Eswar Prasad: China’s exchange rate policy isn’t working
The headline is mine. Don’t blame Dr. Prasad.
But that is the conclusion I took away from Eswar Prasad’s most recent paper. I usually write about how China’s exchange rate policy distorts the global flow of capital, and impedes effective balance of payments adjusmtent. Eswar Prasad – now at Cornell, but formerly one of the IMF’s leading China hands – focuses instead on how China’s peg has distorted China’s domestic economy.
Maintaining the peg, in Dr. Prasad’s view, impedes China’s ability to achieve many of the Chinese government’s stated goals – jobs, an efficient financial sector and a more balanced economy. Moreover, incremental reform no longer works – especially not when the de facto peg effectively constraints a host of other policies.
“There are inherent limits to the incremental reform strategy that has worked well in the past. At a certain level of development and complexity of an economy, the connections among different reforms become difficult to ignore. … Ignoring these linkages – for example, trying to push ahead with banking reforms while holding monetary policy hostage to an exchange rate objective – makes an already difficult reform process harder.”
The right answer is to do more, not less – and to so now, when strong growth makes reforms easier. Dropping the peg is key. Why? Because a host of other policies in China are now directed at reinforcing the peg, and those policies cannot easily be changed if the paramount goal of Chinese policy is a weak RMB.
“The … inflexible exchange rate, while not the root cause of imbalances in the economy, requires a large set of distortionary policies for its maintenance over long periods. It is these distortions that – though multiple channels – hurt economic welfare and could, over time, shift the balance of risks in the economy.”
Dr. Prasad continues:
“China has held the exchange rate of the renminbi relative to the US dollar within a narrow range despite enormous pressure for a substantial appreciation in recent years. … This has been accomplished without the typical rising quasi-fiscal costs of sterilizing the liquidity generated by large capital inflows. … Sterilization has been facilitated by financial repression and relatively closed capital account. This has, among other things, meant very low real rates of returns for households who save a lot and have few investment opportunities other than domestic bank deposits. These policies have also curtailed financial sector development, leading to inefficient intermediation of domestic capital.”
Eswar, drawing on work by Jahangir Aziz (more here, with Li Cui), notes that Chinese job creation has been very weak. The low real interest rates associated with China’s exchange rate policy – along with the absence of any dividend payments by now profitable SOEs — has encouraged the substitution of capital for labor, and thus inhibited job creation.
“Cheap capital has played a big part in skewing the capital labor ratio and holding down employment growth (Aziz, 2006) … The result has been slow employment growth, that is hardly at a pace sufficient to keep with the growth in the labor force, absorb workers laid off from state enterprises that are retrenching and to absorb excess rural labor …. During the period 2000-05, growth in non agricultural employment averaged less than 3% per annum, compared to average non-agricultural GDP growth of about 9.5%.
One of the most remarkable features of China’s boom is that it has been accompanied by a very strong fall in household income as a share of GDP. Household income – to be sure – has increased. But it has grown more slowly than the overall economy. That is a key reason why consumption is shrinking as a share of GDP.
Holding nominal interest rates down to support the peg keeps the real returns on Chinese savings low. It it also means that demand for borrowing – at least at current interest rates– is quite strong. But the government doesn’t want the banks to meet this demand. A burst of lending would add to inflationary pressures – and it would make it a lot harder for the government to sterilize ongoing reserve growth.
The solution: administrative controls. The problem: the controls work against meaningful financial sector reform. Prasad:
“One of the principle concerns is that the lack of exchange rate flexibility not only reduces monetary policy independent it also hampers banking sector reforms. The inability to of the PBC to use interest rates as the primary tool of monetary policy implies that credit growth is often controlled by much blunter and non-market oriented tools, including targets/ ceilings for credit growth and as well as “non-prudential administrative measures.” Prasad and Rajan (2006) argue that this vitiates the process of banking reform by keeping banks’ lending growth under the administrative guidance of the PBC … this constraint has also perpetuated large efficiency costs via provision of cheap subsidized credit to inefficient state enterprises. [The resulting costs] are probably ultimately born by deposits in the form of low real returns on their savings.”
Throw in Yu Yongding’s point — the banks increasingly are stuffed with low-yielding sterilization bills – and it is hard not to conclude that the Chinese government has held down the costs of using the central bank’s balance sheet to support Chinese exports by shifting a lot of the costs to Chinese savers. Chinese savers are subsidizing the Chinese state – and indirectly American and European consumers – by accepting very low real returns on their savings.
China’s taxpayers also will ultimately absorb – one way or another – large losses on the central banks balance sheet. Buying a depreciating asset is a good way to loose money. Buying ever large amounts of a depreciating asset is good way to loose a very large amount of money.
And that is what happens if everything goes well. It things go badly, Chinese savers will get a low real return on their deposits and get hit with an additional tax bill to bailout the banks for making another round of bad loans …
Dr. Prasad shows why the fragility of the domestic banks isn’t a good reason to avoid more exchange rate flexibility – the banks fragility doesn’t stem from currency exposure. And the risk of a large capital outflow from the banks is an argument for going slow on capital account liberalization, not to go slow on the exchange rate. I agree on both points. China simply doesn’t have the currency mismatches that made Asian banks vulnerable ten years ago. Bad banks aren’t the problem per se. Banks that have lots of foreign currency exposure are.
Eswar is implicitly critical of China’s decision to try to substitute a relaxation of controls on capital outflows for RMB appreciation. “This [encouraging institutional investors to move funds abroad and relating restructions on the amount of financial capital that can be taken out of the country by households] poses a significant risk because deposits in the banking system now stand at 160% of GDP whil foreign exchange reserves now amount to less than 50% of GDP. The risk of massive flight out of bank deposits is small, but let’s consider a more plausible scenario. What if depositors become concerned enough to move say 10% of their deposits out of the banking system into foreign assets.”
Good question.
The banks ,in Dr. Prasad's view, would cut back on their lending – creating a credit crunch. Nervous households would increase their savings, “setting off a deflationary spiral.”
That seems right to me. I would just note that if a booming China has a current account surplus that now looks to be close to 12% of GDP, a slumping China – one with less investment and more household savings – would have an even bigger current account surplus. China likely would come close to being able to finance a 16% of GDP capital outflow from its current account surplus. It wouldn’t need to dip into its reserves at all.
