from Follow the Money

Words of Wisdom from Ted Truman

July 29, 2005

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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It is always worth paying attention to what Ted Truman - former director of the Federal Reserve's international staff, and former Assistant Secretary of the Treasury -- is saying.

And right now he is saying that China needs to do more than move to a basket.   That at best means it won't follow the dollar down against the euro again if the dollar's slide resumes (something Truman thinks will happen), or it won't join the dollar is the dollar rises against the euro as it has done this year.  It won't generate the needed appreciation against everyone.

From John Berry:

... economist Edwin M. (Ted) Truman of the Institute for International Economics, a former senior official at both the Federal Reserve and the Treasury Department, raised another issue about linking the yuan to a basket of currencies.

Truman noted that China had a current account surplus last year equal to about 4 percent of its gross domestic product and appears to the headed for a surplus equal to 6 percent or 7 percent this year.

Eventually ``China's surplus has to go down,'' and that will require the value of the yuan to rise substantially, Truman said. ``If the yuan is in a basket, it is going to appreciate against no one, and it has to appreciate against everyone.''

``China now has to play a disproportionate role'' in reducing the very large imbalances that are a danger to the international financial system, including the huge and rising U.S. current account deficit, he said.

At first glance, revaluation of the yuan looked like a step in that direction. A close look at the details indicates that may or may not be the case.

Certainly there's no sign the Chinese are even thinking in terms of the sort of adjustment Truman believes ultimately will be needed. Then not many others are thinking in those terms either, certainly not the politicians in either the U.S. or Europe.

And after spending most of the week trying to infer the composition of China's reserves from US and European data, let me reinforce another of the key recommendations in Ted Truman's recent paper on global adjustment : Central banks should be a lot more transparent about the currency composition of their reserves. 

By the end of the year, the difference between a 60/40 split and a 70/30 split China's total reserves could be about $100 billion.  And on a flow basis, the difference between a 33/67 split and a 67/33 split will also be $100 billion.  Its annual reserve accumulation (adjusted for valuation) is close to $300 b, and rising.  Think about it: by the end of 2008, if nothing changes, China may have about $2 trillion in reserves. 

Ted Truman even argues that the US should encourage ongoing diversification, so avoid a bigger future shock.  I presume that advice applies to Japan - which clearly lags behind China and the rest of emerging Asia in diversifying its reserves.

I'll wade into the debate over McKinnon's argument that "China needs to resist US advice to let its currency appreciate to avoid becoming a second Japan" more fully next week.   Suffice to say that I think Stephen Roach is right - a simple comparison between Japan and China is dangerous.   Not only is China today a much power country than Japan in the 1980s, but it is a much bigger country, with much bigger implications for world markets.  China today already exports more than Japan, and some think it is just getting started.

McKinnon believes in China's currency peg.  But he also believes China should experience real appreciation through inflation differentials.  We usually think that means higher inflation in China than in the US, with the US rate staying constant at levels we in the US find comfortable.   That is what happened with Japan in the 1960s.   But China's inflation rate - for reasons that I at least don't fully understand - remains very modest, despite rapid money growth and the pressures that come from strong commodity prices.

That worries me.  China is big enough that the adjustment - should China cling too stubbornly to its peg - could come from stable prices in China and falling prices in the US and Europe.  That would be good for bonds (and Bill Gross), but otherwise it would not be much fun ... 

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