It is a real toss-up as to which generates more bizarre comment in the international press: Beijing’s long-feared dumping of US Treasuries, or the use and value of the PBoC’s central bank reserves.  The revelation last week that Chinese holdings of US Treasury obligations fell in December by $34.2 billion, to $755.4 billion, generated a frisson of fear and excitement, leading one prominent newspaper to worry that “If there is one thing that gets investors twitchy, it is the fear that China is losing its appetite for US government bonds.”

And shouldn’t they get twitchy?  After all this reduction in Chinese holdings of Treasury bonds comes from the USG’s TIC data, so it must be true that China is dumping dollars, right?

No need to twitch, it means no such thing.  First of all, the data from which this was derived indicates national ownership of USG bonds only to the extent that foreigners are directly registered holders.  It says nothing about what happened to the large amount of bonds held by the PBoC and other Chinese investors indirectly or in street names. Those could have easily gone up by more than the reduction in bonds directly held by Chinese investors in their own name.  If the PBoC had let maturing Treasury bonds get repaid, for example, and reinvested the proceeds into the USG bond market through another account, or in a street name, its total holdings would have actually increased even though its registered holdings would have declined.

More importantly, the TIC numbers completely fail to disclose whether China’s reduced holding of USG bonds was matched by increased holding of other dollar assets, thereby increasing the pool of capital available to fund USG bonds by an amount equal to its reduced Treasury holdings.  If Chinese investors decide to take on more risk, for example, they might sell USG bonds and use the proceeds to buy corporate bonds.  Of course the seller of these corporate bonds will then have cash, which must be put to work, and ultimately this ends up back in the USG bond market.

China did not reduce its dollar holdings

So was China a net seller of dollar assets in December?  Almost certainly not.  Just look at the PBoC balance sheet.  PBoC reserves rose in December by $61.3 billion, of which $39.0 billion was the trade surplus.

Remember that China has a large current account surplus which necessarily must be recycled abroad, and the US has a large current account deficit which necessarily must be funded abroad. It would be astonishing if, under these circumstances, total Chinese holdings of USD assets declined, and of course it is impossible that they declined faster than the willingness of other foreigners to replace them.

Of course if the US current account deficit declines, net new foreign purchases must by definition decline too.  If the US wants its current account deficit to decline so that the USG can reduce the fiscal spending needed to generate any fixed number of jobs, this cannot possibly happen without a concomitant decline in net foreign, including Chinese, purchases of dollar assets.  But it need not result in any difficulty in funding the new, lower amount of debt issuance.  Depending on why it happens, reduced purchases by foreigners should probably be seen as a good thing for the US Treasury market, not a bad thing.

Confused?  How can a reduction in foreign purchases help the USG fund its massive fiscal deficit?  Because the purpose of the fiscal deficit is to create jobs in the US by boosting US spending.  Since some of the jobs that higher USG spending creates will accrete outside the US, via demand that “leaks” abroad through the deficit and creates employment for foreign manufacturers, a smaller trade deficit can itself be expansionary for the economy.  That means the USG will need to borrow less to create the same number of jobs. Fear of Chinese “dumping” of US treasury bonds, even if it were possible, should be a non-issue, but since it plays easily into various geopolitical conspiracies, we seem to love to worry about it needlessly.

Among other strange comments the TIC data generated last week were those by the Financial Times, arguing that “if the latest numbers mark the beginnings of a diversification by China away from US Treasuries and other dollar assets, a widely speculated rise in the value of the renminbi against the dollar is on the cards.”  Aside from the fact that it marks the beginnings of no such thing, it still wouldn’t be an indication of any future RMB strategy.  A rise in the value of the RMB may very well be in the cards, but this has absolutely nothing to do with what Beijing did with its USG bond holdings in December.

Why?  Because if China had intervened less in December, the RMB would have already shot up – in December, not at some time in the near future.  Of course if the PBoC believes that a rise in the RMB will cause the dollar to fall against the euro, it might have swapped out of dollars into euros as a clever trade based on its inside knowledge of the RMB strategy, but since the opposite is almost certain to be the case, it is hard to believe that any PBoC net sales of Treasury bonds would indicate its plan to raise the value of the RMB.

The TIC data in December tells us almost nothing about what will happen to the RMB.  To see why, it makes sense to discuss a little how and why the PBoC has accumulated dollars, and what those dollars mean for China and the central bank.  Here, the first thing to recognize is that the PBoC does not “decide”, as a banker, to lend money to the US.  It basically has very little choice.

Beijing is not Washington’s banker

If China runs a current account surplus, it must accumulate net foreign claims by exactly that amount, and the entity against which it accumulates those claims (adjusting for actions by other players within the balance of payments) ultimately must run the corresponding current account deficit.  And as long as China ran the largest current account surplus ever recorded as a share of global GDP, and the US the largest current account deficit ever recorded, and especially since China also ran an additional capital account surplus (i.e. other non-PBoC agents ran a net capital inflow), it was almost impossible for the PBoC to do anything but buy US dollar assets.  Given the sheer amounts, a substantial portion of these assets had inevitably to be USG bonds.

This was not a discretionary lending decision.  It is the automatic consequence of China’s currency regime, in which it pegs the RMB to a foreign currency, in this case the dollar.  Why?  Because when the PBoC decides on the level of the RMB against the dollar, it does not do so by passing a law, and making it a capital crime for anyone to trade at a different price.  What it does is far simpler.  It offers to buy or sell unlimited amounts of RMB against the dollar at the desired price.

No one will sell dollars for less than what they can get from the PBoC, nor will anyone buy dollars for more than what they can pay the PBoC, so all transactions get done at that price.  That is how the PBoC (or any other central bank that intervenes in the currency market) sets the foreign exchange value of its own currency.

This means that as long as it wants to set the exchange rate, then, it must take the opposite position of the market.  Since the rest of the market is a net seller of dollars (China runs a current and capital account surplus), the PBoC has no choice but to be a net buyer of dollars, which of course it must then invest.

If it stops buying dollars, it must let the market decide by itself on the new equilibrium price of the dollar.  In that case the value of the dollar has to plunge in RMB terms (or the RMB soar, which is the same thing) in order for buyers and sellers to match up and for the market to clear.  The moment the PBoC stops buying, in other words, the RMB will rise in value – and so it cannot stop buying in anticipation of the RMB rising in value, as the FT article suggested.

Of course the PBoC must fund the purchase of these dollars.  It does so primarily by borrowing in the domestic money markets, selling PBoC bills or entering into short term repos (although it also issues some longer-term bonds), or by “creating” money by crediting the accounts of the commercial banks who sell it the dollars.

This means, to simplify, that the PBoC has a balance sheet consisting on one side of dollar assets (and here “dollar” is short-hand for all foreign assets).   Against this and on the other side it has a roughly equivalent amount of RMB liabilities (I say “roughly” because when you run a mismatched balance sheet, changes in the relative value of assets and liabilities will create losses or profits).

Here is where things get interesting.  China’s reserves are often thought of as if they were a treasure trove available for spending.  They are not.  They are simply the asset side of the mismatched balance sheet.  If the PBoC wanted to “spend” $100, say for example to recapitalize a bank, it could do so, but this would automatically create a $100 dollar hole in its balance sheet. – it would still owe the RMB that it borrowed originally to purchase the $100.  To put it another way, the reserves are not a savings account, free for the PBoC to spend as it likes.  Reserves are effectively borrowed money.

Can PBoC reserves protect China?

So the PBoC cannot give away the reserves without causing an increase in its net indebtedness.  This is why I have often said, to the confusion of some of my readers, that Beijing cannot just recapitalize the banks with reserves.  A substantial amount of NPLs will one way or another increase government debt.  The only way Beijing can recapitalize the banks is by borrowing, or by raising direct (or hidden) taxes.  Having the PBoC recapitalize the banks is just another way for the government to borrow, and since almost everyone would agree that losses in the banking system should be paid directly out of fiscal revenues, and not indirectly by the central bank, it would be a very inefficient way of doing so.

So what are reserves good for?  As long as China maintains its own currency and denominates all domestic transactions in RMB, the PBoC reserves cannot be used in China.  They cannot go to pay doctors’ salaries, to build bridges, to lower taxes or to subsidize consumption.  They can only be used to purchase or pay for things from outside China.  This means that reserves ensure that China can import foreign commodities and other goods as long as it can pay for them domestically.  It also means that the PBoC can ensure the availability of dollars to repay foreign debt and foreign investment.

Here is where a great deal of confusion arises.  The US crisis of 2007-08 notwithstanding, we seem implicitly to believe that a financial crisis is always caused by an inability to repay foreign debt and investment, in which case having huge amounts of reserves certainly should protect a country from financial crises.

But this is only partly true.  Reserves are useless in preventing domestic debt crises (not totally, because they affect the credibility of the currency, but the RMB today doesn’t seem to suffer from a lack of credibility).  As I pointed out two weeks ago, there are many cases of countries with huge amounts of reserves that nonetheless suffered from all kinds of financial crises.  It is just that they never suffered from external debt crises.

When it comes to domestic debt crises, large levels of reserves actually can make things worse.  Why?  Because financial crises are always caused by mismatched and highly inverted balance sheets, and the central bank’s accumulation of reserves is exactly that kind of balance sheet.

Of course when the rest of the country has an equally mismatched balance sheet in the other direction – like when South Korean companies in 1997 had huge amounts of won assets financed by dollar debt – the central bank mismatch enhances financial stability.  It acts against the mismatch carried by the rest of the economy, and the net impact is that the economy is less vulnerable to financial crisis.  In that sense reserves are a kind of insurance to protect against excessive foreign borrowing.  Because South Korea, unlike China today, had too few central bank reserves against the rest of the country’s too-large dollar obligations, its overall balance sheet was mismatched and it was susceptible to a collapse of the won.

But China has very little external debt – certainly very small compared to its reserves – and so this clearly isn’t an issue for China.  But then could the huge mismatch on the PBoC’s balance sheet create the opposite risk for China?

Balance sheet mismatches

Yes and no.  And this is where another great misperception occurs.  Many people in China and abroad have argued that China cannot afford to raise the value of the RMB against the dollar because it would mean that China will take huge losses because of its massive reserves.  After all, if the RMB rises by 10% against the dollar, the value of its reserves will have necessarily declined by $250 billion in RMB terms.

This is almost completely wrong – China will not take losses anywhere close to that amount and may probably even take a gain if it revalues the currency.  Unfortunately this kind of confused thinking is nonetheless the source of some strange claims.  One foreign economist even published a rather loony piece three months ago, which excoriated the Obama administration’s “bogus” trade argument for revaluation as done purely for nefarious and no doubt imperialistic reasons – and to strengthen the conspiratorial air it somehow ignored the fact that nearly every country in Europe and Asia has made the same argument.

Ironically enough, it replaced the very reasonable trade argument with one that is truly bogus, and indicates how foolish and even hysterical the discussion can become.  The argument is that the US wants China to revalue the RMB not because of trade rebalancing (wrong, and this makes a common but still annoying mistake about the relationship between the currency and the trade balance) but rather because of a secret American scheme to reduce the amount that the US government has to pay China on its PBoC holdings.  Appreciation of the RMB, according to this theory, represents a transfer of wealth from China to the US because it effectively reduces cost to the US of servicing the debt:

If the arguments presented for RMB revaluation by the US administration have no factual basis, why are they being put forward? The real answer lies not in trade but in debt – as other writers, such as Daryl Guppy, have rightly pointed out. In asking for RMB revaluation, President Obama’s advisers were, in effect, asking China to donate $150-$300 billion in RMB to the US via debt reduction.

The arithmetic of this is simple. China’s holdings of US dollar assets, chiefly Treasury Bonds, are around $1.5 trillion, or 10.2 trillion RMB. A 10 percent devaluation of the dollar vis-à-vis the RMB would reduce the value of these holdings to 9.3 trillion RMB, and a 20 percent dollar devaluation would reduce their value to 8.5 trillion RMB. In either case the U.S. is asking for its debt to China to be reduced by 10-20 percent in RMB terms.  It may now be seen why President Obama’s advisers have a vested interest in not examining the factual situation of China’s trade. They are seeking a large debt relief package.

Sigh.  The arithmetic is apparently not as simple as it seems.  When one of my central-bank seminar undergraduates showed me this article in December, he was chortling with glee at its bad economics and suggested I used the article to teach the freshman class – the assumption being that no PKU finance student above the level of freshman could have ever made this kind of conceptual mistake.  Perhaps not, but certainly anyone writing about currency policy should have at least done the math first.

Although this article is more confused than most about the impact of an appreciation on central bank reserves, it is worth explaining why it is wrong so as to address the less excitingly conspiratorial mistakes made by the merely confused.  First, can an appreciation of the RMB reduce the cost to the US government of its debt obligations?  Of course not.

The US government transacts almost exclusively in dollars, raises dollars in the form of taxes and borrowing, and owns dollar assets.  Since it will pay exactly the same number of dollars to Chinese investors after the change in the RMB value as it did before the change, simple arithmetic should indicate that there will be no impact at all on the cost to the US of repaying the debt.  After all, if a revaluation of the RMB causes the euro to drop against the dollar (a highly plausible outcome), could it possibly be true that the USG would reduce its payments on $100 of obligations owed to Chinese investors while increasing its payments on $100 of obligations owed to European investors?  Exactly how would this work?

Are there no winners and losers?

It wouldn’t.  The claim is nonsensical and violates simple arithmetic.  But if the RMB is revalued are there no losses and gains anywhere?  Yes, of course there are, but the distribution of these gains and losses is completely different from what this article claims, and depends wholly on the structure of various balance sheets.  In a nutshell, anyone who is net long dollars against RMB loses, and anyone who is net short dollars against RMB gains.

First of all, will China as an economic entity lose?  Leaving aside the vigorous discussion about whether an RMB revaluation will increase or reduce China’s long term growth prospects (I think it will), the net balance-sheet impact of a revaluation depends on whether China is net long or net short dollars.  There is no precise way of answering this question, because every single economic entity in China implicitly has some complex exposure to the dollar (by which I mean foreign currencies generally) through current and future transactions, but generally speaking China is likely to gain from a revaluation because after the revaluation it will be exchanging the stuff it makes for stuff it buys from abroad at a better ratio.  The value of what it sells abroad will rise relative to the value of what it buys from abroad, and if we could correctly capitalize those values on the balance sheet, it would probably show that the Chinese balance sheet would improve with a revaluation of the RMB.

Some people might make a more sophisticated argument that since China is a net creditor – i.e. it is net long dollars – it will lose by a revaluation of the RMB.  This argument also turns out to be wrong, but for more complex reasons, and to explain why I have to put on my former-trader’s hat and explain the difference between a real loss and a realized loss.

If you believe that the RMB is undervalued then you must accept that China takes a “real” loss every single time it exchanges a locally produced good or asset for a foreign one.  It does not “realize” the loss, however, until it revalues the RMB to its “correct” value.

In other words, the PBoC, as the representative of China’s net creditor status, will immediately realize a loss when the RMB revalues, but this loss did not occur because of the revaluation.  It occurred the very day the trade took place.  When a Chinese producer sold goods to the US and took payment in US dollars, there was an unrealized economic loss equal to the undervaluation of the RMB.  This unrealized loss was passed onto the PBoC when it bought the dollars from the exporter and paid RMB.

This loss, however, will not actually show up until the RMB is revalued, which forces the real loss to be realized (i.e. recognized as an accounting matter).  Postponing the revaluation, then, is not the way to avoid the loss – it is too late for that.  The only way to avoid future additional loss is to stop making the exchange, which means, ironically, that the longer the PBoC postpones the revaluation of the RMB, the greater the real loss it will take.

So a revaluation of the RMB will not cause any real loss to any Chinese entity today.  The loss already occurred but hasn’t been realized.

But wait, if the RMB is revalued by 10%, the value of the PBoC’s assets will immediately decline by $250 billion in RMB terms.  Since the Chinese measure their wealth in RMB, isn’t this a real additional loss for China?

