Serious Money:China has come a long way since reforms were first introduced in the late 1970s and its subsequent expansion has been the largest growth surprise experienced by the world economy.
In recognition of its growing stature, the International Olympic Committee awarded the 2008 games to the Middle Kingdom seven years ago, just as it had endorsed the Japanese economic miracle with the Tokyo games of 1964 and South Korea's achievements with the Seoul games of 1988.
China's economic miracle is beyond dispute but there are increasing signs that its investment and export-led expansion is out of control and that its gradualist approach to reform is no longer appropriate.
China's top political leadership recognised almost three years ago the need to rebalance the economy away from investment and export-led development towards consumption, but visible signs of a more sustainable growth path are few and consumption accounts for less than 40 per cent of gross domestic product (GDP) as compared with roughly 70 per cent in the US.
Attempts to cool the economy have been similarly fruitless, as growth has accelerated by two percentage points since the tightening campaign began in 2004. Indeed, GDP grew by almost 12 per cent in this year's second quarter and the contribution from net exports remained above three percentage points for the fourth consecutive quarter.
It is clear that current policies are not working.
Much of China's difficulties in its attempts to both cool and rebalance its economy can be traced to its exchange rate policy. While a well-publicised yuan revaluation of roughly 2 per cent versus the dollar, alongside the adoption of a daily trading band of 0.3 per cent, were announced two years ago, the evidence to date suggests that a de facto peg still exists.
Despite a nominal appreciation against the dollar in the interim, strong productivity gains mean the real exchange rate has barely moved at all.
Meanwhile, the greenback's travails versus most major currencies means that the yuan, which has shadowed the dollar's decline, has seen Chinese exporters become even more competitive, particularly against the euro.
This is no longer a matter of economic curiosity, as China's current account surplus as a percentage of GDP soared to more than 9 per cent in 2006 and could reach 12 per cent this year, levels that are likely to provoke political retaliation in the long run.
The upward pressure on the yuan is enormous, given the large current account surplus and hefty capital inflows, but the People's Bank of China has prevented appreciation through substantial intervention in the currency markets.
The accumulation of foreign currency has been staggering. China's foreign-exchange holdings have risen six-fold over the past five years and early last year its stock became the world's largest, exceeding those of Japan. The level of reserves exceeded $1 trillion (€724 billion) within a matter of months and currently amounts to more than 40 per cent of GDP. The rate of accumulation suggests that reserves could exceed $2 trillion at some point in 2008, a staggering amount relative to the size of China's economy and an extraordinary waste of resources.
A quasi-fixed exchange rate compromises monetary policy independence and the central bank's ability to slow the economy through conventional means. Interest rates cannot be raised significantly because the resulting capital inflows would place further upward pressure on the currency, which would then require acceleration in the rate of reserve accumulation and substantial sterilisation operations to prevent a sharp increase in money growth and inflationary pressures.
Consequently, recent increases in the lending rate have been far too small to raise the real price of capital to a meaningful level for an economy that is experiencing double-digit growth.
The lack of exchange rate flexibility not only reduces monetary policy independence but also hinders banking sector reforms. The price signal emanating from the exchange rate encourages banks to lend predominantly to the export sector, which could lead to a surge in bad loans should the authorities revalue or the world economy slow significantly.
Additionally, large-scale sterilisation operations have seen the banking sector's holdings of low-yielding central bank bills soar, which is encouraging greater risk-taking in their lending portfolios in order to boost income.
Social friction is a huge issue in the Middle Kingdom but current policy does nothing to reduce tensions. Investment and export-led growth has led to growing income inequality and job gains have not been sufficient to absorb labour force growth and migrants from rural areas. Indeed, employment growth in the non-farm sector has lagged economic gains by roughly six percentage points on average over the past five years.
China's growth strategy is not working but change is unlikely ahead of the party congress this autumn and next year's Beijing games. However, the imbalances are growing larger and macroeconomic models show that, if the nominal exchange rate does not adjust in response to a change in fundamentals, then relative prices will eventually adjust through a destructive bout of inflation. The time to act is now.
