Will China Allow the Renminbi to Appreciate?

Brad Setser writes:

RGE - Show me the money (really, show me China's reserves): In order to understand China's exchange rate policy, I think it is becoming increasingly important to understand China's exchange rate politics.... Different parts of the state have different interests.... The central bank fairly clearly wants a stronger exchange rate, accelerated banking reforms and more monetary policy independence. It is worried that China's economy is too dependent on investment and exports - and thus is dangerously unbalanced. Other parts of the Chinese state are not so sure.... I don't think China's unwillingness to let the exchange rate move more is just normal prudence... there are times when not moving is more risky than moving. I think this is one of those times.

The combination of faster productivity growth in China than in the US... and the fall in the dollar/ renminbi v. Europe led to a surge in investment in China's export sector.... By the end of 2005, exports will account for 40% of China's GDP, up from about 20% a few years ago. About 2/3s of those exports... go to the US and Europe. That is an enormous sum. More importantly, China is investing over 50% of its GDP, and a very large of that investment is going into the export sector. China is gearing up to export 60% of its GDP - with most of that output going to the US and Europe....

It is widely known that the central bank wanted a bigger move in July, but was overruled by the State Council.... [T]he longer China waits, the bigger the impact of any change will be. The more China invests, the more unbalanced China's economy becomes - the more vulnerable it becomes to a global slump, or to a political tsunami that would reduce the openness of the US and European markets...

Comments

[Barkley Rosser]

Yeah, nobody wants to touch this one with a ten foot pole. I would suggest that the confusion among the PRC policymakers is simply the mirror image of the debate on the fringes of the Jackson Hole conference over here between the "domestics" and the "internationals" about the effect of a dollar dive, the flip side of a yuan/rmb surge. We don't know, and they don't either.

[Camilo]

"We don't know, and they don't either." An investment analyst for HSBC once told me pretty much the same thing. No one really knows. Anyone care to share with me how they think China's exchange rate policy can affect Latin Ameirca?

[Camilo]

"We don't know, and they don't either." An investment analyst for HSBC once told me pretty much the same thing. No one really knows. Anyone care to share with me how they think China's exchange rate policy can affect Latin America?

[tod mcavoy]

"Power comes out of the barrel of a gun, and the Party must always control the gun."

Question: Is there any reason to believe the Party thinks anything less of the central bank?

If not, people at the mercy of the PBC have perhaps as much to fear as people at the mercy of the PLA, assuming those institutions are equally competent. Of course they're not, but I still need it explained to me why financial rationale will inevitably trump politics.

[anne]

Brad Setser always argues well, but possibly a little too dramatically here :)

China is growing well, with little inflation and powering a development the likes of which ought to remind us somewhat of America after the Civil War. Why should the development not be sustained? China is powering growth and development through Asia, and selectively in South America and Africa. The benefits to us are low long term interest rates and low inflation even through the increase in energy costs.

Look to Japan from 1985, and find a rapidly growing developed economy in which the currency was propelled and allowed to dramatically increase in value, and find an economy that struggled for 15 years partially, I would argue, as a result of the currency value increase. The Chinese leadership and Chinese advisors are highly educated and technically skilled, including a number who were educated in America, and they are inclined to move very very carefully before disturbing growth that is the envy of all developing countries.

[brad setser]

actually anne, right now, China is a growing competitive challenge to manufacturing asia/ mexico and is powering the development of resource exporters worldwide, including most of south america and africa. that is a bit different than in 03/ early 04, when china was absolutely booming and was importing manufacture goods (steel, chemicals) from the rest of asia. this year is a bit different -- domestic capacity is coming on line in china, reducing china's import growth. china's export growth to usa has stayed strong, while korea and taiwan's exports to the us are hardly growing. so many asian economies are getting squeezed between stagnant exports and higher oil prices/ rising oil imports (see thailand). japan is in a bit different position.

the big surprise has been the limited impact of rapid money growth/ enormous sterilization on domestic financial conditions in china ...

