Brad Setser

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The $1.3 billion question: What will happen to the renminbi

by Brad Setser
March 22, 2005

A week in China certainly does not make me an expert. Like many, I see China through the filter of English-speaking Chinese economists, and, to more precise, through the filter of those economists and analysts that Nouriel Roubini and I spoke to during our visit.

Roubini’s basic views were pretty hard for any Chinese policy maker with a Bloomberg terminal (or subscription to the Herald Trib) to miss. That no doubt influenced the set of people willing who were willing to meet us.

Still, I came away thinking the odds of a major move in the renminbi — say a revaluation of more than 10% — are higher than I thought going in. Why? Because Chinese economists, including economists in research institutes with links to the People’s Bank of China, are very aware that the-oft discussed 3-5% revaluation in the renminbi would not do much. It is too small a move to have much of an impact on China’s (growing) global trade surplus. More importantly, such small move would leave investors expecting a further renminbi appreciation. Consequently, it would not significantly reduce the pace of China’s reserve accumulation.

I suspect that the People’s Bank of China is privately arguing for a significant revaluation. Of course, the People’s Bank of China is only one voice among many on exchange rate policy. The policy process in China remains opaque, at least to me — but it seems that any change in exchange rate regime would require a decision from a committee of the state council. That is no real surprise: the choice of exchange rate regime is usually a political, not a technical, decision and the renminbi has been pegged to the dollar at its current value that any move will be big news. China’s state council no doubt worries about a lot of things other than the difficulties China’s rapid pace reserve accumulation is creating for the central bank. China’s export sector is a lobby just like Walmart is a lobby here in the US. Committee policy making lends itself toward compromise and small steps — not bold moves. I certainly have no real idea how China’s internal debate will play out.

There clearly is a fair amount of concern in China about the dollar’s path. I guess that is only natural if you hold as many dollar reserves as China does. The Chinese are quite cognizant that the dollar’s value has slipped relative to the euro, and relative to oil. They certainly worry — rather publicly — that the US is not doing all that good of a job looking after the value of China’s existing investments in dollar-denominated securities. But they are also worry that Europe is perhaps not dynamic enough to be all that great an alternative; the Europeans have made it clear that they both don’t need and don’t want any more financing from China. The euro is quite strong enough already. All this is leading a decent of number of Chinese economists — including economists with links to China’s central bank — to conclude that China already may have as many (if not more) reserves than it really needs.

No doubt, there was a bit of selection bias in the voices Nouriel and I heard. We did not talk to any property developers enjoying the cheap financing made possible by rapid growth in bank credit fueled, in part, by rapid reserve growth, or to anyone with major investments in China’s export sector. We did hear a number of economists echo the themes Guo Shuqing, the outgoing head of China’s State Administration of Foreign Exchange, laid out in the China Daily last week — namely, that fast export growth and large FDI inflows are not necessarily good for China — and even that trade surpluses and large reserve increases are not always a sign of economic health.

There is growing concern about the impact rapid reserve growth is having on monetary policy. It is true that inflation subsided over the course of 2004, helped by a strong harvest that kept food prices tame and lots of steel and auto capacity. But there could well be a new round of inflationary pressure building: reserves grew rapidly in the fourth quarter, and fiscal policy may help control money growth less in 2005 than it did in most of 2004. China’s 2004 tax revenues wildly exceeded expectations in 04, and the surplus was kept on deposit until December, helping to limit overall money growth. It seems, tough, that there was a burst of spending at the very end of the year and reserves are likely still growing rapidly, even if they probably are not growing quite as fast as in q4.

This concern matches one of the points Nouriel and I made in our paper. However, Chinese critics of the current exchange rate policy also make some points that Nouriel and I missed.

First, they note that FDI comes to China in search of a return of 15% or more. But China doesn’t need the money per se. It has more than enough savings of its own to finance a very high level of investment, so foreign funds invested in China end up in the PBOC earning something like 4%, maybe a bit more, maybe a bit less. That is not a good trade for China. China of course likes the technology transfer that comes with foreign investment, but it seems a bit less interested in attracting foreign investment in standard labor-intensive manufacturing sectors. I expected to hear concerns about hot money flows and foreigners speculating on Chinese real estate. I did not expect to hear a critique of FDI flows: I don’t think it is an accident that Guo argued that China is giving foreign investors too good of a deal.

