Brad Setser

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My testimony on China – and the Bergsten/ McKinnon debate …

by Brad Setser
August 24, 2006

I had the opportunity to testify before the US-China Economic and Security Review Commission on Tuesday – on a panel with C. Fred Bergsten and Professor Ronald McKinnon of Stanford.  

It is quite fair to say that I was the warm-up act for the main card – the Bergsten-McKinnon debate.    

Bergsten believes that RMB revaluation is essential – to help bring the US trade deficit down, to help slow China’s own economy without adding to its current account surplus and to maintain a relatively open international trading system as the US economy slows.   Regular readers (and in August, are there are any others?) know that I basically agree.

Dr. McKinnon, by contrast, believes that any additional appreciation of the RMB against the dollar would be a terrible mistake.   It would compound the mistake that China already made when it broke the RMB’s longstanding peg at 8.28 … and replaced it with what seems to be a crawling peg against the dollar. 


McKinnon’s argument is spelled out in his most recent paper.   RMB appreciation would not necessarily reduce China’s current account surplus.   Sure it would lower Chinese export growth.  But if it slowed China’s economy, it might also slow China’s import growth. If you prefer to reason from the savings and investment gap, McKinnon argues that the savings and investment gap is independent of the exchange rate.   If anything, he thinks change in the RMB would lead to less investment in China’s export sector and a larger Chinese surplus …

But that isn’t all.  Expectations of RMB appreciation, according to McKinnon, would drive down Chinese interest rates.  If Chinese interest rates are equal to US rates and the RMB is expected to appreciate, everyone should want to hold RMB rather than dollars.  The obvious solution here – pushed by Bergsten — is a big initial revaluation that ends expectations of future appreciation.  But that isn’t politically realistic.   Another argument: expected exchange rate appreciation do not have to match the interest rate differential if there are capital controls.   McKinnon’s response: China’s controls are relatively ineffective … since China already has a market economy.   The last point certainly seems a bit over-stated to me. 

Above all, though, in McKinnon’s view, RMB appreciation risks push China into a Japanese-style liquidity trap.  China would enter into an era of deflation.  The low nominal interest rates created by expectations of RMB appreciation wouldn’t lead to a boom, but rather stagnation.  

McKinnon’s argument hinges on an analogy between China today and Japan in the 1980s and early 90s.   China gets “bashed” for its large bilateral trade surplus today.   Japan got bashed in the 1980s.    But when Japan acceded to US demands for yen appreciation, its economy slowed (after the bubble years).    A slowing Japanese economy, in turn, maintained the Japanese surplus.  And pressure for further yen appreciation …  

McKinnon consequently argues that China should resist pressure to let the RMB appreciate.   And, in a change (I think) from his earlier writing, McKinnon also argues that there are good fundamental reasons why the rapid growth of China’s export sector hasn’t bid up prices for non-tradable services and thus led to a real appreciation.    There are lots of under-employed Chinese in rural areas that can be pulled into agricultural jobs.   Consequently, McKinnon believes that China should target an inflation rate below the US inflation rate (which is too high in his view) – something that is consistent with Chinese interest rates that are somewhat below US interest rates and a very modest pace of nominal appreciation.

And if China’s nominal appreciation against the dollar only makes up for higher inflation in the US, well, the real exchange rate remains unchanged.  Despite China’s large and growing trade and current account surplus.    Despite rapid reserve growth.   And despite all the pressures rapid reserve growth – and the associated increase in base money – places on China’s domestic financial system.  

Bergsten argues that yen appreciation played a key role in reducing the US trade deficit in the 1980s.  I think he is right on that point.   Toyota wouldn’t be producing in Kentucky and Honda wouldn’t be a fixture in Ohio if the dollar remained at its 85 highs.

Bergsten also argues that yen appreciation didn’t cause – at least not directly – Japan’s bubble economy.  Or cause the bubble economy to burst. 

According to Bergsten, the bubble economy of the late 1980s came not from yen appreciation, but from the Bank of Japan’s attempt to offset the impact of yen appreciation on Japan’s domestic economy with loose monetary policy.  That loose monetary policy gave rise to the surge in the Nikkei, the surge in Japanese real estate and all the other features of the bubble economy.   The lost decade that followed came from the collapse of the bubble economy, not from a strong yen.    

