from Follow the Money

Is China’s peg creating more problems than benefits for China?

February 25, 2006

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 Stephen "current account deficits don't matter, at least not in the dollar zone" Jen is starting to sound a bit like Brad "Doom and Gloom caucus, trade deficit division" Setser. 

At least on China's peg.    In his weekly note -- which appeared in abridged form in Monday's Global Economic Forum  -- Morgan Stanley's Jen makes a bunch of arguments that could have come straight from my mouth.

  • China has as many reserves as it wants (if not more).  Jen writes "no longer is it clear to the policymakers in China that "the more reserves, the better" 
  • Intervention without full sterilization is contributing to excess capacity in China - presumably because it is leading to rapid credit growth - and thus is putting downward pressure on prices.  I am not fully with Jen on this  one point: lots of money growth usually is inflationary, not deflationary.  But then again, China is different.
  • The cheap RMB doesn't just make Chinese goods cheap; it also makes Chinese assets cheap.   Amen, brother.   China deals with this problem by prohibiting foreigners from trading dollars and euro for real Chinese assets.  Foreigners can do Greenfield investment, but not snap up existing Chinese firms.    But it also means that foreign assets are quite expensive for Chinese buyers - something that deters Chinese firms from venturing forth on the world stage.
  • The lack of meaningful currency risk inhibits the development of "hedging" markets - why buy insurance against currency risk when the government is already insuring against currency risk?  Amen.  I can see why exporters might want to hedge against faster than expected RMB appreciation (if they don't trust the government), but I don't see why any importer would want to hedge.   The RMB just isn't going to fall v. the dollar, and if the RMB appreciates more than expected, that only cuts the importers costs.

Jen's conclusion: "[China's policy which has resulted in a cumulative 0.8% move in the dollar/ RMB] is creating more problems than benefits for China."

Surprise, surprise.  I agree.

It is sometimes argued (see PGL, who is far more willing to read the NRO than I am) that China's peg means that Chine gets to import the best of America.   The US outsources assembly work to China, and China outsources monetary policy to the US.   A fair trade, supposedly.  Who wouldn't want Alan Greenspan or Ben Bernanke to run their central bank. 

Alas, as PGL also notes, it doesn't really work that way.   China isn't importing US monetary policy.  It is importing a monetary policy that is substantially looser than the monetary policy here in the US. 

Right now, key domestic interest rates in China - whether the deposit rate or the interbank rate or the PBoC sterilization bill rate - are well below US rates.    That is the product of a conscious policy decision by the central bank: to deter hot money flows, it wants Chinese rates to be well below US rates.   The "negative carry" on the RMB compensates for the expected appreciation of the RMB, or, put differently, it means that there is a price to betting on the RMB's rise.

And even with lower rates than in the US, China is still getting large capital inflows, and those inflows, combined with China's own trade surplus, are driving rapid reserve growth.    Since those inflows are not fully sterilized, Chinese money growth has been quite fast recently.

Now, it seems that hot money inflows slowed - though I don't think they stopped - in the fourth quarter.  But (unconfirmed) leaks that China spent $34 billion in the FX market in January suggest that hot money flows picked up again at the beginning of this year, big time.   Those leaks have some credibility because capital inflows to all of Asia picked up in January.  

It almost goes without saying that the resumption of hot money flows - if confirmed - would only make the central banks job more difficult.

And help to highlight why China's current dollar peg with a slow (but perhaps accelerating) crawl isn't working for China. 

Chinese policy makers are concerned about too-rapid-investment growth and too much capacity.  As they should be.   Chinese investment ratios are now exceptionally high by Chinese standards, or by the standards set by other high-savings fast-growing Asian economies.  Too much investment now means fast growth now, but problems later.

The standard cure for too much investment?  High interest rates.

Yet in order to deter hot money flows, China has to keep its rates low - and keeping rates low (particularly the interbank rate) means not sterilizing a big chunk of China's reserve growth and allowing fast money growth.    And partially as a result, it has been hard to slow investment growth.   Back when investment growth first accelerated, there was lots of talk about whether it would end with a soft or a hard landing China.  The answer so far is that there really hasn't been any landing at all. 

Stephen Green of Standard Chartered pointed out as much in his weekly note, which, alas, isn't free to the world.    China's attempts to slow investment growth have not exactly had much of an impact.    Bank lending slowed once China slapped on tight administrative controls, but slower lending growth has led to a slowdown in investment growth.   And, according to Green, the rate that banks are lending the funds that they can lend out is falling.  As are the informal lending rates offered by the informal financial system that operates outside the formal banking system.    Again, low lending rates what the Chinese economy needs if China's own authorities are concerned about excessive investment.

Some in China also worry (correctly in my view) about excessive reliance on exports.  

Exporting to customers than can only afford your products with subsidized credit is a bit risky.  

Yet so long as the RMB is cheap, firms - both foreign and domestic - still have strong incentives to produce for the international market.    For season reasons, January and February data out of China has to be interpreted with caution.   Rather than looking at individual monthly data, the accepted practice is to compare January-February data from one year with January-February data of another.   And we don't have February trade data yet, but there doesn't seem to be much evidence in the December or January data of an export slowdown.

There is another - more controversial - reason why I don't think China's current policy mix is working for China.  It isn't generating many jobs.  That flies in the face of the conventional wisdom (spurred by Michael Dooley and company's influential paper) that rapid growth in the export sector is the only way to employ China's surplus labor. 

But China right now is complaining of jobless growth.   Shutting down inefficient state enterprises is one reason why - but that process was a lot more brutal a few years ago than it is now.   So why not stronger job growth now?  One potential reason: credit inside china is cheap, which means that it can make sense to substitute capital for labor.   

Don't get me wrong - I realize that shifting away from China's current investment and export-driven growth won't be easy.  I also realize that there are big entrenched interests in China's export sector (and in the US corporate sector) that would prefer not to see any change at all.   I realize that most people are not as worried as I am about the health of the central bank's balance sheet, and don't think that big currency losses will have big consequences. 

But like Jen, I suspect that it is becoming increasingly clear to many in China that China's current policy mix isn't helping the Chinese government achieve many of its own objectives.  China doesn't have US monetary policy.  It has a monetary policy that is far looser than US policy.  

And China doesn't actually need US monetary policy.  It needs a Chinese monetary policy.   That would give China a tool to help manage the risks associated with its current rapid investment growth.    The primary goal of Chinese monetary policy shouldn't be keeping Chinese interest rates lower than US rates to try to deter hot money inflows. (without obvious success, if the leaked data for January is right)

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