My summary of Eswar’s argument – itself a summary of the insights he has gleaned from watching China’s economy closely over the past few years – doesn’t do it justice. Read it all. And don’t forget to look at the charts and tables at the end. Eswar may have left the IMF, but he hasn’t forgotten the value of a set of charts and tables summarizing a country’s key economic data.
Update: a bit more from Richard McGregor of the Financial Times. He notes:
Chinese leaders publicly stress the priority of employment creation, but economic incentives continue to favour capital intensive industries, not the job-generating service sector. The huge profits these industries have made in recent years have flowed back to state investors and officials, not the workforce. The other winners have been foreign multinationals, often in local joint ventures, using China as an export base.
Claims that China's current policy mix are necessary to create the jobs China needs should — in my view — be subject to more critical scrutiny, particularly in light of the strong fall in labor's share of total Chinese national income.
I agree with Dr. Prasad that the micro economic distortions are real, but even he argues that much of the macro risks are simply strawmans.
“if the paramount goal of Chinese policy is a weak RMB”
I don’t think that is the case. The problem is that the current system works well enough. The real economy is doing well. It is certainly not good enough if China wants to attain a world class economy. But that is setting a goal too high. China will be happy if it can lift its per capita income to half or even a quarter of that of OECD countries. The constraints will come from natural resources and political stability (internal and external), not exchange policies.
“by accepting very low real returns on their savings”
That is the path Japan took. It did well until it matured into a developed economy, which China would happily replicate if possible. But what is cause and effect here? I’d say high propensity to save together with outflow control causes low cost of capital. Certainly low return does not lead to high savings (if anything it should depress savings). Low ratio of household income to GDP exacerbates it by further depressing current consumption. Anyway I don’t see what Fx rate could do for this situation - esp if high Fx rate coincides with lower income in RMB.
“What if depositors become concerned enough to move say 10% of their deposits out of the banking system into foreign assets.”
Hmm, isn’t that what PBC is asking for? PBC can compensate for the contraction of the monetary base by selling sterilization bonds, buying treasuries (Chinese ones, that is), lowering reserve requirements and possibly the interest rate. Its options are numerous. It is far from straitjacketed by the Fx policy in this case.
The real risk I see is if everyone is convinced of RMB’s rise and starts borrowing in Fx — then comes the day when they all want to unwind, probably when RMB overshoots and surplus turns into deficit. For this reason PBC keeps an iron grip on Fx borrowings by banks (I believe a quota system is in place).
As for capital loss, Prasad said half of the reserve can be matched to FDI. Equity value can be effected through taxation so the cost to taxpayers is not exactly same as cost to Chinese taxpayers. And trade flow could reverse too. For central banks with fiat currencies nominal changes like this mean little. The real loss is the mispricing of resources, environment degradation, labor etc. But there the loss is water under the bridge — already incurred.
I think the real catalyst for change is his scenario of collapse of external demand. Whether because of a US recession or trade barriers, China will be forced to change. And it will also be a good opportunity to change, because the pressure of capital inflow will also be much more attenuated.
I am amused at the plethora of advice that China is getting (always “for its own good,” of course) from outsiders. I think all their lucubrations are pointless if the Chinese aren’t of a mind to accept them. And I don’t see China in much of a mind to accept outside advice, even “for its own good.” Is it fun to continue to talk to a deaf man?
Japan was also on the receiving end of endless advice in the early 1970s pushing it to revalue the yen. It finally did so when the US detached the dollar from gold. But in the Japanese case a revalued yen made imports cheaper and was thus a large benefit to the Japanese economy. China is less dependent upon imports and a revalued yuan would have less benefit in that respect for China. So selling China on revaluing the yuan won’t be so easy.
2007-08-01 03:45:21 - ‘China’ has sought ‘Western’ advice and knowledge for quite some time - buy sending it future elite to Western universities, making deals with entities such as Blackstone, hiring U.S. consultants…
So would Eswar Prasad have China sharply revalue the yuan, leaving tens of millions of low skilled textile workers unemployed. The Washington controlled IMF has never expressed any concern over the plight of Indonesian workers in the wake of the Asian Economic Crisis in the late 1990’s triggered by Wall Street Hedge Fund speculative currency attacks. The primary concern of IMF bureaucrats is only for the profitability of Western Banking institutions, and not Chinese social stability.
As I mentioned elsewhere, I disagree with just about everything Prasad says in that article, and I’ll try to organize my disagreements today.
Just to name one big disagreement. He reverses cause and effect as far as financial intermediation. There is a lack of good investment opportunities for Chinese savers, but this has nothing to do with the RMB peg. It has to do with the fact that developing a functioning financial market takes a lot of time and effort to develop a legal and financial infrastructure. If you don’t put in the time and effort to do it carefully and step by step, you end up with a casino rather than a market. This is *precisely* what happened in the early-1990’s, and a lot of recent policy has been to avoid the mistakes of those early years.
As far as loans to SOE’s. Monetary policy doesn’t make a huge dent into production because most SOE investment comes from invested returns and not bank loans. Also China uses administrative measures and things like reserve rates to control the economy rather than interest rates because raising interest rates *doesn’t* cool the economy (it was tried in 2005) when raising lending rates actually caused the economy to speed up.
My suspicion is that if you raise interest rates, you end up being able and willing to loan to a larger number of riskier clients, and this expands the money supply rather than contracting it.
Excellent post on an excellent article; thank you; but it gets worse: Not only “low returns on their savings,” but negative returns (fig. 1b; 5a). And (Aziz and Cui, Jul 07) document the various reasons household consumption continues to decline as a percent of GDP, which means . . . . .I hope I’m not belaboring the obvious, but this is conscious policy.
Prasad writes, “closed capital account has, among other things, meant very low real rates of returns for households who save a lot and have few investment opportunities other than domestic bank deposits”.
Say what? In reality Prasad has everything ass backwards, low real rates of return force households to save less, not more. When the Federal Reserve lowered the discount rate to a historic low of 1 percent, well below the real inflation rate, the US savings rate plummeted into negative territory, sparking a speculative asset bubble in real estate.
By holding the interest rate of return well below the current “real” rate of inflation, the Federal Reserve risks sparking hyperinflation; estimated broad M3 money supply base is expanding at a 12 percent double digit rate. It’s really no wonder why spot crude oil closed yesterday at a record $78.40 per barrel, with Gold, Silver, and Platinum also close to decade highs.
