Why China Should Abandon Its Dollar Peg by
Nouriel Roubini1
Stern School of Business, NYU and
Roubini Global Economics (www.rgemonitor.com)
January 2007
Introduction
This paper argues that China should allow its currency to significantly appreciate and move to a regime of more flexible exchange rates. It should thus phase out the effective peg with a snail pace of appreciating crawl that characterizes its current exchange rate regime.
The Chinese trade surplus and current account surplus are now growing at accelerating rates, thus leading to market pressures for the currency to appreciate. At the same time massive amounts of FDI and hot money inflows into China have also added to the appreciation pressures on the currency. Thus, the only way the Chinese authorities have been able to prevent a sharp exchange rate appreciation has been to aggressively
intervene in the foreign exchange market. This accumulation of foreign exchange
reserves has run at annual rates that have staggering: about $250 billion per year in 2005 and 2006.
Numerous studies have shown that the renminbi (RMB) is grossly undervalued and that sustained growth in China is consistent with a real appreciation of its currency. Analysis also suggests that failure to allow a nominal appreciation would eventually entail
significant risks and costs for the Chinese economy. These risks and costs include: the risk of protectionism in the US and Europe if Chinese net exports keep on growing at their recent very fast rates; the excessive creation of liquidity and credit that a policy of partially sterilized intervention entails thus feeding the overheating of the economy; the imbalanced nature of the components of aggregate demand with excessive reliance on
1 Email: [email protected] . The usual disclaimer applies.
net exports and real investment and a very low level of private consumption; the eventual large capital losses on holdings of foreign reserves once the currency eventually
appreciates; the risk of an eventual surge in inflation.
Thus, even leaving aside the unfair “China bashing” that is occurring in the US and the protectionist pressures in the US, it is in the interest of China to move to a more flexible exchange rate regime. Some argue that a sharp RMB appreciation would entail
significant risks for China: an excessive slowdown of growth, deflationary pressures in the economy, and increased poverty in the rural sector. But such risks are modest once one considers the evidence on them and the appropriate policies that can be taken to reduce such costs. Instead, delaying the necessary nominal and real appreciation of the RMB increases the risk that China will eventually experience a hard landing from its excessively overheated economy. Such a hard landing was experienced by China in the 1990s when the investment bust following an investment bubble led to a severe growth slowdown.
1. Growing Chinese current account surpluses and reserve accumulation signal an undervalued RMB
The growth of exports and of the trade surplus in China has been phenomenal in the last few years. In 2002, Chinese exports of goods were about $325 billion in goods. In 2006, such exports may be as high as $950 billion, an almost tripling in four years. China’s current account surplus is expected to be $220 billion in 2006, up from $35 billion in 2002.
In 2005 China intervened in the foreign exchange market and accumulated foreign exchange reserves to the tune of $250 billion as a way to prevent its currency from appreciating in the face of a massive current and capital account surplus. This reserve accumulation derived from the fact that China’s current account surplus was close to
$100 billion, the inflow of FDI was about $50 billion and hot money inflows surged to about $100 billion. Without such aggressive intervention the RMB would have sharply appreciated.
In 2006 the trends of 2005 have continued; exports are still growing at a 30% annualized rate and the current account surplus has increased further relative to 2005. At the same time FDI and hot money inflows are running at rates that are only modestly lower than in 2005. Thus China accumulated about another $250 billion of reserves in 2006 while its stock of foreign reserves already officially reached the staggering figure of $1,000 in late 2006. It is thus clear that the RMB would have sharply appreciated if the Chinese
authorities were not intervening to prevent such appreciation from occurring.
Some argue that the Chinese authority demand and accumulation of foreign assets does not prevent a RMB appreciation as it is a substitute for the repressed domestic private demand for foreign asset while there are still strict capital controls on private outflows.
This argument is specious: as Chinese and foreign investors expect a sharp appreciation of the RMB even a significant liberalization of the controls on outflows would not lead to
a significant short term demand for foreign assets by the Chinese private sector. Indeed, hot money is flowing into China, not out of China, in expectation of an RMB
appreciation driven by massive trade surpluses and FDI inflows.
This expected appreciation is not driven by the US “browbeating” China into letting its currency appreciate: it is instead driven by the massive market pressure into a
strengthening of the RMB given the huge and growing current and capital account surpluses of China. Only once the RMB has sharply appreciated and Chinese private investors could then buy foreign assets at much lower fire-sale prices. If capital controls were phased out, one would start to observe over the longer run a significant increase in the Chinese demand for foreign assets as part of a long-run international portfolio
diversification trend. In the short and medium run liberalizing capital controls on inflows and outflows would increase net inflows and the pressure for an appreciation in the absence of official intervention.
The staggering growth in Chinese exports and in its trade and current account surplus is prima facie evidence that the RMB is significantly undervalued. But other more formal studies have reached the same conclusion.
