My testimony on China - and the Bergsten/ McKinnon debate …
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My testimony on China - and the Bergsten/ McKinnon debate …

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I had the opportunity to testify before the US-China Economic and Security Review Commission on Tuesday – on a panel with C. Fred Bergsten and Professor Ronald McKinnon of Stanford.  

It is quite fair to say that I was the warm-up act for the main card – the Bergsten-McKinnon debate.    

Bergsten believes that RMB revaluation is essential – to help bring the US trade deficit down, to help slow China’s own economy without adding to its current account surplus and to maintain a relatively open international trading system as the US economy slows.   Regular readers (and in August, are there are any others?) know that I basically agree.

Dr. McKinnon, by contrast, believes that any additional appreciation of the RMB against the dollar would be a terrible mistake.   It would compound the mistake that China already made when it broke the RMB’s longstanding peg at 8.28 … and replaced it with what seems to be a crawling peg against the dollar. 


McKinnon’s argument is spelled out in his most recent paper.   RMB appreciation would not necessarily reduce China’s current account surplus.   Sure it would lower Chinese export growth.  But if it slowed China’s economy, it might also slow China’s import growth. If you prefer to reason from the savings and investment gap, McKinnon argues that the savings and investment gap is independent of the exchange rate.   If anything, he thinks change in the RMB would lead to less investment in China’s export sector and a larger Chinese surplus …

But that isn’t all.  Expectations of RMB appreciation, according to McKinnon, would drive down Chinese interest rates.  If Chinese interest rates are equal to US rates and the RMB is expected to appreciate, everyone should want to hold RMB rather than dollars.  The obvious solution here – pushed by Bergsten -- is a big initial revaluation that ends expectations of future appreciation.  But that isn’t politically realistic.   Another argument: expected exchange rate appreciation do not have to match the interest rate differential if there are capital controls.   McKinnon’s response: China’s controls are relatively ineffective … since China already has a market economy.   The last point certainly seems a bit over-stated to me. 

Above all, though, in McKinnon’s view, RMB appreciation risks push China into a Japanese-style liquidity trap.  China would enter into an era of deflation.  The low nominal interest rates created by expectations of RMB appreciation wouldn’t lead to a boom, but rather stagnation.  

McKinnon’s argument hinges on an analogy between China today and Japan in the 1980s and early 90s.   China gets “bashed” for its large bilateral trade surplus today.   Japan got bashed in the 1980s.    But when Japan acceded to US demands for yen appreciation, its economy slowed (after the bubble years).    A slowing Japanese economy, in turn, maintained the Japanese surplus.  And pressure for further yen appreciation …  

McKinnon consequently argues that China should resist pressure to let the RMB appreciate.   And, in a change (I think) from his earlier writing, McKinnon also argues that there are good fundamental reasons why the rapid growth of China’s export sector hasn’t bid up prices for non-tradable services and thus led to a real appreciation.    There are lots of under-employed Chinese in rural areas that can be pulled into agricultural jobs.   Consequently, McKinnon believes that China should target an inflation rate below the US inflation rate (which is too high in his view) – something that is consistent with Chinese interest rates that are somewhat below US interest rates and a very modest pace of nominal appreciation.

And if China’s nominal appreciation against the dollar only makes up for higher inflation in the US, well, the real exchange rate remains unchanged.  Despite China’s large and growing trade and current account surplus.    Despite rapid reserve growth.   And despite all the pressures rapid reserve growth – and the associated increase in base money – places on China’s domestic financial system.  

Bergsten argues that yen appreciation played a key role in reducing the US trade deficit in the 1980s.  I think he is right on that point.   Toyota wouldn’t be producing in Kentucky and Honda wouldn’t be a fixture in Ohio if the dollar remained at its 85 highs.

Bergsten also argues that yen appreciation didn’t cause – at least not directly – Japan’s bubble economy.  Or cause the bubble economy to burst. 

