Should China Continue to Peg its Currency Against the US Dollar - Assignment Example

Should China continue to peg its currency against the US dollar? Should China continue to peg its currency against the US dollar? [The name of the writer appears here] [The name of institution appears here] Introduction China should allow its currency to appreciate significantly, and should move to a regime of more flexible exchange rates. China has pegged the renminbi (RMB) to the United States dollar since 1994, only recently allowing a very slow rate of upward crawl after a small revaluation in July 2005. It should phase out this peg, and allow a faster rate of currency appreciation. The significant market pressure for a currency appreciation is driven by the increasingly large Chinese trade and current account surpluses, with additional pressure resulting from the massive amounts of foreign direct investment (FDI) and hot money flowing into China. The Chinese authorities have been able to prevent a sharp exchange rate appreciation only by intervening very aggressively in the foreign exchange market. This accumulation of foreign exchange reserves ran at staggering annual rates of about $250 billion per year in 2005 and 2006. Numerous empirical studies have shown that the RMB is grossly undervalued, and that China’s rapid and sustained economic growth implies that the equilibrium real exchange rate is appreciating over time. Thus, actual nominal appreciation is required to allow the real exchange rate to move toward its equilibrium value without causing higher inflation. A failure to allow a nominal appreciation poses significant risks and potential costs. First, if Chinese net exports continue to grow at their current rapid rates, protectionist policies will gain further legitimacy in the United States and Europe. Second, the policy of partially sterilized intervention is creating excessive liquidity credit and asset bubbles, which are fuelling the already overheated Chinese economy and exacerbating the risk of an eventual hard landing. Third, the imbalanced composition of aggregate demand has resulted in excessive reliance on net exports and real investment, and in a very low level of private consumption. Fourth, once the currency eventually appreciates – which it will, given that its fundamental value is appreciating over time – there will be capital losses on holdings of foreign reserves. Delaying the appreciation will create larger losses as the stock of reserves will be greater and therefore the required and actual appreciation will also be larger. And fifth, there is the risk of an eventual surge in inflation if the nominal exchange rate is not allowed to appreciate. However, some argue that an RMB appreciation would involve significant risks as well, such as an excessive slowdown of growth, deflationary pressures and increased poverty in the rural sector. But these risks are modest – the evidence for them is weak, and appropriate policies could reduce any potential costs. In contrast, given the risks associated with the status quo, even ignoring the unfair ‘China bashing’ and protectionist pressures emanating from the United States, it is in China’s interest to move to a more flexible exchange rate regime. Delaying the necessary nominal and real appreciation of the RMB increases the real risk of a hard landing similar to what China experienced in 1994–98, when an investment bubble burst and led to a sharp slowdown in growth. Risks for China’s Economy from the Continuation of the Present Currency Regime There are several looming risks for the Chinese economy from the continuation of its regime of effectively fixed exchange rates supported by a massive accumulation of foreign exchange reserves. The first risk is growing protectionist pressures in the United States and Europe. If China’s net exports continue to expand and exports maintain a 30% yearly rate of growth, there will eventually be a backlash in the United States and Europe. China could be branded a ‘currency manipulator’ by the United States Treasury, or be characterized as having a ‘fundamentally’ undervalued currency. A US economic slowdown with growth below potential – or worse, a recessionary US hard landing – would heighten these protectionist pressures. Compounding this threat is the recent change of political control in the United States Congress, which is likely to lead to a generally less free trade friendly political posture. The political economy of trade policy is such that protectionist pressures will grow if Chinese net exports, as a share of GDP, increase without bound for the foreseeable future and China fails to contribute to reducing global trade imbalances. The second risk for China derives from its current policy of partially sterilized intervention. China is unable to fully sterilize the effects on the monetary base of its $250 billion a year forex intervention. Partial sterilization aggravates the money supply growth and credit growth that is feeding their investment bubble and the asset bubble – especially in real estate – and is overheating the economy, increasing the risk of an eventual hard landing. In 2006, excessive growth of the monetary base fed a credit bubble that is now becoming dangerous. Marginal investments are being undertaken only because the cost of capital is so cheap – investment in new capital and capacity is now close to 50% of GDP. No economy can have so many highly profitable investment opportunities that it can take half of its annual output and profitably reinvest it in productive capacity. A similar Chinese investment boom in the early 1990s ended up in an investment bust, and by 1998 it caused a hard landing, with GDP growth falling sharply. The recent investment boom is even bigger than that of the 1990s, and so is the risk of a bust. The third risk is that the present currency policy will eventually