Jeffrey Frankel2 has used the Balassa-Samuelson effect to assess the RMB’s
undervaluation. The nominal exchange rates of poor countries are usually well below their purchasing power parity exchange rates. The difference between a country’s nominal exchange rate and its purchasing power parity exchange rate usually tends to become smaller as a country’s per capita GDP increases. However, the difference between China’s purchasing power parity exchange rate and its nominal exchange rate is unusually large even compared to other low income economies. In 2000, prices in China were 23% of the level of US prices. To be consistent with standard for countries at a similar stage of economic development, Chinese prices should have been around 36% of the level of US prices. The gap between China’s actual prices and those predicted by Frankel is likely to be larger today as Chinese growth has been rapid in the last six years while the nominal exchange rate has barely moved.
Chinn, Cheung and Fujii3 have taken a similar approach by considering the relationship between a country’s income level and its real exchange rate. Empirically an increase in a country’s per capita income relative to the US leads to an appreciation of its real
exchange rate. In the case of China, however, the real exchange rate has been
depreciating while its per capita income has sharply increased. Based on their estimates, the Chinese currency needs to appreciate by around 50% for its real exchange rate to be comparable with the average for developing countries with similar income levels.
Other studies have also found, using a variety of methodologies, that the RMB is sharply undervalued even if the results on the degree of undervaluation depend on the
assumptions and methodologies of different studies.4
2 http://www.nber.org/papers/w11274
3 http://www.ssc.wisc.edu/~mchinn/RMB_paper.pdf
4 http://www.imf.org/external/pubs/ft/wp/2006/wp06220.pdf
2. Is the Chinese surplus mostly due to the weak currency or rather domestic and global factors?
There is a strand of thought that argues that the growing Chinese surplus has little to do with the value of the RMB. In this view even a relatively large RMB appreciation would have little effect on the Chinese trade surplus. This argument goes along several lines.
First, it is argued that global imbalances are caused only by the US fiscal deficit rather than an excess of savings in China. Second, as far as China contributes to these global imbalances through its excess of savings, the factors driving this savings glut are claimed to be structural rather than being related to the exchange value. Third, as long as
“expenditure reduction” (increase) policies are not adopted in the U.S. (China) movements of the exchange rate will have little effect on these current account imbalances. In other terms, the “expenditure switching” effects of changes in real exchange rates are alleged to be small.
A fair and balanced assessment of the evidence suggests that global imbalances are due both to US policies and Chinese policies, including its exchange rate policy. US fiscal deficits were certainly an important driver of the growing US current account deficit especially in the 2001-2004. Then, the US fiscal balance moved from a large surplus to a large deficit and the current account thus worsened in spite of a sharp fall in the
investment rate in the US.
But in 2005-2006 the US current account deficit further worsened in spite of an
improvement in the fiscal balance. Indeed, in 2005-2006 an excess of savings from China as well as from oil exporters helped keeping global nominal and real long term interest rates lower than otherwise, the so-called “bond market conundrum”. These low interest rates, in turn, stimulated real investment and reduced private savings in the US. The latter effect exacerbated by the effect that lower rates had on housing price, housing wealth and thus private consumption. Thus, in equilibrium the Chinese surplus of savings
contributed to US, Chinese and global current account imbalances.
It is correct that Chinese savings are high in part because of structural factors. Chinese households save a lot for a variety of reasons. They need funds for education and health care as public provision of these goods is dismal. They need to save because there is no sound social security system for old age and there is no social safety net in the case of unemployment. Also, the underdeveloped credit markets do not allow such households to borrow intertemporally to smooth temporary fluctuations of consumption or to easily finance housing investment.
But the exchange rate regime has also had an important role in driving the trade balance of the China: as economic theory suggests trade balances depend both on expenditures switching policies (the nominal and real exchange rate) and expenditure
reduction/expansion policies. A persistently weak RMB has made imports expensive and exports cheap reducing in relative terms both overall consumption and consumption of imports. This weak currency has also induced an excessive allocation of productive resources to the tradeable export sector. A weak currency has also made FDI highly
profitable by allowing foreign firms to buy Chinese assets at low prices and/or set up at lower costs productive capacity for exports in China.
The weak currency has thus fostered a growth model based on low consumption, low imports, high investment in tradeables and high and profitable exports. Thus, high relative prices of foreign goods via a weak RMB have led to low consumption, high savings and high investment in tradeable exports, thus expanding the current account surplus.
It is correct that reduction of global imbalances will require expenditure reduction policies in the US and expenditure expansion policies in China. But trade balances also react to, and require for their adjustment, changes in relative prices (what economists call
“expenditure switching” policies) driven by changes in nominal and real exchange rates.
The evidence that China’s trade balance does indeed depend on the level of the exchange rate comes from the evolution of its trade with Europe following the very sharp
depreciation of the RMB relative to the Euro in the 2002-2006 period. In this period the RMB shadowed the US dollar apart from the modest 2.1% appreciation of July 2005 and the very modest upward crawl afterwards. And it thus followed the US dollar downward relative to the Euro.
