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Exit Schumer and Graham, Enter Grassley and Baucus

March 29, 2006

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Schumer-Graham won't be brought to a vote until September.  

China's central bank governor Zhou must  be persuasive.  Maybe he plotted out where the RMB will likely be if China continues with its current (accelerated) rate of appreciation v. the dollar. Or maybe he said point blank that if you all go forward, we absolutely won't move.   Or maybe he promised further changes if you all back off.  Remember, last summer Greenspan and Snow told Schumer and Graham they were sure China would move, but only if they held back.  Or maybe Schumer just got cold feet.  The Street wasn't exactly on board with his latest caper; too much money is betting an unbalanced world stays unbalanced.

But Schumer-Graham isn't the only legislation out there.   Grassley and Baucus have their own bill. 

Christopher Swann and Edward Alden (in an earlier version of this article that lacks McGregor's contribution) note that Grassley and Baucus would make three key changes to the current law:

  1. It shifts the focus from manipulation to misalignment, on the theory that the Treasury would have to conclude China's exchange rate is misaligned.  Jeff Frankel settled the question for me some time ago.
  2. It makes sanctions automatic after six months; the current law sounds scary but it only mandates negotiations after a declaration of manipulation.
  3. It makes the sanctions less nuclear.   No tariffs.  Indeed, some of the Grassley-Baucus sanctions may lack teeth.  China doesn't really needs US, World Bank or IMF financing,  and removing OPIC (Overseas Private Investment Corporation Guarantees) might not cut into FDI flows.  US firms don't account for that much investment in China in any case. The anti-dumping stuff might hurt though ...  

I wonder if the the shift from Schumer-Graham to Grassley-Baucus means that Treasury will give China another six months as well?   Or if Treasury remains worried that it will lose credibility and Congress will strip it of any discretion if it doesn't act?

Swann and Alden: "The US Treasury has angered many law makers from branding China a currency manipulator in its twice-yearly reports to Congress on exchange rates and trade ... the proposals by Senators Grassley and Baucus would make it harder to avoid chastising China officially for its currency policies."

That sounds right to me (subsequent versions have a blander on-the-record quote from Grassley).

The Treasury's Tim Adams clearly hoping for more from China before mid-April.

Neither China, nor the global economy, has reaped the benefits of a more flexible exchange rate. The Chinese government must allow market forces to play a much greater role in the determination of the RMB's value. The obstacles are no longer technical; China could easily move more rapidly towards greater flexibility. It should do so now.

UPDATE: Adams also is prepared to back Grassley-Baucus.  That must have been part of the deal with Schumer and Graham.

I don't necessarily share the general consensus view (pushed by the Chinese as well as China hands) that China won't move under pressure.  

Former Treasury Undersecretary John Taylor certainly did not put any pressure on China to change its exchange rate during his tenure at the Treasury.  And China certainly did not change its peg during that time either.  

China still needs to demonstrate that if it is given time to act without US pressure, it will make real changes.  Not only act when US pressure concentrates decision-makers minds.

China (in my view) should have adopted a basket peg back in 2002 or 2003 - before the dollar fell against the euro - not after.   China also missed another window of opportunity to revalue and move to a basket in the summer of 2004, when speculative pressure on all of East Asia fell significantly.  

From afar, it sometimes seems that only an external push can prompt China's consensus-driven and cautious leadership to many any change.  Otherwise - whether because of inertia or because interests that benefit from China's undervalued exchange rate have as much influence over the policy process as the PBoC - the default policy is to do nothing.

Particularly as the benefits of the current policy are very visible, and while the costs are very effectively hidden. 

Zhou's proposal for a bigger initial revaluation last summer was rejected the State Council, and, as I constantly note, the 3.2% nominal appreciation of the RMB since last summer (really since 1995) at best just offsets higher inflation in the US than in China.    China may be accelerating the rate of crawl now, but it should have done so in August.   The 1% appreciation since last July has been exceptionally timid.  

Of course, there may be is a Laffer curve for pressure as well.  Too much, and nothing happens.  Both sides dig in and slug it out.  Too little, and nothing happens.   Inertia wins out.  Finding the level that is just right, though, is hard.  

Zhou's recent speech rejected any sharp big moves -- noting (correctly) that the US hasn't exactly made any sharp big moves to address its fiscal deficit or its own low savings rate.   His frustration is palatable, even if expressed diplomatically: "Some participants [at IMF conferences] suggested that the US has been too slow in making an internal adjustment ...  not to mention that the US has not taken the lead to use "shock" to adjust its imbalances."
I only would add that China also hasn't slowed its financing of the US in response to US intransigence.  There is an optimal level of external pressure on the United States too.

