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China reads the Economist. Is the Renminbi undervalued?

by Brad Setser
January 26, 2005

While China’s delegation to Davos seems a bit less than enamored with the dollar, the People’s Bank of China seems have read last week’s Economist, and concluded that there is no need to change the renminbi-dollar peg.

The Financial Times has also picked up on the same theme. Both pieces that argue that the renminbi is not really overvalued draw on work by Stephen King at HSBC, but there are no shortage of other economists making similar arguments. Andy Xie of Morgan Stanley for one.

I have no idea when China plans to adjust its peg, though I suspect it is a question of when rather than if. Some small changes seem likely. But the broader arguments made in these articles, and the related argument that a renminbi revaluation won’t help reduce the US trade deficit, are worth examining in some detail. I’ll look at each point in turn, and lay out the reasons why I don’t find the argument persuasive.

A warning though: this is a long post.1. China’s global trade surplus is much smaller than its bilateral trade surplus with the US.

True, but irrelevant. Bilateral deficits and surpluses are not the right measure of a currency’s strength. But just because China’s overall trade surplus is smaller than its bilateral trade surplus with the US does not prove China’s exchange rate is fairly valued. China is still running a trade surplus of 2% of GDP, and a slightly larger current account surplus. More importantly, it is running that surplus in the face of surging commodity prices and a domestic investment boom. Trade deficits and trade surpluses need to be looked at in a broader macroeconomic context, and the context strongly suggests booming China should be running a trade deficit right now. China imports lots of commodities, and it is in the midst of an absolutely enormous investment boom. Capital investment has surged to 45% of GDP, up from the 38%-40% typical from 95 to 00. Had savings stayed constant, China’s trade balance would have swung into a substantial deficit.

Put differently, China is currently undergoing a much large investment boom than the US enjoyed in the late 1990s. But while the US investment boom led the US current account to go from a small to a large deficit in the 1990s, China’s investment boom has not triggered a fall in its current account surplus.

That is unusual. It suggests China’s underlying trade surplus is much larger than its current trade surplus — Morris Goldstein estimates that China’s cyclically adjusted trade surplus is close to 5% of GDP. Moreover, given China’s ongoing ability to attract the FDI needed to safely finance trade deficits, there is no reason why its trade should be in balance. The swing that would be needed to shift China’s $32 billion trade surplus to the deficit of $50 billion that it could easily finance out of incoming FDI is every bit as large in relation to China’s GDP as the swing eventually needed to reduce the US trade deficit.

2. China’s trade surplus of $32 billion is no where near large enough to finance the US current account deficit.

True, but irrelevant. China is attracting enormous capital inflows, and since it is not using those inflows to finance a trade deficit, the funds from these inflows are also available to finance the US. The overall increase in China’s reserves — $200 billion – is certainly big enough to have an impact. Even if China only put have those reserves in dollars, $100 billion covers about one sixth of the US current account deficit. That is worth emphasizing: One single institution in a relatively poor country — the China’s central bank — is providing at least one sixth, and perhaps closer to a quarter ($150 billion), of the external financing the US needs.

It is true that the US lack of savings drives the US current account deficit; but it is also true that the financing made available to the US as a result of China’s peg also reduces the (short-run) costs of low savings. In other words, the US savings rate would probably not be so low if not for the easy availability of reserve financing. Without foreign demand for Treasuries, for example, the US budget deficit would put more pressure US interest rates — and the pressure higher interest rates put all asset values (think homes) would generate much more political pressure to reign in the deficit.

3. If China dropped its capital controls, funds would flow out of China …

Maybe, but it is a lot less obvious that many think.

Moreover, it is irrelevant: China is not about to drop its controls, and there is no reason why exchange rate adjustment has to be linked to capital account liberalization.

But let’s think about what would happen though if China opened up its capital account anyway. Private Chinese citizens presumably would want to diversify their assets, and might want to hold significantly more foreign assets. But if private Chinese citizens currently hold fewer foreign assets than they would like, the government of China certainly holds more foreign assets that it needs (reserves are almost 40% of GDP). Private capital outflows linked to asset diversificatoin could easily be accommodated if the government of china sold some its accumulated assets, redistributing China’s current external assets from the state’s hands to private hands.

But if private China’s citizens are underweight foreign assets, then US citizens (and others too) are also underweight Chinese assets. And the US government does not hold an enormous stake in China Inc it could sell off to meet US demand for Chinese equities. So it is not clear that the flow of funds would be one way: Chinese citizens may want “safe” foreign claims, but US and other citizens probably also would want more “risky” but potentially high yielding Chinese assets. I would be happy to trade two year treasuries for two year renminbi bonds if I could.