The consequences of this sharp weakening of the RMB relative to the Euro have been significant: Chinese exports and net exports to Europe have grown at an even faster rate than their exports to the US. Thus, exchange rates and relative prices do matter for trade flows and trade balances. The idea that an RMB appreciation would have no effect on China’s overall trade surplus or its surplus with the US does not square with the evidence that exports and imports price elasticities are significant in size. They also do not square with the alleged Chinese concerns that a strong RMB appreciation would negatively affect competitiveness and growth. Claiming at the same time that an RMB appreciation will not affect trade flows and that it risks leading to a sharp slowdown in Chinese growth is logically inconsistent.
Since there is a general agreement that the global current account imbalances are large, growing and eventually unsustainable over time, changes in policies need to occur in both surplus and deficit countries to avoid a disorderly rebalancing of such imbalances. It is correct that such imbalances are partly due to US policies. It is also true that the
undervalued RMB and the Chinese forex intervention policies have been beneficial for some US sectors and economic groups. Specifically, the weak RMB implies that China has kept prices of US imports of Chinese goods low, thus reducing US inflation and benefiting US consumers. Also, the excess of Chinese savings and accumulation of US dollar reserves by China has kept US interest rates lower than they would have otherwise been. In turn, these lower rates have effectively subsidized US private consumption, the US housing boom and bubble in 2004-2005, as well as allowed a cheap financing of US fiscal deficits. Thus, generic critiques of China are unfair as many sectors of the US economy have widely benefited from this Chinese currency policy and the Chinese financing of the US twin deficits.
It is however also the case that Chinese currency and savings policies have contributed – independently of the low level of US public and private savings – to unsustainable global imbalances. As discussed below, they will also eventually impose significant costs to the Chinese economy. Thus, an orderly adjustment of global imbalances will require, in addition policies that increase (in China) and reduce expenditure (in the US) relative to income, also changes in relative prices via currency adjustment. The experience with global imbalances in the 1980s proves that, with a lag, changes in exchange rates have powerful effects on net trade flows when accompanied by the appropriate expenditure reduction or increase policies.
3. Risks for China’s economy from the continuation of the current currency regime There are several growing risks for the Chinese economy from the continuation of its regime of effectively fixed exchange rates supported by a massive accumulation of foreign exchange reserve. The first risk is the one of growing protectionist pressures in the US and Europe. If China were to continue to have an expansion of its net exports and a rate of over 30% export growth a year the protectionist backlash will eventually become severe in the US and Europe. In the US there is the risk that China will be eventually branded as a “currency manipulator” by the US Treasury; or as a country with a
“fundamentally” undervalued currency in the jargon of the proposed modification of the
“manipulation” legislation by Senators Grassley and Baucus. Also, several versions of protectionist legislation are under consideration in the US Congress, including the Schumer-Graham proposal to slap tariffs of 27.5% against Chinese goods if China does not allow its currency to sharply appreciate.
A US economic slowdown – or worse a US hard landing leading to a recession or growth recession – would sharply increase these protectionist pressures. Also, the recent change of political control of the US Congress is likely to lead to a less free trade friendly US posture. Thus, considering the risks of protectionism and of managed trade is something that China needs to consider. The political economy of trade policy is such that these protectionist pressures will grow if Chinese net exports as a share of GDP grow without bound for the foreseeable future and China does little to address global trade imbalances.
A Chinese current account surplus of 10% of GDP or greater is not unlikely in the near future given current trends. And given the size of China in the global economy and the complex real adjustments and reallocation of resources in the US and Europe required by the very beneficial integration of China in a globalized economy, this is a trade surplus that will become at some point politically unsustainable. Integration in the WTO and into a globalized economy entails both rights and responsibilities. Given its important role in the global economy, China deserves to have a greater role in global international policy governance at the IMF and in an expanded G8. But it should behave in responsible ways to address global imbalances that do depend in part on exchange rate values. In an
integrated global economy rights comes with responsibilities: no important economy should free ride on the system. Not the US that has a drought of public and private savings; nor China that has an undervalued currency.
The second risk for China derives from its current policy of partially sterilized
intervention. China is unable to fully sterilize the effects on the monetary base of its $250 billion a year forex intervention. Thus, this partial sterilization aggravates the money supply growth and credit growth that is feeding the investment bubble and the asset bubble, especially in real estate that is behind the excessive overheating of its economy.
And continuation of this overheating increases the risk of an eventual hard landing of the economy.
In 2006 this excessive growth of monetary base has fed a credit bubble that is becoming dangerous as marginal investments are being undertaken only because the cost of capital is so cheap. Investment in new capital and capacity is now close to 50% of GDP. But no economy can have so many highly profitable investment opportunities that it can take half of its annual output and profitably reinvest it into more productive capacity. A similar Chinese investment boom in the early 1990s ended up in an investment bust and hard landing by 1998 when GDP growth sharply fell. The recent investment boom is even larger than in the 1990s and the risk of a bust even bigger now unless this overinvestment is rapidly controlled.