DC — you are mischaracterizing Prasad’s argument — he took savings as a given, and argues that china’s policy pushes the return on that savings down. he wasn’t arguing that china saves a lot b/c rates are low.
and why not adjust your argument about the us to fit current facts? US rates aren’t low now — 1% is long past (and household savings haven’t recovered). And if you are worried about fast money growth, US money growth is well under Chinese money growth.
Twofish — absolutely true that more and more investment is financed internally. but with higher rates, wouldn’t firms with limited opportunities for profitable reinvestment start putting funds in the banks? And wouldn’t higher int. rates on what firms do borrow cut into profitability? my general sense — given all the complaints about high int. rates to defend currencies in asia in 97-98 — is that asian economies are often rather sensitive to changes in interest rates (b/c of the large role of bank loans in the economy)
finally, i am pretty sure that china is at least as dependent on imports as Japan — china has a bit of oil , but i suspect it also has a more energy intensive economy. and its imports to GDP ratio is much higher now — so even if 1/2 of all imports are for processing, the remaining 1/2 generates an imports to GDP ratio above Japan’s imports to GDP ratio.
Indeed, with oil at $80, it would seem that China has a particularly strong incentive to revalue now.
One other thing. I think that there is a lot of legitimate debate over what would happen if China removed the peg. I think that there is a lot less room for debate as to the motives for China keeps the semi-peg. The main reason is that experience has shown that reforms are best done incrementally and that sudden changes create new and unexpected problems.
“…Chinese oil demand would rise strongly next year… Chinese oil consumption, which last year was 7.16 million barrels a day, is expected to grow by an annual 6 percent over the next two years… Even at today’s levels, oil futures are still about $10 a barrel short of the all-time inflation-adjusted peak set in 1981. Oil prices would have to rise to about $90 a barrel to exceed that record…” http://www.nytimes.com/2007/08/01/business/worldbusiness/01oil.html?ref=business
2007-08-01 03:45:21, 2007-08-01 03:56:16, 2007-08-01 06:44:07 - If you had bothered to read the entire post, and just the first page of Prasad’s paper, which says: “I thank… Justin Lin, Luo Ping, Li Ruogu, Andrew Sheng… for useful discussions and comments… Sun Tao for help in obtaining some of the data…”
Brad writes, “US rates aren’t low now — 1% is long past (and household savings haven’t recovered). And if you are worried about fast money growth, US money growth is well under Chinese money growth.”
Reply:
The “real” inflation adjusted interest rate of return in the United States is very low. Bernanke’s fictitious measure of “Core inflation” that excludes energy, food, and commodity prices is absurd. Does Bernanke ever eat food or get driven in an gas powered automobile? Spot crude oil closed yesterday at a record $78.40 per barrel, corn prices are soaring from ethanol production.
Fast Chinese money growth is a serious concern for the China PBoC. That is why banking reserve requirements were raised 0.5 percent last week to 11 percent of bank capital, and deposit interest rates were raised 0.25 percent. Unlike the Bernanke Federal Reserve, the China PBoC takes into account food and energy price inflation that impacts ordinary Chinese consumers.
the concerns of many both inside and outside of China being that too slow a pace will end up forcing a broadly damaging, sharp revaluation.
” Deposits in the banking system now stand at 160% of GDP while foreign exchange reserves now amount to less than 50% of GDP. The risk of massive flight out of bank deposits is small, but let’s consider a more plausible scenario. What if depositors become concerned enough to move say 10% of their deposits out of the banking system into foreign assets … The banks, in Dr. Prasad’s view, would cut back on their lending - creating a credit crunch. Nervous households would increase their savings, “setting off a deflationary spiral.”
I guess this scenario is part of a larger category in economics having to do with capital flow interruptions. But I’ve never fully understood the mechanics of such capital flight as explained in the article or elsewhere.
I assume we are talking domestic RMB deposits where the RMB is now assumed to be convertible under a relaxation of capital controls.
Banking systems don’t ‘lose’ money just because of a movement of money into foreign assets - not unless those assets are purchased from the domestic central bank, which isn’t assumed to be the case here. Domestic money that is exchanged for foreign assets must return to the domestic banking system, albeit with a new foreign owner. (The same effect happens initially in the US NIIP case when a US portfolio manager invests in foreign equities - the FX market initially brings the dollars back into the domestic banking system with a new foreign owner).
(Which begs the question - would the relaxation of capital outflow controls require an opening up of the domestic banking system to foreign held RMB deposits? Or is it simply a return flow of dollars? But the latter contradicts the assumption of a capital outflow that would affect domestic liquidity.)
So while domestic depositors may move 10 % of their deposits out of the banking system under the assumed scenario, that doesn’t imply that the banking system loses 10 % of its deposits. Whatever the ‘liquidity’ effect is, it shouldn’t be viewed in this way.
Capital outflows from China would put marginal downward pressure on the FX rate - which I suppose is partly a good thing from China’s perspective if they actually maintain the peg - as an alternative to intervention.
It’s reasonable to expect some turbulence and dislocation in the distribution of return capital flows within the bank clearing system. This should be a function of transaction velocity and its effect on the exchange rate. But again, RMB deposits won’t disappear simply due to a ‘capital outflow’ effect at the macro level.
The return flows would change the liability structure of the banking system (from domestic to foreign holders of bank deposits). I see the risk for the exchange rate, but I don’t see the logic in a necessary consequence for asset (loan) management or why it means a credit crunch or increased savings or deflation. In fact I suspect the primary effect is almost entirely through the exchange rate, and the rest is fallout - i.e. ‘confidence’ in the banking system.
The risk for China in opening up capital outflows while the peg is still operative would be quite different from the risk if they were opened in conjunction with China deciding to ‘eliminate’ the peg. I assume the risk in the second case would be greater. Perhaps China’s dilemma is that given the interconnected rigidities of the current system, there are just too many moving pieces with potential compounding risks to be considered when opening up the entire system from the anchor of the peg.
On capital flow risk, perhaps there is a fundamental distinction between the maturity of the US ‘intermediation’ function and the novelty of a similar function for China - creating more ‘disruption’ risk in the case of China. Still, the complete explanation of related domestic banking system risk is illusive to me.