Won’t Chinese citizens want to pull money out of China’s rotten banks and seek safety abroad? There is no doubt the state banks are sitting on big losses, and will have to be recapitalized. That won’t be cheap: think $600 billion . That just happens to be about the size of China’s foreign exchange reserves — but dollar reserves don’t provide the renminbi asset the banks need to match their renminbi deposits and cover their non-performing renminbi loans. At the end of the day, the banks will need lots of renminbi bonds to cover the lending losses.

But so long as the government of China is solvent, the government’s backing makes the big banks a relatively safe place to store Chinese savings. US depositors did not flee Citi or other money center US banks in the 80s, when they had their own set of large non-performing loans (think Mexico, Brazil, Argentina … )

Bottom line: China is not going to drop its controls if that would lead to massive outflows. And while some asset diversification should be expected once the controls are dropped, the flows could well go in both directions – and short-term pressures easily could be accommodated by selling off some of China’s reserves. Over time, the fundamentals – China’s high rates of investment and rapid increase in productivity combined with its current trade surplus – still suggest that the renminbi is likely appreciate against the dollar.

4. A small revaluation would not help China regain monetary control, since it would lead to expectations of a further revaluation.

True. But this is an argument for a meaningful revaluation, not a tiny (3-5%) or small (5-10%) move.

5. China needs to keep the peg until China’s financial system is much stronger.

China’s domestic financial system certainly has its problems. The real question is whether keeping the renminbi pegged at 8.28 helps or hurts over the long term. I suspect that it actually makes the financial system weaker over time, for two reasons:

a) Lots of folks do seem to think the renminbi is undervalued, and the flood of money going into China (which shows up in China’s reserves) is fueling rapid growth in China’s money supply, rapid credit growth, real estate speculation and the like. All that risks creating a new generation of bad loans. Administrative controls (think the PBOC sending out a letter to the state banks saying “no more loans for cement factories”) can limit some excesses, but certainly not all.

Moreover, it is hard for China to raise interest rates aggressively to temper demand for credit so long as it keeps the current peg: higher interest rates just increase the incentive for foreign funds to flow into China.

b) The undervalued exchange rate will lead to over-investment in China’s export sector, as too many folks bet that 25% y/y export growth to the US can continue indefinitely. It can not and it will not. 25% y/y growth implies US imports from China will rise from about $200 billion in 2004 to about $400 billion in 2007, and almost $500 billion in 2008. Imagine the resulting talk of China in the 2008 US Presidential campaign if China’s exchange rate is still close to where it is now …

Bilateral deficits generally do not matter. However, given the size of China’s exports to the US, it is hard to see how that kind of import growth from China could be sustained without solid, perhaps even strong, growth in overall US imports. Yet it overall imports continue to grow rapidly, given the (relatively) small size of the US export base, it is hard to see how the US trade deficit starts to shrink. Lots of the investment in China’s export sector may be based on the implicit assumption that the US trade deficit can continue to widen for the next four years … that may not be the best of assumptions.

China has to fix its domestic financial system. It also has to take steps to stimulate domestic consumption and domestic demand growth, so that it relies less on investment and exports for growth. But in both cases, delaying the inevitable just increases the costs of the inevitable.

6. China’s exports are taking market share away from other East Asian economies, not from US domestic production.

No longer true. From 2000-2003, overall imports from the Pacific Rim stayed constant, despite rising imports from China. But in 2004, imports from both China and other Asian economies increased rapidly, and overall imports from Asia rose sharply both in dollar terms and as a share of US GDP. Moreover, China won’t be able to sustain 25% y/y growth in its exports simply by taking market share from other Asian economies.

But rather than look at bilateral balances, let’s think about the global current account balance. The Asian NICs plus China — and emerging Asia more broadly — runs a substantial current account surplus. That is not the way the world has to work – very fast growing regions often run trade and current account deficits. The Asian NICs themselves had a deficit before the 1998 crisis. In broad terms, the 97 crisis shifted the Asian NICs’ current account from a small deficit to a substantial surplus, and that surplus remained long after the crisis passed. It is hard to see how the US can reduce its current account deficit if emerging Asia does not reduce its surplus, it is hard to see how emerging Asia reduces its surplus if China does not revalue. The “China is part of Asia and the Asian value added chain” argument STRENGTHENS the case for a renminbi revaluation as part of a broader Asian revaluation.

7. A renminbi revaluation would not reduce the US trade deficit.

Not true, over a long-enough time horizon.

