from Follow the Money

Martin Wolf makes sense (the Economist does not)

June 27, 2005

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Martin Wolf’s FT column makes a number of crucial points:

1) Asia has let undervalued exchange rates (and reserve accumulation) substitute for policies to promote domestic demand. The (growing) backlash in the US toward these policies hardly should be a surprise.

"So long as exports remain competitive and trade balances strong, the need to promote domestic demand, thereby reducing the surplus of savings over investment, is diminished. Net exports support demand instead. This is modern mercantilism. The adverse reaction now seen in the US congress is predictable and understandable."

2) Continuing this system is risky.

"They [the US deficit and emerging market surpluses] generate growing protectionist pressure in the US; they force the US into monetary and fiscal policies whose consequence is growing indebtedness, both domestic and externally, they are likely to end in a brutal correction, and that correction is likely to be more brutal the longer it is delayed."

3) China’s scale constraints its ability to continue to rely on exports to substitute for a lack of domestic demand.

"A country with a population of 1.3 billion cannot grow at 10% a year and remain as dependent on trade as one with 50m without provoking a backlash from its trading partners."

4) Adjustment ultimately hinges on China’s willingness to adopt policies -- exchange rate adjustment, stimulus to domestic demand -- that will reduce its current account surplus significantly.

"A world in which emerging market economies not only run vast current account surpluses but also recycle the capital investors want to place in their economies is unprecedented, undesirable and unsustainable."

"China, for example, has foreign currency resevers almost as big as annual imports. With current policies, those reserves are likely to continue to grow rapidly for indefinite future. This is not a reasonable pattern of development in the medium term.

The IMF’s estimates China’s 2005 current account surplus will be about $80 billion. That estimate is low. A more realistic estimate is close to $120 billion this year (even with oil at $60). That current account surplus combines with net FDI inflows of $70 billion (maybe less -- on net -- if CNOOC spends $20b on Unocal) to generate a basic balance of close to $200b, or above 10% of China’s GDP. To quote Wolf, that "is enormous by any standards."

Except those of the Economist. They somehow manage to argue that a country with a large and growing current account surplus even in the face of a massive investment surge is not really undervalued.

The Economist article argues that rather than looking at the country’s basic balance, of a country’s fundamental real exchange rate, it makes sense to look at a country’s behavioral equilibrium exchange rate -- that means "economists establish which economic variables seem to have determined an exchange rate in the past ... and then plug in the current values of those variables to estimate the equilibrium exchange rate."

Using work from Stephen "Current account deficits do not matter" Jen, the Economist concludes that yuan is only modestly undervalued.

Let’s repeat that. The Economist looks at a country with a current account surplus of 6-8% of GDP in the midst of an investment boom, and says its currency is NOT undervalued.

I am not sure what the "behavioral" exchange rate measures in the context of a country whose government is spending more than 10% of its GDP to manage its exchange rate. What "behavior" is being captured in the fancy econometrics other than the behavior of the Chinese Communist Party? We all know that they have fixed their exchange rate to the dollar, and have spent huge sums -- over $150 b in 2003, over $200 b in 2004, and probably over $250 b in 2005 -- to keep that peg. My bet: if the PBoC’s behavior changed, the "behavioral exchange rate" also would change.

And the behavioral exchange rate does not explain why China’s current account surplus is rising even in the face of a surge in investment.

The other argument made by the Economist is that "internal balance" in China -- keeping China’s workers employed -- requires an undervalued exchange rate. That is the core of the argument that Dooley, Garber and Folkerts-Landau make in their Bretton Woods 2 paper. That brings us back to Wolf. It is hard to dispute the fact that China’s undervalued exchange rate is stimulating employment in China’s export sector, though its overall impact on employment is a bit less clear (low interest rates encourage the substitution of capital for labor). Wolf, though, argues that it is neither politically or economically sustainable for a country as large as China to offset the absence of internal demand with a huge-- at least 5% of GDP and perhaps closer to 8% of GDP this year -- current account surplus.

I agree. That kind of surplus is not part of the de facto set of rules governing interaction between the world’s largest economies. it is not just a question of adapting exchange rate models to a world of mobile capital; it also is a reflection of unprecedented deficits in one key part of the global economy, and unprecedented reserve accumulation and current account surpluses in another. But you would never know that there was a real problem in the world just from reading the Economist article.

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