from Follow the Money

Exchange rates don’t matter. At not least not the RMB/ dollar …

May 18, 2007

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Sometimes it seems that the larger China’s current account surplus – and the bigger the share of the US current account deficit financed by China’s government – the more insistent the Economist becomes that the RMB’s current value has nothing to do with the United States current account deficit.   Its special report on US/ China trade argues:


“The biggest myth of all is that a revaluation of the yuan would greatly reduce America's trade deficit.” 


Its leader goes further, arguing that neither China's surplus nor the US deficit is tied closely to the RMB/ dollar: 


China's overall surplus and America's overall deficit have less to do with the value of the yuan than with Chinese saving and American profligacy.


The fact that a very credible Chinese-based economist now expects China’s current account surplus to reach $400b this year, or just under half the US current account deficit, doesn’t seem to have altered the basic view of the Economists’ brain trust. 


The fact that China may add over $500b to its reserves and provide up to $400b in financing to the US – calculating the precise number is rather difficult since some of China’s reserve growth represents funds already in China that simply are appearing on the PBoC’s balance sheet, and because of a host of data problems that I have discussed previously at great length -- also doesn't seem to have had much of an impact on the Economist's thinking. 


I obviously disagree.  The availability of a big credit line from China’s government makes it possible for the US to save far less than it invests. Absent such a credit line, the US would be forced to be less "profligate."  It would need to save more and spend less.  Savings and investment imbalances are not independent of the availability of financial flows, and right now no one is willing to provide the US with as much financing on as generous terms as the Chinese central bank. 


Like the chairman of the US Federal Reserve, I no longer find the argument the US savings deficit is determined exclusively by US policies -- and consequently would persist even in the absence of financing by China (and others) -- all that convincing.  

After all, right now the US current account deficit is mostly the product of a shortage of household savings – not a large fiscal deficit.   The ability of US households to consume so much and save so little seems rather tied to availability of cheap credit from the rest of the world.  Less credit = less profligate consumption. 

The argument that the RMB’s depreciation from 2002 on has something to do with China’s huge surplus and its corresponding ability to finance the US isn’t all that complicated. 

The graphs the Economist pulled together for its story kind of illustrate the basic point -- and I'll add a couple more of my own later in the day. 



The RMB tended to appreciate along with dollar from 1995 through 2002.  During this period, China’s current account was in rough balance.  


The RMB by contrast turned down in 2002 – and really depreciated in 2003.   It remains about 10% lower that it was at the dollar’s peak in real terms.  The fall in the RMB in turn correlates rather closely with the rise in China’s external surplus – once you take into account a lag.   As the Economist special report recognizes, that lag is partially the product of policy: in 2003 and 2004, China led an unexpected surge in reserve growth trigger a huge surge in credit.  The resulting investment boom pulled in imports – and drove up inflation.   China looked set to follow the oil exporters.   It then cracked down on lending.   That slowed both inflation and imports.  But not exports.


China's trade surplus soared, and the lending curbs meant that the banks were in a position to lend a lot of Chinese savings to the government, which then lent those funds to the "profligate" US.


The fact that China – an oil importer I might add – now runs a roughly 10% of GDP current account surplus might be considered a sign that its exchange rate is undervalued as well.  


The fact that China’s surplus looks set to rise further -- both absolutely and as a share of China's GDP -- could be considered additional evidence.  


The fact that China’s export growth has generally been close to 30% y/y in nominal terms (and over 20% y/y in real terms) after the RMB started to depreciate and has stayed there might be considered evidence as well.   


The fact that China’s nominal exchange rate is very low relative to its PPP exchange rate – even taking into account the fact that poorer countries generally have nominal exchanges below their PPP exchange rate – is additional evidence.


McKinnon and Mundell, it is true, do not believe that China’s exchange rate is undervalued.   At least they don’t believe China should let its currency float.  Both are big believers in fixed exchange rates.  



Cheung, Chinn and Fugii also didn’t find conclusive evidence that China’s exchange rate was undervalued.   At least not in 2003.   That was the last data point in their study, best I can tell.  2003 – incidentally -- was well before China’s current account surplus had ballooned.   China exported less than half as much then as it does now.   And while China didn’t quite formally meet Chinn, Cheund and Fugii's test for “undervaluation” in 2003, it came pretty close.   The key chart is found here.   You can draw your own conclusions. 


Detailed data on China comes out with a lag -- and formal academic analysis tends to appear with an additional lag.  A lot of the studies purporting to show that the RMB isn’t obviously undervalued are based on data through 2004.   Since then China’s external surplus has increased dramatically.  I suspect that will have an impact on the conclusions that emerge from future academic work. 


The Economist did note -- citing Dr. Roubini (I have also made this argument rather regularly) -- that the evolution of China’s bilateral balance with Europe suggests that moves in the RMB do impact trade flows.  It is hard to tease out how moves in the RMB impact trade flows by just looking at the RMB/ dollar, which hasn't moved much -- especially in real terms, as Chinese inflation has generally been lower than US inflation.   The RMB by contrast has moved wildly against the euro, the pound and other European currencies.  And we know that the RMB's fall v European currencies led to an acceleration in the pace of growth in China's exports to Europe and the emergence of a large Chinese bilateral surplus came only after the RMB’s large depreciation against the euro, pound and other European currencies.  Just look at the data in the IMF’s regional outlook (Box 1.2, p. 24).    