Second, Chinese economists note that foreign investment is concentrated on China’s coast, and tends to widen the economic divide between the coast and interior. An obvious point, but still news to me. This was linked to a broader critique that the current renminbi peg is generating an unbalanced Chinese economy — one that exports perhaps too much for a large continental economy and is a bit too exposed to the global macroeconomic cycle. After all, it is not necessarily a good sign if one of your biggest customers can only afford to buy your products if you extend credit on generous terms. I heard more concern about China’s rapid export growth than concern about China’s amazing real estate boom.

Some in China worry that a revaluation would slow export growth. But some also worry that a revaluation would not slow export growth much, and therefore not eliminate the tensions that come with China’s large bilateral trade surplus with the US. Personally, I suspect that revaluation won’t have much of a short-term impact on the bilateral trade deficit between the US and China. Any increase in US exports to China is likely to more than offset by the higher price the US will pay on its existing Chinese imports. The impact on trade will come over time, as incentives to relocate production to China will be reduced. The more immediate impact could well come through the financial markets. If less capital flows into China, China will have less money to lend to the US … and higher US interest rates will slow domestic demand, reducing the United States’ overall trade deficit.

All in all, I was surprised by the number of people arguing that the current exchange rate system was not working for China. No one strongly made the case that China’s rapid reserve accumulation and export-led growth were key components of a new Beijing consensus that would support rapid growth in any country that tried it.

That may just be a function of those people that Nouriel and I happened to talk to. Stephen Roach talked to people with real power, and got a different picture … less concern, and more satisfaction that China was able to use “administrative steps” (limits on bank lending) to cool off the economy (a bit) and cut back (a bit) on credit growth without lowering overall growth too much.


  • Posted by Jesse

    I wondered why the Fed and Treasury were flooding the markets with liquidity. And here I thought it was just the three amigos of counterparty armageddon: AIG, GM, and C. Perhaps they are merely smoothing the way for a Renminbi shock.

    Sorry about Wolfowitz. We could not find his feeding tube.

    Welcome back.

  • Posted by Ryan Darwish

    Are you saying the Chinese representatives you spoke with believe a de-emphasis on exports will still allow China to address its own internal socio-economic issues such as its employment picture?

    Also, does it seem to be a bit of a quandary that even if the US trade deficit is reduced by decreased US domestic demand resulting from higher interest rates, the fiscal deficit may still increased from reduced US internal demand, pushing down GDP, further reducing tax revenues, and increasing US debt servicing costs from having to roll over US debt at higher interest rates?

    This doesn’t seem like a pretty picture to me in either circumstance.

  • Posted by Elaine Supkis

    Who decides what happens next? Hahaha. Easy one for me to call: the communist leaders of China. If they so decide, they can plunge the world into a world wide depression. We handed them all the tools and Condi hopped over to Beijing this week to dare them to use these tools and yesterday Europe reversed themselves and said they would sell no weapons to China and the leaders of China are very very VERY VERY VERY….INCREDIBLY pissed off this week.

    You can’t talk to them, the last time I talked to them was in 1989 but I know them well in so many, personal, ways. I know their personalities and how they think, deep inside.

    We are so farked now. Truly and utterly. What happens next is up to them, they are mulling over moving up the Time Frame for the Confrontation. They want to bankrupt America but wanted to do it leisurely, on their own time scale. Bush and the Pentagon knows this so they are deliberately pushing forward the date because they think we will win a nuclear exchange. Gads. Disgusting. How is your bomb shelter coming along?

  • Posted by Elaine Supkis

    The intellectuals of China: repeatedly in history, they are brutally suppressed if the Rulers need this. Consulting with them about the future is futile if you forget this tidbit of information.