[anne]

Nice response :) But, I still fail to find the problem in China's general growth model. Domestic markets are developing, and were there a slowing of consumption here and in Europe increased Chinese domestic consumption could compensate. There is however a need for Chinese exports, so I do not believe the Chinese export market will soon be unduly threatened. So far the Chinese model is proving remarkably successful, and the leadership is naturally reluctant to change dramatically. Also, China is not in a poor political-economic bargaining position with westen Europe or America.

[BR]

Anne,

The problem with China's growth model is its reliance on external markets for the continuation of its development. Another aspect of this model is that it relies on continued export growth to the United States, a country which already has a major current account deficit and where consumption growth exceeds earnings growth. If at some point US consumption gets hit, the Chinese really can not redirect their export-oriented goods anywhere. There is no other market of this size, and definately not the Chinese domestic market.

However, if one assumes that US consumer can continue to continuously increase his consumption more than his income, then there really is no problem with the Chinese strategy...

[anne]

BR

We are stretched, for there is a structural budget deficit and household saving has actually turned negative, but I find no reason in the reasonably near term for American demand to falter. There will be a significant fiscal stimulus given passage on the energy and highway bills, along with the reconstruction and repopulation of New Orleans and the Gulf Coast. The deficit budget as such is stimulative. Long term interest rates are low, and the housing market is yet solid. Then again, I would not underestimate the Chinese consumer should China need to generate domestic demand.

[anne]

http://www.msci.com/equity/index2.html

National Index Returns [Domestic Currency]
12/31/04 - 9/20/05

Australia 18.9
Canada 20.7
Denmark 32.6
France 22.1
Germany 17.5
Hong Kong 10.3
Japan 17.8
Netherlands 19.4
Norway 41.5
Sweden 22.9
Switzerland 22.6
UK 15.0

[anne]

http://www.msci.com/equity/index2.html

National Index Returns [Dollars]
12/31/04 - 9/20/05

Australia 16.8
Canada 23.7
Denmark 18.4
France 9.3
Germany 5.2
Hong Kong 10.4
Japan 8.3
Netherlands 6.9
Norway 34.0
Sweden 6.5
Switzerland 9.2
UK 8.1

[anne]

Notice how robust international stock markets are in domestic currencies. Investors are obviously convinced there are significant growth prospects internationally for the time being. Japan finally finally may be on a sustained growth path, and Japan, Australia and China are a powerful powerful growth engine for Asia.

[anne]

I wonder whether the coming fiscal stimulus will overshadow short term interest rate increases and even a gently slowing housing market. Notice that housing slowings internationally have not adversely effected any economy or stock market so far.

[George Colpitts]

Maybe the Renminbi will depreciate ? What do people think of the arguments at http://macroblog.typepad.com/macroblog/2005/09/evaluating_the_.html:

Higgins and Humpage come to this conclusion about liberalization of China's capital markets:

In general, Chinese policies favor net inflows of foreign direct investment,encourage exports over imports, and —most importantly— discourage other types of private financial outflows, largely by limiting the amount of dollars that China’s residents might hold and their ability to invest in foreign assets. Remove the restraints and corresponding policies, and the demand for renminbi will fall relative to the supply and domestic prices will rise.

In other words, the pressure will be in the direction of renminbi depreciation. This conforms to former Commerce Department undersecretary Grant Aldonas' view of things. It decidedly does not conform to Brad Setser's.

[christo]

Mr. McAvoy:

'"Power comes out of the barrel of a gun, and the Party must always control the gun."

'Question: Is there any reason to believe the Party thinks anything less of the central bank?'

Question, are you asking about the Chinese Communist Party or our Republican Party-SLC wing? I'm confused.

Signed,

Duck

[christo]

Tod:

Continuing on, this will strike some academes as tin foil hattish,

"If not, people at the mercy of the (Federal Reserve) have perhaps as much to fear as people at the mercy of (Blackwater domestic U.S. mercs), assuming those institutions are equally competent. Of course they're not, but I still need it explained to me why financial rationale will inevitably trump politics."