No, because remember that the only thing you can do with reserves is pay for foreign imports or repay foreign obligations.  And just as the value of the reserves drops 10% in RMB terms, so does the value of all those foreign payments – by definition they must go down by exactly the same amount in RMB terms.

This means that China takes no loss.  It can buy and pay for just as much “stuff” after the revaluation, and with less implied PBoC borrowing, as it could before the revaluation – and the real value of money is what you can buy with it.  So the real value of the reserves hasn’t changed at all – just the accounting value in RMB, but this simply recognizes losses that were already taken long ago when the trade was first made, and should be a largely irrelevant number (except perhaps for conspiracy theorists).

Wealth is transferred within China

But that doesn’t mean nothing at all happened.  Although the Chinese overall balance sheet is probably a little better off with the revaluation, within China there are a whole set of winners and losers. Which is which depends on the structure of individual balance sheets.  Basically everyone who is net long dollars against the RMB loses in an appreciation, and everyone who is net short dollars against the RMB wins.

Who loses?  Of course the PBoC is a big loser.  It has a hugely mismatched balance sheet in which it is long nearly $3 trillion (if everything were correctly counted), funded by an equivalent amount of RMB obligations.

Exporters and their employees, too, are naturally long dollars and so they would lose.  They are long dollars because more of the net value of their current and future production less current and future costs is denominated in dollars (they are “sticky” to dollar prices) – for example labor costs, land, and almost all other inputs except imported components are valued in RMB, whereas most revenues are valued in dollars.

Chinese companies with more assets abroad then foreign debt might also lose.  Who wins?  Nearly everyone else in China, since everyone in the country is short dollars to the extent that there are imported goods in his life.  The local tea seller is short dollars if his tea is delivered to him in gas-guzzling trucks, as is the family planning to visit Egypt next year, as is the local provider of French perfumes, as is a teenager who wants to buy Nike shoes, and so pay for the corporate sponsorship of a Brazilian soccer star playing for a Spanish team.  Every household and nearly every business in China is, in one way or another, an importer (and this is true in every country), so unless they own a lot of assets abroad they are effectively short dollars and will benefit from an appreciation in the RMB.

Revaluing the RMB, in other words, is important and significant because it represents a shift of wealth largely from the PBoC, exporters, and Chinese residents who have stashed away a lot of wealth in a foreign bank, in favor of the rest of the country.  Since much of this shift of wealth benefits households at the expense of the state and manufacturers, one of the automatic consequence of a revaluation will be an increase in household wealth and, with it, household consumption.  This is why revaluation is part of the rebalancing strategy – it shifts income to households and so increases household consumption.

So a revaluation has important balance sheet impacts on entities within China, and to a much lesser extent, on some entities outside China.  But since it merely represents a distribution of wealth within China should we care about the PBoC losses or can we ignore them?  Unfortunately we cannot ignore them and might have to worry about the PBoC losses because, once again, of balance sheet impacts.

The PBoC runs a mismatched balance sheet, and as a consequence every 10% revaluation in the RMB will cause the PBoC’s net indebtedness to rise by about 7-8% of GDP.  This ultimately becomes an increase in total government debt, and of course the more dollars the PBoC accumulates, the greater this loss.  (Some readers will note that if government debt levels are already too high, an increase in government debt will sharply increase future government claims on household income, thus reducing the future rebalancing impact of a revaluation, and they are right, which indicates how complex and difficult rebalancing might be).   In that sense it is not whether or not China as a whole loses or gains from a revaluation that can be measured by looking at the reserves, and I would argue that it gains, but how the losses are distributed and what further balance sheet impacts that might have.

I apologize for such a long post, but I promised several people that I would try to address some of these issues, and it is hard to do so briefly.  In short, what the PBoC does to the value of the RMB and how it invests its reserves matter a lot to China and the world, but not always in the way China and the world think.  To get it right, we need to keep in mind the functioning of the balance of payments, the PBoC and other balance sheets, and the way the two are interrelated.

Tags: Balance sheets, Policy, wages

I will be in NY and Boston during the first week of February and plan to meet a number of investors there to discuss China.  I believe it becomes official on February 1, but I recently joined the Hong Kong subsidiary of one of China’s top broker/dealers, Shenyin Wanguo.  I will continue teaching at Peking University and doing research for the Carnegie Endowment – this new responsibility simply takes off from my existing work.

Unfortunately it will mean that my blog postings (in the future, and clearly not this one) will become shorter and perhaps more reacting to market events, but of course it also means that it will be much easier for me to travel to meet clients and friends in Asia, Europe, North America and elsewhere for more focused (and perhaps more open) discussions of China and the international economy.

For now I suspect everyone will want to discuss currencies.  One of the more interesting pieces of news for me was yesterday’s Financial Times story on President Sarkozy’s finding “unacceptable” the disordered currency markets (“disorder” means a rising euro).  According to the article:

Nicolas Sarkozy on Thursday stepped up his attack on global exchange rate imbalances saying “monetary disorder” had become “unacceptable”.  The French president said he would make exchange rate policy an important theme of France’s presidency of the G8 and G20 forums of advanced and developing economies in 2011.

“There cannot be financial, economic and social order until we put an end to currency disorder,” he said at a conference in Paris.  Mr Sarkozy has long railed against Chinese “monetary dumping” and the dominance of the dollar, but has sharpened his criticism in recent days reflecting concern in Paris that a balanced economic recovery in the eurozone could be choked off by an overvalued currency.

With a large trade deficit and with exports that are more price-sensitive than Germany’s, France feels more susceptible to exchange-rate movements than its neighbour across the Rhine.  “We can’t increase the competitiveness of our businesses in Europe and have the dollar lose 50 per cent of its value against the euro,” Mr Sarkozy said. “When we produce in the eurozone and sell in the dollar zone, are we supposed to just give up selling?”

So we are sort of stuck, aren’t we?  The dollar is overvalued, and it must rebalance downwards in order to force up US savings rates relative to US GDP, but since it cannot decline against Asian currencies, whose central banks intervene heavily, it must decline against the floating currencies like the euro.

But the euro is probably already overvalued against the dollar, so European manufacturers will be forced to accept the brunt of the adjustment.  This will be painful for everyone in Europe, but I suspect it will be most painful for Germany, a country that is more dependent on manufacturing than the rest of the region and so who will suffer more if there is a sharp drop in demand for European manufactured goods. The fact that President Sarkozy is nonetheless making the most noise about the euro indicates that this is going to become a very popular political topic and has great demagogic appeal.

Later in the article Sarkozy was quoted as saying “You know how close I feel to the US. But this is not possible. The world has become multipolar. We must have a multi-monetary system.”  As a half-French half-American I have to say I suspect that it is not likely to be easy to convince too many Americans of the truth of the first part of his statement.  I think however, that although the US and the world (except perhaps export-dependent Asian countries) would be better off with a multi-monetary system, Sarkozy may be confusing issues.

The dominance of the dollar in reserve accumulation has little to do with a lack of an alternative currency and a lot to do with the inability of any country but the US to absorb the trade deficits created by export-dependent development strategies.  Trade-surplus countries buy dollars because when they buy euros, they cause angry reactions from European businessmen and politicians who are uncomfortable with the impact of a rising euro on domestic manufacturing and employment.  In fact, the rise of the euro against the dollar is precisely what Sarkozy claims to oppose in the first part of his statement and to support in the second part.  If Asian central banks rely less on the dollar and more on the euro for their reserve accumulation, guess what will happen. Yes, the euro will rise against the dollar.

Japan is worried too

It always surprises me how readily people believe that the status of the dollar as a reserve currency has to do with same nefarious conspiracy.  As long as the US is willing and able to run large trade deficits, the dollar will be the overwhelming currency of choice for reserve accumulation.  Once the US ability or willingness stops, which I suspect is likely to be the case over the next few years, central banks will stop accumulating dollars.  Like it did during the period of large US deficits in the 1960s and the 1980s, the talk about dollar hegemony will once again fade away as US trade deficits decline.

Sarkozy’s comments were reinforced, in a way, by comments the same day from Naoto Kan, Japan’s finance minister.  Here is what the South China Morning Post said in an article today.

Japan’s new finance minister backed off his call for a weaker yen following an apparent rebuke from the prime minister yesterday, saying currency levels should be determined by markets.

Still, Naoto Kan said the government should pay heed to the views of the country’s business community, signalling that he was sticking to the view of favouring a weaker yen to boost the competitiveness of Japanese exports.  ”Currencies undoubtedly should be determined by markets,” Kan said. “But I also believe that generally speaking, it’s the finance minister’s job to act against currency moves when needed.”

…He jolted markets in his first press briefing as finance minister on Thursday, saying he hoped the yen would weaken further and that he would work with the Bank of Japan to achieve an appropriate exchange rate level.

For those who remember the 1980s, when many policymakers in Japan insisted that Japan’s trade surplus had nothing to do with the value of the currency, and everything to do with domestic competitive advantages in manufacturing, it is a little weird seeing them now worry so much about the impact of a rising yen on their manufacturing sector and on the process of economic recovery.  Currencies do matter, I guess.

Currency talk is likely to be the flavor of this year.  The currency issue simply will not go away, and the fighting over it is likely to get worse, not better.  On that topic, a research fellow at the Institute of World Economics and Politics at CASS had an interesting proposal earlier this week.  According to an article in Bloomberg:

China should consider a one-time appreciation in the yuan of 10 percent against the dollar to reduce inflows of speculative capital into China, a researcher at the Chinese Academy of Social Sciences said.  The revaluation could be followed by a cap of 3 percent in annual moves up or down for the currency against the greenback, Zhang Bin, a research fellow at the Institute of World Economics and Politics at CASS, which advises the cabinet, said in an interview from Beijing today. He said he couldn’t predict whether his proposal, outlined in an essay, would be adopted by the government.

China may see “huge” inflows of so-called hot money as foreign investors step up bets on yuan gains, Zhang Xiaoqiang, deputy head of the National Development and Reform Commission, said in a statement yesterday. The government has rebuffed calls from U.S. and European officials to allow the market to set the exchange rate and has pegged the yuan at about 6.83 per dollar since July 2008 to help exporters weather a global recession.

“It’s a good strategy to protect China from the impact of short-term capital inflows,” said Zhang. “Now is a very good time. Foreign pressure will intensify this year and China should take an active strategy.”

…A 10 percent revaluation would have limited impact on exports and slow growth in overseas sales by 3.3 percent, said Zhang. Exports dropped 1.2 percent in November from a year earlier, following a 13.8 percent decline the previous month. China’s customs bureau is scheduled to report trade figures for December sometime between Jan. 12 and 14.

Zhang, who has been interviewed by Xinhua news agency on global economics previously, said the revaluation should be adopted soon.  “The earlier, the better,” said Zhang. “We shouldn’t wait until after foreign capital flows into China and expectations on yuan gains increase.”

Does the value of the RMB matter for trade?

What would the impact on trade be?  Strangely enough many of the opponents of RMB revaluation insist that it would have no impact on trade balances.  A new “International Finance Discussion Paper” (Board of Governors of the Federal Reserve System) by Shaghil Ahmed sees it differently (“Are Chinese Exports Sensitive to Changes in the Exchange Rate?”)

The main results of the paper can be summarized as follows: First, including the latest period of greater real exchange rate variability reinforces the conclusions of some earlier studies, such as Marquez and Schindler (2007), which found that Chinese exports respond quite strongly to movements in the real exchange rate, and go against studies which fond little effect of exchange rate changes or effects that go in the opposite direction to conventional wisdom.

Second, considering the components of the real exchange rate, consistent with the theoretical model, when the source of Chinese real exchange rate appreciation is movements of the RMB against other emerging Asian countries, this does not have a significant effect on Chinese processing exports, but it does have a significant negative effect on Chinese non-processing exports.  On the other hand, when the source of the renminbi appreciation is movements against the currencies of non-emerging Asian Chinese trading partners, generally both types of exports go down.  Moreover, even though processed exports remain very important for China, increases in non-processed exports have recently accounted for more of the overall increase in exports.  Finally, model simulations indicate that the path of total Chinese real exports would have been quite a bit lower if the renminbi had appreciated more in recent years.

Overall, the results suggest that greater exchange rate flexibility could have significant impact on China’s trade balance by restraining growth of exports, particularly non-processed exports.

…The implications of the results for global imbalances depend on what is exactly meant by global imbalances, which is not always clear-cut.  If China’s large current account surplus or its bilateral current account surplus with the United States by itself contributes to global imbalances, along with the U.S. bilateral current account deficit with China, then our results suggest that greater degree of appreciation of the Chinese currency would substantially help mitigate global imbalances.  If, however, the big part of global imbalances is the U.S. overall current account deficit and the current account surplus of the emerging market world taken together, then it is less clear that greater appreciation of the Chinese currency would make a significant dent to global imbalances. For example, following an adjustment of the Chinese real exchange rate one scenario could well be that the fall in exports by China is largely matched by a rise in exports by other emerging market economies, including in emerging Asia, leaving aggregate current account balances of the United States and of emerging market economies more broadly unchanged.

But the results do seem to imply that greater flexibility of the exchange rate would help China toward its stated desired goal of shifting the sources of growth more toward domestic demand with less dependence on external demand.

Regular readers of my blog might remember that from late 2006 until the beginning of 2008 I had argued that the best way for China to address the domestic (and of course external) problems caused by the undervalued exchange rate would be for a 15-20% one-off revaluation.  This would both force through a rebalancing and help revive consumption growth, all the while protecting the country from the problem of hot money inflows, which had become terrible by that time.

After the onset of the crisis I backed away from such a large revaluation (not because it wouldn’t be a good idea in the long run, but rather because it would be too painful in short run) while still arguing that a one-off 10% revaluation still made sense.  Needless to say I enthusiastically agree with Zhang Bin although, like him, I am doubtful that policymakers will be willing to absorb the short term cost in exchange for domestic economic benefits that probably won’t accrue until well after 2012, when the current leadership will have retired.

Hot money

My guess is that we will see a much smaller appreciation, perhaps 2-3% during the first quarter.  Apparently I am not the only one who believes that appreciation pressures are mounting.  That terrible bugbear, which made China’s too-little-too-late appreciation strategy from 2005 to 2008 so difficult for the PBoC, hot money inflows, seems to be rapidly becoming a problem again.  Earlier this week a senior policy advisor sounded, and not for the first time, the warning.  According to an article in Bloomberg:

China may see “huge” speculative inflows as overseas investors step up bets on yuan gains, making it difficult to manage liquidity, said Zhang Xiaoqiang, deputy head of the nation’s top planning agency.  Loose monetary polices in developed countries, a weakening U.S. dollar and China’s economic recovery will put renewed pressure on the yuan to appreciate, Zhang, from the National Development and Reform Commission, said in a statement on its Web site today. The country is becoming more reliant on foreign economies, he said.

Already some of my students whose parents own their own businesses have been telling me that Chinese speculative money held abroad is flowing back into the country.  One of my students from rich coastal city Wenzhou, the most free-wheeling and business-savvy city in China, and perhaps the world, just rolled his eyes when I asked him if his family and friends were tying to bring money into the country.  “Of course,” he said.  I didn’t get the impression that he thought mine was an especially astute question.

Meanwhile all the big guns in the “monetary alarmist” camp in China have been pounding the table (in the discreet way preferred of policymakers here) about the risks of monetary expansion.  As everyone now knows, the PBoC yesterday sold three-month bills at a higher interest rate for the first time in 19 weeks.  Long Chen, one of the students in my PBoC Shadow Committee seminar, reported to the class via email as soon as it happened: “Hey guys, the primary yield of 3M PBOC bill increased this week. Significant sign.”