The Prasad article seems quite good.
Looking at the article, it turns out that I disagree with it less than I thought.
There are some key areas where I think he reverses casuality. I don’t think that exchange rate policy has had any effect on building a financial infrastructure, and I think that having a good financial infrastructure is a prerequisite for exchange rate flexibility rather than the reverse.
Also aggregating employment figures over 16 years during which the Chinese economy has undergone some massive changes makes no since to me. During 1998-2002, China was shedding large numbers of jobs due to SOE reforms. Since 2003, job growth has picked up markedly. There are also data quality issues. There is reason to believe that most of the new employment exists in service sectors that aren’t being reflected in the statistics.
One other thing. China funding the United States drastically reduces the possibility of some of the shocks to the Chinese economy. Funding the US budget deficit means that China has to worry less about trade sanctions due to human rights, an extremely assertive US position on Taiwan, a new Cold War, or that China’s sources of oil will get cut. The economic literature tends not to consider political factors in Chinese economic decision making, but these are small issues.
Rising China Sphere of Influence at U.S. Expense across Southeast Asian region
http://www.bloomberg.com/apps/news?pid=20601039&refer=columnist_pesek&sid=aTDisJBzTkY8
U.S. complacency toward Asia is enabling China to make greater inroads into a region that once was near the top of America’s commercial and foreign-policy agendas. At the moment, China is investing in Asia and becoming a viable trading partner where the U.S. once dominated. Supporters will say Bush and Rice are distracted by events in Iraq. Yet that’s just the point. Bush’s foreign-policy blunders are taking energy and attention away from where they should be.
The region, let’s remember, holds massive amounts of Treasuries, reducing U.S. interest rates. It boasts many of the most lucrative markets and is home to a number of geopolitically vital nations with which the U.S. should be building deeper ties.
Such inattention has enabled China to fill the void. ASEAN Secretary-General Ong Keng Yong says a free-trade agreement with China is on track to be completed in 2010. The U.S., by contrast, “is terribly distracted by other things,” Ong says.
It’s odd, really. U.S. officials are increasingly worried about China’s military spending and global aspirations. This week’s 27-member ASEAN Regional Forum offers a perfect opportunity to engage Asia. Instead, the U.S. is essentially forfeiting the event to an ascendant China.
When the Bush administration has engaged Asia it has been all terrorism all the time. Security is important to Asians, though it’s hardly the main issue on their minds. Most care just as much about raising living standards. And the entire U.S. Treasury seems to have become an all-China-all-the-time operation. It’s obsessed with the yuan at the expense of all else in Asia.
Also, China has dropped the peg. China dropped the peg a while back.
re: “China dropped the peg” - my understanding is not enough to make a meaningful difference - that it is not exactly ‘floating’ either, but perhaps this points to the problem of ambiguous terms.
re: “financial infrastructure is a prerequisite for exchange rate flexibility” - I understood part of the problem was China’s lack of a developed derivatives exchange (?) That being said, whether I am the only one who is wondering if or how Hong Kong, which presumably has a relatively well developed financial infrastructure, - or internationally diversified entities like Hutchison and family foundations - may further distort the picture.
re: “most of the new employment exists in service sectors that aren’t being reflected in the statistics” - might this also be a problem with U.S. statistics which may not (adequately) capture sectors like education: http://chronicle.com/temp/reprint.php?id=t2gfjwy0ywbbpbm7c1w23dvbll8rwvqp
true china dropped the peg, but it basically replaced it with a slow (tho variable) crawl rather than a real basket, and it gets teiresome to always write out the details … i often use de facto peg as shorthand.
jkh — depositor withdraws funds from banks. banks draw down cash balance (fewer assets), deposit gets cash (in rmb). rmb is traded for $ at central bank. PBoC reduces its assets and liabilities. net result — smaller banking system (fewer assets and liabilities), smaller PBoC balance sheet, and more foreign assets held by chinese residents/ less by chinese state. and if fewer deposits go into the banking sytem, doesn’t lending growth need to slow (assuming the banks don’t have lots of excess liquidity)?
“PBC can compensate for the contraction of the monetary base by selling sterilization bonds, …”
Should have said “buying back” instead of “selling”, of course.
Brad, Can you explain me how its apt to discuss about China when this subprime mess is making people throw up here in the USA ? Or this blog only for china ?
Brad -
I agree with your example - the PBOC and system balance sheets both shrink in size.
This includes a decline in the domestic monetary base by the same amount - PBOC FX reserves decline, commercial bank deposits decline, and commercial bank reserves with PBOC decline (as the mode of inter-bank funds payment for the FX transaction).
So, other things equal, just as PBOC has successfully sterilized much of its reserve accumulation, it would reverse the monetary tightening that results from the sale of reserves back to the private system.
It would do this by buying assets. I don’t know what flexibility it has to buy assets from the private sector (e.g. through investment dealers), but if it did so, it would restore the level of deposits in the banking system to the previous level.
More likely, I might guess, it could repurchase sterilization bills from the banks. This would restore the base level, but would not affect deposits (only affecting the commercial bank asset side, replacing bills with reserves).
So after this operation, the net change in the banking system balance sheet would be a reduction in deposit liabilities and sterilization bill assets.
If the base and reserves are essentially restored to their original level by PCOC, the banking system can drive on with lending activity based on this. The net effect as intended by PBOC in this case should be pretty neutral on the banks in terms of their perception of their own liquidity and capital adequacy and their capacity to continue to lend.
(At the macro level, credit creation is driven by capital adequacy and reasonable liquidity circumstances, including system reserve levels as supplied by the central bank. Also at the macro level, aggregate system deposit levels are a secondary aspect in the propensity for marginal credit creation. In fact, marginal credit creation is the source of marginal deposit creation for the system as a whole.)
Otherwise, as in your example, the PBOC’s facilitation of private capital outflows results in a domestic monetary tightening, which shouldn’t necessarily reflect the intention of the central bank. These are essentially two separate operational and policy decisions. And if the issue under discussion is the risk that capital outflows pose for the domestic banking system, it seems unlikely that the central bank systematically and simultaneously pursue domestic tightening as a result of supplying dollars for outflow, thereby exacerbating such risk for the banking system.
