Bernanke’s speech at the Chinese Academy of Social Sciences is well worth reading. He quite accurately notes – at least in the written text, if not in the actual speech – that China’s extensive intervention to maintain its dollar peg acts as a de facto subsidy to its export sector:
Greater scope for market forces to determine the value of the RMB would also reduce an important distortion in the Chinese economy, namely, the effective subsidy that an undervalued currency provides for Chinese firms that focus on exporting rather than producing for the domestic market. A decrease in this effective subsidy would induce more firms to gear production toward the home market, benefiting domestic consumers and firms. Reducing the implicit subsidy to exports could increase long-term financial stability as well: If China invests too heavily in export industries whose economic viability depends on undervaluation of the exchange rate, a future appreciation of the RMB could lead to excess capacity in those industries, resulting in low returns and an increase in nonperforming loans.
The subsidy isn't equal to China's total reserve growth, but it is roughly equal to the capital loss the PBoC will eventually incur on its dollars and euros when the RMB eventually appreciates. And those losses are potentially large -- maybe $300b.
Bernanke also notes that China’s exports have grown at an annual pace of around 30% ever since China joined the WTO – far faster than the 12.5% average rate in the preceding five years:
“Since joining the WTO in 2001, China has seen the dollar value of its exports grow at an average rate of about 30 percent per year, compared with annual growth of about 12-1/2 percent over the five years before gaining WTO membership.”
Later in the speech, he also notes that China’s real effective exchange rate has depreciated by 10% since 2001.
As the Chinese trade surplus has continued to widen, many analysts have concluded that the RMB is undervalued. Indeed, the situation has likely worsened recently; because of the RMB's link to the dollar, its trade-weighted effective real exchange rate has fallen about 10 percent over the past five years.
Bernanke doesn’t connect the surge in China’s exports to the real depreciation of the dollar, and the real depreciation of the RMB, but I will. The RMB's link to the dollar is a bigger political issue in the US than in Europe, but China’s exports to Europe have actually grown faster than its exports to the US over the past few years.
Revised estimates for China’s 2006 and 2007 current account surplus are starting to come out. Jon Anderson of UBS now puts China’s h2 2006 current account surplus at about 10% of China’s GDP – up from 8% in the first half. DBS estimates China’s 2006 current account surplus will reach $260b, and its 2007 surplus will reach $320b.
That isn’t as much of a stretch as it seems: China’s q4 current account surplus (not seasonally adjusted) looks to me to be in the $80-85b range, and China's exports are still growing far faster than its imports.
What Bernanke didn’t mention is that China isn’t just subsidizing its exports, it is also subsidizing all sectors of the US with big borrowing needs. The US government, to be sure. But also the US housing sector. 30 year fixed rate mortgages wouldn’t be where they are without demand for Agencies and MBS from the PBoC – and increasingly, demand from Chinese banks stuck holding (depreciating) dollars that they cannot convert into RMB. With a $300b plus current account surplus and $50-60b in net FDI inflows, Chinese purchases of foreign debt could approach $400b in 2007. Wow.
Back in 2004, Bernanke, Reinhart and Sacks found some evidence that Japanese purchases had an impact on US Treasury yields. And as China current account surplus has risen, it clearly become a big contributor to the global savings glut – and a big source of “excess” demand for (non-Chinese) financial assets.
The Fed flow of funds data indicates central banks and official institutions bought about $300b (if the data is annualized) of Treasuries and Agencies in q3 – about as much as they did at the peak of their intervention in 2004. See table F107 of the flow of funds: official purchases of treasures in q3 were $200b and purchases of agencies were about $90b. And the US data almost certainly undercounts official purchases. Some of the $125b in private foreign purchases of agencies in q3 likely reflect disguised central bank purchases.
Warnock and Warnock believe this demand has an impact on yields. The 90 bp impact of central bank demand in their 2006 paper is for central bank flows in 2005 – when central bank flows were lower than they were in 2004 – or now. Warnock and Warnock estimated central banks reduced Treasury yields in 2004 by about 150 bp. That presumably is also close to their current estimate. The PBoC isn’t the only central bank buying US debt to be sure, but it is a big buyer.
Remember that is the estimated impact of the end of new purchases by central banks – not of central bank sales. Warnock has estimated that net sales by the world’s central bank sales would drive US yields up by 300 bp, a huge number. But he also indicated that this would only happen if the Fed stood still and didn’t ease to offset the impact of say Chinese sales.
I rather suspect Bernanke has given this scenario some thought – he knows the PBoC’s actions can have a big impact not just on the health of US manufacturing, but also on financial conditions in the US. Central bank activity is presumably one big reason why US monetary conditions aren’t quite as tight as one would expect with the fed funds rate at 5.25.
I guess the US-Chinese strategic economic dialogue can be thought of as the first high-profile summit of the “balance of financial terror.” I was pleased that the entire focus wasn’t on opening up China’s financial sector to US firms. Paulson needs to show that he is responsive to the concerns of all Americans, including those in Ohia and Michigan -- not just the concerns of Wall Street. Having Paulson push China to allow more US investment in its financial sector when ICBC just generated about a billion of Goldman’s record profits and is a bit awkward. That is an agenda that helps the have-mores from the China trade, not the have-nots.
There is a reason why Paulson had to highlight the exchange rate.
The RMB’s de facto link to the dollar has become a major distortion in the world economy. But I do worry that the issue has now been framed in a way that makes any appreciation of the RMB – a move that many think is in China’s own interest – appear to be a concession to the US.
I also worry though that China’s emphasis on its own sovereign rights -- including its own sovereign right to peg to the dollar and subsidize the US Treasury -- misses a key point. China is no longer a small part of the world economy. China, inc single-handedly may finance about 1/3 of the US current account deficit in 2007. Its domestic policy choices increasingly impact the world. China's policy choices are a growing concern of the rest of the world.
As, of course, are the policy choices of the United States.