Yes, although the increase was tiny, it may indeed be a significant sign that the PBoC no longer wants to wait and is starting to tighten conditions, although I can only add that conditions are so alarmingly loose that it would take an awful lot of tightening to get back just to “loose”, and it would be hard to do this without seriously undermining current growth and employment in the short term.  My guess is that this may be a beginning, but it will be a very slow and tentative beginning.  The PBoC has already been lambasted (unfairly, in my opinion) for jumping the gun in 2007 and 2008 and they have little political capital against which they can afford another “mistake”.

In fact much of their action tends to be signaling – what in the US we would call “jawboning”.  Four days ago, for example, Governor Zhou made another attempt to warn about risks to the banking system in an interview with China Finance very similar to a speech he gave late December.  According to an article in Bloomberg:

Chinese central bank Governor Zhou Xiaochuan reiterated government warnings that investment in industries with excess capacity and in redundant infrastructure projects could threaten banks’ loan quality.

The People’s Bank of China will guide credit, seeking to avoid volatility in lending, Zhou said in an interview dated yesterday on the Web site of China Finance, a central bank publication. Investment in duplicated projects or industries with overcapacity could “pose a risk to the quality of banks’ loans,” Zhou said.

China’s policy makers are seeking to contain risks from an unprecedented credit boom, in which banks extended 9.21 trillion yuan ($1.3 trillion) of new loans in the first 11 months of 2009. Liu Mingkang, chairman of the China Banking Regulatory Commission, said yesterday that lenders have “more than” enough capital, while also cautioning that asset bubbles may emerge in the world’s third-biggest economy.

It is hard to be both soothing and at the same time to raise the alarm.

To move away from currencies and monetary policy, I saw an interesting article about the US in Xinhua.

A recent New York Times/CBS News poll has found that more than half of Americans said they are spending less money in stores and online.  A New York Times report available on its website Saturday quotes the poll as saying that nearly half of Americans said they were spending less time buying nonessentials.

“Some are working longer hours, but a larger proportion are spending additional time with family and friends, gardening, cooking, reading, watching television and engaging in other hobbies,” says the report.  The report also quotes the U.S. Department of Labor’s time-use survey as showing that compared with 2005, Americans spent less time in 2008 buying goods and services and more time cooking or taking part in “organizational, civic and religious activities.”

Net demand from abroad

This is almost certainly good news for the US in the medium term, but if true, needless to say, it seriously undermines hopes that US net demand will revive enough to justify the overcapacity issues exacerbated by China’s fiscal and credit expansion.  There has been some hope that boosting trade with developing countries, and especially with developing Asia, will result in a new source of net demand.  James Kynge said something like this in the Financial Times earlier this week:

Popular narratives sometimes overshoot. One of the latest to outlast its veracity is the conventional wisdom that China’s export engines have been spiked by subsiding consumer demand in the US. This, so the argument goes, leaves Beijing with no option but to spur domestic demand to compensate for lost export revenues.

This became an über-narrative last year. Its snowballing popular appeal was powered by two unassailable charms: it made sense and seemed largely true – but not any longer. Its potency appears set to wane in coming months not so much because of a challenge to its central plot, but by other things happening off stage.

The telling off-stage action is the recent upsurge in trade with south-east Asia and the “newly-rising economies” of Brazil, Africa and India. Although Chinese trade with these places has historically been limited, it has grown so fast in the past five years that a robust performance in 2010 may be enough to offset any moderate weakness in China’s trade with the US.

A friend wrote to me to ask what I thought of this possibility, citing Kynge’s article, and my response (with some editing) was:

The idea that net demand from developing countries can replace net demand form the US is alarmingly widespread, both in China and abroad, and mainly indicates to me a lack of familiarity with the history of developing countries.  The developing world excluding China is roughly the same size as the US, so if you want them to replace the US you need the developing world to run trade deficits of roughly equal to 7% of their GDPs.

Leave aside the huge problem that most developing countries also want trade surpluses and have a stubbornly tough time understanding why they should run deficits in order to help Chinese employment, the historical evidence suggests that just a few years of trade deficits of 2% of GDP will lead to external debt crisis.  For example it took the Asian Tigers just a few years of deficits after 1993-94 to run into the Asian crisis.  Do Malaysia, Indonesia, Vietnam and so on really want to go through that again?  Developing country demand cannot replace the US.  Even Europe cannot replace the US.  This is an unrealistic hope.

No, I think the rapid growth of US consumption relative to (very healthy) US GDP over the past 30 years or longer may have been a special historical circumstance whose life, if not over, is coming to a close.  Except for small countries whose trade surplus can easily be accommodated, I think the days of rapid growth driven by trade-surplus policies may be over.

This is getting to be another of my very long pieces (as my friend Kaiser Kuo reminded me last night at my club), so I will stop, but not before referring to one last interesting article about another controversy in Chinese academic circles.  China is trying very hard to boost the quality of its scientific and technological research, which is, with a few exceptions, of very low quality.  I am skeptical about how successful they will be, in part because the educational system here, as a history teacher in the top high school in Shanxi province once told me, is a machine for stamping out critical and creative thinking, and in part because the process is not being driven by scientists but by bureaucrats.  Here is what the South China Morning Post says:

The exposure of two researchers who published fake data in an international journal is the subject of heated debate in mainland scientific circles, with opinion divided on whether the blame should rest on unscrupulous individual behaviour or deep flaws in the academic system.

Zhong Hua and Liu Tao from Jinggangshan University in Jiangxi published faked datasets in specialist journal Acta Crystallographica Section E in 2007. The fraud would have gone undetected without new computer analysis, the journal said on its website.

Leading British medical journal The Lancet urged China to tighten measures against scientific fraud, otherwise it would not become the research superpower President Hu Jintao has pledged by 2020.

These kinds of problems are so commonplace that normally I wouldn’t bring it up except for two reasons.  The first is that it is a measure of how complex the problem is that there is even a debate about this episode.  Normally, faking research brings universal condemnation, but the researchers have earned some sympathy because they are desperately responding to a very difficult system.  The second reason I cite this article, which follows the first, is because of a very perceptive quote from Professor Jiang Gaoming of the Institute of Botany under the Chinese Academy of Sciences:

“All living creatures have an instinct to survive. When a bad system determines the survival of researchers, they have to do all kinds of corrupt and unethical things to live. The outcome is inevitable,” Jiang wrote.

This is something I often tell my students, especially about the banking system.  It is not because they are especially stupid or dishonest that bankers have made bad loans, but rather because they are responding intelligently to bad incentives.  Any system with distorted incentives creates distorted results.

The US trade deficit unexpectedly narrowed in August, according to the Commerce Department in a report released yesterday. Exports were up slightly and imports down, mostly because of a reduction in oil imports, I think, but the trade deficit was still a hefty 3.6% of GDP.

So does this mean that the rebalancing is grinding forward? Today’s New York Times is appropriately cautious:

“Officials cannot just sit there and do nothing, and expect the rebalancing to continue,” said C. Fred Bergsten, director of the Peterson Institute for International Economics. Indeed, American consumers are already showing hints of their old fondness for shopping rather than saving. The household saving rate shot up from less than 1 percent before the crisis to more than 5 percent this spring, but it has since slipped back to less than 4 percent. In the early 1990s, American families were saving about 7 percent of their income — and even that was less than in much of Asia and Europe.

Simon Johnson, a professor of economics at the Massachusetts Institute of Technology, said it was normal for a country’s trade balance to improve during an economic downturn. “The adjustment we’re seeing right now could be the harbinger of a real adjustment in saving and spending, but we don’t know yet,” Mr. Johnson said. “People in emerging markets want to run big surpluses, because they want to build up reserves.”

There clearly still is a long way to go if the US is really going to raise its savings rate to some sustainable level, and I am afraid that part of the necessary policies that will lead there will cause a lot of disruption and conflict. Basically in order to raise the savings rate the US needs to enact policies that are similar in spirit to the policies that China has enacted especially during the past decade – and of course which China now needs to reverse. These involve putting into place conditions that spur output growth and constrain consumption growth. The difference between the two, of course, is the savings rate, and if output can grow faster than consumption, by definition the US savings rate will rise.

Given the huge differences in the two economies, and the even bigger differences in the accepted roles of the two governments in their economies, the US will have to accomplish this in a very different way than China does. The US of course cannot work to constrain wage growth and force households to subsidize producers out of interest income, as China seems to have done, but there are other policies that will have the same effect.

For example, consumption taxes, or at least much higher taxes on oil, will have the effect of constraining consumption growth by reducing the real value of household incomes, and if these taxes are somehow matched by lower taxes on interest income the net effect will be to use consumption taxes to subsidize the cost of capital for producers. These are the sorts of policies that can force a continued rebalancing in the US economy.

There is another obvious way of doing so, and this involves the currency. Last week Jean-Claude Trichet, president of the European Central Bank warned against the further strength of the euro against the dollar. At roughly the same time Asian central banks, worried that the failure of the renminbi to appreciate against the dollar would cause their economies to lose export competitiveness, intervened heavily in the markets to slow the appreciation of their currencies against the dollar.

Meanwhile China’s press is fulminating against claims that the renminbi must be revalued. An editorial in Xinhua last week had this to say:

The Group of Seven rich nations have again pushed developing China to appreciate its currency, the RMB yuan, so as to promote a so-called “more balanced growth”. On Saturday, G7 central bankers’ meeting held in Turkey’s Istanbul failed to produce any significant boost to the world economy. Instead, they turned fire on China’s currency, blaming it for the financial crisis.

In so doing, the rich nations have obviously intended to shirk their due responsibilities in the wide-spreading global financial turmoil.  As it is known to all that the current crisis has been a result of developed countries’ lax financial regulation, excessive consumption and their lasting monopoly on the international financial system.

They are supposed to review loopholes in their micro-economic policies and financial regulation. However, some of them have tried to link the “under-evaluated” RMB exchange rate to the “global economic imbalance”, which they said had been the major factor behind the crisis.

According to their logic, China should appreciate the yuan considerably to cut exports and increase imports, so that Western nations’ trade deficit can be narrowed and “a trade balance” be achieved. They have turned a blind eye to China’s efforts to make the yuan more flexible.

All of this highlights the fact that a depreciation in the value of the US dollar is probably a necessary part of the adjustment process, but it is going to be extremely difficult. Overvalued exchange rates are part of the mechanism by which the US runs a trade deficit. An overvalued dollar increases the real value of US household income by lowering the costs of imports while effectively taxing manufacturers in the tradable goods sector.

This automatically forces consumption to grow faster than production and helps push the country into a trade deficit. Meanwhile countries with undervalued currencies have the opposite experience. As the cost of imports is forced artificially high and the producers of tradable goods are subsidized by the undervalued exchange rate, it is no surprise that growth in production exceeds growth consumption, leaving these countries with persistent trade surpluses.

So if we expect the US to reduce its consumption levels relative to its production (i.e. raise its savings rate and bring down the trade deficit, it is reasonable toe expect the dollar to decline. In today’s Financial Times an editorial makes just that point:

It would actually be rather helpful if the dollar were to weaken further. Politicians everywhere see strong currencies as national virility symbols, but the effect of a cheaper dollar would be to help American exporters while making imports to the US dearer.

This is what America – and the world – needs. In the medium term, as Mr Summers put it earlier this year, “the rebuilt American economy must be more export-oriented and less consumption-oriented”. In short, the US must start living within its means, and the rest of the world must stop relying on its profligacy.

But against what can the dollar depreciate? Europe and Japan can make plausible arguments that their currencies are not undervalued relative to the dollar and so they should not be forced to bear the brunt of the dollar depreciation. Asian countries, and especially China, have relied on undervalued currencies as an important part of the package of policies aimed at spurring domestic growth and high domestic savings rates, and because the decline in US imports has already proved very painful, they are insisting that they should be forced to bear any more of the cost of dollar depreciation. The FT editorial continues:

This is the prospect that has worried monetary authorities in Asia. The central banks of South Korea, Taiwan, the Philippines and Thailand have intervened in markets in the past week to bolster the dollar’s strength against their currencies. They are trying to slow the pace of any such rebalancing.

That is understandable: this type of reordering of the world economy would be enormously disruptive for these export-led countries, since their economic strategy is to sate the appetites of the consumption-led countries.

Everyone seems to agree that as part of the necessary global rebalancing the US will have to reduce its net imports, and this will be achieved in part by a depreciation in the value of the dollar, but everyone also seems to agree just as fervently that any reduction of the US trade deficit should not come at their expense, but rather at the expense of the rest of the world. Europe says it is Asian that must appreciate, Asians implicitly insist that it is Europe that must appreciate. It doesn’t take a PhD to see the mathematical difficulty.

Like in the 1930s, every country wants to devalue its currency relative to the currencies of its trading partners in order to boost domestic employment and take a larger share of foreign demand. But as we learned in the 1930s, it is by definition impossible for everyone to improve export competitiveness by devaluing.

So how will the disagreements be resolved? Almost certainly by an increase in trade conflicts. What many of the global participants have probably forgotten is that in a world of contracting demand, it is countries who control net demand who are in the strongest position to determine the outcome of a fight over trade. If the dollar is not allowed to depreciate in an orderly way against the currencies of all of its trading partners, trade tensions have no way to go but up.

Evidence? How about this, in an article in Thursday’s Financial Times:

The US Department of Commerce announced on Wednesday it would launch an investigation into the import of seamless steel pipes from China, a move which could lead to new duties imposed and strain already sour trade relations between Washington and Beijing.

The US investigations, which could lead to a 98.7 per cent duty on Chinese steel pipes imports, came shortly after a European Union decision to impose anti-dumping tariffs on the same category of products.

Or this, in another Financial Times article published the same day:

Global trade tensions ratcheted up on Thursday as the US opened an investigation into Chinese steel imports and clashed with the European Union over chickens.

…The US has long complained that the EU has blocked chicken meat washed with chlorine and other chemicals from sale in Europe, despite both US and European scientific agencies concluding that such treatments were safe for consumers. But a panel of the chief veterinary officers of the EU member states rejected the treatments late last year. The outgoing Bush administration started legal proceedings against the EU in January, and negotiations since have failed to resolve the issue.

A European Commission spokesman said that litigation was not the appropriate way to deal with such complex issues. ”However, since the US has chosen this path, we will defend our food safety legislation,” the spokesman said.

The fact is that these trade disputes are not going to go away, and because each side has legitimate complaints, or at least what seems like legitimate complaints to domestic audiences, without serious global coordination (don’t hold your breath) the only very likely outcome is even more trade disputes. And these are disputes which will be won by the country or countries that control the one resource everyone in the world wants: net demand. This means that if surplus countries don’t allow for a rapid and orderly adjustment of the imbalances, which will require a rise in the value of their currencies among other things, the same thing will be achieved by trade conflict.

What are the prospects? I guess regular readers of my blog will be disappointed if I don’t show myself to be a pessimist, but in fact anyway I think the prospects for an orderly resolution are weak. I am not knowledgeable enough about other countries, but it seems to me that China certainly is not prepared for the cost of the adjustment and will continue trying to postpone it. Yesterday Liu Mingkang, chairman of the China Banking Regulatory Commission, told a conference in Hong Kong that “It’s far too early to talk about an exit strategy”, which I interpret to mean that the investment-driven stimulus package is going to continue. He said that Beijing did not need to rescue the banking system, and the measures it has taken to boost investment and to support the infrastructure sector were to help the economy. Of course he also said that he believes the banking sector is sound, so maybe he is just kidding.

For those of you who are able and willing to follow the complex world of chemicals, there is a related and very interesting article by John Richardson on ICIS news, a chemical industry publication (you can also find it here). He says:

Low density polyethylene imports into China were up by 85% in the first eight months of this year compared with the same period in 2008, according to International Trader Publications Inc, a provider of trade data and analysis on chemicals and polymers.

Benzene imports increased by 185%, polyvinyl chloride by 138% and methanol by 431%. These latter two statistics are the result of weaker economics of coal-based production as well as re-stocking and stronger demand.

“Year-to-date totals were up for every commodity polymer, engineering polymer and major organic we follow except expandable and non-expandable polystyrene, polyacetals, polycarbonate and ethylene dichloride,” said Jean Sudol, president of ITP.