Finally, in your example, PBOC is assumed to be the natural supplier of dollars to facilitate the FX required for expanded capital outflows. This makes sense in that it relieves pressure from PBOC to recycle all the dollars, as is the partial intent of allowing more liberal capital outflows. It seems to make sense directionally whether the FX rate continues to be inflexible or becomes more flexible.
In my example, I assumed a broader program of capital outflow liberalization, wherein domestic participants would have the freedom to source dollars elsewhere. Hence my example where RMB are sold to a foreign private sector participant, ultimately resulting in an RMB denominated capital inflow to China, offsetting a dollar denominated capital outflow. In other words, I assumed a marginal capital outflow transaction completely independent of the influence of marginal PBOC activity.
EP — i try to blog about things that I understand/ follow/ and so on — and i don’t have anything particularly insightful to say about subprime. plus i try not to blog on the same things as NR, and he sort of has focused on subprime/ the US. is there any thing in particular you think we should discuss?
jkh — agree. if the pboc wanted to avoid a liquidity contraction, it could. but a scenario where inflows into china finance outflows is very different than the one eswar envisions. he is focusing on a scenario where there is a net outflow (or private funds) out of cHina, an outflow that either is financed by a current account surplus or PBoC reserves.
DC your post is well taken. The stupid move into Iraq will prove both a financial as well as a strategic disaster for the USA far far worse than Vietnam. The consequences are just beginning to become apparent….to many but apparently not to Washington.
Brad writes: “true china dropped the peg, but it basically replaced it with a slow (tho variable) crawl rather than a real basket, and it gets teiresome to always write out the details … i often use de facto peg as shorthand.”
You are right, but what you say is pretty much the answer to the question raised here many times, namely whether a revaluation/non-revaluation hurts or helps China. The answer is, that they will not do a sharp revaluation. What they do and I think will do for many years is a constant 5%/year appreciation vs. the dollar. That is far the best thing they can do. You can say that this is not enough, because it is not really an appreciation against e.g. the euro. That is true, but it will be the problem of the EU. When the euro-area current account starts to have a deficit, or the whole EU’s current account deficit becomes too large, the EU will make steps to weaken the euro against the dollar.
“Indeed, with oil at $80, it would seem that China has a particularly strong incentive to revalue now.”
But you often argue that China’s foreign trade surplus is too high. A 80$ oil and a non-revalued yuan will just decrease that surplus. So, no problem for China.
From Bloomberg.com,
“The U.S. is urging China’s central bank to buy more mortgage-backed securities after a surge in defaults by risky borrowers in the world’s largest economy eroded demand for such instruments.”
“Nobody wants these securities, as they are so default-prone that they are known in the industry itself as “toxic waste”, and now we are reduced to begging the Chinese to buy them, to bail out the market, to bail out investors, to bail out the American banks who created the mess, and to bail out the U.S. government, which is watching in horror as trillions and trillions of dollars in losses seem destined to be deducted from taxable incomes!”
“The official story is that U.S. Department of Housing and Urban Development Secretary Alphonso Jackson is “in Beijing to persuade the Chinese central bank to buy more mortgage securities from Ginnie Mae, a mortgage association under the Housing Department.”
“But the cold reality is that an arrogant, bullying United States is not there to “persuade” the Chinese to do anything, but we are there instead to cram these crappy bonds down their throats, as Mr. Jackson himself said, “It’s not a matter whether they’re going to do more business in mortgage-backed securities, it’s who they’re going to do business with.”
re: “this subprime mess is making people throw up here in the USA”
really - and only in the USA? if so, perhaps because far too much attention may already be focused on that one issue, along with the war in Iraq.
is it possible to make a credible guess about the amount of money that is betting on a rapid, upward RMB revaluation - along with the potential profits, in different increments based on any credible estimate of the full extent of the gain required to ‘fix’ the ‘problem’ - or how the profits associated with such a gain may be allocated (i.e. assuming the revaluation bets have been placed by any number of players both in and outside of China)?
2007-08-01 12:59:05 - in other words, you read, recite, and believe, word-for-word, everything written in the U.S./ ‘Western press’.
The bill to raise the value of the yuan might pass
guest — in the ndf market for everyone betting the rmb will rise father than implied by the forward price, someone is betting that the rmb will rise by less. and in principle, both parties are foreigners — so one wins/ one loses. There is no there there in my view. those who are betting the most on an rmb reval are chinese domestic savers, who seem inclined to hold rmb assets rather than $ assets. mncs are betting against an rmb appreciation — at least so long as they are betting on china as an export platform.
guest who sounds like DC. Ginnie Maes have no default risk. they are i think fully backed by the government (v. jsut the halo around fanny and freddy) — others pls correct me if i am wrong. I don’t think jackson should be a travelling salesman, but i also don’t think he was peddling toxic waste (the crappy tranches of MBS), only an alternative to relatively safe “Agency” bonds.
as a reference to the 2007-08-01 12:59:05 ‘quote’ was omitted, it is likely adulterated, if not entirely fabricated.
I’m thinking about USD mortgages invested in Chinese real estate, and whether it may also be possible to borrow in USD, convert to RMB and buy shares in the Shanghai exchange.
Whether or not it is to become more or less relevant to central banking, if gold merits more attention, given its past correlation with the price of oil, what appears to be an ongoing delay in the decision about what is to happen with the IMF’s gold reserves, and stories of Asian buying and central bank selling: “…The very idea of having gold reserves is left over from the 19th century…” http://www.ft.com/cms/s/1a0466f6-3ffd-11dc-9d0c-0000779fd2ac.html
anonymous guest — if you want to share how you think you would get around china’s capital controls as part of your “borrow against your US home to buy Chinese stocks scheme) please do …. otherwise, i would suggest that you are thinking about something that isn’t possible.
gold alas isn’t relevant here — this is a post about the domestic consequences of china’s peg.
I would like to see a bit more discussion of how the peg impacts employment — Prasad suggests that it is a net negative, as the jobs lost (or not created) due to the substitution of capital for labor trump jobs gained in the export sector.
Guest: The type of mortgage backed securities that HUD is selling and that China are buying have nothing to do with sub-prime. Ginnie Maes in fact are obligations of the US Federal government and are probably one of the safest investments you can buy.
Right now no one in China is worried too much about deflation or a credit crunch. The worry is that there has been a spike in prices recently, and the government has relaxed capital export controls in order to convince people to move assets overseas.