This isn’t just an American view.   Kuroda has made a similar argument.   Kuroda says that the right lesson from Japan is that it resisted pressure for appreciation for too long –at least in the 1970s – and that it let its bubble economy get out of hand in the late 80s. 

Bergsten argues that Japan would have been better off had it tried to offset the impact of yen appreciation with a bit of fiscal stimulus rather than with a relatively loose monetary policy.   His advice for China is similar.   Combine renminbi appreciation with fiscal stimulus.   Sounds good to me.

This debate has obvious implications for China.   If a burst bubble economy and domestic deflation can only come from RMB appreciation, China is safe so long as it resists (bad) American policy advice.   If a burst bubble economy and domestic deflation comes from excessive money growth, asset price inflation and over-investment, well, China is potentially in trouble even if resists pressure for RMB appreciation. 

Actually, it could be worse off if it continues to resist pressure for RMB appreciation, as that implies continued rapid reserve growth, continued difficulties with sterilization, continued strong money growth, continued deposit growth and a constant battle to keep the Chinese banks from lending out all their surplus funds …

In Japan, loose monetary policy came from an attempt to offset yen appreciation.   China’s current loose monetary policy (partially offset by the use of administrative controls) has stemmed from an attempt to avoid yuan appreciation. 

I tend to side with Bergsten. 

China today isn’t Japan in the 1980s.   It is more like Japan in the 60s or early 70s. And the yen appreciated throughout the 60s in real terms without slowing Japanese growth (Japanese inflation was higher than US inflation).  The yen appreciated in the 70s in both nominal and real terms and Japan’s rapid growth basically continued.     

Japan’s catch-up phase was marked by a real appreciation of the yen.   China’s catch-up phase hasn’t been associated with a real appreciation of the RMB.   At least not since the dollar started to slide in 2002.  

I don’t quite see why stability in the RMB/ dollar matters more than stability in the RMB/ euro now that China trades as much with Europe as the United States.   That is a point that often gets missed in this debate.   East Asia is increasingly part of a world economy.  Not just a Pacific economy.   And on a broad trade-weighted basis, the RMB is far weaker than it was in 2001 or 2002. 

Nor is a strong currency always associated with a domestic slump.   Strong currencies and strong growth often (though not always) go together.   Think of the US in the late 1990s.  Or Europe in the late 1980s.   Hell, Europe right now.  Q2 growth in Europe was rather impressive – and the euro isn’t exactly weak.

That said, I increasingly fear that the investment boom in China has now reached such a scale that there is a meaningful risk that it will end badly – yuan appreciation or not.    China should have allowed the RMB to appreciate v. the dollar from 2002 on.   It didn’t.   That had consequences.   

China may have exported its way into a bubble by following the dollar down.  But that doesn’t mean it will be able to export its way out of a burst bubble and an investment slump – should the current boom every end.  I suspect that China has put itself in a position where it will have to find a way to stimulate domestic consumption once investment growth slows.  If for no other reason than I don’t think China will be able to increase its current 25% y/y export growth should its domestic economy slow.

In addition to reactions to the Bergsten/ McKinnon debate, I would be very interested in reactions to my own testimony.   

My written testimony includes a fair amount of material documenting why I do think the RMB is now significantly undervalued — and why global rebalancing requires decoupling the RMB from the dollar.   I tried to highlight how Chinese exports to Europe responded to the RMB’s massive depreciation against the euro.   Overall Chinese export growth has actually been stronger than the growth in China’s exports to the US. 

Probably because the RMB has been stable against the dollar and has declined against many other currencies …


  • Posted by Anonymous

    Thank you for your eply, Gcs.
    I was thinking more internationally than domestically. I wouldn’t have any idea how to look at political power within China, especially given — as one of the other posters pointed out — that I don’t speak/read Mandarin.
    It would seem to me that the longer China ‘agrees’ to support the dollar, then the more influence it amasses on the US’ and other countries’ decisions. And maybe the potential of that influence has more power than if/when it would when exerted outright … which may be another reason — more of a meta-reason — to keep propping.

  • Posted by Laurent GUERBY

    “replaced it with what seems to be a crawling peg against the dollar”

    Hey, looks like the hypothesis I expressed on this blog a few weeks ago :).