This implies high inventories in not just PE – the only polymer in which we gained clear evidence through a survey among 85 distributors and end-users carried out by a major Asian producer. It’s easy to overcomplicate things but to put it simply, it seems impossible that this extraordinary surge in imports has gone into a sufficient increase in finished-goods sales to prevent some major dislocations.

All you have to do to reach this conclusion is look at real consumption growth (not the misleading retail sales figures) versus the decline in exports to work out that a lot of overstocking is likely to have occurred. This would be at the chemical and polymer levels and in warehouses full of unsold washing machines and refrigerators etc.

I am no expert on the chemical industry, and so perhaps I am misreading his piece, but this doesn’t sound like an industry that is readying itself for a world of contracting US demand.

William Cline and John Williamson published on Vox an interesting piece earlier this month June 18), titled “Equilibrium Exchange Rates,” in which they try to “estimate a set of medium-run fundamental equilibrium exchange rates compatible with moderating external imbalances” for the 30 largest economies. They assume that a sustainable equilibrium trade balance for the US implies a current account deficit of 3% of GDP (this is conservative – I would have thought “equilibrium” would have been lower), and try to estimate the amount of currency change needed to get there. They also assume that in general not just the US but all “countries should strive to keep imbalances (surpluses and deficits) under 3% of GDP.”

Using early June 2009 exchange rates, they find that six countries – most of whom are primarily commodity exporters, not coincidentally – have overvalued exchange rates relative to the dollar (Australia, New Zealand, South Africa, Brazil, Colombia, Mexico), and twelve, mostly in Europe, have currencies that are marginally undervalued. Of the 30 countries, eleven have currencies that are at least 15% undervalued relative to the US dollar. For convenience sake I include their 2008 GDP and rank them by size. These are:

Country	Billions	Undervaluation
Japan	$4,908	18.1%
China	$4,221	40.3%
Switzerland	$491	19.8%
Sweden	$479	15.3%
Taiwan	$392	29.4%
Argentina	$330	18.4%
Thailand	$273	16.7%
Malaysia	$222	33.2%
Hong Kong	$215	27.9%
Singapore	$182	26.3%
Philippines	$169	18.2%

Economists can, and of course will, dispute the methodology and the extent of any perceived under- or over-valuation, but in my opinion the most valuable aspect of these exercises is not that they indicate the “correct” exchange rate level, whatever that means, but rather that they can indicate trends or signal interesting anomalies in the aggregate. Two things are noteworthy here, I think.

The first, and most obvious, is that eight of the eleven Asian countries within the top thirty economies (the exceptions are India, Indonesia, and Korea, whose currencies are all undervalued by 4-6%) are on the above list of significantly undervalued currencies, and the list is dominated by them (eight Asians out of eleven countries on the list). This simply suggests the not-exactly-controversial thesis that Asian countries have systematically undervalued their currencies as a strategy to generate employment growth. It also suggests that Asian central banks that worry about the impact of dollar weakness on their reserve holdings are in the funny position of having created the dollar overvaluation at the same time they were actively accumulating those overvalued dollars.

The second noteworthy consequence of their exercise, which I found much more interesting, was a finding that the authors seem to find a little surprising. They say:

The main counterpart to the overvalued dollar is the undervaluation of the Chinese renminbi, along with a few of the smaller Asian currencies. We are somewhat nervous because our estimate (based on the figure of RMB 4.88 to the dollar) of Chinese undervaluation is even larger than it was a year ago (RMB 5.81 to the dollar), despite the fact that the RMB rode the dollar up by 14% in effective terms in the intervening year. It may be that our estimate is now too large because the IMF’s projection of the Chinese surplus seems not to have declined despite the RMB’s real appreciation, although the fall in commodity prices in the past year has presumably worked in China’s favour. But all the other potential biases, notably the way of formulating the Chinese current account target as a substantial surplus rather than the deficit suggested by the FDI inflow, are in the direction of minimising estimated undervaluation. Our analysis is one more piece of evidence that the major macroeconomic imbalance in the world today stems from China’s exchange-rate policy.

Leaving aside the fact of their very high estimate of Chinese undervaluation, I think the authors are saying that although the RMB rose 14% from the last time they calculated these equilibrium exchange rates, nonetheless their measure of the adjustment needed to balance trade suggests that the RMB is actually even more undervalued than it had been a year ago.

What’s going on? How can a currency that has risen 14% against the dollar finish even more undervalued against the dollar? Part of the answer could be differential productivity growth rates, and since Chinese productivity is growing faster than US productivity it would imply that the RMB should revalue against the dollar just to maintain equilibrium. But of course there is absolutely no way Chinese productivity grew by even a fraction of the amount necessary during that time to explain this anomaly.

But remember in my June 3rd post I argued that we make a mistake when we think only currency and tariff policies can affect trade? There is a whole list of policies that, by directly subsidizing production or by implicitly or explicitly taxing consumption, will necessarily affect the trade account. Could it be that even as the RMB was nominally revaluing, other policies were implicitly “devaluing” the RMB – i.e. policies that implicitly increased subsidies to production, and/or taxed consumption – so that the net distortionary impact on trade actually increased? That could explain why a revaluing RMB is nonetheless consistent with an even more undervalued RMB in relative terms.

New lending surges

We are getting reports that June lending numbers are up on May. One of the more bizarre pieces of “good news” recently – very popular among the China bulls – were claims that new lending had moderated significantly in the past two months (so don’t worry too much about that credit bubble everyone’s talking about), but this is true only to the extent that new loans in April and May were compared to the astonishing first quarter numbers. In fact net new lending in April and May was around double the equivalent amounts last year and every year in this decade.

In June, it looks like we are retuning to an upward trajectory. According to an article in the current issue of Caijing:

Commercial bank lending in the first half is expected to hit 6.5 trillion yuan, with new loans in June coming in at about 660 billion yuan, the official Shanghai Securities News reported, citing people close to the matter.

Chinese banks lent out a record 4.6 trillion yuan in the first quarter to help start stimulus projects; while there has been a slowdown since April, the central bank says its policy remains “moderately loose.” Experts have warned against lending quality, unauthorized loan diversions, and the re-emergence of bad loans, which may cause banks to be more cautious in lending in the second quarter.

Discussing the impact of all this lending Andy Xie weighs in with another thoughtful and worried piece in the current issue of Caijing. He writes:

China’s credit boom has increased bank lending by more than 6 trillion yuan since December. Many analysts think an economic boom will follow in the second half 2009. They will be disappointed. Much of this lending has not been used to support tangible projects but, instead, has been channeled into asset markets.

Many boom forecasters think asset market speculation will lead to spending growth through the wealth effect. But creating a bubble to support an economy brings, at best, a few short-term benefits along with a lot of long-term pain. Moreover, some of this speculation is actually hurting China’s economy by driving asset prices higher.

The current surge in commodity prices, for example, is being fueled by China’s demand for speculative inventory. Damage to the domestic economy is already significant. If lending doesn’t cool soon, this speculative force will transfer even more Chinese cash overseas and trigger long-term stagflation.

He goes on to say:

The international media has been following reports of record commodity imports by China. The surge is being portrayed as reflecting China’s recovering economy. Indeed, the international financial market is portraying China’s perceived recovery as a harbinger for global recovery. It is a major factor pushing up stock prices around the world.

But China’s imports are mostly for speculative inventories. Bank loans were so cheap and easy to get that many commodity distributors used financing for speculation. The first wave of purchases was to arbitrage the difference between spot and futures prices. That was smart. But now that price curves have flattened for most commodities, these imports are based on speculation that prices will increase. Demand from China’s army of speculators is driving up prices, making their expectations self-fulfilling in the short term.

I usually don’t quote so much from a single source, but I think Andy Xie’s piece is a very good one and well worth reading (there is a lot more). He makes many of the arguments that all of us who worry about China’s continuing failure to adapt to the huge adjustment in the global and US economies. His conclusions:

What is happening in the commodity market is glaring proof that China’s lending surge is hurting the country. Even more serious is that it is leading Chinese companies away from real business and further toward asset speculation – virtual business.

…Many analysts argue GDP growth follows loan growth, and inflation is a problem only when the economy overheats. This is naive. Borrowed money channeled into speculation leads to inflation. And China may face a lasting employment crisis if private companies don’t expand.

This lending surge proves China’s economic problems can’t be resolved with liquidity. China’s growth model is based on government-led investment and foreign enterprise-led export. As exports grew in the past, the government channeled income into investment to support more export growth. Now that the global economy and China’s exports have collapsed, there will be no income growth to support investment growth. The government’s current investment stimulus is tapping a money pool accumulated from past exports. Eventually, the pool will dry up.

If exports remain weak for several years, China’s only chance for returning to high growth will be to shift demand to the domestic household sector. This would require significant rebalancing of wealth and income. A new growth cycle could start by distributing shares of listed SOEs to Chinese households, creating a virtuous cycle that lasts a decade.

Putting money into speculative investments isn’t totally irrational. It’s better than expanding capacity which, without export customers, would surely lead to losses. Businesses currently lack incentive to invest. But many boom forecasters wrongly assume that recent asset appreciation, fueled by speculation, signaled an end to economic problems. That’s an illusion. The lending surge may have created more problems than it resolved.

Tags: John Williamson, William Cline

I have recently finished reading Martin Wolf’s latest book, Fixing Global Finance, and I strongly recommend it for its very clear laying out of the global balance of payments issues behind the global crisis. I should warn my readers that Wolf and I have come to very similar conclusions about the underlying root causes of the crisis – we are both in agreement, for example, about the distorting effect of Asian policies to constrain consumption and boost investment in manufacturing output – but I am mostly impressed by the fact that we come to the same conclusion from such different angles.

Wolf begins with a model based on analyzing the financial architecture of the past forty years and brings to his analysis a very US-centric view of the world, whereas my conceptual model is based on my obsessive reading in the history of financial flows between rich and poor countries and starts with a China-centric view. Somehow we end up in almost exactly the same place, which suggests to me that we may be right or, at the very least, onto something important.

I won’t try to summarize the book but I do want to set out two paragraphs in which Wolf explains, far more clearly than I have ever been able to, how it is that reserve accumulation in Asia “forced” US households into overconsumption. One of the most common fallacies in popular economic analysis is to assume that countries are somehow analogous to households, and the factors that lead a household to consume “beyond its means” are similar to those that cause a country to do so. In that case if the US over-consumed, it is no different than if a stereotypical welfare family maxed out on its credit cards, and while we can fret at the stupidity of the bankers who gave them their credit cards, ultimately the blame for the mess must rest with the innate profligacy of mom and dad.

But this is not true at all when we are talking about overconsumption at a country level. As I have tried to argue many times, the global balance of payments must balance, and significant change in any component of the balance necessarily requires adjustments elsewhere. If Country A enacts trade policies that result in a surging current account surplus, for example, Country B must see its current account deficit surge by the same amount, and the way that happens will reflect a number of factors including the structure of its financial system. Country B could try to resist the growing deficit by engineering a recession and so causing total demand to drop, but this can be very painful for both countries.

Let us assume, then, that a group of countries, perhaps in response to the 1997 crisis, decide that in order to protect themselves from a repeat of that disaster decide to engineer polices aimed at accumulating reserves and limiting external debt. The most obvious way would be to put into place policies that constrain consumption and boost savings (keep wages and interest rates low, limit credit availability to consumers, limit credit availability to small and medium enterprises and especially to the service sector, maintain an undervalued currency, etc.) and direct credit to the investment and manufacturing sector. As a consequence growth in production would exceed growth in consumption and the balance would represent the trade surplus. Trade surpluses, of course, have to be recycled as investment flows (or reserve accumulation) back to the country against which they are running these surpluses. This is not a choice, or even a real lending decision. It is the automatic and necessary consequence of running a trade surplus.

Since the US is the largest and most flexible economy in the world, and since the primary world reserve currency is the dollar (more on this later), in practical terms only the US can be the deficit country for any period of time, and so the surplus countries must accumulate US dollar assets as the obverse of their trade surplus. Martin Wolf explains what happens next:

The rest of the world’s capital outflow supports the dollar. At the resulting elevated real exchange rate for the United States, the output of the sectors in the US economy that produce tradable goods and services shrinks, other things being equal. The Federal Reserve cuts interest rates to expand the economy, thereby preventing excessive unemployment. As it does so, a large excess demand for tradable goods and services emerges in the United States. This finally, appears in the trade and current account deficits.

One consequence of all this is that US domestic demand has had to grow faster than real GDP, to ensure that the latter grows in line with potential. The difference between the two is, of course, the increase in the current account deficit, in real terms. With trend growth in GDP between 3 and 3.5 percent a year, domestic demand has to grow even faster. That is precisely what has happened. US real demand (or gross domestic purchases) grew faster than real GDP in 1993 and 1994 and then again every year from 1996 to 2004 inclusive. Cumulatively, between 1993 and 2004 US real GDP grew by 46 percent, while gross domestic purchases rose by 53 percent. That is how the current account deficit emerged. It is also how the United States absorbed the supply of excess capital from abroad.

In the face of a sharp contraction in those sectors of the US economy that compete with Asian manufacturers, in other words, the Federal Reserve must either permit a rise in US unemployment, in which case US consumption will decline and with it imports from Asia will decline too, or it must prevent the rise in unemployment by putting into place monetary policies that are consistent with rapid GDP growth. This argument, by the way, is not at all affected by the very common (and incorrect) argument that the main cause of the US trade deficit with China is the fact that China produces things that the US doesn’t want to produce, which I have tried to address in a March 9 blog entry.

Global savings glut

In either case US consumption must grow faster than US GDP, and the choice for the Fed is whether to target a “normal” growth in consumption, and permit rising unemployment, or a “normal” growth in GDP, and so permit rising indebtedness. The Fed must use US unemployment, in other words, as a tool to prevent Asian trade policies from leading to excess US indebtedness.

All this would have been bad enough if it hadn’t been for the need for the US to finance a very unpopular war, the Iraq invasion, in the way that unpopular wars have traditionally been financed – irresponsibly, through borrowing and money creation rather than taxes (remember that the Vietnam War was also associated with a credit bubble in the US). Asian policies, according to this view, definitely helped create the monetary distortions, but we must remember that there were plenty of bad domestic policies compounding the problem.

At any rate for the Fed to use US unemployment as a tool to prevent Asian trade policies from leading to excess US indebtedness is obviously politically very difficult, and it is also obvious that for the past ten year the Fed chose excess indebtedness. Since the 1997 crisis we have seen both household savings and the US trade deficit break out of their normal ranges and either collapse (household savings) or surge (trade deficit). This is a necessary consequence of the process that Wolf describes.

In that light, as U.S. fiscal spending surges in response to the crisis, increased attention will be placed on the way that U.S. fiscal spending leaks out through the current account to boost employment in China and elsewhere. And just as the Chinese complain bitterly, and rightly, that the West outsources polluting activity to China via the trade account, the U.S. will complain, as Martin Wolf pointed out in a March 31 editorial in the Financial Times, that China is outsourcing fiscal indebtedness to the U.S., also via the trade account. Surplus countries, he argues, “relied on the private sectors of deficit countries to do their irresponsible borrowing for them.” In response to the contraction in the borrowing among US households, the U.S. government, in other words, is currently choosing to borrow and spend the proceeds in order to generate job growth in the U.S. as well as in China. This can’t go on forever.

All of this is, of course, a variation on Ben Bernanke’s “global savings glut” hypothesis, and as everybody knows, Beijing wholly rejects this hypothesis as an explanation for the current global imbalances. For Chinese policymakers, the cause of the crisis lays firmly and totally within US monetary and financial policies (or lack thereof), and absolutely no blame can be apportioned to Asian trade policies.