In the self-labeled conservatives thinking Blackwater is competent as it is a private company though government funded.

Are there people who still doubt whether politics will trump rationality given what we know how the SLCs operate?

Signed,

Chicken

[Anthony]

china's export growth to usa has stayed strong, while korea and taiwan's exports to the us are hardly growing. so many asian economies are getting squeezed between stagnant exports and higher oil prices/ rising oil imports (see thailand).

Posted by: brad setser | Sep 20, 2005 1:47:45 PM

To add some observation

Just look at China vs. Taiwan & Singapore number. Taiwan and Singapore has very similar product that China now produces. Both are in serious growth funk.

[DOR]

Camilo,

Latin American companies directly competing with China in the major world markets might get a tiny breather from the Rmb rise, but not much more. The concentration of components suppliers, packaging materials makers and assembly lines in the PRD and YRD available to fill very large orders is hard to beat.

On the other hand, PRC import of copper and other raw materials should slow with the decline in fixed investment growth . . . someday.

Anthony,

You’re right on China / Korea / Taiwan sales to the US. The manufacturing was moved to China, so the US import data from Korea and Taiwan are reflecting a relocation of production facilities.
.

[realist]

anne

you state that the rebuilding of the gulf cities will provide an economic stimulus to the country. i'm already finding the opposite to be true. the panic buying of building materials and the threat of labor moving to the gulf has scared many builders here into abandoning their proposed developments. builders can't predict what it will cost to build anything, but buyers refuse to buy unless they can lock in price. new building is slowing down here on the n.c. coast, and the rebuilding of the gulf hasn't ever started, yet. i doubt the rest of the country is fairing much better. constuction is the main engine of the u.s. economy, and it has been for the last four years. there is nothing on the horizon to replace it.

[tante aime]

Dr. DeLong: For those who have had to move in my career path, IT, salaries are only 66% of what those of my colleagues who were able to stay, collect in their bargaining units. Within IT, all administrative functions have been outsourced as much as possible by now,
and engineering contracted to the maximum.
e.g. User support, software manuals, print, graphics, gutted ... India ... $1.67/hour.
Coding is by short-term contract, and only the integrators, GM's and principals remain.

http://www.uruknet.info/?p=m15920&l=i&size=1&hd=0

Skip about half-way down past the excellent political dialectic, to the economic parse.
EU pays their workers 38 per unit, US only slightly less. China/India pays less than 2,
there are other ASEAN's paying even less.

I've posted here many times that Adam Smith and Milton Friedman economics are dead. The three-cornered hat of international trade: fiat money in the US corner, fiat labor in the Chinese corner, and strategic resources in the third, have tipped textbook economic theory into the dumpster.

We're a sharecropper society, debt peonage.
"What imperial genocide in Iraq unmasked is the extent to which it is a US giant with feet of clay, with shrinking uncompetitive industries and thrashing in a storm-tossed ocean of debt. The cruellest cut is that it has neither a military exit strategy nor a national economic survival (plan)."

What then for Renminbi:Dollar disconnect?
The last time PRC floated, they nearly lost their ship. Argentina, on the other hand, pegged to the US dollar, and quickly sank.
Today the PRC is incrementally floating as it enters low earth orbit. Argentina is one of the fastest returning investments.

All dependent on the US economy, which is dependent on massive external debt, foreign ownership of over half of our debt now. The Fed can print money and issue bonds by fiat. There no longer is any accountability in Federal spending. It's like trying to drink from a firehose, completely out of control.

How could anyone answer your question, when all economic modalities point to trainwreck?
Hardly. The US current account deficit is approaching $1T, and oil production is about to peak. If you're a banker, instead of a manufacturer, this is a **good** scenario.

The rest of the world, including China, is holding *trillions* of our fiat paper. We hold their goods, services and resources.
In my mind, this is dynamic stasis, if you will, a "Mexican standoff". The US rules. Everyone is predicting economic disaster in China by next summer.