According to Bergsten, the bubble economy of the late 1980s came not from yen appreciation, but from the Bank of Japan’s attempt to offset the impact of yen appreciation on Japan’s domestic economy with loose monetary policy.  That loose monetary policy gave rise to the surge in the Nikkei, the surge in Japanese real estate and all the other features of the bubble economy.   The lost decade that followed came from the collapse of the bubble economy, not from a strong yen.    

This isn’t just an American view.   Kuroda has made a similar argument.   Kuroda says that the right lesson from Japan is that it resisted pressure for appreciation for too long --at least in the 1970s – and that it let its bubble economy get out of hand in the late 80s. 

Bergsten argues that Japan would have been better off had it tried to offset the impact of yen appreciation with a bit of fiscal stimulus rather than with a relatively loose monetary policy.   His advice for China is similar.   Combine renminbi appreciation with fiscal stimulus.   Sounds good to me.

This debate has obvious implications for China.   If a burst bubble economy and domestic deflation can only come from RMB appreciation, China is safe so long as it resists (bad) American policy advice.   If a burst bubble economy and domestic deflation comes from excessive money growth, asset price inflation and over-investment, well, China is potentially in trouble even if resists pressure for RMB appreciation. 

Actually, it could be worse off if it continues to resist pressure for RMB appreciation, as that implies continued rapid reserve growth, continued difficulties with sterilization, continued strong money growth, continued deposit growth and a constant battle to keep the Chinese banks from lending out all their surplus funds …

In Japan, loose monetary policy came from an attempt to offset yen appreciation.   China’s current loose monetary policy (partially offset by the use of administrative controls) has stemmed from an attempt to avoid yuan appreciation. 

I tend to side with Bergsten. 

China today isn’t Japan in the 1980s.   It is more like Japan in the 60s or early 70s. And the yen appreciated throughout the 60s in real terms without slowing Japanese growth (Japanese inflation was higher than US inflation).  The yen appreciated in the 70s in both nominal and real terms and Japan’s rapid growth basically continued.     

Japan’s catch-up phase was marked by a real appreciation of the yen.   China’s catch-up phase hasn’t been associated with a real appreciation of the RMB.   At least not since the dollar started to slide in 2002.  

I don’t quite see why stability in the RMB/ dollar matters more than stability in the RMB/ euro now that China trades as much with Europe as the United States.   That is a point that often gets missed in this debate.   East Asia is increasingly part of a world economy.  Not just a Pacific economy.   And on a broad trade-weighted basis, the RMB is far weaker than it was in 2001 or 2002. 

Nor is a strong currency always associated with a domestic slump.   Strong currencies and strong growth often (though not always) go together.   Think of the US in the late 1990s.  Or Europe in the late 1980s.   Hell, Europe right now.  Q2 growth in Europe was rather impressive – and the euro isn’t exactly weak.

That said, I increasingly fear that the investment boom in China has now reached such a scale that there is a meaningful risk that it will end badly – yuan appreciation or not.    China should have allowed the RMB to appreciate v. the dollar from 2002 on.   It didn’t.   That had consequences.   

China may have exported its way into a bubble by following the dollar down.  But that doesn’t mean it will be able to export its way out of a burst bubble and an investment slump – should the current boom every end.  I suspect that China has put itself in a position where it will have to find a way to stimulate domestic consumption once investment growth slows.  If for no other reason than I don’t think China will be able to increase its current 25% y/y export growth should its domestic economy slow.

In addition to reactions to the Bergsten/ McKinnon debate, I would be very interested in reactions to my own testimony.   

My written testimony includes a fair amount of material documenting why I do think the RMB is now significantly undervalued -- and why global rebalancing requires decoupling the RMB from the dollar.   I tried to highlight how Chinese exports to Europe responded to the RMB’s massive depreciation against the euro.   Overall Chinese export growth has actually been stronger than the growth in China’s exports to the US. 

Probably because the RMB has been stable against the dollar and has declined against many other currencies …

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