Or is this really Beijing’s view? The extraordinary thing to me is that while Beijing has insisted almost desperately that any attempt to apportion blame to China is completely dishonest, they have nonetheless more or less welcomed Bernanke’s hypothesis, perhaps without realizing it, through the back door. I say this because the widely-discussed essay by PBoC Governor Zhou last week, in which he assailed the reserve status of the US dollar as being the main cause of global imbalances, is as far as I can tell nothing more than Ben Bernanke’s hypothesis viewed from a slightly different angle.

Why? Because Governor Zhou makes the claim that the reserve status of the US dollar gives the US an unfair advantage in that it can borrow nearly unlimited amounts simply as consequences of the need for foreign countries to accept dollars as reserves and for the purpose of international trade and investment. Of course he is almost certainly right, and he is just as certainly not the first person to make this claim. I think it was De Gaulle’s favorite economist, Jacques Rueff, who first discussed this “exorbitant privilege” as far back as the 1960s (NB: Martin Wolf corrects me — it was Valery Giscard D’Estaing who first said it — but I leave the mistake, and the correction, because it is one so commonly made).

But remember that if we make the very simple (and necessary) assumption that the ability of a country to run current account deficits is constrained mainly by a country’s ability to finance those deficits, then the ability to borrow unlimited amounts also means the ability to run unlimited trade deficits. It was the reserve status of the dollar that permitted the US to run the massive trade deficits it has during the past decade.

Had the US dollar not been the reserve currency of choice (in other words had Asian trade surplus countries not recycled their trade surpluses into purchases of US government bonds), the dollar would have had to decline against world currencies as a consequence of the rising deficit – Asian currencies too, and not just European – and the US trade deficit would have stabilized at much lower levels. This is also another way of saying, as Martin Wolf’s piece directly implies, that the Fed would not have had to choose between unemployment and indebtedness and that the binge borrowing that characterized US household behavior would have been much, much lower.

The world loves dollars because the US seems to love deficits

In fact I would go further. Because of the dollar’s reserve status, only the US could have possibly run the deficits necessary to absorb the huge surpluses that Asian trade policies were generating. Without the dollar’s status as a reserve currency, the Asian development model that stresses expanding production while constraining consumption – which among other things results in trade surpluses and net investment abroad (which of course is the same thing) – would have either required another reserve currency, or it would have failed.

Could there have been another reserve currency – and could it be that the dollar’s “exorbitant privilege” is something that Washington has enforced? Yes and no. The US economy comprises about one-quarter of the world’s economy and one-third of the rich-country economies. In principle it would have been very easy for any country to accumulate reserves of other rich countries – nearly all of whose currencies are easily convertible – so that there is no reason why the dollar portion of all developing-country central bank reserves might not have exceeded roughly one-third of the total, instead of the two-thirds or more that it currently occupies. Another third could be euros, and the rest a combination of the currencies of Japan, the UK, Switzerland, Canada, Australia, South Korea, and so on.

But it can’t just rest there. When a central bank chooses which currency to buy, unlike when you or I make our own portfolio decision, it is also determining the direction of net trade flows. Those other countries would have had to match the investment surplus (net inflows on the capital account) with an equally large current account deficit. If China had followed this balanced policy of reserve accumulation, in other words, the only thing that could possibly have stopped them, and a very big impediment it would have been, was the political or economic willingness and ability of those countries to run the corresponding trade deficits with China.

That, of course, is the problem. Given their much more limited economic flexibility and their less ebullient financial systems, those other countries probably would have never been able to sustain the necessary levels of trade deficit, and they would have almost certainly moved aggressively against China to limit the development of unfavorable trade balances. China, in other words, chose to hold US dollars not because the US government has somehow enforced reserve status on the US dollar and denied it to other currencies (Washington could never have prevented China from buying euros or yen or anything else), but simply because no other country is able to run deficits of the necessary magnitude.

The argument, then, that the dollar’s status as the reserve currency and brings an exorbitant privilege is simply the other side of Ben Bernanke’s savings-glut coin. Without the dollar’s reserve status, the global savings glut would have never occurred, or rather it would have never resolved itself in the way it did, and Asian development models aimed at engineering trade surpluses would have had to fail.

So is Governor Zhou a closet Bernanke-ite? He would probably be surprised at this question, and even more surprised at my answer, I think, but I cannot see how you can separate the two arguments – his on the perils of the dollar’s dominant reserve currency status and Bernanke’s on the impact of high Asian savings on the US balance of payments. He and Bernanke agree fundamentally on the roots of the imbalance.

By the way, the model I have been using to explain the imbalances also addresses another contentious question between the US and China which I did not really think about until I read a fascinating short piece by MIT’s Simon Johnson on his blog, more in reference to Europe but relevant nonetheless. China, as we know, is very worried that the US will resort to monetary policy rather than fiscal policy to address collapsing demand in the US. The former hurts China (supposedly because it might cause an erosion in the value of the dollars the PBoC holds), whereas the latter helps by slowing the contraction in US net demand and giving China more time to adjust its overcapacity problem.

It turns out that there may be another reason, even more powerful, and as soon as I read this paragraph by Johnson I had one of those “Aha!” moments that means I am going to have think much more seriously about the implications:

Remember this. If you run an expansionary fiscal policy (building bridges), I have an incentive to free ride (selling you BMWs) and not engage in a similar fiscal stimulus. But if you run an expansionary monetary policy, your exchange rate will tend to depreciate, putting pressure on my exporters and I’ll be pushed – by BMW-type producers – towards providing a parallel monetary stimulus.

This may be why monetary rather than fiscal stimulus makes sense for the US, and less sense for trade surplus countries. It prevents, or at least reduces, the leaking-out of employment generation effects of US borrowing and spending.

The other China

Talking about BMWs, my argument, of course, is not so much about China and the US as it is about trade surplus and trade deficit countries. In that light there was a very interesting article in Monday’s Financial Times about the difficulties Germany is facing in adjusting to the changes in the global balance. Many people assumed that Germany, which was in a very “strong” position (high savings, large trade surplus, low debt – which are all more or less the same thing, really), would weather the crisis easily, but of course it should have been self-evident that a crisis that affects the deficit sides of the global balance of payments must also affect, by the same amount, the surplus sides:

The risk is that – like Japan in the 1990s – Germany faces a “lost decade”, or a protracted period of economic malaise as it waits for the global economic tides to turn and struggles to find domestically generated sources of growth. “I am convinced it is going to be a slow recovery,” says Mr Staake. “Who is going to be buying anything?”

This downfall is all the more galling because, even a year ago, the country could have expected to weather the global economic storms. There was no danger of a housing crash; prices had been flat for a decade. Consumers had saved; companies had not increased leverage dramatically. “From a structural point of view, this recession should never have happened,” says Commerzbank’s Mr Krämer.

With hindsight, however, Germany was a sitting target after the collapse of Lehman Brothers investment bank in mid-September. Its exports were equivalent to more than 47 per cent of GDP last year – compared with less than 20 per cent in Japan and about 13 per cent in the US. Its industrial base is skewed towards producing machinery and equipment – “investment goods” account for more than 40 per cent of its exports – and towards emerging European and Asian economies.

While the crisis was focused on US housing and capital markets, Germany was unaffected. But after Lehman’s failure paralysed banks, and confidence nosedived globally, companies around the world shelved investment plans – leaving German factories turning out goods nobody wanted to buy. Industrial production in January was more than 20 per cent lower than a year before; overseas orders for investment goods had almost halved.

“Who is going to buy anything?” Good question, and one that must be answered by policymakers planning to export their way out of the crisis.

I especially love the statement “From a structural point of view, this recession should never have happened.” One of my standard complaints about most economists, especially those who focus on a single country or group of countries, is that they ignore balance-sheet and balance-of-payments effects. Of course it should have been obvious that a crisis in the deficit countries would affect the surplus countries – in fact it should have been obvious that the impact on the latter should have been worse.

Meanwhile, and as a continuing part of how the crisis will evolve, there is an interesting article in today’s Bloomberg about one of the ways in which the Chinese fiscal response to the crisis risks making the imbalance, and China’s long-term adjustment, worse.

China’s shipbuilding industry may be about to get a bailout — from its customers. The government may force state-owned shipping groups to buy more vessels as foreign carriers scrap orders, according to Steve Man, an HSBC Holdings Plc analyst in Hong Kong. That risks increasing costs and overcapacity among shipping lines grappling with a collapse in global trade.

“They ‘encourage,’ but my thinking is it’s more of a directive,” said Man. “It hurts every player in the industry and creates excess capacity that will take longer to absorb after an upturn.”

As I have argued many times, the constraints of the Chinese development model and limitations in the financial system mean that it will be very hard for China to shift its behavior quickly enough to match the possible adjustment in the US and elsewhere. Bailing out the ship-building industry is one way in which Beijing’s fiscal reaction – while understandable from an employment point of view – may exacerbate the adjustment. Washington’s bailing-out of the automobile industry is the same sort of mistake, I think, but in the US case it is much easier to justify. The US must reduce its net consumption, and if boosting production is economically inefficient in the long term, at least it fits within the overall adjustment in the short term. This is not the case with China – it should be boosting consumption directly, and not indirectly by boosting capacity.

There is a lot more I wanted to discuss today, but this blog entry is getting to be way too long. But just one quick thing, yesterday I was having coffee with some visiting friends from Goldman when one of them received a notice that there were credible rumors on the March increase in new loans. We had all been expecting a very big March number – between RMB 1.3 and RMB 1.6 trillion.

It turns out that the true number may have been an astonishing RMB 1.9 trillion.

That means that for the first three months of the year we have had loan increases of RMB1.6 trillion, RMB 1.1 trillion, and RMB 1.9 trillion. This amounts to RMB 4.6 trillion for the first quarter of 2009, compared to RMB 4.5 trillion for all of 2008. Notice to my students: learn more about how to resolve and restructure bad loans. This will be a great career option for you over the next few years.

Tags: Exorbitant privilege, Zhou Xiaochuan

Beijing music and art

 

Things have been so busy that I haven’t been posting as much as I would like.  Besides my increased writing commitments and the constant barrage of news, I would like to mention that over the past weekend we completed the second annual festival of experimental and avant garde music, featuring the best Chinese composers and performers from all over the country, and several of my regular blog readers attended – thanks for that, even though this blog is no longer available inside the Chinese firewall.  

 

Twenty hours of music over two days is not always easy, especially when some of the music is “challenging,” to say the least, but I am pleased to say that this festival has become the premier event in China for new and experimental music and the turnout was larger than expected and very enthusiastic.  So far we don’t seem to have been affected by the economic crisis.  In particular performances by Mamur, Li Jiahong and Li Tieqiao, Shouwang’s White Ensemble and a number of others were exceptionally good.  We’re all still exhausted, but already I have been getting urgent enquires about our plans for next year.

 

While on the subject of art I should note that the People’s Daily had an article today on difficulties facing the Chinese art market.

 

The global economic meltdown has hit the city’s art exhibition industry, with several big international events attracting less funds than before or even being postponed, exhibition organizers said.

 

The article goes on to discuss difficulties facing the 798 Art District in Beijing “a center featuring primarily non-government-funded art events, where many shows were cancelled.”

 

I am not totally sympathetic because it seems to me that the commercial art scene here was simply part of the late stage credit bubble, and the young artists I like best were never really able to participate.  But it is a nonetheless interesting story because historically art bubbles have always been part of the bubble cycle.

 

On that topic, I thought I would make a quick, and perhaps a little snide, reference to an article in last month’s New York Times about the Chinese art market.  About a year ago I had dinner with a group of people which included a couple of gallery owners specializing in contemporary Chinese art.  Not surprisingly, they were ebullient about the seemingly inexorable rise of Chinese contemporary art prices, and perhaps also not surprisingly, I was enough of a wet blanket to argue that we were soon going to see a total collapse in art prices. 

 

Why?  Because every serious financial bubble in history was, towards its later stages, accompanied with an even more ferocious bubble in art prices, and when the bubble burst, art prices were among those worst hit (I refrained from adding that although there are a number of young Chinese underground artists whose works I really love – stand up, Cult Youth Collective – for the most part I was very unimpressed with the commercial stuff getting most of the attention).

 

Needless to say most of the dinner guests were politely skeptical, and my pointing out the examples of the Japanese art market in the 1980s and the Arab art market in the 1970s – two markets that people don’t talk about much anymore, it seems – didn’t make much difference.  One month later I read in one of the British newspapers that some well-known London-based art dealer had announced that prices in the art market had reached a level that represented long-term artistic value, and would not be affected by the crisis (art prices have reached a stable plateau? I hope he was otherwise as good an art dealer as Irving Fisher was an economist). 

 

So what does the New York Times article say?

 

A global financial crisis has wiped out vast amounts of personal wealth, prompting a plunge in art prices. Suddenly bereft of visitors, galleries are laying off staff members, and the collectors who patronized them now worry that their art investments may prove a colossal folly.  “It’s been a long, cold winter,” said Zoe Butt, director of international programs at Long March Space, which is closing two of its three Beijing galleries. “The era of Chinese contemporary art commanding such high prices is over.” 

 

…Globally, the recent rise in Chinese artists’ fortunes was unparalleled. Only one Chinese artist — Zao Wouki, a traditional painter who lives in France — ranked among the Top 10 best-selling living artists in 2004, according to Artprice.com, which tracks auction sales. (He ranked ninth.) But by 2007, 5 of the 10 best-selling living artists at auction were Chinese-born, led by Zhang Xiaogang, who trailed only Gerhard Richter and Damien Hirst. That year, Mr. Zhang’s auction sales totaled $56 million, according to Artprice.com. Many collectors were seduced by the numbers. “For people who got into the market three years ago, I feel sorry for them,” said Fabien Fryns, who runs F2 Gallery in Beijing.

 

When people say that it isn’t easy to know if we were in the midst of a bubble, I can only respond that when, in just three years, the number of Chinese artists in the top ten living best-sellers zooms from one to five, it must be obvious that we are in a particularly frothy bubble.  No matter how rapidly talent and access to collectors improve, the quality of an art scene simply cannot adjust at anywhere near that speed.  I am sure even Renaissance Florence under Cosimo de Medici’s very wise patronage took much longer than three years to move so far up the artist-income scale.

 

A new reserve currency

 

But back to less exalted things.  The number one topic of conversation right not seems to be an essay posted in both English and Chinese on the PBoC’s website by PBoC Governor Zhou Xiaochuan.  In it Governor Zhou argues that the world needs a new and better reserve currency, one not dominated by a single country, and that it is in the best interest of the world that this reserve currency be created by a body like the IMF.  Funnily enough for all the attention the essay received I saw no mention of it on either Xinhua or the People’s Daily. 

 

We have heard these kinds of arguments many times before over the course of the 20th century, and usually in response to a global balance of payments crisis.  Is there anything new about this proposal?  Some commentators saw this essay as a purely political move.  Jamil Anderlini of the Financial Times, for example, had this to report:

 

China’s central bank on Monday proposed replacing the US dollar as the international reserve currency with a new global system controlled by the International Monetary Fund.  In an essay posted on the People’s Bank of China’s website, Zhou Xiaochuan, the central bank’s governor, said the goal would be to create a reserve currency “that is disconnected from individual nations and is able to remain stable in the long run, thus removing the inherent deficiencies caused by using credit-based national currencies”.

 

Analysts said the proposal was an indication of Beijing’s fears that actions being taken to save the domestic US economy would have a negative impact on China.  “This is a clear sign that China, as the largest holder of US dollar financial assets, is concerned about the potential inflationary risk of the US Federal Reserve printing money,” said Qu Hongbin, chief China economist for HSBC.

 

Although Mr Zhou did not mention the US dollar, the essay gave a pointed critique of the current dollar-dominated monetary system.

 

Others were more intrigued by the theoretical implications of the essay.  A number of people including Columbia University’s Joseph Stiglitz, are supportive of the idea, arguing that the status of the US dollar as the world’s reserve currency creates unnecessary problems for both the US and the rest of the world. 

