Five myths (or half truths) about China and the renminbi

China’s exchange rate peg has attracted a lot of attention recently, in the market, among the public and in the press. (also here, here and many other places)

Alas, too much of the commentary seems to me to reflect arguments that at least to me don’t seem to be true, or seem to be only half true.

Arguments that appear often include:

1) China runs a surplus with the US, but a deficit with the world; its overall trade is close to balanced. This is a myth. China’s trade surplus with the US exceeds its trade deficit with the rest of the world. It ran a trade surplus of $32 billion in 2004. That surplus is set to widen significantly in 2005, since China’s exports are growing far faster than its imports. China’s trade surplus in 2005 could reach $100 billion or more, according to Jonathan Anderson of UBS. China’s overall current account surplus is larger as a share of GDP than Japan’s, and it is rising rapidly -- it could be 7% or 8% of China’s GDP in 2005.

2) China hasn’t changed its currency peg since 1994, it therefore cannot be trying to keep its currency down. Back in 1998 there was concern that China might devalue. The last statement is true (counting back to 1998), but the rest I would argue reflects a myth -- namely that so long as China is not pushing its currency down in nominal terms, it cannot be "manipulating" its currency to impedge effective balance of payments adjustment. Put simply, a lot has changed since 1994. China’s economy is far more productive. It now exports $595 b of goods, and it is on track to export 750-770 b in 2005 (One note, i previously used a Goldman estimate of end 2004 "exports" that was around $700b; Goldman’s definition of exports was very broad -- goods exports are closer to $600b. My apologies.) v well under $200 b back in 94. That increase in productivity should have led to an appreciation of china’s currency in real terms, whether through higher inflation rates in China or through a rise in the renminbi’s value against other currencies. Neither has happened. One other thing has changed, particularly since 1998. From about 1995 to 2002, the dollar was generally rising; from 2002 (leaving aside its recent rally v. the euro) the dollar has been falling.

There is a reason why China’s current account surplus has been rising, and why China’s reserves are rising even faster. Lots has changed since 1994, and since 1998.

3) Chinese wages are so far below US wages (and for that matter wages in other industrial countries, and many emerging economies) that a change in the renminbi won’t have any impact. Myth. Goldman Sachs estimates that a 1% rise in the renminbi’s real value (which can come either if Chinese inflation is 1% higher than inflation in the rest of the world, or is China’s currency rises by 1% and inflation is unchanged) leads to a 1% reduction in China’s export growth rate.

It is not all that hard to see the impact of changes in China’s real exchange rate on China’s exports even without a fancy model. China’s exports to Europe are up by something like 50% in q1 -- probably a reflection of the fact the the RMB has fallen substantially v. euro over the past few years. And, as I noted previously, from 2002 on, as the dollar has fallen, China’s export growth has averaged over 30% y/y; from 98 to 2001, the average growth rate was only 13.4%.

Whether a slowdown in China’s export growth leads to a slowdown in the growth in the US trade deficit or the substitution of other imported products for Chinese products is a different question -- it depends on what happens to US savings and consumption along with the availability of financing to cover the US savings deficit, not just the RMB/$.

4) China is just taking market share away from other Asian economies. That was true between 2000-03. But it is also no longer true. Hence, this too is something of a myth. The element of truth: in 2003, US imports from the Asian Pacific region were exactly what they were in 2000. Remember, in 2001, overall US imports fell sharply, including US imports from the Asian-Pacific region. It took some time for them to recover. From 2000-2003, imports from China rose as a share of US GDP, but imports from the rest of Asia fell as a share of US GDP. But in 2004, US imports from the Asian Paficic region as a whole rose by 18% -- and consequently rose as a share of US GDP. Even taking away China, imports from the rest of the Asia Pacific grew faster than US GDP. The same looks to be true in 2005 ...

Imports for Asia as whole are up 15.5% in q1; Imports from China (even with the lunar new year effect) are up 30%, imports from Korea are up 14%, Japan 8.5% ... overall imports from Asia are rising far faster than nominal US GDP.

5)China is America’s fastest growing export market. Myth. Y/Y exports to China are up 0% (q1 05 v q1 04). Exports to the Eurozone are up 8.5%, Canada 12%, South America 11%. Over a longer period of time, US exports to China have grown fast in percentage terms (in line with the very rapid expansion of China’s imports from everyone -- China’s overall imports rose from $278b in 2000 to $561b in 2004). But the base was very low. In 2004, US exports to China increased by 22%, or $6.3 billion. Exports to Europe did not grow as fast, but in dollar terms, they increased by much more -- $16.8 billion.

What has grown fast is US exports of debt to China -- China’s reserves increased by $160b in 2003, $206 b in 2004 and look set to increase by at least $300 b in 2005. Most of those reserves are invested in US dollars, even if not all Chinese purchases show up in the US data.

(Continues)

There are two other arguments that are often made about China’s peg that while not exactly myths, are not quite as obviously true as is often assumed.

6) China’s peg increases employment in China by stimulating its export sector.

There is no doubt that the peg, by contributing to rapid export growth, is contributing to rapid increase in employment in the export sector. 30% y/y growth creates jobs in the export sector even with rising productivity. But the overall impact on employment is much more ambiguous, since the peg also keeps China’s domestic interest rates down. With borrowing rates of 5 or 6% in an economy that is growing at 10% (and with producer prices rising rapidly), capital is very cheap in China. And no surprise, cheap capital creates an incentive to substitute capital for labor. I don’t know the magnitude of the different effects, but the peg’s overal impact on employment in China is less clear than is often asserted.

7) Changing the peg would devastate China’s banks. This is a topic worth a post of all of its own, but it not at all obvious.

China’s banks don’t have any real economic capital -- they are technically insolvent, so letting them bet on the exchange rate is not without its risks. But so to is letting them lend domestically. Heads, the bank wins; tails, the China’s taxpayers face an even large bill for cleaning up the banks. Without real economic capital, Chinese banks need to be regulated tightly across the board.

Above all though, it is not at all clear to me that exchange rate stability is strengthening rather than weakening the banking system. Afterall, in 2003, rapid reserve growth was fueling very rapid credit growth -- lots of new lends helped to reduce the ratio of NPLs to total loans, but if rapid credit growth leads to a new generation of bad loans, the banks are not getting better. Right now, the government has crimped credit growth with controls. As a result, the banks are buying government sterilization paper at very low rates. This too has a cost: it makes it harder to finance cleaning up past bad loans out of ongoing profits.

China’s banks generally don’t have direct exposure to a change in the peg. They generally take in deposits in RMB and lend out in RMB. No direct exchange rate risk there. Moreover, the risks of a revaluation are not the same as the risks of a devaluation: a revaluation generally makes it easier to repay dollar debt. Some of the capital of China’s big four banks is denominated in dollars because China used its reserves to recapitalize the banks, creating something of a mismatch. But the authorities know about this, and they will compensate the banks for any exchange rate changes.

A bigger concern is that a revaluation potentially hurts firms that have borrowed in RMB to invest in the export sector. Their dollar revenue falls, the RMB debt stays constant. However, there are offsetting effects -- imported components are cheaper, and if Chinese firms can increase their dollar prices, their renminbi revenue won’t fall much. I suspect most Chinese firms will manage -- even a large revaluation is likely to slow the growth of China’s exports, not end it.

That is why I agree with the leader in this weeks’ Economist: China should revalue, both because it is in its own interest and because it is part of the set of actions needed to generate a less unbalanced world economy.