In that scenario, floating the renminbi only makes sense if they know their ASEAN trading partners are about to dump US dollars. Well?
Do they know something, that we don't know?
More important, where's our fail-safe play?

[bradsetser]

george -- i have commented extensively on the higgins/ humpage analysis on macroblog, and responded to somewhat similar arguments from grant aldonas on my own blog. suffice to say i disagree. i think their analysis only looks at the role chinese capital controls play in locking chinese savings in china, while ignoring the fact that the same controls also lock foreign savings out of china. tis harder than it otherwise would be to speculate on RMB appreciation b/c of inflow controls. this year, china has loosened its outflow controls while tightening its controls on inflows. that tells me something about the direction of capital flows at the current exchange rate, and about the nature of the pressure on the RMB (as does the pace of china's 2005 reserve increase)

[anne]

Brad Setser:

'This year, china has loosened its outflow controls while tightening its controls on inflows. That tells me something about the direction of capital flows at the current exchange rate, and about the nature of the pressure on the RMB (as does the pace of china's 2005 reserve increase)'

Important comment.

[anne]

Construction is surely a major employment and demand driver for the economy, but I find little reason to believe it is faltering now and reason to believe for all the difficulties there will be soon a construction boom along the Gulf Coast.

[anne]

Notice that the long term Treasury rate is 4.18%. The astonishing bull market in bonds has continued, as though there is no need for more than a computer to adjust short term rates at the Federal Reserve. Debt, debt, debt we cry, but the bond market goes merrily along.

[tod mcavoy]

Christo:

"Question, are you asking about the Chinese Communist Party or our Republican Party-SLC wing? I'm confused."

I've been having trouble telling them apart myself. It took this Republican Party to relaunch the Red vs Expert debate. The Cultural Revolution can't be far behind.

[realist]

anne

you are not in the business, and you couldn't be more wrong. builders here are backing out of projects like rats leaving a sinking ship. you can't give a buyer a price if your sub availability and materials prices are moving targets (moving toward fewer subs and higher materials prices). you can't build cost plus, because the mortgage companies only lend on firm prices. unless you are a custom home builder with clients with more money than brains, you are stuck.

didn't you see the builders' doom and gloom survey, this week? if you really believe that the whole country benifits when one region gets some economic stimulation, you should have visited detroit during the dot com boom. hell,visit it now. go visit denver, which is quickly becoming a foreclosure capital, while the housing prices in nyc and scottsdale are on fire. if this is an equal opportunity country, why are the blue states buying the red states, while the red states are ruling the country?

[anne]

Realist, thank you. I understand your argument, and the strength of your argument and suggest that if you prove correct by spring we could have seriously slowed. This is worrisome, for the Federal Reserve is indicating short term rates are going up again, which means pressure on mortgages linked to short term rates.

[realist]

my hope is that a.g. is raising rates, so that bernanke will have something to lower when the recession hits.

[J Thomas]

Once again I see the argument that china must continue to sell to the USA because they need the market. I simply do not understand this argument. It does not make sense to me.

They sell to us and get promises in return. Our promises keep stacking up higher and we show no indication that we could someday pay them. What good is a market like that?

Well, if we were to cancel social security and medicare, would that give us enough money to pay off our foreign debts? Maybe Bush promised them he'd do that, and they're waiting to see if he does? It doesn't sound plausible to me. Why would they think they'll ever get anything tangible out of today's last incremental dollar of export to us?

If they don't think we'll pay off, if they think we'll instead depreciate, or fight a war and declear the debt cancelled or whatever, what good does it do them to ship stuff to us for more electronic dollars? What does it get them?

If they domestically need to keep all those people employed, all those people who work hard making stuff to send to us in exchange for little electronic blips in somebody's computer, wouldn't they do better to just go on making all that same stuff and pile it up in the gobi desert? Assuming it's cheaper to ship to the gobi than to the USA, they'd save shipping costs. If it's cheaper to ship to the USA, just send the ship to the nearest place they don't care about the ocean bottom and dump it. Cheaper than a round trip across the pacific.