 

Most importantly for the US it means that it is very difficult for the Fed to manage domestic monetary policy because the US financial system must accommodate not only conditions in the US but also distortions introduced by the use of the US dollar as a reserve currency, and these distortions can be massive.  The most obvious example is the way over the past decade systematic industrial policies mainly in China and East Asia aimed at running trade surpluses and the accumulation of reserves meant that the US economy and its financial and monetary systems were forced to adjust in ways that created large and serious imbalances, which only now are we resolving.  

 

But although I think the world would be better off if there were an active alternative to the US dollar, I can’t help but think all this flurry of talk is a waste of time and driven mainly by political considerations almost wholly divorced from any understanding of exactly what a reserve currency is and how its status is achieved.  Every decade or so there are calls for the replacement of the US dollar with a more international reserve “currency” but they always lead exactly nowhere, and I can’t think of any reason why this time will be different.  On the contrary, one of my working assumptions is that with the end of the global liquidity cycle the value of liquidity will be higher than ever.  New currencies and currency unions thrive during the liquidity cycle.  They almost never survive the end of the cycle. 

 

Perhaps Governor Zhou has much more faith than I do in the role policymakers have in creating reserve status – as if you could fill a few boxes, make a political decision, and then simply create a new, widely used reserve currency.  But the fact is that excessive reliance on the US dollar was not a policy decision.  If the world truly wants a more “balanced” reserve currency system there are, after all, many currencies that could have functioned alongside the US dollar, but investors, central banks, and international traders seem to have had little interest in acquiring a “balanced” portfolio of reserve currencies. 

 

For one thing liquidity is key, and I think not even the euro – and certainly not SDRs or alternatives to the SDR – can ever hope to achieve anything like the level of liquidity implicit in the US dollar market.  For another thing, for a currency to achieve reserve status there must be some systematic way of delivering the currency to central banks and other players who want to acquire it, and the US does so by its ability and willingness to run persistent trade deficits.  How will the IMF or whoever controls the SDR create and assign reserves?

 

More specifically, if the SDR is indeed a true reserve currency, and not simply an accounting entry that allows central banks to pretend that they are not holding dollars but whose value ultimately rests on its convertibility to the US dollar, who will determine the global money supply and how do we prevent this from becoming a horribly politicized process?  After all the Fed has an interest in seeing stability in the value and use of the dollar, and so it can be counted on more or less to act in the best interest of the reserve currency, but why should anyone care about the value of the SDR over the long term and, more importantly, how can prudent behavior be enforced?  More worryingly, if Europe has had so much trouble managing monetary policy among a group of neighboring countries with fairly similar social and economic conditions, how do we manage monetary policy on a global scale?

 

Perhaps the SDR is a covert way of getting back to something resembling the gold standard by creating a fiat currency with very strict rules about its expansion.  If that is the case, the SDR almost certainly won’t last long.  Since we’ve gone off the gold standard we have forgotten how brutal and unforgiving gold-standard discipline can be, and I think it was Barry Eichengreem who argued in Golden Fetters that the gold standard could only work in a society in which the poor and the weak have little political power, the voting franchise is limited, and the impact of monetary policies on underlying economic conditions was not widely understood.

 

Unemployment

 

All this talk of new currencies and new financial architecture is obviously aimed at the upcoming G20 meetings.  I very much doubt anything useful will come of the meeting except for diplomatically restrained name-calling, and I am currently writing a piece to be published by the Carnegie Endowment (who I recently joined), which I hope to have by the end of this week, discussing some of the issues the participants are going to face.

 

Bu away from the world of high finance I thought I would mention two things.  The first is an article in last week’s Xinhua on hiring prospects.

 

The latest report by major job service provider Manpower indicates that hiring prospects in China may continue to drop by a “considerable 10 percent” in the second quarter as the global financial crisis began to affect the real economy.  The report, based on a survey which covered 4,149 employers across the country, showed that the eastern job markets were experiencing the weakest hiring climate in four years.

 

The next article, on the same topic, is from today’s People’s Daily. It focuses specifically on the job outlook for college graduates.  Last week I read an article – also in People’s Daily, I think, but I can no longer find it – in which it was claimed that the share of Guangdong students graduating in 2009 who already have job offers was less than half of the share last year at this time.  Today’s article seems to confirm this:

 

In an unfortunate reversal of fortune, more than 70 percent of upcoming graduates have yet to secure a job.  “Normally about 70 percent of graduates have job offers in March, but now the situation is completely upside down,” Wu Xiaohui, senior campus recruitment consultant with Shanghai Foreign Service Co Ltd (SFSC), told China Daily yesterday.

 

The article goes on to say:

 

According to another survey by SFSC, about 55 percent of the city’s 104 multinational corporations didn’t intend to recruit new staff this year amid the deepening recession.  Among those who plan to hire, half will recruit fewer than 10 people, compared with an average of 50 to 100 people in previous years.

 

Along with this gloomy outlook the World Bank last week cut its growth forecast for China.  When they cut their forecast last year, I said they would revise it downward at least one more time.  Perhaps this time will be the last downwards revision for 2009, but if it is, expect a series of downward revisions for 2010.  This is from last week’s Xinhua:

 

The World Bank (WB) has cut its forecast for China’s 2009 economic growth yet again — this time to 6.5 percent from 7.5 percent, it said here Wednesday.   This is the second cut the bank has made for China’s 2009 gross domestic product (GDP) growth forecast. Last November its prediction stood at 9.2 percent.

 

This came after the bank lowered its forecast for the 2009 world economy, which was expected to decline 1.5 percent from 2008. In November, the WB forecast the world economy would grow 1 percent this year.

Tags: Art bubble

Replenishing bank capital

One of the students in Peking University’s Guanghua Students Monetary Policy Committee, a group for which I am an advisor, put together last week a summary of plans to raise capital adequacy ratios for Chinese banks.  I thought it would be useful to reproduce his numbers.  According to him, Shenzhen Development Bank, Everbright, China Merchant Bank and CCB have recently issued RMB 83.2 billion ($12.2 billion) in subordinated debt.  Minsheng Bank, ICBC, Industrial Bank and BoC plan to issue an additional RMB 243 billion ($35.5 billion) of subordinated debt.  Minsheng is also planning to issue RMB 1 billion in shares. 

At the same time in December the CBRC required that the big five banks raise their loan loss provisions from 100% to 130% of the loans in the bottom three of the five credit categories.  Off the top of my head I think the second category – “special mention” loans – comprises roughly three times as many loans as the bottom three categories combined, and many analysts assume that anywhere from one-half to all should properly be classified as doubtful or impaired.  Given the huge growth in lending and lax lending standards during the past few years (during what had to be a great time to be a banker), I think skepticism about the quality of bank portfolios is very much in order.

Policymakers are assuring everyone that the banking system is healthy, as policymakers everywhere always do.  I, of course, have my doubts, so I think it is very prudent that while they praise the banking system on one hand the authorities are making banks take on more capital and larger loan loss provisions.  I think it is extremely unlikely that we don’t see a surge in NPLs over the next two years.  This is particularly likely since credit expansion for February turned out to be RMB1.1 trillion, three to four times the amount of new lending last February which, when combined with last month’s RMB1.6 trillion, means than net new loans for the first two months of this year are significantly more than half of net new lending in 2008.  Of course it might be pointed out that most of this new lending is to state-sponsored projects and was strongly “encouraged” by policymakers, so it is likely to come with explicit or implicit guarantees, but in the case of a surge inNPLs I suspect that banks will nonetheless be forced to take losses before the government itself steps in.

Aside from loan and capital-raising figures other numbers are not looking too positive.  The wholesale price index came out today, with wholesale prices falling 6.0% year on year.  Part of this was caused by falling crude and commodity prices, but there is enough left over to make me continue wondering about underlying liquidity conditions.  Logan Wright told me Saturday that he expects to see very low, or even negative, reserve accumulation over the quarter, and regular readers of my blog know that I consider reserve accumulation to be the strongest indicator of underlying monetary conditions in China.

Manufacturing output for the first two months of the year was up 3.8% from the same period last year, which was well below already low projections (because of the moving Spring Festival holidays it doesn’t make much sense to compare individual months in the first quarter).  Much of what little growth occurred was powered by a surge in concrete production and, to a lesser extent, by a sharp increase in vehicle sales.  The optimists would say that this shows that the government stimulus is working.  Pessimists would argue that the increase in auto sales may well be short-lived because it surged largely after a cut in taxes, and there are persistent rumors of a significant increase in car purchases by government-related entities.   In both cases the  growth in sales might then be seen as anticipated purchases that take will have trouble persisting.

Likewise pessimists would also argue that the surge in concrete production is not evidence that the stimulus is having an effect but rather evidence  that people believe that it will have an effect, and so are building inventory in anticipation (the same is probably true of the recent surge in steel production and inventory levels).  This is good news if the stimulus actually does have a big impact on demand, since rising inventory prevents bottlenecks, but of course bad news if the stimulus turns out to be weaker than expected, in which case the need to work off inventory will slow future production to below actual usage. 

Aside from high loan growth numbers and low growth in manufacturing output, retail sales figures also came out last week.   According to an article in Thursday’s South China Morning Post: 

Growth in retail sales slowed to 15.9 per cent over January and February from December’s 17.4 per cent growth and 22 per cent in October, the statistics bureau said.  “It seems clear the domestic demand is slowing in China, and this could be happening at a faster pace than the sales data suggest,” said Moody’s Economy.com analyst Sherman Chan in a report. “Having households pull back on spending is exactly what China does not need.”

Beijing is trying to prod consumers to spend more with measures that include subsidizing appliance purchases for rural families. But families save heavily for education, health care and other expenses, and analysts say they are unlikely to spend more on consumer goods until Beijing creates a social safety net to ease such burdens.  A market research company, DDMA, said a February survey found 45 per cent of those polled had cut back on spending, down from 7 per cent in January. 

Xinhua put a different spin on the numbers in an article the next day: 

China’s retail sales grew 15.2 percent in the first two months to 2 trillion yuan (293.8 billion U.S. dollars), the National Bureau of Statistics (NBS) said Thursday.  The figure, although lower than the 20-percent-plus increase a year earlier, was encouraging, analysts said.

Retail sales growth in January and February was equal to or even higher than last year adjusted for inflation, said Zhuang Jian, senior economist with Asian Development Bank.  The consumer price index (CPI), a major gauge of inflation, hit a 12-year high of 8.7 percent in February 2008 but fell 1.6 percent in the same month this year.  “Domestic consumption has remained stable so far, despite the economic slowdown,” he added.  

I think Xinhua’s interpretation is probably closer to the mark but in either case it seems, not surprisingly, that household consumption is almost certainly declining.  Remember that retail sales are not a great indicator of household consumption in China because they include lots of other things, including government consumption.  In addition I should add thatCICC , one of China’s three leading investment banks, came out with a report on March 11 which I cannot excerpt but which basically advised caution about the retail sales figures and the outlook for household consumption.

A difficult transition

On a very different subject, two days ago I received a very interesting and intelligent email from one of my readers, a student who I believe is from the South of China (I am guessing this because he mentioned his plan to set up a business in Guangxi) although I am not sure if he is currently at Peking University or at another school.  He has allowed me to reprint his email, although I am not sure whether he is comfortable with my using his name, so I will reprint part of his letter while leaving out his name and any private references.  I have edited the letter slightly to make it follow the format that I use in this blog:

Being a student and a loyal reader of your blog, you have all but convinced me that China should continue to allow its currency to appreciate, for China and the world’s sake. This is in spite of the fact that my family runs an export business and appreciation of the currency will most definitely affect our business in a negative way.  In light of the global financial crisis, the big theme in China is how to increase domestic spending and gradually make the export oriented businesses more domestic-dependent. And I always tell myself that the appreciation of the RMB will help because imports will be cheaper and that will directly increase the purchasing power of Chinese consumers. 

Today, I went shopping with my girlfriend at Carrefour and I was trying to find some evidences to support my theory. Today we bought about RMB100 of food, typical of the things that we would need for the next 2-3 days.  Roughly, I would say we bought RMB30 worth of meat (chicken and pork), RMB40 worth of fish, RMB20 of milk/dairy and RMB10 of shampoo.  Then I try to determine how much the Chinese consumers would save if the exchange rate was changed.  Here is what I realize: 

All RMB 100 of food are made right here in China. Even the RMB10 foreign brand shampoo is made by a factory in Shanghai. So, I thought, what would happen if the dollar to RMB exchange rate becomes 1:4? Well, the cost of making these items wouldn’t decrease that much because most of the components that go into producing these items are not imported and would stay pretty much the same. (Please correct me if I am wrong in this assumption.)

However, if the exchange rate suddenly becomes 1:4, a lot of Chinese exporters, including my family’s juice business, which actually has a good margin compared to other labor intensive industries, will go out of business.  

In addition, perhaps now it would make economic sense for western companies to import their products (beef, fish, milk, shampoo) into China (of course assuming that the tariffs stay the same) and domestic consumers would buy imported goods because they are better quality and may now be cheaper.  

So this also adds additional pressure to the manufacturers. furthermore, perhaps now P&G would in this new exchange rate environment consider producing its shampoo in the U.S., because relatively speaking, P&G’s cost of production in the U.S. would have gone down.So China gets hurt in a multiple of ways as a result of China revaluing its currency: 

 So in conclusion, on the one hand, based on PPP or Big Mac index, I get the impression that the RMB is greatly undervalued (i.e. 1 Big Mac in US is $4, and 1 Big Mac in China is RMB 12-15). Yet, if the RMB were to really go up in value, the economy would definitely be hurt in many ways.

This is a great letter because (aside from the fact that it shows why I enjoy teaching here so much, given the intelligence and thoughtfulness of so many of the students I meet) it indicates in a very concrete way how complex the policy decisions are and how difficult the transition process is likely to be.

The first thing I would bring up is the issue of the effect of revaluation on the food purchased at Carrefour.  Of course it is true that the cost to make those Chinese-made goods would not decline in RMB terms except to the extent that they included foreign components (which may be more than many realize, since much of the fertilizer used by Chinese farmers comes from abroad, as does the oil they use to transport their products to Carrefour), but that does not necessarily mean that their cost to the consumer would not decline.  All of these things can be manufactured abroad, and it may be that Malaysian chickens, Australian milk or the same shampoo manufactured in Vietnam would become so much cheaper that either Chinese consumers would begin to buy more foreign food, or Chinese producers would have to lower their costs or improve their quality to compete.  This directly benefits Chinese consumers. 

Of course it might hurt Chinese farmers and producers, and this is why the transition becomes difficult.  In a very abstract way we can argue that whatever pain the farmers feel is less than the gains other Chinese enjoy.  Cheaper food for Chinese consumers means that they have more money leftover to go to restaurants, buy books, or get haircuts, and so Chinese businesses that supply these services will benefit.  

In an even more abstract sense we can argue that China does some things relatively better than other countries, and some things relatively worse – that is, the specific conditions in China, including its infrastructure, labor markets, educational systems, and so on mean that Chinese can do some things more productively and efficiently and other things less so.  By allowing the RMB to appreciate (or by otherwise relaxing constraints that affect the relationship between production and consumption), Chinese businesses and producers will be forced to concentrate on the things they can do more productively and efficiently than others, while leaving others to do the things they don’t do so well.  

This increases the total economic well-being of China and the countries with which it trades, and so at least in principle every country can become a little better off.  Remember that if China buys more from abroad, that doesn’t mean that Chinese producers must sell less.  Whatever money China exports to pay for those imports represents a net increase in either 1)foreign buying of things that Chinese producers are good at making or 2)foreign investment in China, which increases the productivity of Chinese workers.  Both of these are good for China’s economic prospects and both result in rising employment. 

But there is no getting around the fact that the process will be painful in the short term, as the student writing the letter has pointed out.  Although in the long run China and Chinese workers and consumers will almost certainly be better off as China makes the transition to a more balanced and domestic-driven economy, there are nonetheless short term costs.  Resources and labor will not be smoothly reallocated from exporters to domestic service producers and manufacturers who serve the local markets.  What usually happens is that, to use the very dry jargon of economists, these resources and labor will be “freed up” as exporters go bankrupt or downsize.  

