Wednesday, November 18, 2009

Chimerica and China's weak currency policy

In the backdrop of a global economic recession and a world economy plagued with fundamental macroeconomic imbalances, as President Obama embarks on his maiden visit to China, the elephant in the room is clearly China's weak currency policy. China's obstinacy to use it massive forex reserves to keep the renminbi pegged (After letting the renminbi appreciate gradually against the dollar from 2005 to 2008, the government has kept the renminbi at about 6.83 to the dollar since July 2008, with aggressive currency market interventions) to a declining dollar so as to artificially boost its export competitiveness, would not only be tantamount to a beggar-thy-neighbour policy affecting its own developing country counterparts, but would also postpone any re-calibration of the global macroeconomic imbalances that are fundamental to sustainable global economic growth prospects.

As Paul Krugman writes, the Chinese currency market policy is "siphoning much-needed demand away from the rest of the world into the pockets of artificially competitive Chinese exporters". The IMF too have called for a stronger yuan and more Chinese consumer spending to help ease global economic imbalances and assure healthy growth. While the current recession and slump in global trade has slightly narrowed the global imbalances, there is increasing concern that this may be "mostly illusory – the transitory side-effect of the greatest trade collapse the world has ever seen" - and as the economies recover, the US, Germany, China and others will return to their old paths.

However, the more salient feature of the visit will be the fast closing gap (see graphic below) between China and the US on various economic and political parameters, and the US efforts to reassure its primary banker about its burgeoning deficit that threatens to drag the dollar on a downward spiral!

Interestingly, China's weak renminbi policy has played a major role in most of the changes in the aforementioned graphic. Niall Ferguson and Moritz Schularick have this excellent chronicle of the Chimerica relationship between the US and China in this decade and explores the challenges ahead.

Interestingly, China's massive long position on dollar assets will be one of America's most important bargaining points in its relationship with Beijing. As the saying goes, "when you owe a bank $1000 you have a problem, but when you owe $10 million then the bank has a problem"!

Update 1
Tyler Cowen describes the China-US trade relationship thus, "China uses American spending power to enlarge its private sector, while America uses Chinese lending power to expand its public sector."

Update 2
Helmut Reisen uses the Balassa-Samuelson effect to measure the currency undervaluation of the renminbi and finds that the renminbi is undervalued by only 12%. He also argues that "a gradual renminbi appreciation will be sustained only if Chinese corporate and public savings are lowered".

Update 3
Paul Krugman feels that Chinese mercantilist policy of keeping renminbi devalued could trigger off protectionist sentiments and damage the world economy. He also feels that the threat of Chinese government dumping their dollar reserves and diversifying into other currencies is overblown, especially in a world awash with cheap capital, and will end up hurting China and beenfitting the US.

Update 4
Paul Krugman feels that it is inevitable that prices rise in China.

"Consider the real exchange rate, defined as RX = EP*/P, where E is the exchange rate measured as the domestic currency price of foreign currency (so an appreciation of the renminbi is a fall in E), P* is the foreign price level, and P the domestic price level. Basic international macro says that there is a "natural" level of the real exchange rate, determined by trade competitiveness and international capital flows. And the economy "wants" to get to that real exchange rate. If you have a floating exchange rate, you get there via a rise or fall in E. But if you have a pegged rate, there's pressure on prices instead. By deliberately keeping E higher than it would be under floating, China is creating pressures for P to rise; the inflationary pressures are directly related to the exchange rate policy."

James Hamilton feels that the prices may already be rising.

Update 5
Mohamed Ariff makes the important point that China’s exchange rate policy has implications for global trade and particularly other East Asian nations and advocates that, given China’s fixation on the dollar peg, countries such as Thailand and Malaysia may have no choice but to peg their currencies to China’s yuan.

Update 6
Simon Johnson argues that the renminbi is 20-40% under-valued and makes the case for pressing the Chinese to revalue their currency. He also argues that far from having any adverse impact on the US economy, this would boost the US economy.

Update 7 (16/3/2010)
Paul Krugman proposes imposing a 25% surcharge on Chinese exports to offset the impact of China's weak renminbi (estimated to be 20-40% under-valued) policy. He rubbishes concerns that it would lead to China dumping US assets, saying that it would be good for the US - given the weak economy, US interest rates will remain rock-bottom for the foreseeable future; Fed can easily intervene to keep long-term rates under control, if need be; the depreciating dollar will boost export competitiveness; and declining dollar liabilities will lower the real debt burden.

In his blog post, Krugman also makes the point that during the crisis the US private sector has gone from being a huge net borrower to being a net lender (the lending being to the US government), whereas the government borrowing has surged, but not enough to offset the private plunge. Therefore the US dependence on foreign loans is way down, and the surging deficit is, in effect, being domestically financed. The bottom line is that if China decides to pull back, what they’re basically doing is selling dollars and buying other currencies — and that’s actually an expansionary policy for the United States.

Paul Krugman estimates that by running an artificial current account surplus that is 1 percent of the combined GDPs of liquidity-trap countries, China is in effect imposing an anti-stimulus of that magnitude — which plausibly means 1.5 percent of GDP. See video here.

Update 8 (20/3/2010)

Paul Krugman points to the fact that it is China's export of capital, and not eh value of renminbi per se, that is the problem. Though China's capital account (FDI+ FPI + other investments, including capital flows into bank accounts or provided as loans + reserve account) has received massive foreign investments over the last two decades, it has been more than offset by the massive export of capital (by way of purchases of foreign assets, mainly US Treasuries and agency assets). The net result is a negative net capital account. More importantly, these purchases have been large enough to even balance out the large current account suprluses (balance of trade or exports minus imports of goods and services + net factor income from abroad, including interest, dividends, and remittances + net unilateral transfers from abroad, like aid receipts) arising from China's export machine.

As Krugman argues, China is able to maintain this massive capital account deficit (or export capital) because capital controls inhibit offsetting private capital inflows and the de facto policy of forcing capital flows out of the country. Further, by creating an artificial capital account deficit, China is, as a matter of arithmetic necessity (since Capital account + Current account = 0 and Current account = Domestic savings – Domestic investment), creating an artificial current account surplus. And by doing that, (given the absence of adequate safe and liquidi financial investments opportunities in the local market) it is exporting savings to the rest of the world.

In a paradox of thrift world (economies hit by recession and weak demand) anyone who tries to save more reduces demand, reduces employment, and – because investment responds to excess capacity – ends up actually reducing investment. By exporting savings to the rest of the world, via an artificial current account surplus, China is making all of us poorer. A weak renminbi is only the mechanism through which China’s capital-export policy gets translated into physical exports of goods.

Update 9 (22/3/2010)
Paul Krugman estimates that China’s aggressive exports and reluctance on imports could lower global world production by 1.4 percent and cost Americans 1.4 million jobs.

Update 10 (2/4/2010)
Tyler Cowen and Ryan Avent do not agree with the taxing China policy.

Update 11 (10/4/2010)
NYT Room for debate on China's weak currency policy.

Update 12 (17/11/2010)

Excellent article that highlights the tensions between exporters (who stand to benefit) and importers (who lose) from weaker dollar.

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