Guest: I’m thinking about USD mortgages invested in Chinese real estate, and whether it may also be possible to borrow in USD, convert to RMB and buy shares in the Shanghai exchange.
Not that hard to convert USD to RMB and buy A shares or real estate. The hard part is when you’ve made your money, and you want to government back to USD. If you have USD and you want to play the Shanghai markets, you are better off buying B-shares or H-shares.
Prasad’s argument is that peg -(1)-> low interest rates -(2)-> excess capital substitution -(3)-> low employment
I disagree with link 1. I don’t think capital investment in China is excessive so I disagree with link 2. As far as link 3, I disagree both on theoretical and empirical grounds. To justify link 3), Prasad averages across too many years, some in which job growth was low because of SOE-reform and the business cycle.
Also, what seems to be happening is that capital investment doesn’t increase industrial employment, but it boosts industrial income, which results in service jobs, which is what seems to be happening if you look at the last two entries of table 1 in Prasad’s paper.
The other chain I disagree with is peg -> low interest rates -> lack of monetary controls -> use of administrative controls -> lack of financial reforms
The problem with this chain is that the administrative controls that the government uses to control the economy don’t consist (for the most part) of credit limits and orders to the bank on where to lend to. They are mostly orders to state owned enterprises to increase or decrease spending.
Also the reason that the Chinese government has a “no dividend” policy isn’t related to the peg. The trouble is that if you issue dividends and you don’t put the right controls in place, what will happen is that the management and local governments will issue “dividends” to themselves and basically loot the company. (This has happened before.) Also, if you aren’t careful, you might have dividends effectively punish well run companies and reward badly run ones (i.e. you made a profit, great!!!! hand over the money).
“domestic consequences of china’s (crawling) peg” to the USD, which historically has been correlated with the price of gold. Chinese citizens, historically, having the reputation of holding (at least some part of their) savings in gold.
“a bit more discussion of how the peg impacts employment” - you’re ignoring Twofish’s comment
Thank you Twofish 2007-08-01 15:51:05 for understanding and responding to my question
China’s very large FX reserves are common knowledge. Also striking is the relatively small size of China’s total international investment position, in gross balance sheet terms (Prasad - table 5).
2006 reserves were $ 1.1 trillion.
Total foreign assets (including reserves) were $ 1.6 trillion; total liabilities $ 1.1 trillion.
These asset-liability positions relate to a GDP approaching $ 3 trillion.
By comparison, the gross balance sheet size of the US international position handily exceeds 100 per cent of GDP for both assets and liabilities.
And even with it’s large CA deficit, the US net liability position is a much smaller proportion of the US gross position than China’s net asset position is of its gross position.
For China, the relatively small gross balance sheet size, the large reserve share, and the large net position share all seem consistent with underdevelopment of a financial intermediation function. It’s another perspective on the striking disproportion of FX reserves. With eventual liberalization of capital outflows, some of the reserve position might shift to privately held foreign assets, and additional size and depth might be developed in the foreign asset-liability position.
In addition to subsidizing exports via the FX rate, it seems that in maintaining the peg, China is also subsidizing investment via lower domestic interest rates and a lower cost of capital. That seems consistent with promoting capital deepening, at the expense of less employment growth. And investment is 40 per cent of GDP - I think that’s close to twice the world average.
Brad,
Yes GNMA is backed by the full faith and credit of the US.
jkh,
See Twofish’s comment: while capital deepening might anti-correlate with manufacturing job growth, it doesn’t necessarily impede service job growth.
Also jkh, what is the causality link between the (pseudo) peg and low cost of capital. I’d argue it is preference of saving over current consumption and control of capital outflow that keeps the cost of capital low.
BTW low return on capital for households don’t mean households are completely on the losing ends. It is just a different bargain. Let’s take Japan as an example: it also had (and still has) perennially low cost of capital, but households also benefited from the high growth and job security. Obviously this won’t work forever. Witness the stagnation in Japan for the last decade and half. But China is far from having to worry about the Japanese problem of find a new path after the development has matured.
China’s path forward is very easily mapped for decades to come: urbanization. Fx is much more a trade issue than a domestic issue. Does anyone think low exchange rate so far has slowed down the urbanization? I don’t see how it could be any faster.
Fixed exchange rates impede independent domestic monetary policy - low rates rather than high rates are generally consistent with maintaining an undervalued currency. The ‘peg’ is associated with capital outflow controls - also consistent with lower rather than higher domestic rates. The central bank has an interest in economizing on the cost of sterilization requirements due to the peg - also consistent with lower rather than higher rates.
limiting real appreciation in the context of the peg has also led to a relatively restrictive fiscal policy and i think a significant rise in government savings — also consistent with lower rather than higher rates.
expectations of rmb appreciation also have something to do with chinese savers willingness to hold funds in the banks at low nominal and now low real rates.
jkh: The ‘peg’ is associated with capital outflow controls
There certainly is an association, but I think the dispute is what the association is. In my view, successful economic reforms has caused China to move from a capital poor situation to a capital rich situation, and the existence of outdated capital outflow controls puts pressure on the RMB to be overvalued. Weakening outflow controls would make it much easier to avoid appreciating the currency.
bsetser: a relatively restrictive fiscal policy and i think a significant rise in government savings
I’d argue that the restrictive fiscal policy came about for other reasons (mainly a desire to increase governmental efficiency and reduce corruption). As with the rise in SOE savings, the rise in government savings was due to success in reforming the tax system.
jkh: China is also subsidizing investment via lower domestic interest rates and a lower cost of capital.
I’d argue that the low cost of capital in China shouldn’t be thought of as subsidies. One important fact is that no one is forcing Mr. Chen to save money rather than to spent it. The distinction is important because “forced savings for development” leads to shortages in consumer goods typical of command economies.
jkh: And investment is 40 per cent of GDP - I think that’s close to twice the world average.
Personally, I don’t think that China is overinvesting. The problem with comparisons with world averages is that they really don’t tell you very much. Maybe China should be investing 80% of its GDP? The number that suggests to me that China isn’t overinvesting is return on capital, which remains high despite the large capital investments.
bsetser: expectations of rmb appreciation also have something to do with chinese savers willingness to hold funds in the banks at low nominal and now low real rates.