As economic conditions change, and as exporting becomes less profitable, businesses aimed at local consumers will take advantage of newly available assets, resources and labor to begin operating, and gradually China will once again reach more or less full employment with a very different economic structure.  But of course remember that at first, domestic demand (and domestic employment) will actually decline as workers lose their jobs.  This is where the government can and should play an important role, for example by boosting domestic consumption as much as possible so that it quickly becomes profitable for Chinese companies to target the domestic market. 

Allowing and even encouraging this transition may therefore seem like a bad idea for China, but as the global crisis shows, it will be impossible for a large economy like China’s to continue depending so much on the export sector and on foreign investment.  It must make the transition, and the later it does so the more difficult it will be. 

 When the US made a similar transition 200 years ago, after the panic of 1797 when the Bank of England suspended gold payments, and when the US Quasi-War with France and the Napoleonic Wars in Europe decimated the US export trade, it did so over at least two very difficult decades, and after sharp rise in unemployment in the early years.  Eventually the whole country shifted its economic structure and, needless to say, the shift turned out to be crucial for the subsequent success of the US economy.  

Japan was forced to confront the failure of its own export-led model in the late 1980s and early 1990s, and, as everyone knows, the process has not been easy.  Of course it would have been better for the US and Japan if they had try to adjust earlier, when global trading conditions were optimal, but like China in the past decade, it is hard to make an adjustment when things seem to be going so well.  It almost always takes a crisis to force the change, even though this makes the process of change that much more difficult.

By the way although much of the above is a fairly standard exposition on how free trade benefits everyone, I am not necessarily a believer in unfettered free trade for China.  Remember that under conditions of free trade and no currency intervention Chinese businesses and producers will be forced to concentrate on the things they can do better than others, while leaving others to do the things they don’t do so well.  This of course benefits the whole world in the short term, but China may not be happy over the long term with its comparative advantages.  It might find that cheap labor and low technological skills are not the kinds of advantages it wants to enjoy.

In that case a very strong argument can be made that selective protection can alter the relative advantages China has by encouraging innovation and development in areas in which China now has a relative disadvantage.  I won’t say much more about this (which is anyway likely to be highly controversial) except to note that as far as I have been able to determine from the historical evidence, with exception of a few very small trading nations, every technologically and socially advanced country since the British in the 17th and 18th centuries did so behind trade and other barriers aimed explicitly at altering the country’s technological and commercial position. 

Much of this theory is beautifully summarized and implemented in Alexander Hamilton’s writings, and it is worth noting that the US, unlike its largely free-trading counterparts in Latin America, had the highest import tariffs of any major country for most of the 19th Century.  The risk of this kind of protectionist policy of course is when trade protection is allied with attempts to foster national champions, which almost always results in the worst of both worlds.  Competition breeds innovation, and state-supported national champions are almost always global losers. 

Before closing I should switch the subject and mention that Canada’s Globe and Mail had an article Friday about my insistence that a very wide-spread claim — that China is Washington’s banker — is based on a misunderstanding of the reserve accumulation process, and that it is probably more useful to think of China as a shop that sells to the US and accumulates IOUs, rather than as its banker.  You can find the article here.  Banker’s lend discretionary money, whereas grocers only accept IOUs from important clients on purchases from the store.  It is an important distinction, I think.

 

 

 

 

Tags: Subordinated debt

Deflation and debt
On Monday CPI and PPI numbers for February came out. CPI was down 1.6% year and year and PPI was down 4.5%, in line with or slightly below expectations and, according to Bloomberg, the highest rate of deflation among the 78 countries they follow. Some of this may be caused by one-off factors, especially declining food prices, and most of the press and analyst commentary suggested as much, but the figures are still too hazy to say with any certainty whether or not deflation is likely to become a problem. Qi Jingmi, an economist with the State Information Centre, a government think-tank, was quoted in an article in the South China Morning Post as saying “I worry about PPI. The sharp fall in PPI shows that the financial crisis is gradually spreading to the real economy.”

The PBoC’s Governor Zhou has already promised that China will do whatever it takes to prevent deflation, although at this point it is hard to find anyone who believes in the 4% target inflation for 2009. According to an article Friday in Bloomberg he said that “We would rather be faster and heavy-handed if it can prevent confidence slumping during the financial crisis.” The article goes on:

Chinese central bank Governor Zhou Xiaochuan pledged “fast and heavy-handed” policies to restore confidence and prevent the global financial crisis from deepening the nation’s economic slump. “If we act slowly and less decisively, we’re likely to see what happened in other countries: a slide in confidence,” Zhou said at briefing in Beijing. The central bank has “ample room” to fine-tune monetary policy after a record surge in lending in January, he said.

I continue to be very skeptical about the actual amount of control the PBoC has over monetary policy. Until last summer despite PBoC intentions to run “prudent” or “tight” monetary policies all the evidence suggested out-of-control money growth, and since then their promises to expand aggressively have been at least somewhat undermined by evidence of monetary contraction. I am convinced that given the currency regime, net foreign inflows or outflows more than other factors determine underlying money in the system, and since the PBoC has very little control over the net flows, and so little control over the rate at which it is forced to monetize those flows, monetary conditions are at least as likely to reflect external conditions as domestic policy.

That is why what interests me most about the inflation numbers is what they suggest about monetary conditions — a subject on which it is very hard to get complete data and for which we often need to draw inferences from other parts of the economy. In that light, it is worth noting that the money-versus-pork debate seems to have died down since last summer with the decline of inflation at year-end, but I suspect it is going to revive soon enough, as I discussed in one of my entries in December. For example, a Bloomberg article on Monday had this to say:

China isn’t yet facing “typical” deflation, where falling prices are accompanied by shrinking loans and money supply and an economic recession, central bank vice governor Yi Gang said, according to the state-run Xinhua News Agency. The central bank has “sufficient” policy tools to combat deflation, Yi said, without elaborating.

Maybe it is indeed true that falling prices are not accompanied by shrinking loans and money supply, but it seems to me that we can’t really say for sure. We think we know that loans aren’t shrinking because loan growth numbers in the official banking sector pretty clearly show rapid loan growth, but as I have written many times before, much of January’s loan growth represented either balance sheet rearrangements or other forms of loan growth that don’t represent real credit growth to the economy (and by now that is a pretty widely accepted interpretation of the January numbers, although many bank analysts continue to talk up the loan growth as effective).

In addition, there is still anecdotal evidence that the informal banking sector is having difficulty expanding and even that their balance sheets may actually be shrinking. Real credit in China, in other words, is expanding much more slowly than the headline numbers suggest and may even be contracting. We don’t really know. For those who care, the current issue of Forbes has a very interesting article by Gady Epstein on one part of the shadowy credit market in China.

By the way I assume that Vice Governor Yi is indirectly referring to Irving Fischer’s debt-deflation thesis. But in my opinion, and if I read Fischer correctly, the risk for China is not a financial collapse induced by excess and unstable leverage. In spite of the haziness of the debt accounts I really don’t think China has the amount and kind of leverage that is likely to lead to a collapse in asset prices (although my one caveat is that we don’t really know the relationship between asset collateral and debt in the informal banking sector). The risk instead — and a highly probable risk although the timing is a little hazy — is that China will see many years of sub-par growth as it works off its addiction to excess capacity and makes the tough and slow transition to a domestic-led economy. I think Nick Lardy’s warning of a “long landing” rather than a “hard landing” is what we should expect. I am only guessing here, and haven’t really worked it out, but perhaps monetary reflation, which I think would have been Fischer’s proposal for the US today, is not likely to be of much help to China.

Trade figures are out
Meanwhile, and back to the real world, February trade numbers were released today. As I guess pretty much anyone who reads my blog would know, the export numbers were terrible. Exports plunged 25.7% in February year on year, even though this year February did not include the Spring Festival holidays, and so was substantially longer than February 2008. The foreign press seems mostly to think that the sharp decline in exports came as a huge surprise to most experts, while the Chinese press seems to think it was largely expected (the SSE Composite declined on the news, but only by 0.9%). I have always believed that the fact exports were dropping much more rapidly in the rest of Asia than in China was clearly not sustainable, and that it was just a question of (very little) time before we began to see Chinese exports hit much more sharply. I do not believe the process is over.

According to an article in today’s Xinhua:

China’s exports plummeted 25.7 percent year-on-year in February, the fourth straight monthly decline, as global demand shrank, the General Administration of Customs said Wednesday. Exports contracted to 64.90 billion U.S. dollars, while imports slumped 24.1 percent to 60.05 billion U.S. dollars. The sharp declines reflected weakening external demand, which would persist throughout the year as the global recession deepened, said Zhang Junsheng, an economics professor at the University of International Business and Economics. “These huge falls were inevitable, given the global downturn,” he said.

…Exports of labor-intensive products contracted more moderately than total exports, reflecting the government’s moves to raise export rebates starting last July, the agency said. Garment and accessory exports fell 11 percent to 14.62 billion U.S. dollars, while those of toys sank 17.1 percent to 850 million U.S. dollars.

I have heard several times reference to the fact that the increase in export rebates has helped the textile sector, although I would have guessed that this wouldn’t be something policymakers would want to advertise to the outside world. Along that line I think we are going to see a lot more pressure on policymakers somehow to “deal” with the problems in the export sector. On Monday Commerce Minister Chen Deming announced a cut in export taxes. According to an article in Tuesday’s Financial Times:

China will reduce export taxes to zero and give more financial support to exporters as it tries to increase its share of global trade in the current crisis, the country’s commerce minister announced on Monday. China would “use all possible measures to ensure the stable growth of our exports and prevent a large drop in external demand”, Chen Deming said in an interview published by a Communist party newspaper. “We should increase our share of the global market… We must transform ourselves from a big export nation to a strong export nation,” he continued.

It’s probably not a good idea to announce a drive to increase China’s share of the global export market, especially since for the last several months, while the world has suffered a collapse in demand, China’s share of exports has risen dramatically, but this may have been said primarily for domestic consumption. Yesterday Chen spoke again about trade. According to an article in People’s Daily:

The pressure to fix the export sector is clearly rising. My friend Isaac Meng was quoted later on in the same People’s Daily article explaining why policymakers are taking a decision which is not likely to make already-difficult global trade relations much easier:

At a press conference on Friday Zhou Xiaochuan, the central bank governor, refused to rule out a devaluation in China’s currency, the renminbi. “If you can tell us clearly what is going to happen [in the countries where the financial crisis started], it would be easier for us to tell you what measures we will take,” Mr Zhou said when asked directly whether he would rule out a devaluation of the renminbi.

In a sign of how contentious the debate has gotten within China, the trade worriers put in a counterclaim. This from a Bloomberg article:

China should let the yuan rise 3 percent against the dollar in 2009 to deter capital outflows and help the country make overseas acquisitions, said Wang Jian, a researcher affiliated with the nation’s top planning agency. China’s foreign-exchange reserves grew by the least in more than four years in the fourth quarter as sliding exports prompted traders to step up bets on yuan depreciation. People’s Bank of China Governor Zhou Xiaochuan pledged last week to maintain yuan stability as investors pull money out of emerging- market assets because of slowing global economic growth.

“A weaker currency will prompt massive amounts of foreign capital to flee the country,” said Wang, secretary general of the China Society of Macroeconomics, a Beijing-based research institute under the National Development and Reform Commission that advises the government. “It won’t help exports. Foreign consumers still won’t have enough money to buy.” At least $1 trillion of “hot money” may have entered China, Wang estimated, as the yuan gained 21 percent against the dollar since the central bank ended a fixed exchange rate in July 2005. Depreciation would risk spurring a sudden exit of those funds, causing turmoil in the financial system, he said in an interview yesterday.

I think hot money flows are one of the potentially destabilizing factors we need most to worry about because the PBoC’s currency regime means that monetary conditions, as I discuss in the first half of this entry, are largely determined by net inflows or outflows. In that light it is worth noting that while imports in February were also very bad — they dropped 24.1% year on year — the February trade surplus was much, much lower than for any month in a long time. China’s trade surplus for February was $4.8 billion, lower than the $7 billion rumor I mentioned a few days ago and much lower than the roughly $34 billion average monthly surpluses of the past six months (and $39.1 billion for January).

This may be a very good thing for China as it goes into the G20 meeting, since it takes a little of the sting out of China’s growing export of overcapacity, but one month of “good” numbers after a long series of absolutely awful numbers won’t mean much, and we need to figure out more about the composition of imports. In particular I am interested in seeing whether imports include a lot of one-off rebuilding of commodity reserves. By the way with last month’s “low” trade surplus, some people are arguing that the era of massive monthly surpluses are over. This is from MarketWatch:

Trade and industrial policies
I hope Simpfendorfer is right. The Washington Post seems very worried about the trade-policy outlook. In an article titled “US to Toughen its Stance on Trade,” it warns that US policy seems increasingly dissatisfied with global trade and says that “the Obama administration is aggressively reworking U.S. trade policy to more strongly emphasize domestic and social issues.” Today’s New York Times also had a worried editorial on President Obama’s trade agenda, which included the following:

Trade will play an important role in the world’s eventual recovery, transmitting economic growth from one country to the next. Protectionism leads to further protectionism, and yielding to its temptation could unleash destructive trade wars that would crush any chance of recovery. Unfortunately, few politicians are willing to tell their constituents that unpopular truth. Instead, governments are succumbing to protectionism’s dangerous lure. In recent months, Russia has jacked up import barriers on cars, farm machinery and other products. The European Union has reintroduced subsidies on dairy products. Europe, India and Brazil raised tariffs on imported steel.

…If ever there was a need for collective action — on fiscal stimuli, monetary policy, aid to the developing world, fighting protectionism — it is now. A place to start the rethinking is China and how to encourage increased domestic consumption and investment in China and other cash-rich Asian countries so they can start pulling the world out of recession.

China’s leaders, in particular, need to understand that export-led growth no longer works for them or for the world. The United States will have more influence if it stops beating on Beijing for its foreign-exchange policy and engages China’s leaders as partners, not rivals. Vigorous trade will help the world recover. For that to happen, the United States will have to provide strong leadership and a clear commitment to fighting protectionism. Any sign of ambivalence from Washington will only make things worse.

The whole debate over trade is going to be framed within US and European discussions about fiscal stimuli since it is not at all clear that Chinese policymakers are contributing much more than some fairly smug, and perhaps hypocritical, statements about how everyone must embrace free trade. But the US and European discussions don’t seem particularly positive right now. According to today’s Financial Times:

Disagreements between the European Union and the US over how to combat the global recession widened on Tuesday as EU governments made clear they had little appetite for piling up more debt to fight the collapse in output and jobs. Finance ministers from the 27-nation bloc insisted in Brussels that it was doing enough to support world demand and did not need at present to adopt another fiscal stimulus plan, as Washington is urging.

I hesitate to enter these very deep waters, but I think the Europeans, at least as described in this article, might be right. There is a real need for an adjustment in consumption in the US, and I don’t think it makes sense for the US to attempt to replace excess household consumption with excess government consumption. One way or the other the US, along with China and most other countries that have contributed to one side or the other of the global imbalances, is going to have to accept a demand contraction.

Trade friction is an issue that will not easily go away. Not all the information released this week was bad, however. Some was good and some was neutral — by which I mean it could be read either as bad or good depending on your economic model. According to an article in today’s Bloomberg:

China’s investment spending surged as the nation poured money into roads, railways and power grids to counter a plunge in exports, which a separate report showed fell by a record in February. Urban fixed-asset investment climbed a more-than-estimated 26.5 percent in January and February combined to 1.03 trillion yuan ($150 billion) from a year earlier, the statistics bureau said today in Beijing.

