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Words of Wisdom from Ted Truman

by Brad Setser
July 29, 2005

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

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

From John Berry:

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

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

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

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

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

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

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

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

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

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

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

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

30 Comments

  • Posted by Anonymous

    Brad : I think I can remember you had an argument about China’s sterilization being unsustainable (that somewhere ahead either the peg would have to be dropped or the Chinese would have to suffer high inflation). What was it again ? Not enough existing domestic bonds to sell ?

  • Posted by Movie Guy

    Speaking of words…

    MUNDELL’S CHINESE EURO – Reverse Engineering A Black Box?

    Nobel Laureates Beijing Forum 2005
    http://www.ebeijing.gov.cn/feature/Nobel%20Prize%20Forum/News%20&%20Events/t20050512_234914.htm

    Previous remarks from Economist Robert A. Mundell:

    http://www.ebeijing.gov.cn/feature/Nobel%20Prize%20Forum/News%20&%20Events/t20050531_241025.htm

    “Robert A. Mundell said China should ignore outside pressure and keep the yuan exchange rate stable. If the Chinese currency were revalued, overseas direct investment will decrease and lead to more unemployment, affecting even the rest of East Asia, he said.”

    http://en.chinabroadcast.cn/2600/2005-6-1/116@242740_1.htm

    Mundell’s “further guidance to China’s leadership. On the issue of Chinese currency exchange rate, he said it would be “extremely damaging for China to change its fundamental policy” on its exchange rate.

    “China should keep its current policy forever — as long as the (US) dollar remains stable.” By saying “forever,” he said he was talking about 5 to 10 years. But Mundall, now a permanent resident of China, added, If the dollar becomes unstable, as it had in the past 200 years four periods of instability, then China would have to put an end to its policy of pegging its currency to the US dollar, he said.

    http://www.ebeijing.gov.cn/feature/Nobel%20Prize%20Forum/News%20&%20Events/t20050531_241025.htm

    Robert A. Mundell said China should ignore outside pressure and keep the yuan exchange rate stable. If the Chinese currency were revalued, overseas direct investment will decrease and lead to more unemployment, affecting even the rest of East Asia, he said.

    Premier Wen Jiabao told the laureates China attaches importance to listening to global advice and opinion.

    Vernon L. Smith, the 2002 winner, said the huge and growing trade between America and China greatly benefits both countries.

    “By outsourcing to foreign countries, US businesses save money that is available to invest in new technologies, new jobs and remain competitive in world markets. We should let it happen,” Smith said. However, “many American citizens will not now agree with that.”

    “Their job losses are very visible while jobs created by new technology are not yet visible. When American businesses outsource goods and services to China, they save money,” Smith said.

    http://en.chinabroadcast.cn/2600/2005-6-1/116@242740.htm

    Mundell Awarded Honorary Professor. “Mundell has visited China 25 times since the 1970s. In 2004, he became the first Nobel Laureate to live in Beijing as a permanent resident.”

    —-

    Robert A. Mundell – bio – Columbia University, USA
    Massachusetts Institute of Technology; “founding father of the euro”

    http://www.columbia.edu/~ram15/

    bio – http://nobelprize.org/economics/laureates/1999/mundell-bio.html

    vita – http://www.robertmundell.net/

    pubs – http://ideas.repec.org/e/pmu18.html

  • Posted by Edward Hugh

    “China needs to resist US advice to let its currency appreciate to avoid becoming a second Japan”

    This is absolute tripe, and if he says this he simply doesn’t understand what Japan is all about, IMHO. I have posted extended comments on this over at the Dave Altig (MacroBlog) post so I’ll leave it at that.

    “That worries me. China is big enough that the adjustment – should China cling too stubbornly to its peg – could come from stable prices in China and falling prices in the US and Europe.”

    Well this is the big issue. Over-investment and over-capacity, with a strong reserve army of labour depressing wages. A classic late 19th century problem. Yes, it is the stable prices in China, or even, in some sectors steeply falling ones, and the impact of this on a disinflationary ridden OECD world (See 75th Annual report of the BIS) which could pose the problem. This has, to my mind, always been the China issue.

  • Posted by Stormy

    “By outsourcing to foreign countries, US businesses save money that is available to invest in new technologies, new jobs…”

    Yup, there’s the money: Real money really being made. And curiously, it is not exactly Chinese money, either.

    Where is it going? At least half of Chinese exports are from FDI. Roache’s comment some time ago said it all.

    Now the question is: Where is the investment and the new jobs?

  • Posted by drfly

    :::Now the question is: Where is the investment and the new jobs?:::

    China.

