from Follow the Money

Paulson in Beijing: Can’t get no satisfaction

December 14, 2006

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That is what William Hess argues in Newsweek International.  China cannot give Paulson what he wants without jeopardizing its domestic goals.  Hess writes:

"Secretary Paulson will likely return home empty-handed, or nearly so, if only because the Chinese don't have much they can give. Domestic priorities and stability will prove to be as important to them as they were to the winners in last month's U.S. congressional elections."

Tis true that domestic priorities usually trump international pressure -- in the US just as in China.  Mike Mussa is right: Paulson needs to show that his approach to China delivers results in the next 6-9 months or the intiative in the US will shift to the Congress. 

China clearly doesn't like the hardening of Paulson's tone on the RMB.  And it isn't clear if Wu Yi is in a position to deliver much -- or even if she wants to.  See the Yu Yongding quotes in this Stephen Weisman article.  

But I wasn't convinced by the broader argment in the Hess article, namely that the United States' demands are really at odds with China's domestic goals.   Right now, China is worried about too much growth and an overheated economy, not too little growth.  A stronger RMB could substitute for administrative controls on investment.  Rather than leading to slower growth, a stronger RMB might help to rebalance the basis of Chinese growth.

In the past few months, China has used a host of measures -- limits on bank lending, delays approving big projects and the like -- to slow investment.   With strong exports and a rapidly rising trade surplus contributing strongly to China's current growth (see Nick Lardy), China in sense has been forced to take steps to curb domestic demand growth to keep China's economy from overheating. 

This is a point Martin Wolf has made better than anyone.

If exports weren't growing so fast -- the World Bank expects net exports will contribute 3 percentage points to q3 growth in China -- China's macroeconomic policy high command would have more scope to let the components of domestic demand rise more rapidly.  There would be less of a (macroeconomic) case for restraining investment.  China could let the banks lend out some of the spare cash, rather than forcing them to lend those funds to the central bank. And the government could take a host of policy steps to stimulate consumption without worrying about overheating.

Think of it this way.  If net exports are contibuting 2-3 percentage points to Chinese growth in 2006, investment and consumption cannot contribute more than 7-8 percentage points to China's growth without growth exceeding 10%.  And right now, the natural evolution of China's economy is pushing the domestic components of growth above 8%.  So China is forced to take a host of steps to slow dometsic demand growth. 

Earlier this year, China opted not to let the RMB appreciate and instead clamp down on investment when it looked like China was set to overheat .  China did the same thing in 2004.  And the results seem to be same: a rising current account surplus, difficulties with sterilization even  in the absence of large speculative capital inflows, growing concerns about China's dollar exposure and even more US pressure. 

That isn't too say that alternatives to the current weak RMB/ low interest rates to discourage "speculative" inflows/ administrative curb on lending to keep bank-financed investment down policy mix aren't problematic.  

China's domestic interest rates are clearly too low, given China's strong economic performance.  Higher interest rates in theory could help to reduce demand for borrowed funds, slow investment, and perhaps reduce the need to rely so heavily on administrative controls. But higher interest rates also could pull more capital into China -- complicating the life of the People's Bank of China. 

That would require more sterilization from the PBOC, and the PBoC already thinks it is doing as much as it can.  And if the PBoC couldn't sterilize the inflow, the banks woudl have with even more funds to lend out.  That would subverting the goal of the raising interest rates -- and perhaps force the PBoC to rely even more on administratve controls. 

Allowing a faster pace of RMB appreciation poses a similar risk.  It could draw more funds into China. Hess correctly notes:

China's policymakers face a bind: the options available to them to help reduce external imbalances—such as allowing a more rapid appreciation of the Chinese currency—could work against restraint by attracting even larger inflows of foreign capital. Similarly, raising interest rates to cool investment growth could attract further inflows of speculative capital.

The obvious solution -- one long pushed by Morris Goldstein of the Peterson Institute -- is a large one-off surprise appreciation in the RMB.  And right now, it really would be a surprise.  That would end expectations of future appreciation -- and, if it was big enough, even create expectations of a future depreciation that would allow higher domestic interest rates.

Of course, all signs indicate such a policy has been ruled out.    

At the same time, it is a bit too easy to just highlight the problems with any change in policy.  Yes, faster RMB appreciation risks attracting more speculative inflows and fueling more rapid reserve growth.  But China's current policy mix hasn't exactly allowed China to avoid large foreign exchange inflows and problems with sterilization.    The inflows have just come from the current account, not the capital account.  

If anything, China's trade surplus looks set to get bigger, not smaller, in 2007.  Chinese export growth accelerated during the course of 2006.

Staying the course -- so to speak -- leaves China in another bind.  Its large and rising trade surplus will continue to poison its relationship with the US, and increasingly with Europe.   Net exports may continue to add to growth, forcing China to direct its other policy tools toward slowing other components of growth or risk massive overheating.   Investment will continue to be biased toward the tradables sector.  The PBoC will still face problems with sterilization.  And someone in China -- whether the PBoC, state banks for a new investment company -- will still have to add an huge number of dollars to their existing portfolio of dollars.  I am not convinced that SAFE's new whiz kids will find a way to diversify China's reserves so long as China still wants to manage its exchange rate against the dollar.

And then China would have to do the same thing, year after year.   Maybe net exports would stop contributing so much to growth, but large ongoing current account surpluses would imply an ongoing need to build up Chinese holdings of (depreciating) dollars.

Hess makes another point -- one that I don't think gets enough attention.  China's current policy mix hasn't exactly encouraged strong Chinese job growth.  

Yet in China the mood is hardly triumphal. The Chinese media are full of reports about rising urban unemployment, cash-strapped local governments, a falling proportion of consumption to overall GDP and export losses from trade frictions.  Rising unemployment in the world's fastest-growing economy? This scenario sounds implausible. However, policymakers in Beijing are increasingly concerned about the slowdown in job creation in recent years, combined with stagnating real-wage growth and softness in consumer markets. This has all occurred as they are attempting to urbanize tens of millions of people and use "macro controls" to restrain wasteful investment spending.  

Weak export growth can hardly be the reason for the slowdown in job growth.   Job growth seems to have slowed even as export growth accelerated.  Despite what many assert, China's export machine hasn't been a job creation machine.

Why?  I am not sure that there is a consensus answer.  My personal view is that very low interest rates have encouraged Chinese firms to substitute capital for labor at too early a stage in China's development.   Chinese auto firms should not be importing the latest labor saving technology from Germany.

China isn't -- in my view -- obligated to defend the policy mix that supports the current de facto peg to protect interest of Chinese workers. Sure Chinese wages are up -- but they haven't been growing as fast as productivity, so labor income as a share of GDP is down.  (See Chapter 5 of the IMF's regional outlook)   

Of course, there are no shortage of folks inside China who do benefit from the current policy mix.  Exporters, to be sure.   But also property developers and others who benefit from very low interest rates. 

However, deferring hard choices doesn't magically make problems go away.  China's policy dilemmas won't get any easier with more time.   That is one clear lesson of the past two years.  

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