  • Posted by Elaine Supkis

    Also, about talking to the powerful in China: if you imagine they will tell White Ghosts all about their plans and beliefs and desires, this is nuts. They hold everything close to the chest. I have a window onto their thinking because when Cho Enlai asked my father to come over in 1973, the Chinese already knew about my political activies in Europe and in America and they knew I was a notorious lefty so they talked rather frankly with me, and I with them, we had similiar vocabulary since I had read Marx and Mao both and could chat with them using their own political tools.

    I fought with them about capitalism, for I was a CAPITALIST myself and we talked about peasant rebellions and so on, they knew my family history, these people are neither dumb nor illread, they are actually quite knowledgeable, they research your life before talking, trust me on this!

  • Posted by Elaine Supkis

    From 1978 to 1984, we argued, mostly off the record, in my livingroom or at the consulate in NYC and by phone. I was pretty brutal about how captialism works, when Kennedy came out with his seminal work on empires, I made them read it. “Victories are not won on the battlefield, they are won in the industrial field” I hammered into them.

    “When the state builds an industrial base, it only serves the state but when you build a industry that serves the world, you control the world without shooting a single bullet”.

    “The BANKER rules, all other appearances are folly. If you are the BANKER you get to set the rules! Never forget this! Don’t go into debt to build, even if it is harder, do it the hard way, you don’t own something if (the white ghosts) own it”.


  • Posted by Elaine Supkis

    America made the fatal mistake of being a creditor nation. We were told over and over again, the fat lie that if you go way into debt, you own the bank because the bank can’t foreclose.

    History sings a totally different song.

    When a country can’t pay the bills, it falls. An empire goes broke, they implode violently. Dunken fiscal orgies always end up in the gutter. Always.

    One can evade this if lucky but why trust to sheer luck when simple sober care is far better, ask the Swiss. Condi put a gun to China’s head and said, “go ahead, fight us”. For some horrible reason, Bush thinks we will “win” this encounter because he believes his own propaganda every bit as much as Mao thought his propaganda covered all bases and was the basis of all reality.

    Gack. No one listens to me anymore. Heh. I am not surprised.

  • Posted by Stormy


    The link to Roach’s comments that closed with his meeting with the Premier worked temporarily–got to read it once. When I tried it a second time for a closer read, it disappeared.

  • Posted by brad

    Ryan — at least some academics in China (who may or may not be representative) think that China has policy tools available to stregthen domestic demand, and that China needs to develop its internal market rather than focus so heavily on exports. Among other things, stronger domestic consumption might support a pattern of development that reduces the divide between the coast and the interior. Of course, anything that reduces reserve accumulation also makes the PBOC’s job easier, so such views may reflect academics talking the PBOC’s book, so to speak.

    But, as I tried to make clear, I have no illusions about my ability to really get inside China’s decision making loop, or to assess how influential different strands of opinion are inside China.

    Incidentally, I personally think China’s reliance on exports is rather risky, for the simple reason that I don’t think 25% y/y growth in China’s exports to the US, let alone y/y growth of 30% or so, is sustainable for long. China’s share of the US market is too big to make that kind of expansion possible in an environment where overall US import growth (in my view) is likely to slow significantly.

  • Posted by brad

    roach link should work again now — I need to remember to link to the archive version of all morgan stanley columns. I suspect the link disappeared when morgan stanley put today’s material up, displacing roach’s column from yesterday.

  • Posted by Elaine Supkis

    Stop mixing up the needs and desires of the capitalists in China vs the desires of the ruling council and the cadres they command. And the peasants who are not very happy about the capitalists.

    Which group has power?

    Mao: power grows out of the barrel of a gun. Guess what? Power does grow out of the barrel of a gun if the capitalists have no guns.

    In China, the end of the capitalist power there is perfectly OK with the ruling elite who are worried the capitalists will overturn them. There is considerable tension about this. The communist leaders have taken a liking to be capitalists but they can see the side effects: dissatisfaction in the peasantry who can really make life difficult if they get too restive.

    How will they solve this riddle? Easy to call: rally the nation to take Taiwan back and defy the Japanese/American axis.

  • Posted by Elaine Supkis

    Being bogged down in Iraq is OK since we plan to fight WWIII with nuclear subs which will sneak attack China and Russia and hit the missiles there before they can hit us.