If they were to cut the dollar loose faster, what would happen? The dollar would sink. The renminbi would rise -- because they've been holding it down with the dollar. But if they still pegged against the euro etc it wouldn't rise fast or very much, would it? Not unless the basket of currencies they were pegging against rose faster. But the dollar, cut loose, would drop fast.

Ignoring subtle interactions I'm not ready to think about, it mostly wouldn't be the renminbi rising. It would be the dollar falling, along with whatever currencies stay pegged to the dollar. To me this looks like wealth for everybody but the USA. Everything they used to ship to us for dollars, they have available to trade among themselves. Everything they used to import from us is a lot cheaper or (once the prices equilibrate) far more available. When we can't afford to import oil, that's a lot of oil available to fuel other economies.

And, say just for example that US oil cost $300 a barrel, which we can't particularly afford but which chinese and europeans can easily afford. How much of our domestic oil would get sold to rich foreigners for sound currencies? Why sell for inflating depreciating US dollars when you can sell for renmenbis and euros and francs and hard pesos? People keep saying that oil is fungible....

Why would the chinese go slow? How about this. Imagine that china cut the dollar loose, and for all practical purposes it amounted to economic sanctions against us. And then they found that they needed some specialty products from the USA. Special oil-drilling lubricants. Specialty computer-chip reagents. Hundreds or thousands of little things that are vitally important, that could be designed around over time.... And to get those quick they'd need to send in armed teams to evacuate the technicians who knew how to do it, in each case, cutting their way through a country in chaos.

Sounds dangerous. Better to let us sink slowly.

[realist]

instead of selling off the dollar, why not use it NOW to buy hard assets from around the world. even if the chinese were paying too much, they're doing it with "little electronic blips". rita may force an end to this game of chicken. somebody's got to go over the cliff some time.

[Barkley Rosser]

Have been out of town and offline.

Much of Latin America is pegged to the US dollar, so they will move with US $ vis a vis the yuan/rmb.

The Chinese are very aware that they have become a big bull in the China shop, and that they do not know what will happen if they move suddenly. Upshot, considerable caution as exhibited in what is reportedly a "banded basket crawl" for the yuan/rmb, imitating the system being used by Singapore, guaranteeing only small movements of currency value at any time.

It is not out of the question that the yuan/rmb could go down on a trade-weighted measure (or its own internal weighted basket of currencies being use for its bbc), even if it goes up against the tending-to-weakness US dollar. While people in the US are hyperventilating over the huge bilateral surplus the PRC has with the US, the overall Chinese current account is much nearer balance, with it running bilateral deficits with many countries supplying it with raw materials and parts.

[J Thomas]

Realist, what is the practical difference between selling their dollars for what they can get, versus trading dollars for hard assets?

Either way they flood the world with dollars. To prop up the dollar they have to sit on their dollars, not give them to other people who will circulate them.

[realist]

why can't they send those dollars right back here? we've got plenty of hard assets for them to buy. although, some of them (like oil companies), we may not want them to have. we're already so flooded with dollars, no one will know the difference.

[Ari]

Realist and J Thomas

When you use an expression such as "flooded with dollars" why not consider what that means for I have no idea. How are we or the world flooded with dollars? Where is the inflation? Why is the dollar so strong for all the "flooding."

[realist]

ari

have you bought gas in the last few months?
have you paid for health care, a new house in l.a., college tuition, fresh vegetables, a professional sports ticket? wait until you have to heat your dwelling with natural gas this winter. the govt uses a comsumer price index that doesn't reflect the real costs of living. if the govt reported real inflation, the colas would be soaring. it can't pay for the artificially low colas, now.

[realist]

ari

i pressed the send button too soon. the prices have gone up, because the value of the dollar has gone down. this "strong" dollar you write about, has probably lost 90% of its value since the end of wwII. it's weak and will be getting weaker over the next few years.

[J Thomas]

Ari, my understanding of this is qualitative and I don't have the numbers. As Gisli's saga points out, "Nothing prevails against numbers."

So I will go over my vague understanding, and if somebody has numbers that work against me I will be very interested.