The third risk is that the current currency policy will eventually cause high inflation.
Since the rate of productivity of China is well above that of its trading partners, its real exchange rate will have to appreciate over time as its long run fundamental real exchange rate is stronger given this productivity differential. Such real appreciation can occur only in two ways: a nominal appreciation or an increase in inflation. Of the two, a nominal appreciation that keeps inflation low is economically, socially and politically less disruptive than a real appreciation that is achieved via an eventual surge in the inflation rate.
It is true that, so far, Chinese inflation has not surged in spite of its keeping its currency weak. Controlled prices of many goods and public services; bumper crops; a control of wages in a repressed labor market with an excess supply of unskilled labor has kept inflation under control so far. But eventually labor supply bottlenecks will develop especially in the skilled labor sector, as they are now in the coastal areas. Thus, an overheated economy will eventually lead to higher inflation. Thus, achieving the
necessary and unavoidable real appreciation via a nominal appreciation is a more sensible course of policy action compared to risking a socially disruptive bout of inflation like the one that China experienced in the mid 1990s.
The fourth risk is that of a massive capital loss on the holdings of foreign reserves once the unavoidable appreciation occurs sooner or later. A 20% appreciation of the RMB on a stock of $1,000 of reserves amounts to $200 billion capital loss, or about 8% of current GDP; this is a very large loss. Postponing the appreciation of the currency will make these capital losses only much larger for two reasons. First, the base of reserves on which losses will occur will be much larger. At the current rate of reserve accumulation China will hold $2,000 billion of foreign reserves in four years, a doubling of the 2006 stock.
Second, the longer China waits the larger the required equilibrium nominal appreciation will need to be as the productivity differential builds up over time. A 30% appreciation
on $2,000 billion of reserves four years from now would amount to a staggering capital loss of $600 billion, not the still large $200 billion that would occur if a 20% appreciation were to occur at the 2006 level of foreign reserves.
4. Distortions in the economy deriving from the current currency regime China’s export-led economic growth model has relied heavily on FDI to build a
productive capacity base. This openness to FDI together with a weak currency created a foreign demand for Chinese goods/exports and provided an incentive for foreign firms to locate production in China. Foreign investment is small relative to total investment to be sure.5 But there is little doubt that foreign investment has played a larger role in China’s development than in the development of other high-savings economies in Northeast Asia, notably Korea and Japan. The rapid expansion of the export sector has pulled labor out of rural areas and the agricultural sector into urban areas and the manufacturing sector.
Proponents of the “Bretton Woods two” hypothesis argue that this weak currency and export-led industrialization growth model is stable and will last for a long time. It is argued that it will last until the hundreds of millions of poor and poorly employed Chinese rural workers are absorbed in the modern sector. But the validity of this weak- currency cum export-led growth model is being reassessed now by many senior Chinese officials and economists. Indeed, this growth model is creating a number of different imbalances inside China, including the following ones.6
First, there are serious aggregate demand composition imbalances. In China the
composition of aggregate demand is severely imbalanced: as share of GDP consumption is too low, the savings rate is too high, the investment rate is excessive and net exports are unsustainably high. The rate of investment is so high and the rate of consumption is so low that China may be already a “dynamically inefficient” economy that invests too much, consumes too little and reduces its national welfare compared to what would be optimal if consumption were higher. Note that, from an economic point of view, investment by itself is not a source of increased national welfare: it is consumption that increases utility and welfare. Thus, an economy that consumes too little, invests too much and exports too much at too low export prices is not using its resources efficiently. It could increase its welfare by reducing savings and investment and consuming more.
Second, there are important regional imbalances. Foreign investment tends to be geared towards producing goods for external markets. It also naturally tends to cluster on China's coast. Coastal cities have good transportation links to the world, but not necessarily good transportation linkages to China’s interior. Consequently, foreign investment and rapid export growth tends to widen the economic divide between the coast and interior, and add to rather than subtract from income inequality. The new Chinese leadership cares about distribution as well as growth, in part because it worries about the political consequences of rising inequality.
5 See Morris Goldstein and Nicholas Lardy “What Kind of Landing for the Chinese Economy? PB04-7, Institute for International Economics, November 2004.
6 See Nouriel Roubini and Brad Setser “China: A Trip Report” (April 2005) for details.
Third, there are also sectoral imbalances. The export sector is booming, along with the real estate/housing sector. Many other sectors of the economy, including the service sectors where the provision of services is dismally lacking, still lag. In particular, there is a drought of necessary public and private services throughout the economy.
Fourth, there are growing distributional inequalities. The above imbalances in turn have give rise to distributional issues even within booming regions. For example, rising housing prices are a double-edged sword: some are getting a large wealth effect while others are priced out of the market. Real estate profits, including the profits that flow back to corrupt communist party officials, add enormously to expanding income and wealth differentials. More problematic, income and wealth inequality is sharply
increasing both in between regions and between different social and economic classes. A recent World Bank study has shown that poverty and inequality has increased in the poor rural areas of China.