The first effect of a renminbi revaluation would be an increase in US import prices. Chinese exporters would have to increase their dollar prices to pay their renminbi wages. Since the US does not produce many of the items it imports from China, that would – barring a fall in the volume of US imports – increase the amount of dollars the US spends on Chinese imports. Cheap Chinese goods become more expensive cheap Chinese goods. DVD players sell for $100 rather than $50 …

The rise in prices almost certainly will trumps any fall in volumes (the famous J curve), and the US import bill goes up. The run-up in the US import bill would trump the short-run increase in US exports to China, leading the US bilateral deficit with China to expand, at least in the short-run.

So what? The renminbi revaluation would still encourage a broader adjustment in the US trade balance even if it did not improve the bilateral US-China trade balance.

A wealthier China that earned more global purchasing power from its US exports to the US would spend more on imports – whether imports from the US or from the world. And if China uses its surplus dollars to import more from say Brazil, Brazil will have more dollars to spend on imports from the US. Over time, a renminbi revaluation should increase overall US exports, particularly since other Asian economies will let their currencies rise against the US dollar if China’s renminbi also rises.

But perhaps the most important channel for adjustment would be indirect: a renminbi revaluation – a big one – would change the renminbi from a one way bet to a two way bet, and thus reduce “hot money” inflows into China. Chinese reserves will grow more slowly, China will have fewer dollars to send to the US and the US will have to raise the funds it needs to cover its current account deficits in the private markets.

In other words, slower Chinese reserve accumulation and reduced Chinese demand for US assets would tend to raise US interest rates, reduce US consumption (increase US savings) and lead to the eventual adjustment in the current account. Don’t forget about the capital market channel.

Finally, a renminbi revaluation (provided it is large enough) would reduce the incentive to invest in China to make the next generation of products for the US market – and increase incentives to source production in the US. Over time, this dynamic effect would trump the short-run impact of higher import prices.

Renminbi revaluation might not immediately reduce the overall trade deficit: the J curve effect from higher import prices might dominate in the short-term, assuming that the impact of higher import prices is not trumped by the impact of higher interest rates because of reduced Chinese reserve accumulation. But renminbi revaluation is essential to changing the current trajectory: a trajectory where 25% y/y growth in US imports from China leads the US bilateral deficit with China to expand by $30-40 billion a year, making it hard to reduce the overall US trade deficit, and a trajectory where capital inflows to China fuel extremely rapid growth in China’s reserves and China’s reserve growth in turn helps finance large US trade deficits.

19 Comments

  • Posted by Pei, Zhuang

    It seems that Chinese government and central bank fear to float rather than they DON’T want to float, because there are little people have the enough knowledge to carry on the transition job. So, as the old Chinese saying, ‘It’s better not to do something when you don’t konw the real consequences’.

  • Posted by anne

    Wonderful essay. Now, to think :)

  • Posted by anne

    Interesting essay:

    http://www.nytimes.com/2005/01/28/opinion/28fri1.html

    America’s Promises

    Three years ago, President Bush created the Millennium Challenge Account to give more money to poor countries that are committed to policies promoting development. Mr. Bush said his government would donate billions in incremental stages until the program got to a high of $5 billion a year starting in 2006. While $5 billion is just 0.04 percent of America’s national income, President Bush touted the proposal as proof that he cares about poverty in Africa and elsewhere. ‘I carry this commitment in my soul,’ the president said.

    For the third straight year, Mr. Bush has committed a lot less than he promised. Michael Phillips of The Wall Street Journal reports that the White House has quietly informed the managers of the Millennium Challenge Account to expect about $3 billion in the next budget. This follows a sad pattern. Mr. Bush said he would ask Congress for $1.7 billion in 2004; he asked for $1.3 billion and got $1 billion. He said he would ask for $3.3 billion in 2005; he asked for $2.5 billion and got $1.5 billion….

  • Posted by anne

    Again, interesting:

    http://www.nytimes.com/2005/01/28/opinion/28fri1.html

    America’s Promises

    Three years ago, President Bush created the Millennium Challenge Account to give more money to poor countries that are committed to policies promoting development. Mr. Bush said his government would donate billions in incremental stages until the program got to a high of $5 billion a year starting in 2006. While $5 billion is just 0.04 percent of America’s national income, President Bush touted the proposal as proof that he cares about poverty in Africa and elsewhere. ‘I carry this commitment in my soul,’ the president said.

    For the third straight year, Mr. Bush has committed a lot less than he promised. Michael Phillips of The Wall Street Journal reports that the White House has quietly informed the managers of the Millennium Challenge Account to expect about $3 billion in the next budget. This follows a sad pattern. Mr. Bush said he would ask Congress for $1.7 billion in 2004; he asked for $1.3 billion and got $1 billion. He said he would ask for $3.3 billion in 2005; he asked for $2.5 billion and got $1.5 billion….

