What is the most important price in the world economy?

• Dollar/ oil?
• The ten-year Treasury rate?
• The S&P 500?
• European policy rates?
• The fed funds rate?
• The RMB/ dollar?

At an on-the-record event at the Council on Foreign Relations this morning, Martin Wolf implicitly voted for the RMB/ dollar.  I can hardly disagree.

China has to purchase an awful lot of dollars -- $250b this year and perhaps more next year – to keep the RMB from rising against the dollar in the face of China’s huge trade surplus and ongoing net capital inflows.   Those dollars are invested in US treasuries, agencies and mortgage-backed securities, helping to determine the ten-year Treasury rate.

But Wolf goes further.    He argues that China’s determination to keep its nominal and real exchange rate weak effectively ends up determining US short-term rates, not just shaping US long-term rates …   

His argument potentially applies to the eurozone as well, but to keep things simple, I’ll focus on the US. And rather than starting with the US, I’ll start with China.

Wolf argues that China’s determination to keep the RMB weak in real terms effectively forces China to maintain a savings surplus.   

That is more or less the polar opposite of Stephen Roach’s argument.  

Roach argues the US current account deficit reflects its own savings shortfall, China’s current account surplus reflects China’s own savings rate, and that both the low US savings rate and the high Chinese savings rate is independent of the RMB/ dollar.  

One implication – changing the RMB/ dollar won’t change China’s current account surplus. 

Chinese Premier Wen agrees with Roach.  Ronald McKinnon does too.

Wolf by contrast argues that China has a policy of targeting its real effective exchange rate, not just its nominal exchange rate.   Actually, it effectively has had a policy of targeting its real effective exchange rate against the dollar – which has meant that the RMB has depreciated in real terms against a host of other currencies. 

Keeping the nominal exchange rate constant in the face of strong capital inflows and growing trade surpluses requires a lot of intervention in the foreign exchange market. And keeping the inflation rate low – something that is necessary to keep China’s real exchange rate low – requires that China adopt a set of macroeconomic policies that generate a savings surplus. 

Remember, a stable nominal exchange rate and high inflation leads to a real appreciation – and the striking fact about China is hasn’t experienced either a nominal or a real appreciation, since inflation rates have stayed quite low despite a potentially inflationary surge in reserve growth.

Wolf argues that this reflects government policies.  This morning Wolf noted that about 2/3s of China’s total national savings comes from the government, not from households.   Direct government savings are high.   And the high savings of China’s state-owned enterprises also reflects government policy.   

Investment is also a function of government policies, which determine how much investment the government does directly and how much credit the state-owned banking system makes available to the rest of the economy.

Hence, in Wolf’s view, keeping the real exchange rate weak requires not only that China intervene to keep the nominal exchange rate down, but also that it take a series of steps to keep inflation down even in the face of a huge liquidity injection from growing reserves.  And that means adopting a host of government policies that create a savings surplus.

To sum up, China’s savings surplus is a direct consequence of China’s exchange rate policy.   And if the RMB/ $ changed, the savings and investment balance would also change.

I have a great deal of sympathy for Wolf’s argument.  The surge in Chinese national savings certainly seems correlated with the RMB’s recent real depreciation as the dollar fell v. a range of currencies and China resisted pressure to appreciate v. the dollar.  Louis Kuijs has quite convincingly shown that the recent surge in China’s savings surplus doesn’t stem from a surge in household savings, but rather from government and enterprise savings.  Consumption is falling as a share of Chinese GDP not because of a rise in the household savings but because or a fall in labor compensation of as a share of GDP.

Incidentally, Wolf’s argument applies with even more force in oil-exporters who are pegging to the dollar.   Keeping the real exchange rate from appreciating in the face of a surge in oil export revenues effectively required that the governments of the oil exporters sequester a large share of the country’s oil export windfall in offshore accounts.    Such “fiscal sterilization” can be done in a lot of ways – by building up reserves, by building up an oil stabilization fund, or by putting most of the oil windfall in other government investment funds.   Injecting it into the local economy would have pushed up prices … 

But Wolf doesn’t stop there. 

If the emerging world is determined to maintain weak real exchange rates and run large current account surplus, the advanced economies have to run deficits.  And if the emerging world’s weak real exchange rates encourage investment and employment in their tradables sector, the advanced economies have to generate employment in the non-tradables sector.  Think housing.

That implies that the Fed – so long as it wants to maintain full employment in the US -- has to set US interest rates at levels that generate a large US external deficit.  If the US government doesn’t run a big enough fiscal deficit to make use of the rest of the world’s savings surplus, interest rates have to fall to the point where the household sector runs big deficits ... Wynne Goodley has made  similar argument.

In other words, the Fed sets its policy rates to offset the global impact of the RMB/ $ rate set by the PBoC.   And the RMB/ $ is the world’s most important price. 

I suspect Pam Woodall – the author of the Economist’s survey on how emerging economies are influencing the world – would agree.  

Bernanke too.  Wolf though goes further than Bernanke.  Bernanke doesn’t really explain why the emerging world has such a glut of savings, and why so much of that glut has taken the form of an increase in the reserves of emerging economies.   Wolf argues that it is a byproduct of government policies targeting weak real exchange rates in the aftermath of the emerging market cries of the late 1990s.  He emphasizes the impact of Asia’s crisis.  I would also emphasize the impact of $10-15 in 1998 oil on the policies of the world’s oil exporters.