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The New York Times’ conservative columnists certainly know how to get my blood boiling. David Brooks, among other things, apparently thinks the key to a hedge fund salary is good people skills – not a few lessons from Steve Hsu.
And Tyler Cowen apparently thinks the Chinese RMB is not undervalued. And that it wouldn’t matter much if it was, since the value of the RMB has no impact on trade.
I dealt with both arguments in my testimony. Neither, in my view, stands serious scrutiny.
Does the value of the RMB have an impact on the pace of Chinese export growth?
The best data says yes.
Goldman found that a 1% appreciation of the RMB would slow Chinese export growth by about 1.5%, if not more (a 1% depreciation would raise Chinese export growth by the same amount). I can put Dr. Cowen in touch with the Goldman folks if he wants to see their methodology.
Jaime Marquez and John Schindler of the Federal Reserve Board found that the value of the RMB has an impact on the global market share of China’s exports. The fact that China imports to export, in turn, explains why moves in the RMB have little impact on Chinese imports.
Jeffrey Frankel, Menzie Chinn, Yin-Wong Cheung and Eiji Fujii and Binky Chadha of Deutsche Bank have all looked at the relationship between China’s nominal exchange rate and its purchasing power exchange rate. One might expect, given China’s state of development, for that ratio to be something like 2:1. But it is more like 4:1. Prices in China are extremely low – in dollar terms -- relative to what one would expect in countries at a similar state of development.
Finally, we have a natural experiment. The RMB has been stable against the dollar. The dollar hasn’t been stable against the euro. The RMB rose against the euro from 1999 to early 2002, and then fell. There are lots of graphs in my testimony.
Guest what, Chinese exports to Europe took off AFTER the RMB fell against the euro. Chinese exports to Europe have been growing faster than Chinese exports to the US for the past several years. Care to guess why?
Would the US import less from China is the RMB rose in value?
In the short-run, no. The US would just pay more for Chinese goods. Dr. Cowen has that part right.
But China doesn’t plan to remain just an electronics assembler and textile exporter either. Right now, there are strong incentives for auto parts manufacturing and electronic components production to migrate to China. I have no problem with China moving up the value-added chain. But that usually goes along with a real appreciation (see Korea, Japan). That real appreciation brings the fast growing country’s price structure in line with global levels, and creates incentives for low-end manufacturing to move out. China right now is competitive with Bangladesh and Africa in low-end textiles even as it is gearing up to compete in the global auto market …
RMB appreciation therefore is necessary to keep the US bilateral trade deficit from growing more rapidly over time.
Dr. Cowen’s analysis is static, not dynamic. A one time increase in import prices is needed to slow the rate of increase in US imports from China (and China’s pace of reserve accumulation).
Incidentally, if the dollar falls over time – as one would expect – RMB appreciation against the dollar is also necessary to keep the RMB from continuing to depreciate against the world.
What about the argument that the RMB is really overvalued, since if China ever eased its capital controls, tons and tons of money would want to flee China?
Well, it is true that we don’t know what would happen if China eased capital controls. And China certainly should do more to clean up its banks before it liberalizes its capital account. I agree with Dr. Cowen there.
But does the “massive capital flight argument would push the value of the RMB down argument” hold water?
Not in my view.
First, right now, far more money is trying to get into China than to get out, despite China’s bad banks and interest rate differentials that favor the dollar over the RMB. China’s government is trying to discourage inflows and encourage (controlled) outflows. That tells me something.
Second, so long as China’s government stands behind its bad banks, there is no real risk associated with holding a RMB deposit in a major state bank. Chinese taxpayers, not Chinese depositors, should worry about the costs of all the bad loans that China’s banks are likely making.
Plus, many of the bad loans of the big state banks have been shifted off their books and on to the books of China’s asset management companies – that is one reason why American and European bankers (with good people skills) are taking stakes in the big Chinese banks (They also hope to use their people skills to get investment banking business).
Third, the capital controls work both ways. US investors are underweight Chinese assets, just as Chinese investors (really depositors) are over-weight Chinese assets. I would love to be able to buy interest paying RMB denominated government bonds. I cannot. I suspect there are a few folks with good people skills (hedge fund managers and those working on the prop desks of the I-banks) who wouldn’t mind adding a few interest-paying RMB assets to their portfolio … .
Finally, while we don’t know what would happen if China lifted its controls (something it isn’t going to do), we do know that China is going to run a $200b (maybe more) current account surplus this year, and that is probably will attract $50b in net FDI flows.