    Of course, the one flaw in this splendid Hitlerian plan is…they can do the same thing to us. If, in unison, at a very secret meeting, they decide to coordinate a sneak attack on us since we will have repudiated our international debts (this will happen pretty soon) then we won’t know until the missiles are flying which gives us about 20 minutes warning to clear out our cities.

    Incredible. Every day, one should contemplate WWIII and nukes so one can figure out what is going on today. We are really in a crisis situation and the deteriorating economic condition of America is a very dangerous unstable force that will destroy the world.

  • Posted by sbks

    I wonder when the mainstream economists are going to finally recognize that the problem is a currency lacking an intrunsic value. How foolish to let Man print money out of nothing… the architect of our current financial system put it very well: his own words…
    “By a continuous process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method, they not only confiscate, but they confiscate arbitrarily; and while the process impoverishes many, it actually enriches some….The process engages all of the hidden forces of economic law on the side of destruction, and does it in a manner that not one man in a million can diagnose.” – John Maynard Keynes Economic Consequences of the Peace, 1920

    Keynesian economics are simply a delusion because no one can control the whole, when one tries to do so, there is NO free market but the Myth of the model… perhaps time to go back to Constitutional money as prescribed by the Founding Fathers, and apply it internationally.

    There have been more than 1200 monteary systems such tried as our so far in the last centuries, they have all FAILED! Ended with either deflation or hyperinflation. If history is any indicator and we now look at the state of our global economy, we’re head for a global crash. Here we go again?! Qui bono? follow the money of course…. the top 15-20% in this world.

  • Posted by sbks

    the comment pointing at the problem with keneysian economics was not posted Elaine Supkis but sbks. There may be a problem of website settings, please check out. Thanks

  • Posted by Ryan Darwish


    While the scenario you laid out sounds plausible, your analysis seems to leave the subject with the US being ” farked”. While being “farked” seems to have its appropriate place in the foreplay of life, it doesn’t seem to be an acceptable state of final existential residence. Consequently, it would seem to behoove those who give this matter some thought, the impetus to explore the likelihood of various scenarios in the post “farked” state.

    Any thoughts on this subject.

  • Posted by anne

    Nice analysis Brad, though my sense is that Stephen Roach will prove to have come closer to the thinking of leadership. Stability is critical now, and this does not appear to be a leadership that is displeased with direction.

  • Posted by brad

    Anne — I could be wrong, but my guess is that the current policy mix in China will not prove to be consistent with stability, particularly price stability/ financial stability. Too many renminbi are being created … and if China’s trade surplus is on track to top $100 b this year, as some analysis suspect on the basis of the jan/ feb numbers, it may not be consistent with “stability” in China’s relationship with the US either.

    But Roach clearly has access to the top of China’s leadership; Nouriel and I just got the rumblings from the technicians!

  • Posted by w

    Just found this site a few days ago; nonetheless, anyone here want to comment on the following out-takes:

    However, crude goods prices dropped 1.6 percent, with core crude goods costs down 3 percent. It was the third consecutive month prices at the crude goods level had declined.

    Meanwhile, yesterday’s report on producer prices caused economist Ken Mayland of ClearView Economics in Cleveland to conclude, “The tsunami of energy and raw material price increases is receding — witness the decline of crude goods prices, the rolling over of the 12-month change in core intermediate goods prices, and the repeated drops in the Institute for Supply Management’s price index.

    “But the pig is still in the python, working its way to the tail. There are still some pressures in the supply chain that will bubble up to the consumer,” Mayland said.

    Just so long as the python doesn’t find a steady supply of pigs, Fed officials will be patient.

    The Institute for Supply Management’s index of prices paid by manufacturers fell to 65.5 in February from 69. The index of prices paid by services companies fell to 66.4, the lowest since March 2004, from 66.6. Readings greater than 50 indicate expansion.

    Fourth-Quarter Horizon

    The fourth quarter is “the possible turning point for the dollar,” Landon said, as higher borrowing costs start to slow the economy and help shrink the deficit, which reached a record $665.9 billion last year.