But this argument didn’t sway the Economist.  They counter the European data by arguing that the impact of any move in the RMB on US-Chinese trade flows will be small.


Don’t get me wrong.    Even I don’t think that a change in the RMB will reduce the US bilateral deficit with China in the short-run.  There are price as well as quantity effects. A certain amount of further deterioration is already in the pipeline.    But over time, I would expect more RMB appreciation against the dollar to slow the pace of deterioration in the US bilateral deficit with China.    Exchanges do matter.   It will, though, likely take a large revaluation.


The Economist's special report also repeated a set of my least favorite arguments.


It argued that China’s surplus largely comes from a shift in production out of the rest of East Asia.  That is no doubt true to a degree.  But the overarching fact is that the US bilateral deficit with all of Asia, not just the US bilateral deficit with China, is rising.  And for that matter Asia’s overall external surplus with the world is rising, not falling.   I didn't pull the data in the links out of thin air -- it comes straight from the BEA and the IMF's WEO.


The rise in China’s current account surplus hasn’t been offset by growing deficits elsewhere in Asia.    It has instead been offset by a rise in the US deficit – at least in a broad global sense. 


Moreover, the IMF recently noted -- I think accurately -- the China is "becoming less dependent on other Asian economies for inputs."   Box 1.2 again.


The Economist argued that RMB appreciation wouldn’t have much impact on the US since the US doesn’t produce goods that compete with China.   That used to be true.   But by all accounts China is moving up market fast.   I would think though that Economist's correspondants in the US Midwest would be agree that the US still makes some auto parts and cars.    China now does too.  


Over time, the overlap between China's production mix and the US production mix looks set to rise, not fall. China increasingly produces -- and exports -- capital intensive as well as labor intensive goods.    Intel now plans to make chips in both China and the US.   


Moreover, if the US deficit is ever going to come down, the US is either going to have to make things now made in China or elsewhere in Asia (reducing US imports) or export an awful lot more to China, Asia and the Middle east. 


The Economist argued that Americans shouldn’t complain about China's implicit export subsidy since they benefit immensely from cheap Chinese imports.


“Trade with China helps, not harms the average American. Thanks to imports from China, prices are lower and real incomes higher.”


I don’t think though that it makes sense to look at just those areas where China has lowered prices when looking at the complex question of how a weak RMB influences American welfare.  Chinese assembly has made DVD players a lot cheaper, and Chinese exchange rate intervention makes them still cheaper.   But not all prices are lower because of China, even if the price of those things that the US imports from China are lower.   


China’s emergence, for example, has clearly put upward pressure on the price of a host of commodities -- and on the price of things the US exports to China (See Dani Rodrik for an extraordinary discussion on this topic).   The US doesn't export that many goods to China, but it does export a lot of bonds to the PBoC -- so Chinese demand presumably has pushed the price of bonds – and things, like houses, that can be turned into bonds -- up.   That is good if you already owned a house (so long as it wasn’t located by a manufacturing plant that isn’t doing so well), but not so good if you don’t.    


Finally, China's impact on the "average joe" hinges on trade with China has influenced wages, not just how it influenced prices.  The enormous increase in China’s exports – they will basically go from $250b in 2001 to $1,250 in 2007 – hasn’t exactly coincided with strong growth in median real compensation in any of the major advanced economies.   That I think should give anyone arguing that China’s policy of holding the RMB down is an unambiguous benefit to the median worker some pause. 


China’s emergence by contrast clearly has been very good for the financial sector.    Read that radical out in Newport Beach California.   China doesn't buy many US goods, but it buys a ton of US debt.  Lots of folks have made a lot of money selling debt to China’s central bank, selling complex financial products to investors who sold their treasuries and agencies to China’s central bank and are now looking for something that yields more and in some cases selling their skill at leveraging companies up to China's asset managers.  


Those who made slightly more complex bets -- bets that an unbalanced world would be a stable world -- have also done very well.  China’s central bank, along with a bunch of other central bank,  have provided financing to the US when others haven’t been willing to do so, dampening volatility in host of markets.  


The scale of the required financial flows from the world's central banks to the US have now gotten quite large.  In the first quarter – by my calculations, which draw on the US data but try to adjust for some of its limitations  – central banks provided about $175b in financing to the US.    That is a lot.   It works out to $700b a year.    China alone probably provides about ½ of that.


Such large financial flows are a consequence, in large part, of China’s exchange rate regime.  The flows from China, obviously.  But also the flows from countries like Korea and Brazil that don't want their currencies to appreciate by more against the RMB.      

I know the Economist likes counter-intuitive arguments – and arguing that China, not the US, has the most to gain from letting the RMB rise is both counter-intuitive and plausible.  I agree with Eswar Prasad’s argument that the weak RMB is a constraint on financial sector reform in China.   But given the size of China’s surplus and the share of the US deficit that China’s central bank finances, I also find it hard to accept that China hasn’t contributed in some way to the US external deficit.  

Right now – whether because of the weak RMB or other factors – the US is clearly on trajectory where it increasingly depends on Chinese credit to sustain its deficit.  I think everyone should be able to agree on that.  And I personally think both parties – not just China – would benefit from starting to adjust now, not continue to avoid adjustment.  

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