First, the US government is spending more money than it collects. It makes up the difference by selling bonds -- people give the government money in exchange for the promise that they'll get back even more money later. Normally we pay interest on the bonds and that's a big expense for government. But we don't collect enough money to pay the interest on the bonds, we sell bonds to pay the interest on the old bonds. If the time ever comes that we can't find buyers for those bonds we will have hard choices. We will have to raise taxes pretty high during what's likely to be a bad time, or else cut way back on government spending. Or possibly we could raise the interest rate on the bonds until they did find buyers, but that's hard, it means all the other interest rates go up too which is hard on the economy.

The federal reserve is keeping interest rates down. This is necessary since high interest rates would badly hurt the economy and also would make the federal debt balloon faster. To keep interest rates low, they must provide low-interest loans to enough of the people who want them, enough that they don't bid up rates. I will use a shortcut talk and say the Fed "creates money" to loan for this. So qualified borrowers can get money at fairly low rates.

Now, what happens to that money? A lot of it (remember I don't have numbers, it might seem like a lot to me and not to you) goes to buy imports. Foreigners ship us stuff we want and take dollars. But they don't buy a lot of american stuff with those dollars. Apparently we don't make enough stuff they want at a price they want to buy it. What do they do with the dollars? They buy stuff from each other with them. Gresham's law. The currency that people don't refuse that looks the weakest is the one they want to buy things with.

Still, somebody has to either buy stuff from us with the dollars or else get stuck with them. And it's asian central banks that are keeping them. I'm fuzzy about this part. Do they just hold dollars? Do they buy US bonds with the money and collect low rates of interest? It would make sense to me that they'd be doing both of those, in some ratio. The chinese banks collect dollars and pay renminbi to foreigners for their imports. If they paid in dollars like everybody else the dollars would keep getting weaker -- too many of them. These bankers are "supporting" the dollar, they're keeping supply lowe enough our inflation is acceptably low except on things poor people buy and on housing.

Why are these banks taking dollars they have no use for, that they can expect will be worth much less than they paid for them once they manage to unload them? It looks like a stupid thing to do. Maybe it's political. But here's a thought. Right now chinese exports to us are under-priced, and our exports to them are over-priced. This is because they are "supporting" our currency. They sell stuff to us cheap and get money that they don't need. But what if we wind up with the sort of solution that got imposed on argentina? What if at some time in the future we have to sell our sequoyia lumber cheap and or oil cheap, etc? Then it isn't such a bad deal. They sell us paper plates with festive printed designs and plastic wastebaskets and toilet plungers cheap now. We sell them oil and lumber and patents cheap later. They needn't stop taking our wastepaper money until the value of the stuff they will be able to squeeze out of us for it goes less than the value of the stuff they sell us for it.

Then there's the political side. Maybe they're mercantilists, and they feel like they dominate us by giving us stuff cheap and destroying our own industry. There's an inuit aphorism that goes "Whips make dogs and gifts make slaves." The concern then is what they do when they decide they've destroyed us sufficiently and stop doing it.

Anyway, that's how I see it so far. I am not an expert at this. But it looks like our government is flooding the US economy with dollars to pay for itself, and our businessmen are flooding the world with dollars to buy stuff cheap, and the world isn't buying our stuff that much in return. Instead asian bankers are sucking up the flood to keep us from getting a lot of inflation etc. They choose to do that, we can't make them. They can choose to stop doing it when they want to and there isn't much we can do about it short of nuking them or staging a conventional invasion. If they quit doing it, if they peg their currencies to a basket of currencies that don't include ours and let ours sink, or trade their dollars for other currencies (which would help drive the dollar down and other currencies up), or spend the dollars buying whatever actual imports they can get for them -- in all cases it makes it harder for us to keep importing, which would probably include making it harder for us to import oil. I don't see tremendous differences among these. Once they stop subsidising us, we need to look hard for exports and get by without so much importado, and work hard making stuff for ourselves and to sell abroad. And if it happens suddenly we'll get a big shock.