Does China need the dollar peg to ensure domestic financial stability? This has long been a cornerstone argument of the Chinese government, but the IMF thinks otherwise.
We argue that with existing capital controls in place -- even if these are somewhat porous -- the banking system is unlikely to be subject to substantial stress simply as a result of greater exchange rate flexibility. Domestic banks do not have a large net exposure to currency risk, and exchange rate flexibility by itself is unlikely to create strong incentives (or channels) to take deposits out of the Chinese banking system. . . .Unfortunately, the IMF report doesn't say much more than this on the issue of domestic financial stability and the peg.
The current overall exposure of the corporate sector and banks in China to foreign exchange risks appears to be low . . . indicators seem relatively innocuous when compared with those of other countries. Their recent evolution, however, points to a trend that bears watching closely: during 2001-03, banks' foreign currency loans to domestic residents have increased by over 60 percent, net foreign currency liabilities are up by nearly 50 percent, and total short-term external debt (which is denominated in foreign currencies) has risen by over 50 percent.
The relative and absolute values of the Chinese banking system's foreign currency exposure seems a slightly different issue from what The Economist, for example, repeatedly calls the "weak" or even "fragile" Chinese banks. Something that is weak and fragile, of course, cannot absorb the same blow which something robust and resilient can. The question isn't merely exposure to foreign exchange instability, but also the large volume of nonperforming loans in the system overall, a matter the IMF report does not deal with at all. If many of these nonperforming loans are both in foreign currencies and in politically sensitive sectors, all the more reason to fear a move off the peg.
Thus I continue to believe that the expenses of the dollar peg are simply the price of the stability the Chinese leadership so dearly desires. This doesn't mean, of course, that China won't demand higher interest rates on US treasuries . . .
UPDATE: More good discussion on this matter from Sean Corrigan, aka Obiter Dicta at Sage Capital AG.