  • Posted by Stormy

    Using abundantly cheap labor is one way of gaining a competitive edge, at least in some areas. It will substitute for capital investment, until the cheap labor gambit is played out.

    Business will quite naturally use whatever levers it has to ensure that cheap labor stays cheap. Now that is a law of economics, a rather common sense one that does not require any calculus, scatter graphs, or charts.

    Comparative advantage is an ideal that does not remotely include all the players or how they will want to play the game—and that includes “command” economies, however loosely defined; in short, how each government lays out its part of the playing field. From every perspective, the playing field is very bumpy.

    Only dreamers see level playing fields.

  • Posted by psh

    CRMPG II cited long-dated cross-currency options as a weakness of risk measurement. Generally they seemed to be worrying about a focus on historical scenarios, simplistic what-ifs with too few parameters, and a high level of aggregation in risk models.

    Does anybody have a more specific sense of what worries them? I would think that currency options, NDFs aside, are more or less tried-and-true instruments.

  • Posted by psh

    sorry, it’s not reading my HTML
    CRMP II’s at http://www.crmpolicygroup.org/

  • Posted by Stormy

    Not all that money is in China nor is it Chinese money, dryfly.

    I keep asking myself what must be a ridiculous question to economists: Where do the profits from FDI go? Some of China’s tax breaks are very, very nice! Long term investment, no taxes for ten years. Where, in actual fact, does the money go?

    Multinationals that compete against one another have to use buy-outs and investments to stay viable (Chevron’s real problem). But when all of a sudden you are have Christmas all year round….at least for some…whoa. Where are they putting the money?

    Where, in actual fact, does the money go? How about a pie chart presentation of an FDI firm in China? Or do it by key industries. Follow all the money that flows through such a firm. How much is China’s take? The firm’s?

    Let’s look under the covers.

  • Posted by brad

    my weekend reading includes the CPRMG report and the imf article IV for the usa … neither is short!

    re: sterilization –

    the argument goes more or less like this: China’s reserve accumulation is growing — this it may approach $300 b. the desired increase in base money is maybe $75b. That leaves $225 to sterilize — if effect, the PBOC needs to sell over 10% if GDP’s worth of bonds. One would expect that at some point, pumping so many sterilization bonds would drive down their price/ raise their yield, and, as sterilization gets more costly, the central bank would have to choose between faster than desired money growth (i.e. inflation, which leads to real appreciation — domestic prices rise, the exchange rate stays constant, china = less competitive) and less reserve accumulation via a revaluation (nominal appreciation). Korea faced a choice kind of like this a while back.

    alas, so far, events have not been kind to my theory that China would have difficulty steriliziing $300 b increase/ placing $200b of sterilization bonds. So far, they have placed all the bonds they need to (judging from the fact that inflation is falling in china) and nominal yields on their sterilization bonds are falling — indicating that there is plenty of demand (in part b/c of controls on lending mean the banks have spare cash given the still large increase in their deposit base … )

    I think the basic is right at some level of reserve accumulation, but i have to concede that — judging from what we see — china does not seem to have reached that limit.

  • Posted by DC

    “”That worries me. China is big enough that the adjustment – should China cling too stubbornly to its peg – could come from stable prices in China and falling prices in the US and Europe.”

    Well this is the big issue. Over-investment and over-capacity, with a strong reserve army of labour depressing wages. A classic late 19th century problem. Yes, it is the stable prices in China, or even, in some sectors steeply falling ones, and the impact of this on a disinflationary ridden OECD world (See 75th Annual report of the BIS) which could pose the problem. This has, to my mind, always been the China issue. ”

    my main thesis is that we’re in an extended period of productivity driven deflation (just like the end of the 19th century). combining that with the potential adjustment coming through deflation here and stable prices in china – it looks like a sure bet that prices are going down down down.

    the optimist in me is expecting a technological breakthough in the next 0-10 years here in the US that will lead us on the next leg up of a technology driven boom period. the acceleration of technological discovery and practice should imply that the tech booms will occur with greater frequency.

  • Posted by Stormy

    DC,

    The world is dislocated. Some prices will go down, but oil and others that are resource driven may well go up. This is not simple. As industries that capitalize on cheap labor vie with one another or as goods flood the market, that will force prices down: deflation. And when the consumer is tapped out? More deflation?

    But, however we slice it, energy will be inflationary.

    For a while, it may zero out the deflationary pressures.

    That is not classic 19th century stuff, where cheap energy was taken for granted. Hate to be alarmist here, but water may well become one of those resource commodities. But for the time being, the party will continue.