    What’s wrong with 2-3% appreciation a year if no shocks happen outside China (eg: no hard landing for USA economy – if it happens something will likely be done IMHO) ? Slowly rebalance currency portfolio of the central bank and that’s it. At 10% GDP sustained growth differential per year, China needs 15 years to reach France per capita GDP PPP, so there’s no hurry : 15 years at 2% per year means that China will reach a fair FX value (no reserve growth to maintain “crawling” peg) somewhere in between with 100% probability (where peg can be abandonned and policy switch to “normal” central banking).

    If PBoC workers care about chinese people they look at the 15 years picture each morning when coming in the office, not at the hourly picture economists from richer economies are focused upon.

  • Posted by http://nihoncassandra.blogspot

    “If PBoC workers care about chinese people they look at the 15 years picture each morning when coming in the office, not at the hourly picture economists from richer economies are focused upon.”

    If PBoC workers care about Chinese people, they will would do their utmost to prevent systemic breakdown. Though I have no answer(s) other than those Brad has proffered, the question might be simply parsed as: Is the probability of no systemic-related dislocation from inaction times the welfare gains from such inaction > than the probability of systemic dislocation and the welfare loss from a systemic breakdown & associated economic dislocations. The PBoC should pay attention to western economist – particularly the politcally astute ones, for It is likely that these western economist are more attuned to the domestic creaking & groaning that might precede implosion.

  • Posted by bsetser

    Laurent — 2% nominal appreciation v. the $ doesn’t guarantee real appreciation v. the $ (it depends on inflation differentials) or a real appreciation v. the world if the dollar is sinking. it seems a bit too slow. China has kept its exchange rate from rising in line with its productivity growth for some time, so i suspect it needs a period of somewhat faster appreciation.

    A guess wrote:

    “In less academic terms, would you all be saying:
    1) in order to extend US demand for its exports, China has been buying US bonds (keeping US borrowing easy and the value of the dollar ‘high’ … or at least somewhat stable);
    2) China will continue to prop up the dollar until it can sufficiently develop local appetites for its goods (and China will eventually, if it has not already, ask the US to sing for its supper);
    3) China keeping its currency ‘tied’ to the dollar staves off speculation on China’s currency, preventing a more unruly domestic economy ( … not to mention the political power that it has accumulated)??

    1) is more or less right
    2) is more debatable. I would say that my holding down the value of the RMB (i.e. proppiing up the $) China is able to postpone taking some steps needed to develop domestic demand — so I don’t see China’s current policy as an “interim” step that China maintains until domestic demand organically develops. i think the cause and effect relationship is a bit more complex. One other note — I suspect China tumbled into its current policy when the $ tanked v. many currencies in 02-04. China didn;t plan to peg to a depreciating currency — it just happened. and then when China’s economy responded very strongly to the depreciation of the $ and RMB it became hard for China to change course.
    3) I don’t think this is accurate. China’s dollar peg invites speculation, because it seems unlikely that China will be able to maintain its dollar peg for long. Folks believe the RMB should be allowed to appreciate, so they move their funds into China. And those inflows in some ways have made China’s internal economy more not less unruly.


  • Posted by Anonymous

    Thank you very much for your thoughtful reply. If I may ask another few questions?
    re 2: I see that I attribute too much control to China. Instead they are riding a tiger and have to find a way off?
    Also re 2: it is not clear to me why it is in China’s interest to postpone domestic demand. It must involve risks and expense. As propping up the $ involves risks and expense (probably not the same ones)?
    re 3: maybe “staves off stampede”, instead of “speculation”?

  • Posted by DOR

    Anonymous, if I might jump in:

    Most observers attribute far too much power to the PRC government, and far, far too much weight to central planning.

    The “riding a tiger” analogy is correct, but blindfolded and with hands tied would be closer.

    If the typical economist is trying to steer a car down the highway by looking in the rear view mirror, then Chinese economists are looking at the mirror through a kaleidoscope.

    Or, maybe the best analogy is scalpel and sledgehammer policy tools.


  • Posted by ReformerRay

    DOR and I share a common failing. We jump in after most of the commentators have left the scene.

    So much commentary about China on this post I believe to lack sufficient appreciation of the importance of the problem of retaining control of a government in the modern era. What follows is essentially an essay on that theme.