Finally, there are also dangerous financial imbalances. Rapid reserve accumulation feeds rapid credit growth, asset price bubbles and overinvestment in real estate and export sectors, adding to the sectoral imbalances. In the face of concerns that rapid credit expansion was leading the economy to overheat, the authorities have relied on
administrative and quantitative controls on credit rather than on price adjustment, such as changes in the interest rates. The short term interest rate was increased by only by 27 basis points three times between 2004 and 2006, a risible amount for an economy growing as fast as China. The unwillingness to use the interest rate as a tool of
macroeconomic management is in part due to the constraints coming from the peg: any increase in interest rates risks generating further capital inflows from abroad, inflows that would add to the liquidity in the system if they are not sterilized.
Thus, the current renminbi peg is generating an unbalanced Chinese economy. China is a country that invests too much and consumes too little; and a continental economy that is too exposed to the global macroeconomic cycle. It is also an economy marked by too stark a divide between the prosperous coast with good transportation, trade and financial links to the world and underdeveloped and often under-educated interior and rural regions.
5. China’s “Inconsistent Trinity” Trilemma and the need for currency flexibility to control the economy.
When looking at China’s current monetary and exchange rate policy one observes a
“trilemma” that derives from the well known Triffin concept of the “inconsistent trinity”
in open economies. One of the basic concepts in international macroeconomics is that of the “inconsistent trinity”. Specifically, usually policy makers have three objectives: a) monetary policy autonomy/independence to stabilize the economy; b) stable or fixed exchange rates to maintain low inflation and monetary stability; c) an open capital account to benefit from international capital mobility. The inconsistent trinity idea
implies that they cannot achieve all three goals at once: they need to choose between two of them and give up the third.
The problem that China is facing is that it wants to achieve all three goals at once and it cannot do so, thus creating major distortions in its economy. Basically, if a country wants to maintain a free capital account and wants to stabilize the economy with an independent monetary policy, it cannot have a fixed exchange rate: it needs to move to a flexible exchange rate. Thus, an overheated Chinese economy needs more exchange flexibility to cool down excessive growth. Conversely, if a country wants to maintain a free capital account and wants to have a stable or fixed exchange rate to maintain competitiveness and keep inflation low, it cannot stabilize the economy with independent monetary policy. The reason is that it needs to adopt the monetary policy and interest rate of the country it is pegging to; so it needs to give up monetary independence and thus lose control of monetary and credit policy.
And if a country wants to maintain monetary independence while maintaining a fixed exchange rate regime, it needs to give up capital mobility and adopt capital controls. In some sense this is the option that China has chosen: it is still maintaining a semi-peg while wanting to control the economy via interest rate and credit policy. But dealing with large hot money inflows via capital controls on inflows creates its own set of problems.
Specifically, in China those capital controls are highly leaky and a lot of hot money does still enter in the country, to the tune of $100 billion in 2005 and 2006. Thus, the ability to both peg and maintain independent monetary policy is challenged: the monetary creation caused by the leaky capital controls leads to monetary growth that is excessive and feeds the overheating of the economy.
When a country faces a surge of hot money (and even FDI inflows) and tries to maintain a peg in spite of leaky capital controls on such inflows it faces very difficult policy dilemmas. First, it can intervene to prevent the appreciation of the currency via
unsterilized intervention. However, such intervention will push down domestic interest rates and feed the overheating of the economy that needs to be controlled. And, in fact Chinese interest rates are already too low given the high GDP growth. Second, it could do sterilized intervention. But such intervention is ineffective as it keeps interest rates higher and it thus induces further capital inflows. Finally, a country can try to impose capital controls on short term inflows but such inflows may be leaky and ineffective, as they are in China.
Thus, China’s trilemma is that it wants to achieve both currency stability and independent monetary policy in a regime of limited and ineffective capital controls on inflows of capital and hot money. It is unable to fully sterilize the forex intervention given the constraints to the size of domestic money markets. And even if it were successful in doing that full sterilization the resulting higher interest rates would lead to further capital inflows. On the other hand, partially sterilized intervention means that it has been forced to reduce domestic interest rates below US rates to reduce the incentive for hot money capital inflows. But these low interest rates are occurring at a time when the economic overheating requires instead higher interest rates and tighter credit, not lower interest
rates and excessive liquidity and credit. Thus, since intervention is only partially sterilized and creates excessive liquidity and a boom in credit it has relied on distortionary non-price tools such as direct controls on credit to try to control the overheating of the economy. But such administrative controls are themselves leaky and ineffective and thus the credit and investment and asset bubble has continued unabated.
So China is trying the impossible task of squaring the circle or, in this case, squaring the inconsistent triangle of three mutually exclusive policy goals.
The essential problem that China faces is that it needs an independent monetary policy and much higher interest rates to cool down the economy. But at the same time these needed higher interest rates would lead to further capital inflows since controls are leaky.