  • Posted by anne

    “Finally, a renminbi revaluation (provided it is large enough) would reduce the incentive to invest in China to make the next generation of products for the US market – and increase incentives to source production in the US. Over time, this dynamic effect would trump the short-run impact of higher import prices.”

    Brad, the essay is excellent. This passage however strikes me as most important from China’s perspective. Investing in China has meant technology or intellectual property transfer in addition. China does not wish to make the mistakes of other less low wage countries and allow investment that will add nothing to the country’s intellectual capital. Technology transfer is most important to China in opening to international investment.

  • Posted by anne

    China has just ordered 60 7E7 aircraft from Boeing. Part of the aircraft will be made in China, for in return for her business over the years Boeing has been asked to make selected aircraft parts in China. Boeing keeps much of its technical expertise in America, but China has gained expertise as well. China is does developing with foreign investment that is of no importance to the technical ability of her work force.

  • Posted by anne

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

    These figures are exact:

    The Chilean Stock Index was at 100 on December 31, 1987 and was at 2,179.72 on December 31, 2004. So, 17 years to go from 100 to 2,179.72. This return is in dollars and includes all dividends.

    The Chilean Stock Index was at 100 on December 31, 1987 and was at 2,179.72 on December 31, 2004. So, 17 years to go from 100 to 2,179.72. This return is in dollars and includes all dividends.

    These figures are read from a chart, though the exact data are available for a spreadsheet:

    The Chilean market went from 100 to 1,000 from December 31, 1987 to 1993, and stayed at about 1,000 till 2003. Then, a sharp move from 1,000 to 2,180 by 2005.

  • Posted by anne

    Sorry sorry sorry. I was just looking at Chile’s stock market in thinking about a New York Times article on her state-private pension plan, and I posted a finding quite by accident….

    http://www.nytimes.com/2005/01/27/business/worldbusiness/27pension.html?pagewanted=all&position=

    Chile’s Retirees Find Shortfall in Private Plan
    By LARRY ROHTER

    SANTIAGO, Chile – Nearly 25 years ago, Chile embarked on a sweeping experiment that has since been emulated, in one way or another, in a score of other countries. Rather than finance pensions through a system to which workers, employers and the government all contributed, millions of people began to pay 10 percent of their salaries to private investment accounts that they controlled….

  • Posted by marku

    Great article, Brad. Thanks for this blog.

    But what if the Chinese are playing as big a game of chicken with their hot development/hi surplus program as W is with his “double dare you” debt buildup? What if they are _planning_ on a hard landing, and gambling that in the intervening time, they can develop their home markets and the “Greater Asia Co-Prosperity Sphere” so that when the collapse comes, they will be the last man standing, with their military rival, the US, in ruins?

    Thus far they have played the US like a fiddle. It seems that their economists are a lot smarter (or less hide-bound) than ours.

  • Posted by anne

    China has had episodes, as have we, of intense and even fierce nationalism, but there is no reason to imagine China’s leadership or the Chinese harbor ill will toward America. China and America can prosper together, as can so many other countries. There is every reason to believe that economic development in China has brought it closer in interests to America. Why should this not continue?

  • Posted by steveb

    You state that “the US lack of savings drives the US current account deficit.” We now import about 15% of our GDP, and export about 10%. To eliminate the trade deficit primarily through reduced American expenditures would then require a 1/3 decrease in our imports. If imports are assumed to be a constant fraction of total purchases, then total private expenditures for US goods would also have to decrease by 1/3 – an impossibly large number. Thus it doesn’t seem fair to blame the trade deficit on insufficient private savings.

    To selectively reduce imports without destroying the internal economy will require a very large increase in the renminbi; large enough so that manufacturers return their factories to the US. Taking into account both labor and transportation charges, how much would the renminbi/dollar ratio have to change for this shift back to US production? A factor of two? More? Why is this solution economically superior to some type of trade barrier?