The fact that fixed asset investment surged might suggest that the fiscal stimulus plan is having an effect and will counteract to some extent the slowdown in other parts of the economy. A worrier (me) would be very nervous however that the stimulus ended up worsening the overcapacity problem, in which case any benefit would be more than paid for next year. More unambiguously good news involved February car sales, which are up substantially and suggest that some government policies are getting consumers to go back to buying cars, although this was accompanied by bad numbers on car exports.

…However, despite the apparent rebound in China’s own car market, a slump in demand is crimping sales overseas: exports in January fell 33.5 per cent from a year earlier, to US$2.66 billion, the group said. The impact was most severe for domestic-brand cars, with January exports falling 64 per cent from a year earlier to 16,300 units, it said. Imports of vehicles also took a hit amid the deepening economic downturn, falling 20.3 per cent from a year earlier in January to US$1.73 billion, it said.

Finally before closing, and for an indication of rationality that sometimes seems to be missing from foreign expectations about China, few analysts in China seem to buy the idea so popular in the West that somehow Chinese policies may be enough to pull the world out of its economic crisis. Tuesday’s People’s Daily had a long article on the subject. Among other things it said:

Tags: Art, Irving Fischer

As I reported in last Thursday’s blog entry, last week the research institute associated with China’s Ministry of Finance published a report on its website arguing that China’s central bank should “actively guide” the yuan’s exchange rate and devalue the currency to about 6.93 against the US dollar. The purpose of depreciating, the report said, was to help maintain economic growth and bolster employment

An exchange rate of 6.93 implies a depreciation of 1.5%. This is not much of a big deal and unlikely to make much of a difference in Chinese export prices, so I wonder why they would even say this except as a trial balloon. It is not just the research institute that has been making the devaluation argument. Although a number of officials have publicly called for stability in the exchange rate, within China there has been a heated debate about the country’s currency strategy, with several prominent commentators and economists arguing that China needs to devalue the yuan, by substantially more than 1.5%, so as to help Chinese manufacturers achieve greater competitiveness in the global export markets.

I think this kind of talk shows how mutually incompatible China’s two policy objectives are in the short term. First, China wants to boost domestic employment by boosting investment and helping restore manufacturing profitability. Second, China is under pressure, and this will almost certainly increase, to reduce its export of overcapacity, and China must address this pressure before it leads to worsening trade friction.

These policy goals might not seem mutually contradictory on the surface, but I would argue that this is only because policymakers – and many commentators, it seems – are failing to distinguish between total demand and net demand. Global demand is contracting, so anything that China does to boost total domestic demand is good for the world, right?

Not necessarily. Domestically, any increase in total demand will have positive implications for employment, but globally the world needs increases in net demand – that is, consumption minus production. Since China provides negative net demand to the world (it runs a trade surplus), what the world needs from China as global demand contracts is a reduction in the amount of negative net demand China provides.

China can boost total demand by boosting manufacturing – every worker not fired is a worker able to consume more – but boosting manufacturing also boosts Chinese production. If it increases production relative to consumption, then China is actually reducing net demand, even while it is increasing total demand. That this is happening, by the way, shows up in the rising trade surplus.

In that light devaluing the currency would be a mistake. Although it might make Chinese manufacturing exports seem more competitive in the near term, there are at least two sets of problems with devaluing the yuan. First, as should be very apparent, the slowdown in China’s exports is not a function of rising domestic costs but rather caused by declining global demand. With imports contracting rapidly, it is a mathematical necessity that countries like China that export excess capacity will, in the aggregate, be forced to export less. The fact that China’s exports have contracted by much less than most of its Asian trading neighbors suggests that in fact China has suffered much less than the average Asian exporter from the contraction in global demand, which makes the argument that China is losing export competitiveness hard to sustain. In that case devaluing the currency would almost certainly set off competitive devaluations.

Some in China are arguing that other Asian countries are already devaluing, so by devaluing China would simply be keeping up, but this argument is a weak one. With Chinese exports declining by less than other Asian countries, and the Chinese trade surplus rising, it will be hard, as I point out above, to argue that China has lost trade competitiveness.

More importantly China is the third largest economy in the world and has the largest trade surplus in the history of the world. It cannot act as if it were a Vietnam, whose economy is small enough that devaluation would only have a slightly negative impact on the global balance. China must understand the impact of its actions on the global, which necessarily must constrain its behavior.

This is because with global demand contracting, any attempt by China to force more overcapacity onto a struggling world – i.e. reducing net demand even further – will require an even sharper contraction in manufacturing among its trade partners. China’s trade surplus is the measure of the amount of overcapacity, or negative net demand, it is exporting into the global economy, and January’s astonishingly high trade surplus of $39 billion, the second highest on record, caps a six month period during which China’s already record-breaking trade surpluses have surged. But with global demand contracting, any increase in China’s trade surplus requires that manufacturers in the rest of the world on average must cut production and fire workers by more than the amount implied by the global contraction in demand.

This will almost certainly lead to widespread claims that China is playing unfairly. Already China is in serious trade disputes with India and Indonesia, and with protectionist sentiment on the rise in the US, Europe, and the rest of the world, this is not the time to create more protectionist fury. A devaluation of the yuan, however small, would be seen as China’s answer to the Smoot-Hawley tariff increase, the notorious bill passed by the US Congress in 1930 that put the nail in the coffin of international trade (and a great example of the US failure to understand in 1930 that, like China today, it was too big to ignore the global impact of its domestic policies). In that case devaluation would almost certainly lead to an increase in trade friction.

In the 1930s, Smoot-Hawley had that very effect, and as the country with the world’s largest trade surplus in the 1920s, the US found itself, ironically, as the greatest victim of the contraction in world trade it did most to sponsor. As I have argued many times in a world of contracting demand, it is countries with excess capacity or negative net demand – the trade surplus countries – who are most vulnerable to a collapse in international trade. Even more than the US in the 1930s, China would suffer enormously from trade war.

The second set of arguments against devaluation involves a little longer term thinking, and so might easily be ignored in the panic of the crisis, but China’s economy must make the transition from export orientation to reliance on its domestic market. The process is never easy. To devalue the currency now would mean failing to take advantage of the shift that is already taking place and would push the economy in the wrong direction – that of further constraining already-too-low domestic demand, while increasing the importance of the export sector in the Chinese economy. The difficult transition from export reliance to reliance on domestic consumption is not a problem that can be evaded, and postponing it will only make the transition worse.

As counterintuitive as it may seem, I think China should actually continue revaluing the yuan, but before doing so it must reach an explicit agreement that in exchange for revaluing, its trade partners will maintain open markets for China’s exports. This is key, and on Wednesday I think I will have a piece in the Financial Times that tries to make this point very explicitly. A trade war would force China to adjust quickly, and I think that would be socially disastrous for China, and at any rate given the structure of the country’s financial system and development model it cannot make the transition quickly.

As the world’s leading provider of excess capacity, China cannot avoid a difficult adjustment in a world of collapsing global demand. The goal of policymakers must be to slow the necessary adjustment over several years by negotiating an orderly decline in global trade imbalances. This requires cooperation, not devaluation. Sunday’s softer G7 communiqué which, according to an article in today’s the Financial Times, “adopted milder language than recently regarding China’s handling of its currency,” is a welcome step towards more civil discourse, but it should not mask the risk of rising protectionism. Among themselves the G7 can be as diplomatic as they like, but governments respond to domestic pressure, and nothing creates pressure like rising unemployment. Japan’s awful 2008 Q4 GDP numbers (down an astonishing 12.7% on an annualized basis) shows just how heavy that pressure will be.

I am off to Washington DC later today to testify before the US-China Commission and meet a bunch of friends in Treasury and State. On Saturday I will try to write about what I hear there.

Tags: Net demand

I have been on the road for the past few (and next ten) days, in part because of Spring Festival, so I haven’t been able to post as much as I normally do, but I was asked to write an article for a Chinese magazine, which I recently finished, on comparisons between today and the beginning of the 1930s.   As the recognition grows around the world of the similarities between China in 2008 and the US in 1929, it is worth considering why the Great Depression in the US was so severe and what lessons China should draw from it.  I and a few others have discussed one of the similarities so many times and in so many different places that I think by now the whole issue of the trade impact of US overcapacity in the 1920s and 1930s and how it relates to China today is pretty widely recognized.

But there is more.  I just finished rereading Barry Eichengreen’s Golden Fetters, a book on monetary conditions in the 1920s and 1930s (and in my opinion one of the great books of financial history).  One of the points he makes – in fact it is probably the main point of the book – is the way currency policies (i.e. adherence to the gold standard) sharply constrained the ability of policymakers to deal effectively with the monetary consequences of the 1929-31 crisis.  It wasn’t until various affected countries escaped from their monetary handcuffs and rejected gold that monetary policy became flexible enough to permit them to loosen sufficiently to counteract the banking collapse that accompanied the crisis.  Eichengreen makes the point often and forcefully that there was a strong positive correlation between the speed with which countries went off the gold standard and the mildness of the subsequent economic crisis.

As an aside I would add my impressionistic sense that countries that ran large balance of payments surpluses (most obviously the US, but there were others too) were in the strongest position to hang on to gold, and so were the last to go off gold.  They were also the ones most harmed by the 1930s crisis.  I am not sure if this is primarily because of the monetary straitjacket or because most countries with strong balance of payments positions were also countries with large trade surpluses, and so they suffered most from a contraction in global demand and a collapse in international trade, but I suspect that the two are very closely linked.

Let me summarize my view of the key conditions in the 1920s and 1930s that shed light on current conditions.  Besides the standard impact of the 1929 crash on consumer confidence, domestic consumption, and the cost of capital, economists generally speak of two factors that compounded the difficulties facing the US economy:

1. The first I have discussed many times.  Throughout the 1920s, the US created significant industrial overcapacity, which it was able to export even as massive foreign borrowing in the US markets financed those exports.  However just when the 1929 crash caused US consumption to decline, it also eliminated foreign financing for the trade deficit countries.  As international trade collapsed – especially after the US tried to force the adjustment abroad by the passage of import tariffs – domestic demand was not nearly high enough to absorb everything US factories produced, and the US was forced to resolve its overcapacity problem domestically.  It could have done so by increasing domestic government demand, as Keynes advised, but although the US was in a very strong position fiscally, it failed to take advantage of this strength and barely expanded government spending.  This ensured that overcapacity would not be resolved by rising government demand but rather by factory closings and rising unemployment.  Of course the passage of Smoot-Hawley and other mercantilist acts, by inviting retaliation, made the process much more difficult.
2. To make matters worse, excess money expansion caused by the massive accumulation of reserves in the 1920s had led to over-investment and risky lending.  The stock market crash set off the process of deleveraging that always signals the end of a liquidity boom, and banks, financing companies and securities firms saw their balance sheets contract.  When the Federal Reserve failed to accommodate the sudden collapse in money supply as banks cut lending in response to the crisis, the resulting money contraction in the US converted a sharp economic slowdown into a disaster.  According to Milton Friedman (and I think most other economists) this was the biggest policy blunder that ensured that the crisis would be so devastating.

Compared to the US in 1929 China fares better on some measures, but not all.  The first and most obvious is the scale of China’s overcapacity problem.  China’s trade surplus, the cleanest measure of overcapacity, is of the same magnitude as that of the US in 1929 – roughly 0.5% of global GDP – but its economy is less than one-fifth the relative size of the US in 1929.  Resolving the overcapacity problem will be much more difficult for China, especially if the world descends into trade friction and if international trade contracts.  For that reason China must be at the forefront of trade liberalization and avoid the mistake the US made in 1930 of trying to increase its export competitiveness and reduce domestic demand for foreign goods.  In that direction lays trade friction, which would have a devastating impact on Chinese businesses.

Perhaps not nearly as strong as the US in 1930, China is nonetheless in a reasonably strong position fiscally – although municipal reliance on land sales for revenues, contingent liabilities in the banking system and in provincial and municipal borrowing, and overall lack of transparency, make it difficult to judge.  More importantly, however, there is widespread recognition among policymakers, unlike in the 1930s, that rapid and forceful fiscal expansion is key to creating new demand.  Unfortunately it is not yet clear exactly how aggressively the Chinese government will expand fiscally and whether it will do so fast enough to replace declining US and European imports.

The second point may be the more important.  Like the US in the 1920s China experienced a huge run-up in central bank reserves and, as the inevitable counterpart, low interest rates and excessive money supply growth.  When this happens the financial system often responds by taking on excessive credit risk and over-investing.  Given the complexity of the China’s formal and informal banking systems and the lack of transparency, it is difficult to know how vulnerable the banking sector is, but it is clearly something about which to worry.  Warren Buffett once quipped that you can never know who is swimming naked until the tide goes down.  The tide is receding and we are about to see how many naked bankers there are.

How the PBoC will respond to any signs of sharp money contraction is probably the most important question to answer and also the most difficult.  On the optimists’ side the mistakes made by the US central bank in the 1930s have been so widely discussed that there is no question that Chinese policymakers understand the risk.  The PBoC will undoubtedly do all in their power to counteract any monetary or credit contraction.

But things are not so easy.  In the 1930s as long as the US was on the gold standard, it had limited flexibility in dealing with domestic monetary management.  This is one of Eichengreen’s key points.  Once the US got off the gold standard in 1933 it was able to pursue a wholly independent monetary policy, but its failure to counteract the initial credit contraction was a blunder with huge implications, and one from which it was only able to recover after tremendous pain.  Certainly the PBoC would not make the same choice this time around, would it?

But can it choose differently?  Unfortunately the PBoC is not as free to manage domestic monetary policy as the Fed was after 1933 because its primary obligation is to manage the foreign exchange value of the currency.  This means that a crucial aspect of monetary policy in China is determined largely by net inflows or outflows on the trade and capital account.

The PBoC has other tools: most importantly its influence on credit creation (I am skeptical about the usefulness of open market operations) which it can expand partly by reducing the minimum reserve requirement for banks and partly by moral suasion within the banking system, but I am not sure how effective this is likely to be.  Remember that much of the credit expansion from previous years seems to have migrated off the balance sheets of commercial banks (including into the informal sector) when the PBoC tried to constrain credit growth.  In my opinion when underlying monetary conditions are consistent with rapid credit expansion there, is little the regulators can do to prevent this from happening.  At best they can decide whether it happens in the regulated parts of the system or whether it simply migrates to other areas.

The reverse is also likely to be true.   Attempts by the PBoC and other policy-makers to force banks to expand credit may result in higher loan growth reported on bank balance sheets, but overall credit growth within the economy is likely to be much less.  If the underlying money supply is consistent with contracting credit, the system will most likely see contracting credit (and I am saying nothing about the possibility that much of the formal credit expansion reported by the banks will consist of empty lending into future NPLs).

With international trade falling, it is probably only a question of time before China’s trade surplus begins to shrink sharply (although a number of commentators who I respect a lot, including Brad Setser, might disagree with me on this), and as I wrote last week there is mounting evidence that some of the hot money that poured into China one year ago is now starting to leave.  This suggests that China may begin to see rapid contraction of foreign currency holdings and, with it, a contracting domestic money supply.

This may be the biggest unexpected risk China faces.  We must remember that as long as the main task of monetary policy is to set the value of the RMB in foreign currency  terms, the PBoC has limited ability to manage the domestic money supply.  If net outflows are large in 2009, the PBoC may be forced to preside over a monetary contraction, and this would be exacerbated if there were problems in the banking system that caused formal and informal banks to cut lending.  This would undoubtedly worsen China’s difficult economic adjustment to the problem of overcapacity.  It is vitally important that Chinese policymakers recognize the monetary constraints under which they work and prepare contingency plans.  China can learn a lot from the mistakes of US policy in the 1930s.

By the way whenever I say that money outflows could become a problem for China, inevitably someone rushes in to pour scorn on the idea that China is vulnerable to a 1997-style Asian crisis.   I agree it isn’t, and I will repeat (again) that this is not and never has been the point of my concern about hot money outflows.   China does not have a currency mismatch risk worth bothering about.  The reason to worry about hot money outflow is that it has a domestic monetary impact.

Tags: Eichengreen