So, the only consistent way to solve this trilemma is to give up on the fixed exchange rate goal. If China were to allow its currency to appreciate, it would solve many of its
dilemmas and trilemmas.
First, it could cool down the economy via a reduction of the current account surplus.
Second, it could increase interest rates without triggering major new capital inflows that then need to be sterilized. Third, it could avoid using ineffective administrative controls to keep a credit boom that needs to be contained. Fourth, it would not have to deal with the problems of excessive forex intervention that is partly sterilized and partly not. Fifth, it would not have to accumulate forex reserve at a rate that is becoming costly and dangerous. And finally, it could even consider starting to liberalize capital controls to induce some private sector capital outflows to reduce the home bias in the asset portfolio of its private sector.
Thus, moving to a more flexible exchange rate regimes is a an essential step towards achieving monetary and credit control in an economy where administrative policies to achieve a soft landing from an overheating has proven so far distortionary and
ineffective.
6. Should a flexible exchange rate regime wait until the Chinese financial system is stronger?
Some argue that China cannot afford a more flexible exchange rate regime until its banking and financial system is reformed and strengthened. One often hears the argument that Chinese banks cannot afford a more flexible currency since they are still weak and undercapitalized. These arguments have little basis.
Financial sector reforms are necessary in China but the lack of such reforms should not be an excuse for delaying the change in the currency regime and letting a more
substantial appreciation soon. Such financial sector reforms will, in addition to a currency move and structural reforms that reduce precautionary savings, allow households to borrow more and thus stimulate consumption. This will lead to a rebalancing of aggregate demand from net exports and investment towards consumption.
But delaying the currency appreciation while structural reforms and reforms of the financial sector are undertaken is mistaken. Reforming the financial system is less urgent for the soundness of the banking system than controlling the credit bubble in an economy where credit is dirt cheap and growing at an uncontrolled rate. In an economy whose nominal GDP growth is about 14% the cost of capital, measured by the banks’ lending rate for firms – is still below 6%. This very low real cost of capital, forced by the choice of a pegged exchange rate, is a much more severe distortion and immediate vulnerability for the financial system than the slowness of structural reforms in this sector. To control the dangerous credit bubble in the economy China needs to have an independent
monetary policy that is impossible to achieve in the current fixed rate regime. So, more than financial sector reforms, currency reform is essential to stop the overheating and eventual bust of investment and growth.
The current exchange rate policy is the biggest threat to Chinese financial stability as it is leading to a credit growth that could lead to a massive surge in non-performing loans, possibly as high as 50% of Chinese GDP. This could occur once bad loans from the new excessive bank credits to the private sector pile up on top of an already massive stock of old bad and non-performing loans to state owned enterprises. If the current
overinvestment and credit bubble cycle is not controlled a large fraction of the bank loans extended in the last four years could go bust once marginal and duplicative investments in a variety or traded and non-traded, such as real estate, sectors turn sour.
Also, the current regime of fixed rates and attempted sterilization of foreign exchange intervention generates direct losses to the financial system. To sterilize the massive intervention and keep the fiscal costs of it low, China has effectively forced financial institutions, via moral suasion over government controlled banks, to hold hundreds of billions of dollars of sterilization bonds at very low and below market interest rates (about 2.5% average in 2006). So, sterilized intervention forces the financial system to effectively subsidize the central bank, thus generating losses for the financial system.
Other losses for the banks from the current policy derive from the increases in required reserve ratios that China has recently and increasingly resorted to as a way to rein in credit growth. So, the current policy of effective peg and sterilization generates a variety of costs and losses for the financial system.
Finally, the often-heard arguments that the Chinese economy cannot afford a more flexible exchange rate regime until the domestic and international capital markets are cleaned and liberalized have very little conceptual basis7. Also, liberalizing too fast a financial system where directed lending and political biases in lending are still pervasive and supervision and regulation are still poor would be itself a recipe for disaster. Thus, such liberalization will take a long time and should be gradual. Conversely, maintaining the current exchange rate and credit regime is the biggest threat to the financial market.
The problem that China is facing is that its growth model, net exports/FDI/Investment- driven rather than more reliant on consumption, is becoming increasingly unsustainable and is a source of growing economic and financial imbalances for its economy.
7 See Setser for more on this point (http://www.rgemonitor.com/blog/setser/104735)
7. A RMB Appreciation is Unlikely to Cause a Japanese-Style Deflation in China One of the many arguments of the opponents of a revaluation of the Chinese currency has been that such currency move could trigger in China a deflation similar to the one that dogged Japan for most of the 1990s and until recently. The argument is not new and was originally made a while ago by Ron McKinnon. It was recently restated by McKinnon in a Wall Street Journal column 8and by Steve Roach, the chief macroeconomist at Morgan Stanley9.
McKinnon argues that a Chinese move is inappropriate as a way to reduce global imbalances. The global rebalancing can fully occur, in his view, via "expenditure reduction" policies, in particular a reduction in the US budget deficit, without the need for the "expenditure switching" effect of changes in nominal and real exchange rates. His view is based, in part, on his long-standing arguments that a regime of global fixed exchange rates among major advanced economies would be ideal. In his view, currency adjustments are destabilizing rather than stabilizing.
