I recently gave a guest lecture on the global balance of payments. After the lecture, I was asked what would happen to the US economy if China let the RMB float.
I think I was right to say the RMB would rise if the PBoC stopped intervening. Right now, China is spending somewhere north of $250b to keep the RMB from rising against the dollar. That tells me something. And I think I got another point right: for the time being, it is a purely hypothetical question. China isn’t about to let the RMB float. The real debate over the pace of RMB appreciation. China isn’t about to stop intervening.
But I wasn’t happy with the rest of my answer. I got tied up in knots thinking about how a change in the RMB/ $ would influence the bilateral US imbalance. And never felt like I really gave a clear answer. At least not as clear an answer as the question deserved.
The nice thing about a blog, though, is that I can attempt a do over.
And rather than starting with the impact of a rise in the RMB/ $ on the US-China bilateral trade balance, I want to start with the impact of a rise in the RMB on China’s overall current account balance.
Let’s assume that sustaining China’s current de facto peg requires that China add about $275b a year to its reserves. That reflects a $225b current account surplus, and $50b in net capital inflows. If Chinese export growth continues at its torrid August pace, $275b might be too low. And the relatively subdued net capital inflows reflects the fact that China is actively encouraging outflows – by encouraging outward FDI, by loosening controls on outflows, and by holding domestic interest rates well below US rates.
Floating means that equilibrium in the foreign exchange market would have to be achieved without this $275b in intervention. And that means one of two things:
The RMB could appreciate to the point where rising imports overwhelm any increase in China’s dollar export revenues. China’s current account surplus would fall.
Or the RMB appreciates to the point where Chinese (and foreign investors) do not want to hold RMB – at least not at current interest rates – and private capital outflows match China’s current account surplus.
Both imply some changes in the composition of financial inflows into the US. In the first case, a surge in Chinese imports leads China’s savings surplus to disappear. That means a fall in demand for US financial assets of all kinds – a disproportionate share of China’s reserves are currently in dollars. And particularly a fall in demand for Treasury and Agency bonds.
In the second case, a $225b Chinese current account surplus is offset by $225b of private capital outflows from China. That too would likely imply a net reduction in Chinese demand for Treasuries, Agencies and mortgage backed securities. The People’s Bank of China has a relatively diverse portfolio – for a central bank. But its reserve portfolio is still way overweight US fixed income assets with limited credit risk. Private Chinese investors would presumably demand a different mix of US and foreign assets – probably fewer dollars and more equities. So even in this case, there would be a change in the composition of capital inflows.
All in all, I think it is clear that there would be some fall in demand for US long-term debt – and thus somewhat higher US interest rates. But the overall impact depends on what ends up happening. Does China’s current account surplus fall. Or does the RMB rise to the point where Chinese private capital outflows replace Chinese reserves.
That leads to an analysis of the impact of a stronger RMB on China’s trade.
The impact of a stronger RMB on Chinese imports is obvious. They would go up. In the near-term and over time. That would benefit the US.
But the US isn’t likely to be the biggest beneficiary of a surge in Chinese import demand. The US doesn’t produce lots of goods to begin with. Europe and Japan have a bigger share of the industrial world’s manufacturing capacity than the US … and many US-produced goods are geared for the high-income US market, not for low-income markets.
The impact on China’s exports is a bit more ambiguous, as least in the short-run. In the long-term, I do think there would be a slowdown in the pace of China’s export growth – and the overall volume of Chinese exports would be lower than it would be in a world where China holds the RMB down.
But in the near-term, the world might just end up paying more for Chinese computer assembly, not buying less Chinese computer assembly. It isn’t obvious that there are real alternatives to China, at least in the short-run. Of course, if the world pays more, it will buy a bit less. But the price effect might trump the volume effect: the terms of the Chinese-assembled goods for financial assets/ natural resources/ capital goods trade would shift in China’s favor.
In effect, there are two potential channels for adjustment. In one, Chinese firms maintain their current profit margins (in RMB) by raising their dollar prices to offset changes in the RMB/ $. And the world pays more rather than buying a lot less. China’s exports rise substantially.
As does the amount of money the world spends on Chinese assembly. From the US point of view, the price of Chinese imports rises – and this trumps any rise in US exports. The US-Chinese bilateral deficit rises in the short-run.
In the other, Chinese firms defend their market share and reduce their RMB prices – cutting into their profit margins – to offset the RMB’s rise. US import prices still rise, but not by as much. And in dollar terms, China’s exports don’t rise by as much.
This is a scenario where China’s current account surplus likely falls. Why. Imports rise in dollar and RMB terms as China imports more. But exports don’t rise by much in dollar terms … and in the extreme even fall in value in RMB terms. Chinese firms are squeezed, so they save less. And that should cut into China’s saving surplus.
Of course, Chinese firms aren’t the only ones who would be squeezed. So would all the MNCs who operate in China. Their profit margins would fall.
And they would have far less incentive to shift future production to China.
To sum up, there would be a:
- A shift in the composition of Chinese demand for US financial assets and perhaps a fall in Chinese demand for US assets. That depends on whether or not China’s external accounts end up balancing because China’s current account surplus ends up falling, or whether they balance on the back of large private capital outflows.
- A rise in US import prices.
- A fall in the profit margins of US firms producing in China (or subcontracting from firms who produce in China).
- A rise in US exports to China. And a rise in US exports to other countries that export more to China.
Obviously the impact of different sectors of the US economy will differ. Some will clearly gain (US exporters, US workers in sectors that compete with Chinese imports). Some will clearly lose (US consumers who buy lots of Chinese goods, US workers in sectors that produce the kinds of debt that the PBoC likes to buy)
The mix between these different effects, though, is hard to assess. China external accounts are so far from balance and only clear with massive PBoC intervention. So the adjustments required to bring them into balance could be quite violent.
I believe RMB adjustment is necessary. But that doesn’t mean that I think the immediate impact on the US will be overwhelmingly positive. The US right now specializes in the production of the kinds of financial assets the PBoC wants to buy (think housing debt), not in the production of the kinds of goods China might want to buy. Or in the kinds of goods and services that those countries who are better positioned to sell to China might want to buy …
That means the US, not just China, has an interest in gradual adjustment. Martin Wolf is discussing a similar set of issues in a much more high profile way. In the comments on his last column, Willem Buiter argued, more or less, that China should be running large – say 10% of GDP current account surpluses. He didn’t persuade Martin Wolf. Or me. More on that later.