborers and thus the income of
the population that is close to that of the US, the EU and Japan combined. The elevated
income level in the rural sector will raise the current domestic demand that is currently
not able to meet the excess capacity of the Chinese manufacturing sector. As a result,
China has to export to the rest of the world. Indeed, China’s economic growth has been
mainly pulled by government fiscal stimulus packages and external demand in recent
years. This is also reflected by a very high percentage of trade to GDP ratio, which stands
at close to 50 percent. As China is a continental-sized and a large economy, the current
trade to GDP ratio is rather abnormal and obviously unsustainable. If China’s large
domestic demand can be raised, it will alleviate the fear associated with the emergence of
China. Therefore, both developed and developing countries would continue to enjoy
prosperity on a sustained level brought by globalization.

IV. Concluding Remarks

Almost 90 years ago when Henry Ford offered his workers the wage of 5 dollars a day –
a much higher wage at that time, he had an economic insight not apparent to most people
at that time. If a majority of his workers could not afford to buy his Model-T automobiles,
who would then demand them after productivity and efficiency were improved immensely
that a mass production of cars was no longer a fantasy. His insights proved to be right.
Today, the world is facing a similar dilemma: Integrating large, populous and poor
developing countries into the world market will boost their manufacturing capacities
because of their large pool of semi-skilled industrial workers and it will also directly
impact on welfare of industrial workers of the developed world. To solve this dilemma,
the wage rates and income of those developing countries will have to be allowed to go up
so that some of the goods produced can be demanded by their own large internal markets.
Other than waiting for the labor market alone to adjust the wage rates in developing
countries, this process can also be facilitated if governments in both developed and
developing countries collectively pay attention to and enforce their labor laws so as to
allow wage bargaining between workers and employers to take place. On the other hand,
this also means that the beneficiaries, mostly the transnational corporations, from the
20 Liu Ligang / 11-20, Vol. 12, No. 1, 2004

globalization process will have to share some of their profits with the industrial workers
in the developing countries. Similar to the insight of Henry Ford, it may be a difficult
policy for some to accept at the moment. But for the sake of global prosperity, such
measures could be proven to be beneficial for everyone. Presumed as a champion for the
welfare of workers and peasants, the Chinese government can play a decisive role in
initiating a global movement that will first benefit its own millions of industrial workers
and peasants at home.
The new leadership in Beijing came to power with an image of pro-poor, pro-rural
sector, and pro-peasants. So these medium-term policy initiatives proposed here are
consistent with their policy agenda of raising income and enhancing health and education
of the rural poor. What is the most important is that such policies, long ignored, would
generate sustained domestic demand, thus paving a way for another two decades of rapid
economic growth.

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