He blames the US pushing for a revaluation of the Japanese yen in the mid 1980s that, in his view, caused the ensuing bubble and then deflation that plagued Japan in the 1990s.
He is concerned10 that forcing China to move its peg would lead to the same destabilizing deflation that plagued Japan in the 1990s. Thus, in his view, quantities, i.e. global
savings-investment imbalances, can and should be adjusted without “destabilizing”
relative price movements. In his view, the real appreciation that fast productivity growing countries require can be achieved via domestic inflation rather than a nominal
appreciation.
A view similar to McKinnon's, on the risks that a Chinese currency appreciation may lead to deflation in China in the same way that the yen appreciation allegedly led to deflation in Japan, has been recently presented by Steve Roach:
This is not the first time that Washington has tried to browbeat a major US trading partner into submission by using the blunt instrument of currency appreciation as the
"remedy" for a trade imbalance. Repeatedly during the 1980s, when the US was in the midst of its first external crisis -- a current account deficit that peaked at a then-unheard of 3.4% share of GDP -- Washington pounded on Japan to let the yen rise. After all, the bilateral deficit with Japan was the biggest piece of the then-gaping US multilateral trade deficit. The theory was if Japan repriced its "unfair" competitive advantage, all would be well for an unbalanced world. Unfortunately, the Japanese heeded this advice, and the yen/dollar cross rate soared from 254 in early 1985 to an intraday peak of 79 in the spring of 1995. Sadly, Japan's "endaka" (strong yen) was a major factor behind its subsequent undoing -- fueling the mother of all asset bubbles in equities and property that ended with a sickening collapse into a protracted post-bubble deflation. Politics never cease to amaze me, but I am incredulous that a mere 20 years later, America is
8 http://online.wsj.com/article/SB114549982502130794.html?mod=todays_us_opinion.
9 http://www.morganstanley.com/GEFdata/digests/20060421-fri.html#anchor0.
10 http://www.stanford.edu/~mckinnon/briefs/ChinaJapanDV.pdf
offering the Chinese the same bad advice that took Japan down a road of unmitigated macro disaster. Fortunately, saner minds have prevailed in Beijing.
However, McKinnon's and Roach's views overstate the role that the yen appreciation in the late 1980s had in triggering the Japanese real estate bubble and its burst into deflation in the 1990s. Other more structural micro distortions in the allocation of savings to capital explain the bubble of the 1980s and its deflationary bursting in the 1990s. They incorrectly downplay the role that exchange rate movements had in the late 1980s in leading to an orderly global rebalancing. Then, a US fiscal contraction cum a US dollar depreciation led to a gradual shrinkage of the US twin deficits of the early 1980s.
Nominal exchange rate movements have had an important role in adjusting equilibrium relative price for a country such a Japan during its 30 year period of high growth since the early 1960s. In 1960, the yen was at 360 to the dollar while today it is closer to115. In spite of such a sharp long run nominal appreciation Japan has not lost its competitiveness.
The reason is that high productivity growth until the early 1990s allowed Japan to experience an appreciating currency without a loss of competitiveness. Also, Japan grew very fast in the years after the breakdown of the Bretton Wood system in 1971when the yen started its appreciation. Japan grew rapidly for almost two decades after the yen became flexible and well before the 1990s slump. Thus, it is incorrect to blame flexible exchange rates for the economic stagnation of Japan in the 1990s.
Similarly, China has already had a long decade of high productivity growth with
essentially fixed nominal exchange rates. Since its equilibrium real exchange rate is now appreciated, an orderly adjustment of the actual real exchange rate requires a nominal exchange rate adjustment as well. Otherwise the real appreciation will eventually occur via socially and politically disruptive increase in inflation. McKinnon mistakenly downplays the risks of high inflation in China: in the early-mid 1990s when China experienced high inflation the real economy went into a hard landing with growth slowing sharply in the late 1990s.
One should also note that the Balassa Samuelson effect will imply that Chinese inflation will, over the medium-long run, be higher than the inflation rate of more advanced economies. In fact, if productivity growth in traded good sectors outpaces that of non- traded goods, the ensuing increase in nominal wages in the traded sector will increase the costs of production and prices of non-traded goods faster than those of traded goods.
Thus, overall inflation in China will be anyhow higher than in more advanced economies just because of such Balassa-Samuelson effect, as pointed out by Jeff Frankel11.
So, McKinnon and Roach are correct in stressing the important role that US fiscal adjustment can play in supporting an orderly global rebalancing. But their view that such rebalancing does not require any exchange rate adjustment in China is at odd with over thirty years experience with flexible exchange rates. This experience shows that exchange rate flexibility has helped undoing exchange rate misalignments that do occur from time
11 http://ksghome.harvard.edu/~jfrankel/On the Renminbi.pdf
to time. Adjusting relative prices via nominal exchange rate movements is less costly than trying to adjust such relative price via costly deflation or inflation.
