1. Alternative sterilization tecniques: A comment on Prasad and Rajan Ricardo Hausmann Kennedy School of Government Harvard University

2. The problem Large balance of payments surplus in China Capital controls prevent residents from reallocating assets abroad Sterilization creates a fiscal cost and a risk to the balance sheet of the public sector

3. The proposed solution Partial flexibilization of the capital account Allow close-end funds that invest abroad

4. Advantages Allows the government to maintain control over the volume of capital outflows  May permit a more orderly stock adjustment  May protect a weak financial system Transfers the risks and rewards directly to the private sector Allows for a reduction in the external imbalance by reducing the capital account surplus

5. Comments Not relevant for Latin America at this time  Capital accounts are open already More flexibility is always better.  The government can always set the amount back down to zero. Incentives may have the wrong time profile  Demand will be low (high) when expectations are for the RMB to appreciate (depreciate)

6. Comments If fund managers actively manage exchange rate risk, the effects on the currency market may be mute Conflicted virtue (the opposite of original sin) may become an issue  Not a critique of the scheme itself

7. The Chinese external imbalance What causes it? What to do about it?

8. China’s external imbalance China has a current account surplus of some 4 percent of GDP It also has an FDI surplus of another 4 percent of GDP  Potential round-tripping of 2 percent of GDP In addition, it has speculative capital inflows in anticipation of revaluation Reserves have been accumulating very fast Money supply and sterilization bonds are also growing very quickly There are international political pressures for appreciation What should China do?

9. China’s external surplus China: Current account balance and inward FDI

10. Analysis A current account surplus involves an excess of domestic savings over investment Investment is at world record levels The country suffers from excess-savings, or insufficient consumption

11. China’s investment rate is almost at world record levels (2003) Gross fixed capital formation (% lpppgdp 6.2501410.2997 8.82839 55 AGO ARG AUT AZE BDI BEL BEN BFA BGD BGR BLR BOL BRA CHL CHN CIV CMR COL CZE DEU DNK DOM DZA ECU EGY ESP ETH FIN GBR GEO GHA GIN GRC GTM HKG HND HTI HUN IDN IND IRN ISR ITA JOR JPN KAZ KEN KGZ KHM KOR LKA MAR MDG MEX MLI MOZ MWI MYS NER NGA NIC NPL PAK PER PHL POL PRY ROM RUS RWA SAU SEN SLE SLV SVK SWE SYR TCD THA TJK TUN TUR TZA UGA UKR UZB VEN VNM YEM ZAF ZAR ZMB

12. External and internal balance Real Exchange Rate Demand External Balance Full employment Unemployment Surplus Unemployment Deficit Over-heating Surplus Over-heating Deficit depreciation

13. Where is China? Where should it go? Real Exchange Rate Demand External Balance Full employment Unemployment Surplus Unemployment Deficit Over-heating Surplus Over-heating Deficit depreciation

14. What should macro policy do? A real appreciation by itself risks generating unemployment and deflation  Inflation is running at 1.8 percent (March 2006)  …In spite of the rise in commodity prices and energy It needs to be complemented with an expansion of demand This could come from monetary or fiscal sources The banking system is already very leveraged …and would allocate the resources in the most prosperous areas where there is good collateral Fiscal policy can be targeted socially and regionally

15. An expansionary demand policy? Is China over-heating? Over-heating vs. over-investment  Excess demand vs. excess supply Slow vs. fast policies  Exchange rate is a fast policy  Fiscal policy is much slower to put in place If appreciation needs to be allowed to happen, it better be preceded by the adoption of the fiscal expansion

16. Conclusion Real appreciation may be hard to avoid …but it should be accompanied by a fiscal expansion The resources should be used in the context of a development strategy that maintains growth and deals with social and regional imbalances