    The current account is the broadest measure of a nation’s international trade.

    JPMorgan forecasts the euro will peak in the third quarter at $1.38, then fall to $1.34 in fourth quarter.

  • Posted by anne

    Global: China Goes for Growth
    Stephen Roach (Hong Kong)

    “At the end of the meeting, the Premier shook his head and exclaimed, ‘I cannot sleep well at night with this issue of the RMB.'”

    Thanks, Brad. I am convinced you and Nouriel are right, but then China’s leadership needs to be convinced. Wen Jiabao’s comment is interesting then on several levels.

  • Posted by gillies

    thankyou for the interesting report from china. the chinese policy makers may possibly feel like passengers in a global economy that is a car speeding on ice. they have asked america, the driver, to ease off a bit. we in the back seat seem to be talking as though there is no choice but america putting the boot to the metal, or china independently grabbing the handbrake. – but in the coded messages exchanged has been the word ‘orderly.’

    easing off a bit would mean higher u s interest rates, and the consequences that would follow from these.

    you have to accept that neither america nor china wants a crash, and we must anticipate actions that try to avoid violent shocks to the vehicle of the global economy. formosa is an insurance policy for china, a suitable focus for popular anger if things start to go wrong.

    the only alternative view to all of that is that the mushrooming deficits are a deliberate bear raid on america and the dollar. if you think that that is not credible, ask the people who shorted the airlines’ shares before 9/11. some people would sell their own mothers short if they saw the prospect of a decent return.

  • Posted by gillies

    what is a reserve currency ? is it a currency in such general use and in such volumes that you can always safely buy or sell some, while other smaller currrencies would be too volatile to act as a reserve?

    so the size of japanese,chinese, korean reserves in particular, which makes them barely tradeable, must mean that the dollar is not a reserve currrency once reserves ( your own or other peoples’) are over a certain size?

    so the careful reduction of asian reserves, and the careful raising of interest rates – far from threatening america – would restore the dollar as a reserve currency and potentially strengthen it.

    so why the note of panic? is it the rising interest rates? have you guys and gals all got big mortgages or credit card overdrafts or something?

  • Posted by anne

    Thinking along with Brad DeLong:

    Seemingly the Fed has decided there can be no chance that inflation might be set off by rising commodity prices or a decline in the relative value of the dollar at a time when the Fed might actually want to ease monetary policy. Then, make sure rates are high enough soon enough not to have to make a choice between defending the dollar or the domestic economy. Interesting and sensible.

    Then, we can assume there will be Federal Funds increases of 50 basis points or even a 75 basis point increase to temper market anticipations. Now, we have a Fed cycle.

  • Posted by anne

    March 16, 2005

    Death of the dollar
    By Steven Irvine

    In his keynote address to CSFB’s Asian Investment Conference yesterday (March 15), Nobel Prize winning economist, Joseph Stiglitz predicted the demise of the US dollar as the world’s reserve currency.

    The former World Bank Chief Economist told the audience: “Reserve currencies must serve the role of being a good store of value. The dollar is no longer serving that function and there are alternatives.”

    Stiglitz said from the perspective of a European, if they had held dollar assets, they would have seen those assets decline in value by 40-50% in terms of their own currency, the euro. “That’s the same thing,” Stiglitz pointed out, “as if they had seen their purchasing power eroded by 40-50% by inflation. This exchange rate instability is therefore as destructive to a currency’s suitability to be a reserve currency as inflation is.” …

  • Posted by calmo

    Does gillies know the extent to which banks are exposed to income associated with mortgages? Hard to say, but “careful raising of the interest rates” suggests he does.
    I don’t detect any note of blogger panic here. But that national media headline “Stocks inch ahead” (CBS) today after a 200pt loss over the last 2 days when in fact the DOW lost ground today, suggested atleast some catharis if not panic.

