Brad Setser

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Cross border flows, with a bit of macroeconomics

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China’s Dual Equilibria

by Brad Setser
November 28, 2016


A couple of weeks ago, Daokai (David) Li argued that the “right” exchange rate for China isn’t clearly determined by China’s fundamentals. Or rather that two different exchange rates could prove to be consistent with China’s fundamentals.

“Currently, the yuan exchange rate regime yields multiple equilibrium. When we expect the yuan to depreciate, investors will exchange large amounts of yuan into dollars, causing massive capital outflow and further depreciation. If we expect the yuan to remain stable, cross-border capital flow and the exchange rate will be relatively stable. The subtlety that causes the equilibrium is that liquidity in China is the highest in the world. If there is any sign of change in exchange rate expectations, the huge liquidity in the yuan translates into pressure on cross-border capital flows.”

If China’s residents retain confidence in the currency and do not run into foreign assets, China’s ongoing trade surplus should support the currency at roughly its current level.

Conversely, if Chinese residents lose confidence in the yuan, outflows will overwhelm China’s reserves—unless China’s financial version of the great firewall (i.e. capital controls) can hold back the tide.

I took note of Dr. Li’s argument because it sounds similar to an argument that I have been making.*

I would argue that there aren’t just multiple possible exchange rate equilibria for China, there are also at least two different possible macroeconomic equilibria.

In the “strong” yuan equilibrium, outflows are kept at a level that China can support out of its current goods trade surplus (roughly 5 percent of GDP), which translates to a current account surplus of around 2.5 percent of GDP right now, though it seems likely to me that an inflated tourism deficit has artificially suppressed China’s current account surplus and the real surplus is a bit higher.**

In this equilibrium, a larger “on-budget” central government fiscal deficit—together with an expansion of social insurance—keep demand up, even as investment falls.

In the “weak” yuan equilibrium, China lets the market drive its currency lower—and a weaker currency increases the trade and current account surplus. Such surpluses would finance sustained capital outflows in excess of half a trillion dollars a year without the need to dip further into China’s reserves.

The resulting surpluses would be shockingly large—especially for an era where popular support for trade is somewhat lacking. For example, a 15 to 20 percent depreciation in the yuan—on top of the 10 percent depreciation that has already occurred over the last year —would reasonably be expected to push China’s goods surplus from its current level of around $525 billion dollars (balance of payments basis) to say somewhere between $800 billion and a trillion dollars. The rule of thumb based on China’s own experience and the IMF’s cross country work is that a 10 percent move in the yuan raises/lowers the trade balance by between 1.5 and 2 percentage points of GDP —with a parallel shift up in China’s current account surplus.

That large goods surplus would finance both tourism imports and capital outflows …

And, of course, a larger trade surplus would also provide support for the economy. As investment slows, China would in effect pivot back to exports – and it wouldn’t need to use the central government’s fiscal space to support demand.

Both are plausible outcomes.

The strong yuan equilibrium is obviously better for the world than the weak yuan equilibrium in the short-run. And, I suspect, in the long-run. In part because a weak currency today creates political pressures that tend to keep the currency weak tomorrow.

That at least is my read of China’s experience with a “weak” currency in the mid 2000s. After 2000—and particularly after 2002— the yuan followed the dollar down, depreciating 13 percent in real terms from 2001 to 2005. That depreciation coincided with WTO entry, and gave rise to one of the most spectacular export booms ever. And the surge in exports created a set of interests that were vested in keeping the currency weak.

The policy mandarins feel pressure from the export sector to avoid appreciation. And, so long as exports (and import substitution—which is likely to be nearly as significant in China’s case going forward) keep the economy humming, they do not feel pressure to take the politically difficult decisions needed to provide visible on-budget fiscal stimulus and to build a stronger social insurance system. Exporting savings through large current account surpluses substitutes for reforms that would lower China’s high levels of national savings.

I think something like this also happened in Korea after the won depreciated in 2008 and 2009.

Korea’s exports responded to the weaker won. Autos notably. Subsequently there was pressure to keep the won weak, by intervention if necessary (concerns about currency volatility tend to be more pronounced when the won is strengthening).

The modern way to maintain an undervalued currency isn’t to intervene to weaken your currency.

It is to step back and allow the market to drive your currency down–

And then intervene to resist subsequent pressure to appreciate (and rebuild reserves) when the market turns.

In countries that have a history of managing their currencies and strong export sectors, cyclical currency weakness can turn into permanent currency weakness. Call it the political economy of currency weakness.

* I have not always agreed with Dr. Li on currency issues, hence my surprise.
** My guess is that some of the tourism deficit is really hidden financial outflows. If that is the case, China’s true current account surplus is above 2.5 percent of GDP. I would guess that it is now around 3.5 percent of GDP—a number that implies that there tourism deficit includes about a percentage point of GDP in hidden financial outflows.


  • Posted by Savannah

    Quiet interesting opinion! never thought about it! UK exchange!

  • Posted by Felipe

    The exchange rate regime moves in a much faster fashion than the economy. The interplay of shorter and longer run effects would create a dynamic soft landing, in this case. Nice to see how it would unroll:
    So, for instance, in the case of the weak equilibrium, we would de a depreciation and drawdown on reserves on the short run, followed by a longer run reserves buildup from larger exports.

  • Posted by David O'Rear

    “The subtlety that causes the equilibrium is that liquidity in China is the highest in the world.”

    Really? Rmb liquidity is greater than USD?

    As for capital controls, I have often said that anyone who can’t seem to move money into or out of China isn’t really trying very hard.

  • Posted by Haitao Zhang

    Hello Brad,

    Good to find you blogging again after all these years. Alas it is back to Chinese reserve watching again!

    You were quite sore on PBOC reserve building last time we talked. How the tide has turned! What is in your opinion the right level of reserve holdings (if any) for the PBOC?

    I remember your concern about the potential black hole on PBOC’s balance sheet created by the interest differential of the reserve assets. Do you know how it is addressed? If the Yuan continues to depreciate the PBoC may even get a chance to remove that deficit?

    I remember arguing with you regarding the practicality of addressing the trade imbalance mainly through exchange rate adjustment. I was in favor of large wage increases and domestic inflation (through the service sector) to share the productivity gain of the tradable goods sector. I think that is how it largely worked out and despite the downsides it seems to have worked out okay.

    With regard to your post on the Reserve Puzzle about the mismatch between the settlement data and the reserve data, couldn’t it simply be that the Chinese nationals are buying USD in their onshore accounts?

    Best regards,