That means a net inflow of China from the basic balance of payments of $250b, or around 10% of China’s GDP.
That implies that there needs to be a $250b capital outflows from the banking system to keep the RMB from appreciating. $200b wouldn’t cut it.
And since those big surpluses are forecast to last for some time, that kind of outflow would have to be sustained. If the $250b capital outflow only happens once, the RMB would appreciate the next year.
Argentina experienced a 10% of GDP capital outflow in 2001. Turkey did as well. That was the year when both experienced enormous crises.
Basically, if you look at China’s balance of payments data, in order to believe the RMB is undervalued, you need to believe that China is set to experience an Argentine style crisis – not just next year, but for the next several years.
There is a legitimate debate on whether the China’s de facto peg to the dollar is good for the US (it cuts both ways, helping parts of the US economy and hurting others), is good for China (also cuts both ways) and is good for the world economy. I tend to side with Andy Mukherjee.
But I honestly don’t see how anyone who has looked at China’s trade with Europe can argue that the value of the RMB has no impact on trade flows. China's broad real exchange rate hasn't been stable over the past ten years. I know many American economists think of Europe as nothing more than a vacation spot, but in this case, it provides a natural test.
Dr. Cowen argues (very politely) that I misstated his argument. He doesn’t argue that changes in the RMB have no impact on trade flows, only that the benefits of pushing China to change its peg are too small – indeed, probably negative (“yuan revaluation is unlikely to benefit the United States”) – to be worth the effort.
My read of his article was that its goal was to throw cold water on the notion that RMB revaluation would help bring the US economy – and the global economy – into better balance. The basic thrust of the article was that – to quote Dr. Cowen that “the trade effects of the revaluation of the yuan are unlikely to be large,” that the evidence that the yuan is undervalued is rather weak (a “market-determined value of the yuan might well be lower than today’s exchange rate”), and that “most of the growth in Chinese exports has come from switching manufacturing and assembly from other more expensive Asian countries” so it basically is a net gain to the US (cheaper imports of goods the US already would import.
On those points, I do disagree.
I think the RMB’s real depreciation is a big reason for China’s big current export boom (Chinese exports to the world are growing faster than its exports to the US), that the trade effects of a significant real appreciation in the yuan would likely be significant, that the huge surplus in China’s basic balance suggests that there is a lot of pressure for RMB appreciation barring capital flight on an absolutely enormous scale and finally, while it is true that “most” Chinese export growth has come from a shift within Asia, increasingly, Chinese export growth is coming from a shift in production to Asia, not just from a shift in production in Asia.
Overall US imports from Asia have been rising as a share of US GDP. (Data here)
Dr. Cowen notes that any major shift in the RMB poses real challenges – as the costs (higher import prices) kick in more rapidly than the benefits (an increase in US exports – and I agree with Dr. Cowen that the impact here would be modest). That is true. Shifting the basis of US growth away from its current trajectory toward a trajectory based on increasing exports (to close the trade gap) won’t necessarily be easy, or painless.
But that is one of the reasons why China needs to change. If the US is going to grow out of its trade deficit by growing its exports, the dollar almost certainly needs to fall further. So long as China pegs to the dollar, that means China will also depreciate v. the world. And that is the last thing Chinaneeds. One of the reasons -- in my view -- why the dollar's depreciation v. the euro didn't have a bigger impact on the US trade balance is that it had such a big impact on China's trade balance.
Dr. Cowen thinks the US has too high a propensity to spend. I agree. But that propensity to spend is partially a function of China’s propensity to lend, so to speak.
I consequently think Dr. Cowen set aside the long-term costs of US dependence on a Chinese (financial) subsidy – something Dr. DeLong ably highlights. The interest-sensitive sectors of the US economy have benefited from Chinese purchases of US debt. No one disagrees to my knowledge. But I like Dr. DeLong, I worry about the long-term impact this has on the composition of US output (too much investment in homes, too little in other sectors) and the risk that at some point, China may take the subsidy away.
Realistically, the risk may be less that China will stop subsidizing the interest-sensitive sectors of the US than that China may prove unwilling to increase the subsidy in now provides interest-sensitive sectors in the US should a change in global conditions increase the cost of providing that subsidy.
As Dr. Cowen notes, China has been far more willing to finance the US than I expected two years ago. But I would expect at some point there will be a limit to even China's capacity to absorb massive reserve increases. China has managed $250b. But in some scenarios, it might need to do $400b. Would it?