  • Posted by anne

    Marku, there is an essay in the NYTimes that speaks to your comment. Though I find nothing mystical in markets, still market development in China strikes me as politically liberalizing :)

    http://www.nytimes.com/2005/01/28/opinion/28wright.html?pagewanted=all&position=

    The Market Shall Set You Free
    By ROBERT WRIGHT

  • Posted by marku

    anne,
    Actually what I have read is that political liberalism, i.e. freedom of speech and freedom to assemble, is actually worse now than it was before tienamen (sp?) square. The theory of the leaders seems to be that as long as they can keep growth high, the demand for freedom and democracy can be supressed.

    steveb; makes sense to me. I’d propose an X% tariff on all imports from all countries with per capita GNPs higher than Africa (free trade with Africa, for once), with the stipulation that the tariff rate increases or decreases with the change in the trade deficit. AS trade approches balance, the tariff goes away. The WTO allows for emergency tarifs for countries with CA problems, I suppose it is our hidebound belief in David Ricardo that prevents any discussion of this.

    I like the comment from economist Dr Blecker from American University, who said “Chronically unbalanced trade is not and cannot be comparitive advantage trade.”

  • Posted by anne

    There are problems in China, many problems. From loss of land for farmers who in a collectivized state lacked ownership, to absence of effective unions in private companies to environmental and health problem. But, imagine a country of 1.3 billion people developing so dynamically. Imagine the freedom that comes from tens of millions of people beginning to lead securely middle class lives. I am most hopeful about China, economically and socially.

  • Posted by la

    I think Anne has been drinking Kool Aid with regards to the benign motivations of China.

  • Posted by Jesse

    Microsoft’s Gates, World’s Richest Man, Bets Against the Dollar

    Jan. 29 (Bloomberg) — Bill Gates, the world’s richest person with a net worth of $46.6 billion, is betting against the U.S. dollar.

    ”I’m short the dollar,” Gates, chairman of Microsoft Corp., told Charlie Rose in an interview in front of an audience of about 200 at the World Economic Forum in Davos, Switzerland. ”The ol’ dollar, it’s gonna go down.”

    Gates’s comments reflect the same view as his friend Warren Buffett, the billionaire investor who has bet against the currency since 2002. Buffett said last week that the country’s trade gap will probably further weaken the dollar, which fell 21 percent against a basket of six major currencies between January 2002 and the end of last year.

    ”It is a bit scary,” Gates said. ”We’re in uncharted territory when the world’s reserve currency has so much outstanding debt.”

    The U.S. is borrowing to finance record budget and trade deficits. Total U.S. government debt stood at $7.62 trillion as of Jan. 27, up 8.7 percent from a year earlier.

    Forbes magazine’s list of billionaires ranks Gates, 49, No. 1. Buffett, 74, is second, with more than $30 billion. Almost all of it is in Berkshire stock.

    The two have been friends for years, taking vacations together and playing online bridge. Gates in December joined the board of Berkshire Hathaway Inc., the investment company that Buffett runs.

    China ‘Change Agent’

    The country is importing more than it exports, and the government is funding part of its budget deficit by selling bonds to foreign investors, Buffett said in an interview with CNBC Jan. 19.

    ”Unless we have a major change in trade policies, I don’t see how the dollar avoids going down,” Buffett said.

    Gates described China as a potential ”change agent” for the next two decades. ”It’s phenomenal,” Gates said. ”It’s a brand new form of capitalism.”

  • Posted by Jesse

    Microsoft’s Gates, World’s Richest Man, Bets Against the Dollar

    Jan. 29 (Bloomberg) — Bill Gates, the world’s richest person with a net worth of $46.6 billion, is betting against the U.S. dollar.

    ”I’m short the dollar,” Gates, chairman of Microsoft Corp., told Charlie Rose in an interview in front of an audience of about 200 at the World Economic Forum in Davos, Switzerland. ”The ol’ dollar, it’s gonna go down.”

    Gates’s comments reflect the same view as his friend Warren Buffett, the billionaire investor who has bet against the currency since 2002. Buffett said last week that the country’s trade gap will probably further weaken the dollar, which fell 21 percent against a basket of six major currencies between January 2002 and the end of last year.

    ”It is a bit scary,” Gates said. ”We’re in uncharted territory when the world’s reserve currency has so much outstanding debt.”

    The U.S. is borrowing to finance record budget and trade deficits. Total U.S. government debt stood at $7.62 trillion as of Jan. 27, up 8.7 percent from a year earlier.

  • Posted by still working it out

    Marku,

    I am sure you are spot on when you said

    “But what if the Chinese are playing as big a game of chicken with their hot development/hi surplus program… …they can develop their home markets and the “Greater Asia Co-Prosperity Sphere” so that when the collapse comes…”

    Its the only way the Chinese fiscal positions make any sense. Although I doubt they are keen on a hard landing. They can see that a US with a wrecked economy could very possibly lash out in many quite irrational ways and still do a lot of damage to China. Something they would no doubt rather avoid.

  • Posted by phentermine

    The object of war is not to die for your country but to make the other bastard die for his.