from Follow the Money

China reads the Economist. Is the Renminbi undervalued?

January 26, 2005

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While China’s delegation to Davos seems a bit less than enamored with the dollar, the People’s Bank of China seems have read last week’s Economist, and concluded that there is no need to change the renminbi-dollar peg.

The Financial Times has also picked up on the same theme. Both pieces that argue that the renminbi is not really overvalued draw on work by Stephen King at HSBC, but there are no shortage of other economists making similar arguments. Andy Xie of Morgan Stanley for one.

I have no idea when China plans to adjust its peg, though I suspect it is a question of when rather than if. Some small changes seem likely. But the broader arguments made in these articles, and the related argument that a renminbi revaluation won’t help reduce the US trade deficit, are worth examining in some detail. I’ll look at each point in turn, and lay out the reasons why I don’t find the argument persuasive.

A warning though: this is a long post.1. China’s global trade surplus is much smaller than its bilateral trade surplus with the US.

True, but irrelevant. Bilateral deficits and surpluses are not the right measure of a currency’s strength. But just because China’s overall trade surplus is smaller than its bilateral trade surplus with the US does not prove China’s exchange rate is fairly valued. China is still running a trade surplus of 2% of GDP, and a slightly larger current account surplus. More importantly, it is running that surplus in the face of surging commodity prices and a domestic investment boom. Trade deficits and trade surpluses need to be looked at in a broader macroeconomic context, and the context strongly suggests booming China should be running a trade deficit right now. China imports lots of commodities, and it is in the midst of an absolutely enormous investment boom. Capital investment has surged to 45% of GDP, up from the 38%-40% typical from 95 to 00. Had savings stayed constant, China’s trade balance would have swung into a substantial deficit.

Put differently, China is currently undergoing a much large investment boom than the US enjoyed in the late 1990s. But while the US investment boom led the US current account to go from a small to a large deficit in the 1990s, China’s investment boom has not triggered a fall in its current account surplus.

That is unusual. It suggests China’s underlying trade surplus is much larger than its current trade surplus -- Morris Goldstein estimates that China’s cyclically adjusted trade surplus is close to 5% of GDP. Moreover, given China’s ongoing ability to attract the FDI needed to safely finance trade deficits, there is no reason why its trade should be in balance. The swing that would be needed to shift China’s $32 billion trade surplus to the deficit of $50 billion that it could easily finance out of incoming FDI is every bit as large in relation to China’s GDP as the swing eventually needed to reduce the US trade deficit.

2. China’s trade surplus of $32 billion is no where near large enough to finance the US current account deficit.

True, but irrelevant. China is attracting enormous capital inflows, and since it is not using those inflows to finance a trade deficit, the funds from these inflows are also available to finance the US. The overall increase in China’s reserves -- $200 billion - is certainly big enough to have an impact. Even if China only put have those reserves in dollars, $100 billion covers about one sixth of the US current account deficit. That is worth emphasizing: One single institution in a relatively poor country -- the China’s central bank -- is providing at least one sixth, and perhaps closer to a quarter ($150 billion), of the external financing the US needs.

It is true that the US lack of savings drives the US current account deficit; but it is also true that the financing made available to the US as a result of China’s peg also reduces the (short-run) costs of low savings. In other words, the US savings rate would probably not be so low if not for the easy availability of reserve financing. Without foreign demand for Treasuries, for example, the US budget deficit would put more pressure US interest rates -- and the pressure higher interest rates put all asset values (think homes) would generate much more political pressure to reign in the deficit.

3. If China dropped its capital controls, funds would flow out of China ...

Maybe, but it is a lot less obvious that many think.

Moreover, it is irrelevant: China is not about to drop its controls, and there is no reason why exchange rate adjustment has to be linked to capital account liberalization.