  • Posted by anne

    Note the sector pattern:

    Sector Indexes
    12/31/04 – 3225

    Energy 18.1
    Financials -7.2
    Health Care -2.2
    Info Tech -8.6
    Materials 3.3
    REITs -7.8
    Telecoms -7.9
    Utilities 2.9

  • Posted by anne

    Investment Bubble Builds New China

    YANGSHUO, China – Nature spent millennia carving the jagged limestone mountains of Guangxi Province into the fanciful forest of stand-alone peaks so prized by ancient painters and modern tourists.

    Ren Ping and his crew of a few dozen migrant workers have been at their jobs only a few months, but the elevated superhighway they are building has already burrowed a path through the prehistoric crags. ‘We’ll go around this one, but we will have to slice through that one over there,’ Mr. Ren said over the roar of dump trucks pouring cement. ‘Drivers on this road will have the most beautiful view in all China.’ …

  • Posted by Elaine Supkis

    Germany wants to sell weapons to China. Despite our arm twisting in Europe. Evidently, the Chinese are arm twisting, too, this is driving the Europeans crazy.

    China is very determined about this and they really resent the “you are not humane” issue coming, as it is, from “we love torture and aggressive invasions” America.

    Germany wants to sell China arms

  • Posted by Elaine Supkis

    Reserve currency: means dollars buy oil. You can’t buy oil directly except via dollar denominations. This is great power which we squandered not once but twice. When we inflated the dollar back in the seventies when oil shot up in price, we pretty much took back, so to speak, what we sent out.

    But the American lower classes never recovered! Wages vis a vis inflation: down, way down. Solution: the working class had to go to work, all of them women and children, gramps and granny! And the insidious magic carpet: endless debt.

    There is an upper limit to debt. Right now, the American working class is using credit to pay creditors. Bankruptcy in expanding economic years is way up, thus the bankruptcy law changes (blood from stone time!). A serious downturn with a tightening of credit now equals disaster.

    This irresponsible mess could have been fixed if we were fiscally responsible but when hit by 9/11, we were told to go shopping and we rewarded ourselves with open ended credit and interest rates way below the rate of real inflation. When the markets took off, instead of stopping emergency measures, for political reasons, our rulers increased the emergency aids which is a disaster, unparalleled except it happens all the time, this is true temptation: to have your cake and eat it too.

  • Posted by ying-yang

    What are the blogs going to do when spring comes, and Elaine is too busy on her/his farm, to post comments, about China.

  • Posted by Tom Marney

    Ryan Darwish wrote, “While being ‘farked’ seems to have its appropriate place in the foreplay of life, it doesn’t seem to be an acceptable state of final existential residence.” Well, of course not. Being farked means being at the point-or-no-return phase of a chain of events that was undertaken without regard to its ultimate outcome, or at least not in regard to the farked. Argentina, for instance, is farked, though its hapless creditors may or may not be depending or their degree of exposure to the potential for farkedness (farkation?).

    Being farked doesn’t necessarily mean that there’s no potential for eventual recovery. It does mean, however, that the institutional and cultural factors leading to farkation must be removed or neutralized before recovery can have any prospect for success. For example, Germany in 1945 was pretty well farked, as it had been since, say, the winter of 1942. Naziism, of course, was at the root of Germany’s farkation; denazification was the essential element in Germany’s recovery. In contrast, the underlying causes of Argentina’s farkation are still intact, which means that they probably will remain farked for quite some time, even if it’s not that obvious right now.

  • Posted by Dean A. Nash

    Brad, nice piece of work. Elaine, your comments are always interesting, I’m hoping for a long winter.

    I’ve been in China for going on 3 years now, studying just what makes the Chinese tick. STABILITY, far and away is number one. After you’ve been here for awhile, it’s easy to understand why.

    If you can understand this (agree that it’s true), the idea that China would like to peg the RMB to gold (the gold standard), and delink it from the dollar makes great sense.

    China’s internal markets have the potential to be all the market she will ever need. At that stage of development, having the RMB be the world’s reserve currancy – oil priced in RMB – would be ideal (for China).

    Like a spoiled heir, America has ‘pissed away’ the inheritance that we received. The damage that we allowed Nixon to do will be felt for all of history.

    Brad (and Elaine), I’m interesting in hearing your comments on this type of possiblity.