Zhou is right to argue exchange rates are only a part of a much broader adjustment.  The US needs to consume less/ save more; China save less/ consume more.   But I think he downplays the role of exchange rate flexibility in the adjustment process a bit too much.  

Exchange rates shape firm profitability (and thus business savings).  They send an important signal that influences the location of future investment (where will the next generation of auto parts plants be located, how many more ports does the US need to build) as well as the composition of Chinese investment (should Chinese firms produce for external markets, or domestic markets?).  And, as Menzie Chinn notes, the exchange rate influences capital flows not just trade flows, and thus shapes Chinese reserve growth the ease with which the US can finance its deficits. 

Moreover, it is pretty clear that the acceleration in China's export growth (see the graph on p. 13 of the Economist Survey) coincides well with the dollar's slide v. other major currencies.   Europe wasn't China's biggest trading partner when the dollar was strong.  Exchange rates do matter.

Let's also be clear on one thing: China's weak financial system is not a good reason not to change the RMB.  That's why this line in the New York Times annoyed me.

Chinese officials have said they are moving cautiously toward a more free-floating currency in order to give the country's manufacturers and financial system, which is considered weak by many experts, a chance to prepare for the change, which is expected to bring with it wide swings in capital.
 
There is no doubt that China's financial system is considered weak by many experts.   Though apparently not by the foreign banks scrambling to invest in China, who emphasize how much has changed ...
 
But China's financial system is weak because the banks made lots of bad loans denominated in RMB in the past, and may be making even more bad loans denominated in RMB right now.    Those weaknesses have nothing to do with the level of the RMB/ dollar.   Or the RMB/ euro.  China's financial system has managed big fluactations in that exchange rate.
 
China's doesn't have the kind of financial weaknesses - big currency mismatches, heavy dependence on short-term external cross-border loans, lots of foreign currency denominated loans - that made exchange rate moves problematic in many emerging markets.  Plus, foreign-currency denominated loans are far more of a problem in the face of a depreciation than an appreciation.  Don't take my word on it; the IMF came to the same conclusion.      
 
Moreover, keeping the peg creates all sorts of problems for China's financial system.  It is being stuffed with low-yielding sterilization paper to keep the central bank's sterilization costs down for one.    Money growth remains pretty strong - and keeping it from prompting a 2003 style credit blowout has required ongoing administrative limits on bank lending.  Limits that are hardly consistent with eventually transitioning to a market system.  
 
This last phrase "which is expected to bring with it wide swings in capital" also seems off, or at least devoid of context.   It sort of assumes that the peg has avoided large swings in capital.     Yet the reality is far different.   From 98-00, large amounts of capital were leaving China.   From 2003, large amounts of capital have been trying to get into China.  
 
Keeping the RMB stable against the currency of just one of China's trading partners hardly guarnatees broader macroeconomic stability.  The RMB rose in real terms from 98 through 2001, and then fell from 2002 to 2004.  Investment has surged from say 35% of GDP to roughly 45% of GDP over the past few years.   And so on.

While I am at it, let my deal with another pet peeve: attributing China's high levels of savings to capital controls that lock savings into China.

It sure isn't obvious to me that forcing folks to keep their savings in low-yielding deposits in crappy banks encourages savings.  

I guess there are income as well as substitution effects; the low real yield on Chinese bank deposits makes current consumption more attractive (why save if there is no reward), but also increases the amount Chinese savers have to set aside to build up a cushion against big changes in the future.

But still, lots of countries with capital controls, low real interest rates and financial repression have low savings rates, not high savings rates.

I see how China's capital controls help the banking system (by helping keep deposit rates low) and encourage low quality investment (since China's banks have more funds to play with).  But not how they obviously encourage higher levels of savings.

Moreover, I don't see how China's controls on outflows explain the recent surge in Chinese savings.  China saves a higher fraction of its GDP now than it did in 2000, or even 2002.  Yet  China's controls on outflows were a lot tighter then than they are now.  Remember, if the face of a surge in capital inflows, China has been tightening controls on inflows and loosening them on outflows - not what you would expect if tons of folks are desperate to get out of China's banks ...

As I noted earlier, right now, hot money is coming into China.  Those who escaped China's capital controls back in the late 1990s and were safely invested in high-yielding international assets are moving their funds back into China's crappy financial system.  That doesn't really fit with the capital controls lock savings into China world view.

Soaring business savings (firms now account for about half of national savings) and the insecurities created by the absence of a social safety net seem to be far better explanations for the recent rise in Chinese savings. 

Though maybe the IMF is too left-wing a source for Stephen Kirchner?  After all, he seems to think both the AEI's Desmond Lachman and Treasury's Tim Adams (of Bush-Cheney) 04 are insufficiently true to the conservative cause ...  since they, like notorious leftie Larry Summers, believe in IMF surveillance of exchange rates

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