  • Posted by sun bin

    “Where does the P&G & Coca-cola profit go?”

    1. Their business in China is still growing rapidly. Therefore, the bulk of the profit was used in operating the business. Those who have done financial modelling would know that in a growing business requires higher cashflow input (even if there is no new investment), mainly because A/R is much larger that A/P
    2. Yes, part of the profits are already reflected in the consolidated P&L in their Annual Report in US. (also in the rise in housing price everywhere in the world)
    3. Many companies may choose to keep the profit in China in RMB, expecting an appreciation before repatriating them back home. So they are saved as RMB in PBC (as “hot money”)

    However, because they are reported as proftis in these companies, that improve their balance sheet position back home, and does allows for more investment across the board. So the statement of “increase in job opporrtunity in new sector” is correct.
    e.g. mroe I/T investment, more new product lines from P&G (hence employ more marketing staff), etc.

  • Posted by Movie Guy

    sun bin,

    Good follow up post on the other thread regarding China’s leadership.

    On balance, I would note that we have two gangs competing to run the USA. But these gangs cater to the business community and, as such, are allowed to exist. And people vote for their choice. Red gang or Blue gang. (some humor here, but some truth)

    But I will take the U.S. Constitution over all others. A great framework for freedom and personal choice.

  • Posted by sun bin

    movieguy,

    I agree, there are some fundamental advantages that the US have, which is unmatched by japan or China, and will remain so for a long time.

    see this:
    http://www.dallasfed.org/news/speeches/fisher/fs050729.html
    “Remember that Japan grew much faster than we did for three decades after World War II but slowed as it converged to U.S. levels of per capita GDP. The same goes for Germany. And Korea. And Taiwan. There is a good reason economies converge as wealth increases: It is easier to run down a path already cut by the leader than to hack your way through virgin jungle.”

  • Posted by sunbin

    About Unocal, as Chevron reports a disappointing profit fall, its proposal becomes less attractive. We may see some revived competition in the bidding…

  • Posted by cranagh

    stormy -
    “But, however we slice it, energy will be inflationary.” 

    i have reservations about that. you can be short of energy because demand is rising, and you can be short of energy because overall production has reached a plateau. you can also suffer exaggerated price rises or falls from manipulation, war, changes in taxation / subsidy, and market speculation.

    o p e c know that there is a point beyond which oil price rises only tend to a short term spike and are self defeating.

    my guess is that there is little to worry about when energy prices are still rising – lots when they start to fall . . .

  • Posted by sunbin

    i tend to agree with cranagh’s.

    imo oil price will fall back in a couple years, but maybe $30-40 level.

    i would make the analogy with the silver price in the 1970s, where supply increased as the housewives in (e.g. india) began to melt and sell their silverware when the price peaked.
    same for energy, other sources of energy (solar, nuclear, wind — but mainly nuclear) becomes more price competitive, so are more energy efficient equipments (hybrid car), and more costly way of drilling (deep water, less attractive oil fields)

  • Posted by dryfly

    :::Where, in actual fact, does the money go? How about a pie chart presentation of an FDI firm in China? Or do it by key industries. Follow all the money that flows through such a firm. How much is China’s take? The firm’s? :::

    Stormy it is really hard to get money out of China whether from FDI or native firms indigenous growth… The Chinese gov’t very much discourages firms with operations in China from exporting profits via cash conversion & transfers… it is possible but difficult.

    It is MUCH easier to export profit as products… convert the cash profit in China to stuff (buy something) then export the stuff and sell it for cash somewhere else… they fully encourage that practice.

    I’ve been involved with some of these… as an agent for other companies… We found no 100% SURE way of getting our personal RMB profit out except by buying something else in China and exporting it then selling that here. And I had incentive let me tell you… my personal take would have been about $500K/year for a couple 2-3 years… just couldn’t find a way to easily do it short of relocating to China & bringing the profit out a container at a time… then selling that here… and even then no guarantees… a lot a risk and a lot of hassle and a lot of maybe.

    So if you wonder where the FDI profit in China is… look on the shelves of Walmart, Target, etc. Because that is the surest way of repatriating the profit… take your cash, but Chinese stuff, export to West, sell to someone there (like WalMart) to realize the profit.

    So when I said ‘China’… I really meant the investment & jobs go into China… the stuff and repatriated profit… found on shelves & registers of WalMart.

    This was not intended to be tongue-n-cheek.

