from Follow the Money

Stephen Roach is well worth reading today

March 22, 2006

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Roach has access to a slightly higher level of policy makers than either the author - or I suspect most of the readers - of this blog.   Particularly in China.   He didn't learn of Wen's critique of US economic-scapegoating in the FT.   Nor does he need to read the New York Times to know what Chuck Schumer thinks.

I share his implicit conclusion: the political foundation for the current - and I would argue distorted -  process of globalization is eroding.   And neither China nor the US is willing to make the changes needed to put this process on a more sustainable footing.

Actually, I increasingly fear that the moment to make the changes needed to build a more sustainable foundation came and went.   Even if changes are made now, it may be a bit too late.   China's export and investment boom and the United States borrowing and consumption boom already have run for too long, and have too much momentum.

There is little doubt that China is committed - in principle - to shifting the basis of its growth away from exports and investment toward consumption.  Good thing too.  I am not sure that investment and exports can keep rising (relative to China's GDP) as fast as they have.  Scratch that.   I am pretty sure that investment and exports cannot keep rising (relative to China's GDP) at their current pace.

But Roach's reporting also makes it clear that China is committed to only modest changes in its exchange rate regime.  

Many China watchers believe that if China's government wants something to happen, it will.   They consequently are inclined to believe that China will find a way to "rebalance" its own internal economy.    And do so in way that doesn't imply any real slowdown in China's growth.

China's (nominally) Communist government has lots of fans in the upper echelons of American capitalism.

I remain a skeptic.   China's commitment to its (every so slightly changing) peg is likely to limit the effectiveness of China's attempts to rebalance its economy.

At current exchange rates, I suspect it still makes sense to invest in China's export sector.  Maybe not in low-end textiles.  At least not in coastal China. But in electronics components and in auto parts and vehicle assembly other higher-valued added sectors.

And to limit market pressures (limit, not eliminate) for appreciation, China has to keep interest rates very, very low.   In China's context, that encourages ever-more-investment.    Why not borrow at 5 or 6% in an economy that is expanding by 12% in nominal terms? (I have not formally checked nominal growth rate, apologies if it is a bit off)  Why not issue short-term commercial paper at an even lower rate to finance long-term investment, if you can? 

China's unwillingness to change the market signals - a cheap currency and low interest rates - that have encouraged export and investment led growth may make it hard to smoothly transition to another basis for growth.

Actually, the market signals have changed a bit, at least on the export -side.  Not because of the RMB's trivial moves against the dollar (even if China's government has now allowed the pace of the "crawl" to pick up).  But rather because of the dollar's rally against the euro and the yen in 2005.    Steve Johnson of the FT reports that China's real effective exchange rate appreciated by 13% in 2005.

But that comes after the RMB depreciated - big time - against the euro and a host of European currencies from 2002 through 2004.   The result: a boom in Chinese exports to Europe.  This is something that is under-appreciated in the US - and also under-reported.     In dollar-terms, China's exports to Europe grew faster than China's exports to the US in 2003 and 2004, and China now exports about as much to Europe as to the US.  That matters far more - in my view - that the changes to China's fx market infrastructure that the FT's Lex column trumpets.   When the central bank is buying $250b a year (maybe more - we don't yet know how much the PBoC bought in January and February) the "market" is nothing more than a bet on where the PBoC will step in.

Keeping the RMB stable against the dollar doesn't assure exchange rate stability against what are by now some of China's biggest trading partners.   But I wouldn't want to count on a stronger dollar to bring about the exchange rate adjustment China needs.  2005 may not be repeated.

Even if China doesn't allow the RMB to appreciate against the dollar, export growth will eventually slow.   At some point, the US will be shopped out.   Particularly if labor income doesn't rise.   Demand growth can only be supported by borrowing more for so long.  Or the US political system will throw a monkey wrench into China's export machine.

And even if interest rates don't go up, eventually a glut of capacity in China will lead investment to slow.  

What cannot go on forever will not go on forever.

But the process that brings about the adjustment may not be smooth.  I don't yet see the policy actions needed to give substance to the State Council's evolving rhetoric - which to me adds to the risk that nothing much will change in the near-term, and the ultimate adjustment will be more disruptive.

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