from Follow the Money

Why can’t we have a better press corp (Asian Times edition)

June 28, 2005

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With apologies to Brad Delong for the title, and with broader apologies for yet another post on the RMB.

This article struck me as confused, even for an article that tries to summarize a range of different views on the RMB.

I just don’t see how a RMB revaluation can both:

1. Have a limited impact on the US bilateral trade deficit with China.

Many in the United States are beginning to realize that while calls to revalue the yuan have a strong populist appeal, revaluation would have only a limited effect on the US trade deficit with China, valued at US$160 billion. US Federal Reserve Chairman Alan Greenspan warned Congress last week that a rush to impose punitive tariffs on imports from China would harm US consumers and protect "few, if any American jobs".


2. Decimate Chinese exports.

If the scale of any revaluation is too great, China risks pricing domestic companies, many of which already operate on razor-thin margins, out of the market. The National Bureau of Statistics has estimated that a 15% revaluation could turn export growth negative this year. A 3-5% revaluation would slow export growth to less than 10% in 2005, from 35% last year. Such changes would surely result in such potentially serious consequences as unemployment and even social unrest.

If China’s export growth slows, wouldn’t that tend to reduce China’s bilateral deficit with the US below what it would otherwise be?

Of course, the bilateral US deficit with China has plenty of momentum given the huge gap between what the US imports from China and what the US exports to China. So even if a revaluation slows the pace of China’s export growth, the bilateral deficit would still tend to widen. It would just widen at a slower pace than before. China exports about $200 b to the US and imports only around $40b, so US exports to China have to grow five times faster than US imports to keep the bilateral deficit constant.

Similarly, the article suggests Chinese authorities fear that a revaluation would lead to a surge in hot money flows into a China.

The authorities fear that any significant move on the currency front could trigger a wave of money flooding into the country, fueling inflation and sending stock markets into an uncontrollable spin.

And that they fear a revaluation would lead hot money flows to collapse, leading the property market to collapse.

Another painful side-effect [of a big move] could be the bursting of China’s real estate bubble by ending flows of speculative money into the national property market.

There is a way to reconcile these arguments -- a small change the RMB would likely lead to more hot money flows, as people bet on further changes. Conversely, large enough change would lead some people to stop making new bets and to take profits on their existing bets.

But the Asian Times did not explain that relationship clearly.

The Asian Times also did not subject the oft made argument that with a revaluation, "China risks pricing domestic companies, many of which already operate on razor-thin margins, out of the market" to any critical evaluation.

If razor thin margins reflect competition among Chinese firms, changing the RMB neither helps or hurts Chinese firms. Margins will remain low because of domestic competition inside China to supply the export market. But China as a whole though would benefit from a revaluation, since a revaluation would improve China’s overall terms of trade. All Chinese firms would raise their dollar prices to keep their renminbi revenues constant after a revaluation, and their customers would just spend more (in dollar terms) to buy the same set of goods. China as a whole ends up with more dollars - and more external purchasing power - for the same volume of production.

A revaluation only has an impact if Chinese firms are competing against firms in other countries, and the advantages of China’s dense network of skilled manufacturers and well developed component supply chains are relatively small, so it is easy to shift production out of China.

More importantly, how can the "razor thin" margins of Chinese exporters be reconciled with the enormous investment now flowing into China’s export sector? And if margins on production in China for export are so low, why are foreign firms still investing in China as an export base?

Margins must be wider than margins on the sale of goods inside China, or there would be less investment in the export sector. China’s exports have grown at more than 30% a year for several years, something that only can happen if there is enough investment to expand capacity dramatically. Margins must be high enough that they exceed the (admittedly low) cost of capital inside China. Economics 101 suggests that China’s exports would not be growing so fast if production for export did not remain profitable ...

One other thought -- which goes in a different direction. If China really is getting low margins on its export production -- and that low-margin export production can only be sold to the world if the government of China extends the needed financing on subsidized terms (very subsidized terms) to customers outside of China, why is the overall trade in China’s interest? The private Chinese firms don’t make any money of export sales, and the government loses money on "vendor financing." Presumably, the government could spend a similar amount of money domestically in ways that would employ a comparable number of people, and would generate less friction with the rest of the world.

And one suggestion. Articles like this would be stronger if they emphasized that China’s real exchange rate has NOT been stable over time, even if the RMB/ dollar has been stable. It is not as if we don’t have any evidence to look at and see how China’s exports respond to exchange rate moves.

Europe is now as large an export market for China as the US. And the renminbi-euro has been anything but stable. Why not do an article looking at how Chinese firms that export to Europe have been impacted by the recent rise in the renminbi against the euro? It probably is too early too tell, but it would be interesting to know if they are raising their "euro" prices to keep the renminbi revenues the same, or if they are cutting into their profit margins to keep their hold on the European market.

Based on the data showing how China’s overall exports responded to moves in China’s real exchange rate in the past, I’ll make a simple prediction.

When China’s real exchange rate was appreciating along with the dollar (roughly from 95 to 01), its exports grew at a solid pace, but nowhere near as fast as when the real exchange rate started to depreciate along with the dollar. That is when export growth really took off -- presumably because exporting, particularly exporting outside the dollar zone, became more profitable than selling inside China. Exports to the US grew too, as productivity in China increased faster than in the US but the exchange rate stayed constant. A country with fast productivity growth typically should experience a real appreciation over time.

So I would bet that a small real appreciation would lead to a modest slowdown in China’s export growth -- though in the very short-term, the dollar value of its exports might increase as the same volume of exports is sold at a higher dollar price -- the so called J-curve effect. And even in the absence of any change in the real exchange rate, I would expect China’s pace of export growth to slow, simply because it is harder and harder to sustain 30% y/y export growth off a bigger and bigger export base. China exported $600 b in goods in 2004. For export growth to stay at 30% a year, its 2007 exports would need to total $1200-1300 b. I don’t think that will happen even if the RMB/ $ stays at 8.28.

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