from Follow the Money

Chinese growth accelerates, RMB depreciates

July 19, 2006

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That was yesterday’s headline.   Or, given the time differences, perhaps the headline from two days ago. Chinese second quarter growth picked up to 11% plus.  The only real surprise here was that the Chinese government reported an acceleration rather than a smoothed number.   And the RMB moved back into the 8s on Tuesday and started Wednesday there as well.    The basket peg you know.  If the dollar appreciates v. the euro, the RMB needs to depreciate.  China has to make sure its products are competitive in Europe. 

I am not sure where to begin.   

Survived Sars lays out why China would be well served by RMB appreciation.    Yu Yongding has made the case as well.    And I am pretty sure he has a line into the PBoC.  

There is now even a bit of price pressure in China.   Inflation remains well below US levels, but it is creeping up …  for all the talk about how China’s integration into the global economy would be deflationary, right now China sure seems to be putting upward pressure on prices globally.

And who knows, with the anniversary of the RMB’s initial step revaluation approaching on the 21st, China might even surprise us -- despite their promises not to.   But if they did, I would really be surprised.   The striking thing to me – and many others – is that China hasn’t made use of the flexibility that it created over a year ago. 

Another striking thing – at least to me -- is the extent that the policy process remains paralyzed inside China.    George W. Bush’s foreign policy seems to be to be premised on not making hard decisions and hoping Iraq (maybe the entire Middle East?) becomes someone’s problem in 2009 – while praying that the financial flows needed to sustain a no-savings economy don’t give out in the meantime.   China’s exchange rate policy seems kind of similar.    Do nothing (Ok, fiddle around the edges) and hope the problem – the pressures that rapid reserve growth places on China’s domestic financial system, no matter how hard China tries to limit or suppress these pressures with administrative measures -- goes away.

So far it hasn’t.  Read Obstfeld.

Another striking thing, at least to me, is that with oil above $70 and domestic oil demand increasing rapidly (all those new cars), China’s trade surplus is expanding.   I certainly wouldn’t have expected that China would be paying roughly twice as much for imported oil as it did two years ago and still have a growing trade surplus.    Nor would I have expected two years ago that Chinese exports would still be growing at 25% off by now a very large base. 

My surprise can be expressed differently: China is in the midst of one of the biggest investment booms the world has seen in a long time.   And its current account surplus is still growing, because savings has grown even more. 

A final surprise:  according to a new synthesis study of China put out by Edwin Lim, Michael Spence and Ricardo Hausmann (under the aegis of the center for international development at Harvard) , household disposable income (think wages) is declining as a share of Chinese GDP – and profits rising as a share of Chinese GDP.  I guess China’s economy is more like that of the US than anyone thought.  Enterprise savings now matches household savings (see p. viii of the Lim report) – and they are growing faster.

But that certainly isn’t what one would expect if a labor-rich capital-scarce economy is integrated into the global economy.  Global demand for Chinese labor should push up the wage share of GDP – and, with capital less scarce, profits should fall.   

I suspect part of the explanation for this puzzle is that China is both slowly reversing communist-era policies that suppressed profits even as it integrates.   That may explain why over-capacity doesn’t lead to fall in investment as well.  Just a hunch.

But, to paraphrase Robert Rubin’s comment to the effect that no one predicted that a large number of exchange rates wouldn’t adjust in the face of substantial pressures for adjustment, I don’t think anyone would have predicted ten years ago – or even five years ago -- that Chinese integration into the world economy would lead to downward pressure on labor income relative to Chinese GDP, an investment surge that took investment to around 50% of Chinese GDP, and even bigger surge in savings -- and massive financial flows from China to the US.  Judging from the survey data, $190b in Chinese lending financed about a quarter of the US current account deficit from mid 2004 to mid 2005.

Garber, Dooley and Folkerts-Landau did predict this.  I said no one would have predicted all this five years ago for a reason.   Their seminal article didn’t appear until 2003.  They still deserve a lot of credit – it is hard to make a bold call and get it more or less right. 

Back when I first started to write about China, China had around $515b in reserves.   Check out its stated reserves at the end of September 2004.    Really it had around $560b then, counting the $45b reserves that were transferred to the state banks.    Today China has $940b in reserves.  Probably more – we are now well into July, and China didn’t push its exchange below 8 without buying a few dollars. 

Indeed, using my metric, which includes reserves transferred to China’s state banks, China already has $1 trillion in reserves.  Add $60b to $941b …    They formally will have over a trillion by the end of the third quarter.   

Reserves will have doubled in two years.  They are rising by about $250b a year.  Sure that includes some valuation gains on China’s euro reserves (not on the euros it bought before September 2005, but on the euros it bought between the end of q2 2005 and the end of q1 2006 … ).   But that is still a pretty impressive growth rate.  China’s current account surplus has grown even more.  

So my question to China’s leadership is simple:  What is your exit strategy?   Do you intend to add another $500b, maybe more, to your reserves over the next two years?  Another trillion, maybe more, over the next four?   

Do you think that exports can continue to grow at a 25% annual clip for the next two years?   The next four? 

By my calculations, that would take monthly Chinese goods exports from around $80b now to around $200b.   25% growth for two years implies a monthly total of more like $125b.   

I recognize that my credibility is a bit limited since I certainly did not think Chinese exports could continue to grow at close to their 2004 pace through 2006.  But I really don’t think China will be exporting $200b a month in the middle of 2010 either.  Moving into higher-end products may help keep the growth rate up, but it also will only increase the political backlash against trade in the US and Europe.

Via Survived Sars, I came across an interesting quote from Xia Bin of China's Development Research Council.   I thought it showed an appropriate degree of realism.   Xia Bin noted that the US is not exactly noted for taking the interest of other countries into its decisions. 

The U.S. always tends to cast the interest of any other country to the winds. It has its currency revalued to fix its own economic problems. If China holds massive dollar assets, possible damages will be notable in the case of sharp depreciation of the dollar. 

W’s performance at the recent summit probably did not lead Xia Bin to change his point of view.  If I were sitting in a plush office somewhere in Beijing, I wouldn’t be counting on the US to help devise my exit strategy.  Or to take policy decisions that would preserve the value of all the funds China has lend to the US. 

I would be reading the policy recommendations in the Harvard report – recommendations developed with input from a number of folks in China, not just outside academics (including M. Blanchard and M. Giavazzi).   And I would wonder if it is now too late to change course …

China avoided a hard landing after the 2003-04 investment boom and growth acceleration.    I am not sure it will be so lucky after a similar investment boom and growth acceleration in late 2005 and the first half of 2006.  

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