from Follow the Money

I hope Andy Xie is wrong about this

March 8, 2005

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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Xie argues that Chinese prices won’t converge to US levels; rather US prices are likely to need to fall to Chinese levels.

When a small economy like South Korea begins to develop, it is quite reasonable to assume that its prices (e.g., wages, property prices, or the cost of a haircut) will rise to the same levels as in developed economies. South Korea has a population of fewer than 50 million. If it invests to join the global economy, global demand will be met by Korean supply at the margin. As South Korea’s labor force is less than 5% of the OECD labor force, it will reach full employment quickly -- and the extra global demand will pull up its wages to international levels. Rising wages will cause inflation, and asset and goods prices will also converge towards international levels. The price trends in China will be very different from those in Japan or South Korea at similar stages of development, in my view. China’s labor force is bigger than the OECD labor force. When it can make a product more cheaply than others can, even if all the production of that item relocates to China, its wages will not increase. ... the global financial markets are speculating in China-related assets, in the belief that Chinese prices will rise to OECD levels. I believe that OECD prices are more likely to fall towards Chinese levels.

Xie is right to warn that Shang Hai real estate is not gonna be priced like London or New York real estate tomorrow. Speculation seems to have gotten a bit ahead of reality.

But on a broader level, I hope he is wrong. If China is going to keeps its peg and changes in competitiveness need to come from changes in prices, I would rather see prices in China rise than prices in the US fall.

Deflation is generally a quite unpleasant was to bring about an improvement in a country’s real effective exchange rate. Ask Argentina. They experienced something close to outright deflation from 99-01, and three consecutive years of recession.

This is one of the things that bothers me about "the China does not need to revalue the renminbi, let inflation differentials bring about the needed adjustment in the real exchange rate" argument that Ronald McKinnon and others, notably Stephen King of HSBC, have been making.

McKinnon is right to note that if China were to have higher inflation rates than the US over a sustained period of time, China’s real exchange rate would appreciate even if the renminbi-dollar remained constant. The renminbi price of Chinese goods would rise, leading their dollar price to rise.

There is little evidence that this is happening though: these charts from the Cleveland fed (via Macroblog) should that inflation differential have led the dollar to appreciate against the renminbi, in real terms, since 1994 (largely because US inflation exceeded Chinese inflation from 1997 to 2003).

Moreover, the needed "inflation differential" does not necessarily have to come from higher prices in China. It also could also come if Chinese prices stay constant and US prices fall. Adjustment from deflation in the US hardly fits the model for an expansionary current account adjustment laid out in the Federal Reserves Board’s recent paperr. The Fed found one common denominator of countries that grew even as their current account deficits fell: a fall in the nominal exchange rate led to fall in the real exchange rate, and rapid export growth (More on the Fed paper later).

At the end of the day, I don’t think China will get to set US price levels. The Federal Reserve has the tools to keep US prices from falling, no matter what happens to renminbi wages in China. The printing press is a pretty powerful tool. If the US starts printing dollars, China would have to increase its purchases of dollar reserves to keep the dollar-renminbi exchange rate stable, and effectively print renminbi to buy dollars. In other words, China would have to expand its money supply to keep the renminbi-dollar constant (that makes intuitive sense -- if there are more renminbi as well as dollars, the renminbi-dollar does not need to change). China could try to offset the increase in the money supply by selling bonds to take cash out of circulation (sterilization), but China is not able to sterilize its current reserve increase, let alone all the dollars it would have to buy to fight the US printing presses.

Rather than "import" inflation, I suspect China would decide to let its currency appreciate. Still, a scenario where the US ends up printing dollars to force China to change its peg hardly sounds like recipe for international monetary stability.

Incidentally, it is not obvious that Xie’s analysis is right. Classic economic theory suggests that trade between the US (labor scarce/ capital rich) and China (labor rich/ capital scarce) would lead wages in China to rise/ and returns on capital in China to fall, and the opposite (alas) to happen in the US. Hecksher-Ohlin factor price equalization and all.

Xie’s analysis, in contrast, suggests that wages in China will stay constant because of an inexhaustable supply of labor in China’s country side, which implies, I suspect, that all the gains from growing productivity in China will be captured by capital -- as a share of national income, profits will rise and labor compensation will fall.

There are lots of reasons why the argument that trade always leads to factor price equalization is a bit too strong. I don’t want to get into them here. All I want to do is to note that Xie’s analysis effectively assumes the opposite, namely that integration into the world economy will increase returns to capital in China but not (substantially) increase returns to labor.

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