from Follow the Money

Martin Wolf explains the fall in the renminbi-dollar

December 22, 2004

Blog Post

Martin Wolf did the math: it turns out the renminbi-dollar zone has a current account deficit (projected) of $260 billion with the world this year. The United States’ current account deficit of $650 billion must be offset by a roughly $400 billion surplus in Japan and emerging Asia. A fall in the renminbi-dollar helps in two ways -- it at least slows (one hopes, the evidence is still rather lacking) the expansion of the US trade and current account deficit, and it increases emerging Asia’s surplus with the world. Bigger surpluses in Asia = a smaller overall deficit between the renminbi-dollar zone and the rest of the world. So long as Asia is willing to save all of its surplus (actually, all of its current account surplus and then some -- China also lends its capital account surplus to the US) in reserves and then lends those reserves to the US, the US can keep on running large deficits.

No surprise: I agree with Martin Wolf’s proposed solution to the US current account deficit. The global adjustment that will lead to a fall in the US deficit will require emerging Asia -- basically Asia minus Japan -- to shift from a significant current account surplus with the world to a current account deficit to the world. That process will support global demand -- and US growth -- during the shift, since US demand growth has to slow.

And Wolf is right in another way: if emerging Asia’s deficit is financed by ongoing inflows from foreign direct investment, it does not need to give rise to the same financial imbalances (too much short-term debt relative to reserves) that gave rise to the 1997 Asian crisis. The pattern of global capital flows before Asia’s 97 meltdown was not all wrong. Aging Japan should be running a current account surplus and using that surplus to finance emerging Asia: Japan’s investments in emerging Asia today will let let aging Japan finance a future trade deficit off the profits from its overseas investments. If you invest abroad, in principle, you don’t need to import labor to sustain your living standards as your population ages (and shrinks). Conversely, emerging Asia should be running a current account deficit during the "boom" phase of rapid development, as it did before the 1997 crisis. I have long argued that booming China should be running a current account deficit of $50 billion (financed by FDI inflows) right now, not a current account surplus of $50 billion. China currently saves its $50 billion or so current account surplus in reserves, saves $50 billion plus in FDI in reserves and saves $50 billion or so in "hot money" inflows in reserves as well -- accumulating so many dollar denominated reserve assets make no long term sense, as Wolf rightly notes. And all the evidence suggests the pace of China’s reserve accumulation is growing, not falling.

Four other notes:

1) It would be nice to look at global capital flows to the "renminbi-dollar" area, not just the current account numbers. That, alas, is a bit more difficult. We know China is attracting large capital inflows, but don’t know how much of those inflows are coming from outside the "dollar" zone. We know that large amounts of capital -- probably around $200 billion -- are flowing out of the US (both for FDI abroad and for portfolio investment), but we don’t know what fraction of those flows are going to countries (like China) inside the dollar zone. If the renminbi-dollar zone has a net capital outflow (driven by outflows from the US) as well as a current account deficit (driven the the US current account deficit), its total financing need from the rest of the world would be quite large.

2) It is pretty clear that the "emerging Asia" portion of the dollar zone is attracting net capital inflows from the rest of the world. Emerging Asia then uses those flows to build up its reserves, and thus to lend to the US. China is attracting at least $100 billion in net inflows this year (the final number will likely be substantially higher), though not all from outside the renminbi-dollar zone. Add that $100 billion to the $400 billion Asian current account surplus, and the Asian portion of the dollar zone is financing $500 billion of the $650 billion US current account deficit. My numbers are a rough guess, but it seems likely that in addition to running current account surpluses to offset the United States’s deficit, Asia is attracting some of the external financing the renminbi-dollar zone needs to avoid falling against the rest of the world. For the renminbi-dollar zone to work internally, emerging Asia has to turn capital inflows into Asia into capital inflows into the US -- i.e. act as a financial intermediary.

3) If my numbers are right -- or close to right -- the US needs roughly $150 billion in capital inflows from the non-dollar zone to cover the remainder of its current account deficit. The US also needs a bit more from the world to finance the United States’ citizens own desire to purchase of "non-dollar zone" external assets. If $50 billion of the United States’ roughly $200 billion of FDI and portfolio outflows is going to emerging Asia and Japan, then $150 billion is heading out of the dollar zone. That would imply the US needs to attract around $300 billion in net financing from outside the dollar zone -- $150 billion to finance that portion of the current account deficit not financed by Asia, and $150 billion to finance "capital flight" by Americans ...

4) There is a huge misalignment inside the renminbi-dollar zone. One pole -- China -- entered into a de facto currency union with the US at an massively undervalued (in my view, and given Wold’s analysis, clearly in his view as well) parity with the dollar. That generates many of the same set of problems that were created when East Germany entered the German monetary union at an overvalued parity. East Germany has been sustained by ongoing financial transfers from former West Germany. The US is being sustained by ongoing financial transfers from China (and others in Asia). The financial transfers are taking the form of ongoing low interest loans rather than outright grants, but no matter -- the net effect is the same, it lets the US avoid adjustment. If the financial transfers were to disappear -- and if the monetary union were to be preserved without any change in the renminbi-dollar nominal rate -- US prices and wages would need to fall to make the US more competitive (deflation), and Chinese wages and prices would need to rise to make China less competitive (inflation).

Of course, the analogy between East Germany-West Germany and China-the US is not perfect: the former West Germany is supporting an overvalued parity in a smaller (both in terms of population and economic weight) and poorer region -- East Germany; China is supporting an overvalued parity in a larger (in terms of economic weight, though not population) and richer region -- the US. The tensions in such an arrangement -- the financing burden it places on China, the deflationary impact on labor in the US -- are why the renminbi-dollar zone cannot survive in its current form without some major internal changes ...