By BOB DAVIS
WASHINGTON—Inflation, real-estate bubbles and weak monetary controls pose "significant risks to financial and macroeconomic stability" in China, and Beijing should boost the value of its currency to combat those threats, the International Monetary Fund said.
The IMF used its annual review of China's economy to lay out a broad agenda of change for China—including a stronger currency, higher interest rates, reduced advantages for big state-owned enterprises and a liberalized financial sector. Such changes were necessary, the IMF argued to improve Chinese living standards and reduce conflict with its trading partners.
The IMF declared the yuan to be "substantially" undervalued. An IMF panel estimated the yuan is undervalued between 3% and 23%, depending on the methodology used.
Over the past year, the Fund estimated that the value of China's currency against all its trading partners actually fell by about 2% adjusted for inflation. Against the dollar, though, it gained about 8% after inflation over the past year.
The IMF review was aimed boosting those inside China, including at the People's Bank of China, who have been arguing for change, although perhaps not on as sweeping a scale. The report, though, could be used by China's many opponents in Congress and elsewhere who want the U.S. government to take a much harder line on the currency and other issues.
China's representative to the IMF, He Jianxiong, sharply disagreed with a number of IMF's conclusions—including its assessment of the currency. He said that one reason that China's reserves have grown to more than $3 trillion is that central banks in the U.S. and Europe have kept interest rates so low that capital has surged into emerging markets.
"The report fails to mention China's role as an important source of global stability and growth," Mr. He and his senior adviser, Zhang Zhengxin, wrote in a statement attached to the IMF report.
For the short term, the Fund was more optimistic about China's prospects than some other economists. It forecast that China would grow 9.6% this year and that the pace of consumer price inflation would fall to 4% by the end of 2011, from more than 6% currently.
But the IMF, like many China specialists, said fundamental change was needed for China to continue to grow strongly and for gains to be more widely shared.
The IMF seized on China's determination to keep its exchange rate from rising as a major obstacle. To keep the yuan from rising, a development that would hurt China's exports, the Chinese central bank prints a lot of yuan and uses them to buy dollars. That keeps the yuan from rising more rapidly against the dollar than markets would take it. Then the PBOC tries to "sterilize" the effect of printing all those yuan, which could produce unwelcome inflation, by forcing state-owned banks to trade yuan for low-interest government bonds instead of lending yuan out.
One consequence is that the PBOC and its superiors in the Chinese government have an incentive to keep interest rates low. If interest rates went up, those sterilization bonds would have to carry a higher interest rate, and the tab for managing the currency would rise.
But that has side effects. Bank deposit rates are set well below inflation, so ordinary Chinese put their money instead in real estate, feeding property bubbles. Big capital-intensive state-owned firms borrow at very low rates, while more labor-intensive service companies have trouble getting bank loans at any rates.
Even though China has been growing at about 10% a year since 2004, it is only adding jobs at 1% a year, the IMF reported.
Boosting the value of the yuan is a "key ingredient to accelerate the transformation of China's growth model" so it produces more jobs and reduces the advantages of state-owned firms. But winning political support for such a change is difficult in China, where exporters and state-owned firms have immense political power and ordinary Chinese households don't.
The IMF cautioned that the U.S. and Europe wouldn't be big winners from a jump in value of the yuan, at least initially. A 20% yuan appreciation would boost U.S. growth by between 0.05% and 0.07%, the IMF calculated, and the euro zone's growth by less than 0.12 %. The IMF report didn't explain why but a number of economists have argued that the vast bulk of exports that China lost would shift to other low-cost nations, not to the U.S. or Europe.
Write to Bob Davis at email@example.com