But let’s think about what would happen though if China opened up its capital account anyway. Private Chinese citizens presumably would want to diversify their assets, and might want to hold significantly more foreign assets. But if private Chinese citizens currently hold fewer foreign assets than they would like, the government of China certainly holds more foreign assets that it needs (reserves are almost 40% of GDP). Private capital outflows linked to asset diversificatoin could easily be accommodated if the government of china sold some its accumulated assets, redistributing China’s current external assets from the state’s hands to private hands.

But if private China’s citizens are underweight foreign assets, then US citizens (and others too) are also underweight Chinese assets. And the US government does not hold an enormous stake in China Inc it could sell off to meet US demand for Chinese equities. So it is not clear that the flow of funds would be one way: Chinese citizens may want "safe" foreign claims, but US and other citizens probably also would want more "risky" but potentially high yielding Chinese assets. I would be happy to trade two year treasuries for two year renminbi bonds if I could.

Won’t Chinese citizens want to pull money out of China’s rotten banks and seek safety abroad? There is no doubt the state banks are sitting on big losses, and will have to be recapitalized. That won’t be cheap: think $600 billion . That just happens to be about the size of China’s foreign exchange reserves -- but dollar reserves don’t provide the renminbi asset the banks need to match their renminbi deposits and cover their non-performing renminbi loans. At the end of the day, the banks will need lots of renminbi bonds to cover the lending losses.

But so long as the government of China is solvent, the government’s backing makes the big banks a relatively safe place to store Chinese savings. US depositors did not flee Citi or other money center US banks in the 80s, when they had their own set of large non-performing loans (think Mexico, Brazil, Argentina ... )

Bottom line: China is not going to drop its controls if that would lead to massive outflows. And while some asset diversification should be expected once the controls are dropped, the flows could well go in both directions - and short-term pressures easily could be accommodated by selling off some of China’s reserves. Over time, the fundamentals - China’s high rates of investment and rapid increase in productivity combined with its current trade surplus - still suggest that the renminbi is likely appreciate against the dollar.

4. A small revaluation would not help China regain monetary control, since it would lead to expectations of a further revaluation.

True. But this is an argument for a meaningful revaluation, not a tiny (3-5%) or small (5-10%) move.

5. China needs to keep the peg until China’s financial system is much stronger.

China’s domestic financial system certainly has its problems. The real question is whether keeping the renminbi pegged at 8.28 helps or hurts over the long term. I suspect that it actually makes the financial system weaker over time, for two reasons:

a) Lots of folks do seem to think the renminbi is undervalued, and the flood of money going into China (which shows up in China’s reserves) is fueling rapid growth in China’s money supply, rapid credit growth, real estate speculation and the like. All that risks creating a new generation of bad loans. Administrative controls (think the PBOC sending out a letter to the state banks saying "no more loans for cement factories") can limit some excesses, but certainly not all.

Moreover, it is hard for China to raise interest rates aggressively to temper demand for credit so long as it keeps the current peg: higher interest rates just increase the incentive for foreign funds to flow into China.

b) The undervalued exchange rate will lead to over-investment in China’s export sector, as too many folks bet that 25% y/y export growth to the US can continue indefinitely. It can not and it will not. 25% y/y growth implies US imports from China will rise from about $200 billion in 2004 to about $400 billion in 2007, and almost $500 billion in 2008. Imagine the resulting talk of China in the 2008 US Presidential campaign if China’s exchange rate is still close to where it is now ...

Bilateral deficits generally do not matter. However, given the size of China’s exports to the US, it is hard to see how that kind of import growth from China could be sustained without solid, perhaps even strong, growth in overall US imports. Yet it overall imports continue to grow rapidly, given the (relatively) small size of the US export base, it is hard to see how the US trade deficit starts to shrink. Lots of the investment in China’s export sector may be based on the implicit assumption that the US trade deficit can continue to widen for the next four years ... that may not be the best of assumptions.