One can also point out that the risks of a deflationary spiral in China are minimal.
Currently, in China inflation risks are increasing, not decreasing: the actual inflation rate is artificially kept low via various administrative freezes on the price of energy and the price of many public services. So, the risk of deflation via a currency appreciation is minimal. If anything, by appreciating its currency China could successfully control inflationary pressures while providing to its citizens an increase in terms of trade or purchasing power over foreign goods. Those potential inflationary pressures derive from skilled labor shortages pressures on wages in the high growth regions of China.
Also, the McKinnon concern about the deflationary effect of a Chinese and Asian appreciation on their economies can be turned on its head: a failure to flexibilize the Chinese and Asian currencies may lead to deflation in the US, Europe and Japan.
Suppose that the Chinese/Asian appreciation does not occur via a nominal appreciation and it does not occur via higher inflation in China as slow growth of Chinese real wages may keep such inflation under control. Then, the only way in which such real
appreciation can occur is through the fall in the price of traded goods in the rest of the world, i.e. a fall in prices in the US, Europe and Japan. Thus, while McKinnon worries about Chinese deflation, he does not consider the possibility that the needed real exchange rate adjustment could occur in principle through a destabilizing deflation in advanced economies. And, as the experience of Japan in the last decade suggests, such deflationary pressure would have severe consequences on the traded sectors of the advanced economies.
Thus, a US fiscal adjustment without a change in relative prices, i.e. a Chinese/Asian nominal and real exchange rate appreciation, will not trigger enough of an expenditure switching effect that is required to reduce the global imbalances. Both are required to have an orderly global rebalancing.
A final variant of the “deflation” argument against an RMB appreciation considers the effects of such an appreciation on the prices and incomes of the Chinese agricultural sector. The argument is that such an appreciation will reduce the price of imported agricultural goods and will thus reduce the incomes of the already very poor Chinese farmers. Thus, an RMB appreciation will be socially regressive and possibly destabilizing the already poor Chinese rural sector.
This argument has little basis for it once one considers the details of it. The first point to be made is that it would be absurd and inefficient for any country to set its currency value based on the productivity of its most inefficient and unproductive sector, agriculture in the case of China. That equilibrium currency value should rather depend on the
productivity of the sectors that are most productive and in which the country has a comparative advantage, these being labor intensive tradable sectors in China. If the equilibrium value of the currency should be the one that allows the most inefficient sector to compete in global markets, there would be no gains for any country from trade and
from exploiting comparative advantage. So, choosing the currency value in China based on the miser productivity of the agricultural sector is nonsensical economic theory and policy.
The second point is that, if an RMB appreciation were to hurt the agricultural sector, the first best policy for China would be to provide direct income subsidies to this farming sector. Alternatively, given the dismal state of health, education and other public services in the rural sector of China, instead of direct income subsidies, the Chinese authorities could and should increase the provision of such services to the rural sector. Such policies would, over time, increase the productive capacity and skills of such workers in the rural regions. Thus, the first best policy is not to protect an inefficient agricultural sector via a weak currency. It is rather to provide the appropriate income transfers and public services to this weak sector of the economy. This sector needs a long term increase of the
education, skills and productivity of its workers.
8. Concluding Remarks
This paper has argued that it is in the national economic interest of China to move soon to a more flexible exchange rate regime. The current effective peg to the US dollar prevents the pursuit of an independent monetary and credit policy that China needs to control its overheated economy. The current policy of partially sterilized forex intervention is ineffective in controlling the credit boom. While the accumulation of foreign reserves, now in excess of a staggering $1,000 billion, will eventually lead to massive capital losses once the required currency adjustment occurs. Delaying this necessary currency adjustment will only eventually increase such capital losses.
Given its high productivity growth the Chinese economy can thrive and grow at a more sustained rate by letting its currency appreciate at a significant rate over time. Such appreciation will also prevent an increase in inflation that the economic overheating and required real appreciation of the equilibrium exchange rate would eventually induce in the absence of a nominal exchange rate appreciation.
Finally, an orderly rebalancing of global current account imbalances requires changes in economic policies in both deficit (US) and surplus (China) countries. And the exchange rate, together with appropriate expenditure increasing/reducing policies, is an effective complementary tool for an orderly adjustment of excessive trade imbalances. Experience suggests that the expenditure switching effects of changes in real exchange rates are necessary and effective in modifying the demand for exports and imports and trade balances. Thus a successful and orderly integration of China in the global economy requires a move away from market distorting policies and towards a policy regime where price signals, including the exchange rate, drive the allocation of resources to the right sectors and the composition of aggregate demand.
Maintaining a fixed exchange rate is one of the inefficient relics of a command and control economy that China has worked so hard to shed in so many other dimensions, and to its own long run economic benefit, during the last two decades. Thus, moving to a
more flexible exchange rate regime will be an important step of China’s move to a market economy that is fully integrated in the global economy.