I really don’t think so. Chinese savers hold funds in banks because it is easier than putting the money in mattresses and coffee cans (which people do by the way). To the consumer, Chinese banks are more “cash storage agencies” than places where anyone expects to make money. You don’t make money by putting money in a bank, but you don’t lose money either. You use a bank as a checking account to store your money that you invest by starting your own business or the business of your brother-in-law.
One thing that I find fascinating in finance is how this thing called a “bank” does radically different things in different countries.
Also I don’t think that in general the cost of capital in China is low. It certainly is if you are a SOE, then the cost of capital is quite high. (One should note that in China, SOE is a particular corporate form, and there are lots of state-owned companies which aren’t SOE’s and which would have trouble getting capital. There is a lot of economic literature which confuses “state-owned enterprises” from enterprises which are state-owned.)
There is also an interesting feedback cycle. SOE gets low cost capital. This low cost capital is then invested in something that makes a lot of money. The result is corporate profit which keeps the cost of capital low and allows further investment.
Someone asked about Hong Kong. There is a lot of economic talent in Hong Kong, which can’t be effectively used right now in the Mainland Chinese economy because of capital controls. Hong Kong is “outside the wall” right now, which is a huge incentive for Beijing to make the RMB more convertible. One thing about currency rules. If you are running a manufacturing company or are a business tycoon, you can play fast and loose with currency rules. If you are trying to do investment banking or run a mutual fund, you can’t.
The interesting story which will be “tomorrow’s headline” is how Taiwan fits into all of this.
One good thing is that I think there is now a scenario where everything can end nicely. What has spooked people in the Chinese economic press is the high (by Chinese standards) inflation figured (4% y/y) for June.
The conventional wisdom is that this is because China is importing too much money and that the limits of sterilization has been reached. The alternate scenario is that these numbers are just a blip due to pork ear diseases. If the July figures show a high CPI, then what is likely to happen is that the PBC is going to take more aggressive measures to cool the economy which include easing capital outflow restrictions and increasing the rate of RMB appreciation.
I should point out that one common theme in all of this is the idea of “catastrophe success.” All of the problems I see now are because the last round of reforms, worked. In this I think that Prasad’s paper is asking the wrong question. The interesting question to me is not “Can the Chinese boom continue?” but what are the problems that will come out if China does everything right and the boom *does* continue.
Twofish:”I don’t think capital investment in China is excessive; I don”t think China is overinvesting” China’s steel industry is Balkanized; from 3551 steel firms in 2002 to almost 7000 today; 35% of the global market; obviously capital and energy (and pollution) intensive;much the same story for aluminum, paper, pulp, glass, cement, chemicals and automobiles - last I looked over 100 “brands” of Chinese automobile.
Twofish: “You don’t make money by putting money in a bank, but you don’t lose money either.” But of course you (the vast majority of Chinese people) do; they basically subsidize the above list of SOEs
looking at the Dave Chiang on 2007-08-01 09:42:14 version of the Pesek article ‘quoted’ above, here’s how it reads, as written by Pesek, starting mid-paragraph with:
“…U.S. complacency toward Asia is enabling China to make greater inroads into a region that once was near the top of America’s commercial and foreign-policy agendas. China has been beset by bad public relations of late. Its product-safety scandal is a case in point. So are concerns that worsening pollution will derail the economy. And then, there are the actual growth figures. China advanced 11.9 percent in the second quarter, fanning concerns about overheating…”
and moving on through:
“…Asia’s No. 2 economy faces daunting - and growing - risks. China needs rapid growth to reduce poverty and dispose of bad loans in the banking system, while also cooling things down to avoid inflation and asset bubbles. It must keep pollution from overwhelming its outlook and figure out how to build a market economy while limiting free expression. Lots could go wrong in China…”
before arriving at: “…At the moment, China is investing in Asia…”
http://www.bloomberg.com/apps/news?pid=20601039&refer=columnist_pesek&sid=aTDisJBzTkY8
An excerpt of Pesek’s most recent piece is here:
“…Anytime the yen does rise, Japanese officials begin talking about “unnatural moves” in markets. Then comes the “watching trends closely” warning: In other words, “back off” to anyone tempted to buy the yen. Having raised verbal intervention to an art form, Japan no longer needs to intervene. China, of course, does - as evidenced by its more than $1.3 trillion of currency reserves. The difference is that China makes no bones about its desire for a competitive exchange rate; Japan disingenuously claims it lets market forces set the yen’s value. If that’s the case, Tokyo should just shut up and prove it. Then, China would have fewer excuses to hold down its own currency…” http://www.bloomberg.com/apps/news?pid=20601039&sid=a2gGHsGjvQBk&refer=columnist_pesek
Any stats on service industry employment growth in China - such as tourism, financial services and the professions that support it - should be enlightening - although presumably much of that depends on resolution of the risks described by Pesek.
Qingdao: China’s steel industry is Balkanized; from 3551 steel firms in 2002 to almost 7000 today; 35% of the global market; obviously capital and energy (and pollution) intensive;much the same story for aluminum, paper, pulp, glass, cement, chemicals and automobiles - last I looked over 100 “brands” of Chinese automobile.
So investing in raw materials is a bad idea because of overproduction issues. It doesn’t follow from this that China has too much capital investment. China may have too much steel, but it has too few of other capital items (like roads and factories).
The way you tell is by looking at capital return. Capital returns on steel have been falling. Returns on capital in general have not.
The other point is that China has a lot of steel factories and a lot of automobile brands, but most of them are tiny. One thing that will happen in the next three to five years is massive mergers and accquisition activity.
Qingdao: “You don’t make money by putting money in a bank, but you don’t lose money either.” But of course you (the vast majority of Chinese people) do; they basically subsidize the above list of SOEs
Not anymore. That problem has been fixed.
Twofish:
Thanks for feedback.
I’m assuming capital outflow controls are associated with lower rates and a lower domestic cost of capital, because there is less global price competition for domestic sources of financing.
The Prasad paper argues that capital outflow controls are the riskiest component in the set of China’s current monetary arrangements. He prescribes that FX rates should become flexible, but liberalizing capital outflow controls should be done more slowly. Controls add to the task of current FX intervention, but the risk in their abrupt removal is that if the FX rate becomes more highly valued and/or more flexible in future, it would be exposed to more downside volatility risk.