  • Posted by Stormy

    sunbin and cranagh,

    I hope you are both right about energy, but I am not optimistic. Simmons predictions are still out there. We can hope that he is wrong, but he certainly is in a better position to understand the Saudi fields than we are. I wish the Saudis were a little more transparent.

    There is a lot of bustle around the Alberta oil sands. China is there big time. And Washington is concerned about that. All kinds of rumors are flowing around Alberta. This oil may well be needed, but it will not be cheap.

    “…Chinese companies pouring hundreds of millions of dollars into the vast northern Alberta oil sand deposits.”

    http://www.latimes.com/business/la-fi-canoil17jul17,0,6470814.story?coll=la-home-headlines

    One question that has been nagging is why the rise in oil prices has not been more inflationary. I suspect that the deflationary pressures have been offsetting it.

    By December we may have a better understanding of the energy question.

  • Posted by Stormy

    dryfly,

    that was a great answer…and clear. First time I had heard that. Thanks!

  • Posted by sun bin

    I think China does allow JV to repatriate profit out of the country today. (back 5-10 years they made it difficult to do so)
    I would also think they should especially be encouraging such conversion recently as the speculators are building pressure on RMB.

  • Posted by nate

    I keep asking myself what must be a ridiculous question to economists: Where do the profits from FDI go? Some of China’s tax breaks are very, very nice! Long term investment, no taxes for ten years. Where, in actual fact, does the money go? -stormy

    I’ve been curious about the answer to a similar question.

    Say an American company manufactures all of our production in China. If a European customer orders a product and it is shipped directly from China, with the profits ending up in Antigua, how does the transaction reflected in the trade balances of the countries involved? How is it reflected in GDP?

    Up until china joined the WTO, most FDI factories were restricted in how much of their output they could sell domestically. Many of those factories used their output to supply their regional customers so the above transaction had to be quite common. Wouldn’t the trade balances inaccurately reflect who benefit from the transaction?

  • Posted by Anonymous

    Dryfly, It all depends on how much money you need to repatriate. Many have used “Bags ‘o Cash” metod with great success.

  • Posted by dryfly

    ::::::::I think China does allow JV to repatriate profit out of the country today. (back 5-10 years they made it difficult to do so) I would also think they should especially be encouraging such conversion recently as the speculators are building pressure on RMB:::::::::::::

    sunbin,

    It is getting easier but still not easy… each and every transfer requires permission & paperwork & delay. Even for JV’s & FDI… the main question you have to answer is why you want to take it out? With the implication that ‘wouldn’t you rather re-invest here in China?’

    On the other hand… if you would rather buy a couple container loads of nuts & bolts to export to US? Paperwork can get done right now if you got the money to buy the product. You can have those nuts & bolts in the bins at Home Depot and US cash in your hands before you get the approaval for the transfers… believe me I’ve heard this story over and over.

    Of course you have to be able to make the sale to Home Depot or you might be out cash with containers of nuts & bolts in Long Beach… and you won’t be the only one with the idea.

    Imagine how happy you would be if you made nuts & bolts in say Rockford Illinois and lost your bigest account at Home Depot this way… To a great extent that is what US mfg’ering is facing and why they are so DAMNED mad at the Chinese.

  • Posted by Stormy

    dryfly and nate,

    You may find the following link interesting regarding FDI in China:

    “Foreign Direct Investment in China: What the Figures Don’t Tell Us”

    http://www2.warwick.ac.uk/fac/soc/pais/staff/breslin/research/fdi.pdf

    Apparently there was a change in 1986 that does allow profits to be repatriated, although I am sure that lots of hurdles would be put in place, as dryfly says.

    The article traces the incentives and events that slowly brought China to the stage it is at now. Interesting.

    Again, thanks, dryfly. Your comments are always incisive and informative.

  • Posted by sun bin

    i know about people have no problem sending money out. but of course they need to deal with bureaucracy, and the process is faster for some than others, as everyone does in any developing country.

    as for major MNCs like P&G, they could have send goods from their Gungadong factories (in fact, it supplies to HK and a few other places). But the accounting treatment/etec is messy and the big MNCs prefer to do it the ‘right’ way.

  • Posted by STS

    For those who haven’t seen it, this report is quite interesting:

    http://pull.jpmorgan-research.com/cgi-bin/pull/DocPull/30969-AFE3/95584298/Global_Savings_GIut.pdf

    In answer to the question, “where’s the money going”, the reply is G6 corporate balance sheets. And in large amounts.

  • Posted by stormy

    sunbin,

    that sounds right. If money cannot get out even officially, then that discourages investment.

  • Posted by Stormy

    Still would like to see a simple pie chart of who gets what.