    The communist party of China has done a tremendous job in guiding their country through the process of becoming a modern nation.

    They had the advantage of knowledge of previous history. It is to their credit that they we able to take useful lessons from history.

    1. The western world has shown that market forces and financial rewards to individuals and organizations for good work are essential to modernization.
    2. Colonialism has shown that previously developed nations are all too eager to exploit undeveloped countries.
    3. The collapse of the Soviet Union (and the failures of so many African nations) has shown that control over the use of force in a territory by a government is the first requirement for modernization.

    Years ago, The Economist, described the beginnings of industrialization in China as the marriage between entrepreneurs of Chinese descent living outside China (Taiwan, primarily) and their relatives living in China. The Taiwanese provided the machinery and know-how and the leaders of the rural communes provided a disciplined work force. Developed world moves into the undeveloped world, using resources that are possessed only by people of Chinese descent. Financial rewards went to the commune (and the Taiwanese), not the individual workers in China.

    Sounds reasonable. No disruption or threat to the chain of command in China.

    The Chinese have wisely retained control over inflows of investment into China. Access to the Chinese labor force comes at a price. No duplication of Colonialism in China.

    The willingness of the Chinese government to use force in Tianam Square was essential to the development of modern China. A government that is unwilling (or unable) to successfully crush a serious challenge to their right to rule the country, will not long rule the country. I remember being very impressed with the beginnings of the protests. As the days stretched into weeks, at became clear that the protesters wanted to destroy the current governmental leadership without having any substitute waiting in the wings. Moving from one form of government to another is not easy, as the Soviets proved. I may have been the only citizen of the U.S. who thought, at the time, that the Communist government acted correctly. They also acted wisely, in not moving until the protests had become less important to the average Chinese citizen.

    The Communist tradition, in which the current leadership was nurtured, has long ago recognized the need for pragmatism (after the disastrous great leap forward under Mao). They learned from that experience.

    I expect the leadership of China to continue to exhibit the same clear eyed focus on moving China into the first ranks of modern nations. Ideology has long ago been relegated to a back seat. Retention of power as an objective has not been discarded, and should not be discarded.

    Where China goes, how much power is delegated to voters will be decided in China by the leaders of the government, in response to developments in China. If the current Chinese leadership falters, or fails to change in response to problems of corruption and inefficiency, it will be up to the Chinese to create a viable successor. China should be granted the same freedom to develop its own form of government as the U.S. grants to itself.

    The United States should cease trying to tell China what they should do because it will be in the best interests of China. Their leadership has shown itself to be much more nimble footed than western nations. China leadership is perfectly capable of deciding what is in their own best interest. At the same time, the United States should look to its own future with the same clear-eyed selfishness as the Chinese are exhibiting. If defense of the future of the U.S. requires some degree of conflict with China, so be it.

    There should be room in the modern world for a powerful China, alongside but not instead of, a powerful Japan, Germany, United States, India and other nations.

    The United States should quickly discard any notion of being the leader of the free world. The modern U.S. has not shown itself capable of protecting its own interests, much less the interests of other nations.

  • Posted by ReforemerRay

    As for Brad’s testimony. Very impressive mastery of data and reasonable conclusions.

    I still have the feeling that Brad’s advice is somewhat conflicted, in that it is directed at the Chinese leadership but it does not look at the problem solely from the perspective of what will maintain and increase the power of both the nation and the current leadership. I assume that expansion of control over their own environment, including trade, is their objective. If I am right, rebalancing can be done by someone else. They see themselves as possessing all the trump cards. They see no difficulty, for China, in continuing along their current path. Brad’s and others discussion of potential problems they are likely to encounter seem weak to me. Whatever others do, they will find a way to take care of China.

  • Posted by Joseph Wang

    Curious thing, I read McKinnon’s editoral in the WSJ, and it made a lot more sense to me than the paper linked to this article. In the WSJ article, he says that he supports the current appreciation which he asserts just matches US and China inflation rates. What he is against is a sudden appreciation.

  • Posted by bsetser

    Right — in other words, McKinnon does not want any real appreciation in the Chinese exchange rate over time (at least relative to the us dollar), and if the dollar falls, the RMB would still depreciate on a broad-trade weighted basis.