from Follow the Money

A question for Sebastian Mallaby

March 6, 2006

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Isn't setting the RMB/ dollar exchange rate at levels that keep China's small rice farms (and its interior provinces more generally) competitive sort of like setting Germany's exchange rate at a level that keeps East German industry competitive?   Or setting the dollar at a level that keeps the US textile industry competitive without tariffs?

Seriously, if every country set its exchange rate at levels that keep its least competitive sector competitive on global markets, its most competitive sectors will end up with an enormous advantage.    In China's case, massive intervention to keep the exchange rate at levels that keep local food prices up (by pushing up the price of imported food) implies keeping the exchange rate at levels that will make China's export sector (and those on Wall Street betting on China's continued peg) very, very happy.

If China cannot change its peg because of the impact on agricultural prices and rural income in China, that has consequences for manufacturing prices in the US, wage income in the US manufacturing sector and US politics.  Ohio and Michigan are contested states.

It has consequences for the global economy as well.   I don't quite see how anyone can rail against large US external deficits and defend policies that contribute to large external surplus elsewhere.  Deficit countries cannot reduce their deficits unless surplus countries reduce their surpluses.   China isn't the only country with a large current account surplus (look at the oil exporters), or even the only country with a large current account surplus and a pegged exchange rate (again, look at the oil exporters), but if China doesn't adjust, it will be hard for a lot of other countries to adjust as well.   

Sebastian Mallaby is not a defender of China's peg.  He seems to think China should allow more currency flexbility.  He just thinks this is unlikely, because of China's concerns about its agricultural sector.  

He consequently forecasts a rough period in Sino-american relations.   I agree with his forecast, though I suspect I would put a bit more of the blame for the current impasse on China's leadership than Mallaby does. 

Yes, China's leadership worries most about domestic concerns.  But lots of folks have been warning China that continuation of its current policies would generate a backlash in the US --  one that would have implications for China, and the ability of China's leadership to achieve its domestic goals.   If you rely on exports to achieve your internal goals, then you need to worry about political as well as economic developments in your biggest markets.

Yet China has opted not to change its basic policy course even as the political risks associated with that policy course have grown. 

Or more accurately, it has insisted on changing its policies on its own very, very, very slow timeframe.  And not just slow relative to the US political calendar.   China's timeframe for changing its exchange rate regime has been too slow to have a noticeable impact on China's own economy.

Despite all the talk of reorienting the basis of China's growth, China's growth is still driven by exports and investment.     Just look at their respective growth rates relative to the growth rates of China's economy.  Reorienting China's growth requires more than just talk; it requires changing incentives that currently favor heavy investment in China's export sector.

I am aware that the rate of crawl in the RMB/ dollar seems to have picked up in February -- but even so, the pace of change strikes me as rather slow.     A bit of band widening (as China's central bank governor has suggested) would help ...

Incidentally, setting the RMB/ dollar at levels that protect China's small rice farmers gives China's labor-intensive truck (vegetable/ fruit) farming a big advantage in external markets, not just the Chinese market.   China's apple industry is doing well and taking export market share from the US.   I just heard that China is taking over the Japanese broccoli market, too.  Apparently, using the exchange rate to protect rice farmers favors apple and broccoli exports, not just electronics exports.

None of this should be interpreted as suggesting that I do not take concerns about the impact of exchange rate moves on rural China seriously.

In the past, I have suggested that coastal China and rural China shouldn't be part of the same currency union.  The exchange rate that it right for coastal China may be wrong for the interior, and vice versa.

But the Chinese currency union is here to stay.   And solving China's internal problems by setting its exchange rate at levels that protect the weakest parts of China's economy is not a real solution.  It creates problems for the world and, at least in my view, it creates problems for China too.  Among other things, it implies that domestic Chinese interest rates have to be kept very low to discourage speculation.   And that in turn means that firms have an incentive to substitute capital for labor - hardly what China needs.

And it implies that the central government will continue to have to spend 10% of China's GDP a year (give or take a few percentage points) intervening in the foreign exchange market.

What other approaches might work, politically as well as economically?

China could use some of the funds it now uses to subsidize its exports (through the central bank's vendor financing) to subsidize its agricultural sector.

The costs of reserve accumulation are hidden, as the central bank's losses won't be realized until the exchange rate moves, while the costs of agricultural subsidies are transparent.   But doesn't it make more sense for urban China to subsidize poor Chinese farmers than to subsidize wealthy American suburban home owners (and the US government)?

Or develop its own version of Europe's system of regional aid and internal transfers, so rich provinces make more funds available to poor provinces.

Or China could prevent a stronger RMB from lowering the cost of imported food.  Most industrialized Asian economies protect their rice farmers.  Look at Korea, or Japan.   I suspect that is where China is headed in any case. 

Yes, that is government intervention in the market.   But so is persistent, one-sided intervention to keep the RMB at levels that protect  parts of China's agricultural sector from external competition.  

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