China has to fix its domestic financial system. It also has to take steps to stimulate domestic consumption and domestic demand growth, so that it relies less on investment and exports for growth. But in both cases, delaying the inevitable just increases the costs of the inevitable.

6. China’s exports are taking market share away from other East Asian economies, not from US domestic production.

No longer true. From 2000-2003, overall imports from the Pacific Rim stayed constant, despite rising imports from China. But in 2004, imports from both China and other Asian economies increased rapidly, and overall imports from Asia rose sharply both in dollar terms and as a share of US GDP. Moreover, China won’t be able to sustain 25% y/y growth in its exports simply by taking market share from other Asian economies.

But rather than look at bilateral balances, let’s think about the global current account balance. The Asian NICs plus China -- and emerging Asia more broadly -- runs a substantial current account surplus. That is not the way the world has to work - very fast growing regions often run trade and current account deficits. The Asian NICs themselves had a deficit before the 1998 crisis. In broad terms, the 97 crisis shifted the Asian NICs’ current account from a small deficit to a substantial surplus, and that surplus remained long after the crisis passed. It is hard to see how the US can reduce its current account deficit if emerging Asia does not reduce its surplus, it is hard to see how emerging Asia reduces its surplus if China does not revalue. The "China is part of Asia and the Asian value added chain" argument STRENGTHENS the case for a renminbi revaluation as part of a broader Asian revaluation.

7. A renminbi revaluation would not reduce the US trade deficit.

Not true, over a long-enough time horizon.

The first effect of a renminbi revaluation would be an increase in US import prices. Chinese exporters would have to increase their dollar prices to pay their renminbi wages. Since the US does not produce many of the items it imports from China, that would - barring a fall in the volume of US imports - increase the amount of dollars the US spends on Chinese imports. Cheap Chinese goods become more expensive cheap Chinese goods. DVD players sell for $100 rather than $50 ...

The rise in prices almost certainly will trumps any fall in volumes (the famous J curve), and the US import bill goes up. The run-up in the US import bill would trump the short-run increase in US exports to China, leading the US bilateral deficit with China to expand, at least in the short-run.

So what? The renminbi revaluation would still encourage a broader adjustment in the US trade balance even if it did not improve the bilateral US-China trade balance.

A wealthier China that earned more global purchasing power from its US exports to the US would spend more on imports - whether imports from the US or from the world. And if China uses its surplus dollars to import more from say Brazil, Brazil will have more dollars to spend on imports from the US. Over time, a renminbi revaluation should increase overall US exports, particularly since other Asian economies will let their currencies rise against the US dollar if China’s renminbi also rises.

But perhaps the most important channel for adjustment would be indirect: a renminbi revaluation - a big one - would change the renminbi from a one way bet to a two way bet, and thus reduce "hot money" inflows into China. Chinese reserves will grow more slowly, China will have fewer dollars to send to the US and the US will have to raise the funds it needs to cover its current account deficits in the private markets.

In other words, slower Chinese reserve accumulation and reduced Chinese demand for US assets would tend to raise US interest rates, reduce US consumption (increase US savings) and lead to the eventual adjustment in the current account. Don’t forget about the capital market channel.

Finally, a renminbi revaluation (provided it is large enough) would reduce the incentive to invest in China to make the next generation of products for the US market - and increase incentives to source production in the US. Over time, this dynamic effect would trump the short-run impact of higher import prices.

Renminbi revaluation might not immediately reduce the overall trade deficit: the J curve effect from higher import prices might dominate in the short-term, assuming that the impact of higher import prices is not trumped by the impact of higher interest rates because of reduced Chinese reserve accumulation. But renminbi revaluation is essential to changing the current trajectory: a trajectory where 25% y/y growth in US imports from China leads the US bilateral deficit with China to expand by $30-40 billion a year, making it hard to reduce the overall US trade deficit, and a trajectory where capital inflows to China fuel extremely rapid growth in China’s reserves and China’s reserve growth in turn helps finance large US trade deficits.

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