from Follow the Money

If it is still a dollar peg, where is the monetary policy flexiblity?

September 4, 2005

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I rarely agree with Steven "trade deficits do not matter" Jen.   His models for G3 exchange rate determination leave out a variable - the pace at which the US is adding to its external debt and its resulting external borrowing need - that I suspect will be increasingly relevant going forward.   I don't see how the dollar can rally to around 1.10 to the euro (Jen's long-standing estimate of its fair value) without pushing the 2006 US current account deficit to above 8% of GDP.

But I agree with Jen on one point: China's new basket peg looks an awful lot like a dollar peg in practice.  Rather than pegging at 8.28, China is now seems to peg at 8.095-8.11.  

Sun-bin's empirical work lends analytical support to the conclusion one draws from eye-balling the data: the implied dollar weighting in China's exchange rate is above 85%.  i have not done the math, but I don't think the recent tick up in the RMB to 8.095 (an appreciation of 0.2% since July 21) changes the basic conclusion.  The dollar has slumped a bit against the euro since July 21 (when the dollar/ euro was at 1.211), Katrina and all.  As I understand it, with a basket peg, when the dollar falls v. the euro, the renminbi should rise v. the dollar to limit the renminbi's fall v. the euro.  Note this would work in reverse if the dollar rose v. the euro -- the renminbi would need to fall v. the dollar.   That would not go down so well on the hill  ... .

But the bottom line is that the renminbi has not moved much, and it basically remains tied to the dollar at a level that can only be sustained so long as the PBoC intervenes massively.

That is why I am a bit surprised that both John Taylor - and the World Bank - have claimed that China's (trivial) move has increased China's monetary policy flexibility.   I don't quite see where the flexibility will come from.    Interest rate parity does not hold in an economy with capital controls.  But it still provides some useful insights.  In broad terms, if China wanted to raise interest rates above US rates to reduce investment (and perhaps, by increasing the return to savings, increase the savings rate), it could only do so if it let its currency appreciate to the point where investors expected a future RMB depreciation.  China is a long way from that point. 

Otherwise, China needs to keep its domestic interest rates low, as an expected appreciation over time will add to the expected dollar return on renminbi assets.

Consequently, it sure seems to me that China's monetary policy choices are still hemmed in - if the PBoC raised rates without allowing further appreciation, it would only increase the incentive to bet on the RMB.   Right now, after all, the carry on RMB deposits (and short-term PBoC bills) is negative.   Bank deposit rates in China are capped at 2.5%, below the 3.5% federal funds rate.

If China intends to allow a series of small appreciations in the RMB to avoid the (perceived) mistakes made by Japan, then it either has to: 
  1. Keep its interest rates below US rates, so that low interest rates offset the expected return from renminbi appreciation over time; 
  2. Intervene massively, as its capital controls are not so effective that they preclude all speculation on the renmimbi;
  3. Or, most likely, do both.

Either way, a policy of slow, gradual appreciation -- see this Eichengreen/ Hatase paper -- basically forecloses an independent Chinese monetary policy.  

Gaining true monetary policy independence requires China to do more than allow the renminbi to appreciate to the point where an expected depreciation becomes plausible.  China also needs to recapitalize its banking system in a big way.  Recapitalization means, more or less, letting the banks give their bad loans to the government at close to par in exchange for government bonds, with the government eating the losses - it basically amounts to giving the banks government bonds to close the gap between their deposits and their stock of performing loans.   That way the banking system would no longer rely on low deposit rates to maintain the large spread between deposit and lending rates a banking system with lots of NPLs needs to remain profitable.

OK.  I concede there is one reason to emphasize the increase in "flexibility" - It helps bolster the political position of the central bank, and the central bank is the key domestic actor inside China pushing for change.   The central bank wants - eventually - to become a real modern central bank.  It would rather change short-term interest rates to try to manage the economy than rely on controls on bank lending to manage the economy.

But we shouldn't kid ourselves.  It will take more than a tiny appreciation to generate that kind of monetary flexibility.  My read is that the political traffic in China is not ready to allow a big enough change in the RMB parity to provide the PBoC with any real policy freedom.   

That is why I am a bit surprised by how strongly Taylor, Greenspan and others have endorsed the (tiny) initial revaluation.   It seems pretty clear that the State Council was unwilling to embrace the central banks (scaled down) proposal for a 5% initial revaluation - and 5% itself was too small an initial move.    China has its own domestic politics - and exporters are a powerful interest.  And since the government owns a decent share of China's export capacity, it has an interest in looking after them.   It is possible that, rather than indicating a desire to make a long-term transition away from the peg, the shift was nothing more than a symbolic gesture to avoid US accusations of manipulation in the fall. 

If all the Treasury gets from its patient, quiet financial diplomacy is a 2.1% move, I suspect the Treasury's efforts to claim victory will ring a bit hollow, at least in the US domestic political context.   I suspect that is why Tim Adams, the new Treasury Under Secretary, has been a bit more restrained in his praise of the Chinese move than Dr. Taylor.    He has emphasized that the initial move is only the first of many needed steps.  That's right.  Too bad he is not also willing to look more forthrightly at adjusting US policies to reduce the US need for external financing.

China hands all say that the best way to get results is to avoid public pressure.  But to be honest, it is not obvious to me that quiet diplomacy alone would have broken the policy logjam inside China.   Remember, the White House temporarily abandoned financial diplomacy in favor of public pressure in the face of Schumer-Graham this spring, only to ratchet the rhetoric down once it got word a change was coming if the US would just keep quiet.    It may have taken the threat of a "manipulation" charge to overcome internal opposition inside China to any move at all.  That does not bode well for putting US-Chinese relations on a less confrontational path.   

Political scientists will debate this one for a long-time.  But I was struck by the fact that China kept missing opportunities to move on its own, before the US ratcheted up the pressure.

The real impact of China's move remains to be seen.   It certainly gives China the flexibility not to follow the dollar down (or up, if Jen is right) in the future.  That is something.    And under the guise of widening the band around the peg, it allows China to allow further step revaluations, since I suspect that the RMB will hit the upper edge of every band the PBoC creates, or, it would if the PBoC allowed the RMB to hit the upper band rather than defending another value.

Remember, China is spending about 1% of its GDP a month to keep its currency from appreciating - it is on track to spend about 15% of its GDP fighting appreciation this year.  And unless something changes, it will do the same next year.   

I also am bit surprised by the arguments coming from another former Bush Administration official - Grant Aldonas - that but for China's capital controls the RMB would depreciation.  Hello 10% of GDP Chinese trade surpluses.    But I'll leave my objections for another post!

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