I talked to Bill and John about your thoughtful post on their FEERs work, and the discussion that ensued. There are 2 points that are worth sharing.

First, they would probably argue that at the most basic level, the problem is misdiagnosed, in that it is less about RMB-USD than USD:

a) The needed effective exchange rate appreciation of the RMB remains unchanged;

b) The needed effective depreciation of the dollar has become larger.

c) It follows directly that the needed bilateral change against the dollar is larger than before.

China’s greater need to appreciate against the dollar than before can be seen in this light as merely the mirror image of the US greater need to depreciate on an overall basis than before.

This is the meta-perspective that differs from your analysis.

Second, there may be one error in the numbers you lay out when you ask “How can a currency that has risen 14% against the dollar finish even more undervalued against the dollar?” The 14% increase was not against the dollar, it was the trade-weighted rise, most of which was from the rise of the dollar against other currencies; the rise against the dollar (from Feb 08 to Mar 09) was only 4.8 percent.

Finally, keep in mind John and Bill’s work is meant as a regular second-guessing of the Fund’s tracking of rates, not a China-assessment per se (though you can and do argue that they are close to the same!).

All best,
Dan Rosen

New bank loans worth about 1.16 trillion yuan (HK$1.32 trillion) on the mainland were invested in the stock market in the first five months of this year, China Business News reported, citing a government economist.

That was 20 per cent of the 5.8 trillion yuan in loans that banks extended in the period, Wei Jianing, a deputy director in the macroeconomics department of the Development and Research Centre under the State Council, was reported by the newspaper as saying.

The Shanghai Composite Index has rallied 63.41 per cent this year and is the world’s third-best performer. The market plunged a record 65.39 per cent last year.

Property sales in the country jumped 45.3 per cent to 1 trillion yuan in the first five months of the year, compared with a 19.5 per cent decline for all of last year, the statistics bureau said.

Record lending after the central bank scrapped loan quotas in November last year is helping the economy revive after its weakest growth in almost a decade.

Some new loans must have entered the nation’s stock and property markets in the first quarter, said Cheng Siwei, a former vice-chairman of the Standing Committee of the National People’s Congress.

About 2.4 trillion yuan worth of bank loans in that quarter were invested in projects, leaving a further 2.18 trillion yuan in new loans to be accounted for, Mr Cheng said.

“Where did it go? It is undeniable that a portion of the lending may have flowed into stock and real estate markets and triggered the rebound in these two markets,” he said.

A further 30 per cent of the loans in the first five months might have been used for discounted bill financing, or short-term credits used to fund working capital needs, China Business News said.

Peng Wensheng, an economist at Barclays Capital, said the rally in stocks and property was to be expected, given the size of the stimulus spending and the resultant bank loans.

Buy our products or accept our currency.

So, China should either buy products from the west, or accept whatever happens with the currencies in the west.

China has no justification for talking about new reserve currencies. If China wishes, they may buy gold for their entire currency reserve. But the west must never accept to have its debt to China denominated in gold or anything else than its own currency.

Buy our products, or accept our currency.

There are other options beyond those you list. They could use their excess production capacity to accumulate/build real assets within the country. Examples: 1) Infrastructure and public owned assets such as roads, bridges, power plants, pollution control improvements, electric distribution systems, hospitals, restoration and permanent improvements to government owned land, development of underdeveloped portions of the country. 2) Business assets. 3) Personal assets such as housing, improvements to privately owned land, automobiles, and other durable goods.

All of these examples (and more) represent accumulation of real wealth within the country. Unfortunately China has chosen to accumulate primary fiat currency or equivalents (US Treasury bonds) rather than use their excess production capacity to increase domestic consumption and accumulation of real wealth within China. This may or may not be a conscious decision but it is the outcome of their overall policies. The evidence I have seen on this blog and elsewhere suggests they are unwilling to change those policies on their own. It will likely take substantial external pressure to make it happen, such as imposition (or at least threat) of substantial protectionist measures by countries being damaged by their policies.

Options:
1) Purchase natural resources in other countries, thereby guaranteeing the country as a whole long-term benefits.

2) Stimulate private demand, i.e stimulate private imports. This would mean more welfare-optimized demand for individuals, however maybe suboptimised on a national level.

3) Continue speculating on the value of the dollar.

Increasing domestic lending leads to 1) or 2) depending on who gets the loans. The currency-peg leads to 3).

For the outside world it is irrelevant whether China purchases copper due to real demand or due to speculation. It is just important that China purchases something, thereby avoiding a huge debt imbalance (be it nominal/perceived or real, the effect is negative).

Thank you for you continuing updates. I have a question regarding the “implicit” government backing for this stimulus lending. I think as I have mentioned before, the “commercial” state owned banks are being very outspoken about how their lending doesn’t need guarantees – implicit or otherwise – and follows their own “strict” guidelines.

In what way would you say that the lending has an implicit guarantee? IS it that the government wouldn’t allow a bank to fail…hence the lending is guaranteed? (on this point i think this is not necessarily true for local city banks) OR is it contained in a logical argument – the government demanded stimulus lending, the (supposedly non-policy) banks responded, hence the government was always expecting to back up at least some of the lending?

Sorry to be a bit fuzzy in my question