I agree that averages are as useful or useless as their interpretation. I don’t know if China is over-investing or not. Perhaps it is fully compatible with the massive population and employment challenges they face. But, as part of a trifecta of high investment, high saving, and high current account surplus relative to GDP, it is unusual. Perhaps B. Setser can confirm, but I believe the global investment share of global GDP is around 24 per cent or so - and only mildly volatile through economic cycles. So I suspect China is a number of standard deviations away from the global average - in the ‘head in the oven’ zone of observations. It may well be explainable, but it says something about imbalances and challenges.
re: “guest who sounds like DC. Ginnie Maes have no default risk. they are i think fully backed by the government…”
Presume this is the Bloomberg’s version:
“The Bush administration is urging China’s central bank to buy more government-backed mortgage bonds in an effort to sustain financing for U.S. home loans. U.S. Department of Housing and Urban Development Secretary Alphonso Jackson is in Beijing to persuade the Chinese central bank to buy more securities from Ginnie Mae, a corporation under HUD that guarantees $417 billion in federally insured, fixed-rate mortgages. “It’s not a matter of whether they’re going to do more business in mortgage-backed securities,” Jackson told reporters in Beijing. “It’s who they’re going to do business with.” HUD aims to tap China’s $1.33 trillion of foreign-currency reserves…” http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aE7I.0mnjrSY
If information about China’s media industry may also be instructive.
‘Murdoch’s dealings in China: Building personal ties for business’ http://www.iht.com/articles/2007/06/26/business/murdoch27.php
‘Wife and Ex-Wife Now Shape News Corp.’s Fate’ -”…underlying tension is growing over eventual control of the News Corporation, the globe-spanning media company that Mr. Murdoch has built over four decades, with Ms. Deng and Mrs. Mann playing crucial roles…” http://www.nytimes.com/2005/08/02/business/media/02murdoch.html?ex=1280635200&en=5c789c6ad6150e79&ei=5088&partner=rssnyt&emc=rss
“…Dow Jones now has more than 10,000 indexes, spanning 58 countries and covering commodities and hedge funds along with stocks, according to its Web site. The company calculates and markets indexes created by Wilshire Associates, including the Dow Jones Wilshire 5000, the broadest gauge of U.S. stocks. The company also has a one-third stake in Stoxx Ltd., a joint venture with the owners of the German and Swiss stock exchanges that calculates pan-European indexes… Murdoch’s News Corp. stands to reap benefits of future growth once his $60-a-share offer for Dow Jones succeeds…” http://www.bloomberg.com/apps/news?pid=20601039&sid=a.rxtlMQubE8&refer=home
One other thing. It’s in discussions like this that nit picky details start becoming important. For example, most steel and automakers are “state owned enterprises”, but most glass and cement makers are “collective enterprises.” They are enterprises which are “state-owned” but they aren’t legally SOE’s.
The reason *that* distinction is important, is that SOE’s have access to easy bank credit from the big state banks, but collective enterprises don’t.
Maintaining the peg, in Dr. Prasad’s view, impedes China’s ability to achieve many of the Chinese government’s stated goals
Stated goals vs real goals?
It is great to be a capitalist in communist china!!
Twofish: “Not anymore.” The benchrate deposit rate is 3.33%; June CPI: 4.4%. Am I missing something?
Qingdao: The SOE sector is now profitable and bank deposits are no longer used to fund losses in SOE’s. Most SOE funding in fact, no longer come from banks but rather from internal funds.
Most bank funding of SOE’s involved social service programs which have either been shut down or are now funded from other sources such as direct government revenues.
Even a lot of the funding for the SOE’s ultimately didn’t come from personal savers. Keeping the SOE’s afloat led to bad loans and insolvent banks. In order to keep the banks afloat, much (probably about a third) of the $500 billion in bad loans ultimately was funded by the Chinese government when it recapitalized the banks. OK, putting money in a bank account, you might lose 2%/year due to inflation. Put it into a stock or real estate, and you could easily lose 90%.
And from the point of view of an SOE employee, losing 100% of their income in exchange for a few extra percentage points on their bank account is a really, really bad deal.
I think what is happening a lot is that people look at a situation and are making assumptions based on what happened in the Soviet Union or Japan or what was happening in China in 1998, and those assumptions may not be valid.
What I’m arguing is that a lot of the problem is that circumstances have changed, and institutions haven’t quite yet adapted. I’m also arguing that too much of the economics literature is still thinking about scenarios in which “China fails” and not thinking enough about the real problems (energy issues, nationalistic backlash, environmental issues) that exists if “China succeeds.”
Also, before anyone asks here is a link to my assertions about the sources of investment in China.
http://www.imf.org/external/pubs/ft/wp/2006/wp06265.pdf
Bank loans haven’t been a huge driver for recent capital investment in China.
Sounds like you may be disagreeing with Pesek on all counts, including this view:
“…”Asia’s equity markets have gone as far as they can go without a real bond market… livelier debt markets would reduce companies’ reliance on banks for loans, making for more- efficient allocation of wealth and risk. Asia also is facing another “mismatch” scenario, de Boursac said. In 1997, the region imploded because plunging markets created a mismatch between exchange rates and foreign-currency debt payments… The creation of pan-Asian bond funds is making it easier to buy debt without the hassle of dealing directly with individual countries and issuers… Such efforts will have two big payoffs in the long run… they will help Asia bring home some, if not all, of the trillions of dollars of savings parked overseas in assets such as U.S. Treasuries… The trouble is, Asia could use those benefits now. Countless companies that now borrow from banks would prefer to tap the capital markets for financing. Governments often crowd out private issuers. Asia has been slow to create the kinds of non-government markets like ones for mortgage-and asset-backed securities. Hedging investment positions can also be a challenge…”
http://www.bloomberg.com/apps/news?pid=20601039&sid=aNUIfY78VqV8&refer=columnist_pesek
and agreeing the DBRS: “…”There has been a lot of over-reaction in the market,” said Alan Reid, a DBRS managing director of U.S. financial institutions in New York. “We do not expect wholesale downgrades of banks with exposure to subprime.”…” http://www.reuters.com/article/fundsFundsNews/idUSN0223320120070802
Pesek is right that a corporate bond market would be a wonderful thing to have. Now all we have to do is to wave a magic wand, wish really hard, and one will come into existence….. Not that easy….