cause high inflation. As China’s productivity rate is well above that of its trading partners, its real exchange rate will have to appreciate over time – its long run fundamental real exchange rate is stronger. Such real appreciation can occur in only two ways: a nominal appreciation or an increase in inflation. Of the two, a nominal appreciation that keeps inflation low is economically, socially and politically less disruptive than a real appreciation achieved via an eventual surge in the inflation rate. (Chinn, 2006) It is true that, so far, Chinese inflation has not surged in spite of its weak currency and the very fast growth rate that is causing an overheating of the economy. Controlled prices of many goods and public services, bumper crops and control of wages in a repressed labor market with an excess supply of unskilled labor has, to date, kept inflation under control. But labor-supply bottlenecks will develop, especially in the skilled labor sector; this has already begun to occur in the coastal areas. Thus, an overheated economy will eventually lead to higher inflation. The fourth risk is that of a massive capital loss on the holdings of foreign reserves once the inevitable appreciation occurs. A 20% appreciation of the RMB on a stock of $1 trillion of reserves amounts to a $200 billion capital loss, or about 8% of current GDP – a very large loss. Postponing the appreciation of the currency will only make these capital losses much larger, for two reasons. First, the base of reserves on which losses will occur will be much larger. At the current rate of reserve accumulation, China will hold $2 trillion of foreign reserves four years from now, double the 2006 stock. Second, because the productivity differential builds up over time, the longer China waits the larger the required equilibrium nominal appreciation will need to be. A 30% appreciation on $2 trillion of reserves four years from now would amount to a staggering capital loss of $600 billion. Distortions in the Economy Resulting from the Current Currency Regime China’s export-led economic growth model has relied heavily on FDI to build a productive capacity base. This openness to FDI, together with a weak currency, created a foreign demand for Chinese goods and exports and provided an incentive for foreign firms to locate production in China. To be sure, foreign investment is small relative to total investment (see Goldstein and Lardy 2004). But foreign investment has played a vastly larger role in China’s development than in the development of other high-savings economies in Northeast Asia, notably Korea and Japan. While the latter sharply restricted FDI, for a long time China has welcomed, and therefore attracted, massive amounts ($50 billion in 2005 alone). Some argue that China is at the centre of a new Bretton Woods regime of fixed exchange rates in Asia.1 The supporters of this ‘Bretton Woods Two’ hypothesis argue that the undervalued pegged currency and export-led industrialization growth model of China and other Asian economies is stable and will last until the hundreds of millions of poor and poorly employed Chinese rural workers are absorbed into the manufacturing sector. But the validity of this weak-currency cum export-led growth model is now being reassessed by many senior Chinese officials and economists. Indeed, this growth model is creating a number of serious distortions and imbalances in the Chinese economy (Roubini and Setser 2005). First, there are serious imbalances in the composition of aggregate demand. As a share of GDP, consumption is too low, the savings rate is too high, the investment rate is excessive (about 50%) and net exports are unsustainably high. The rate of investment is so high and the rate of consumption so low that China may already be a ‘dynamically inefficient’ economy. With investment close to 50% of GDP and growth close to 10%, it takes 5% of investment relative to GDP to increase GDP by 1%. In other words, the macro return to investment (the inverse of the ‘capital-output incremental ratio’) is very low. And this low return on high investment and savings rates comes at the cost of a very low rate of private consumption – about 40% of GDP. Note that from an economic point of view, investment by itself is not a source of increased national welfare. Rather, it is consumption that increases utility and welfare. Thus, excessive investment can reduce national welfare, especially if returns become very low. Second, there are important regional imbalances. Foreign investment tends to be geared toward producing goods for external markets. It also naturally tends to cluster on China’s coast. Coastal cities have good transportation links to the world, but not necessarily good links to China’s interior. Consequently, foreign investment and rapid export growth tend to widen the economic divide between the coast and interior. The new Chinese leadership cares about distribution as well as growth, in part because it worries about the political consequences of rising inequality. Distributional inequalities are increasing both between regions and between social and economic classes. The share of income going to capital is increasing and real wages have failed to increase in proportion to productivity. Unskilled workers and farmers are lagging behind skilled professionals. A recent World Bank study found that poverty and inequality – both relative and absolute – have increased in rural areas of China; real incomes of poor farmers have fallen in the last decade. Even booming regions are suffering from distributional problems. For example, some households benefit from a large wealth effect as a result of rising housing prices while others are priced out of the market. Real estate profits, including profits that flow back to corrupt Communist Party officials, add enormously to expanding income and wealth differentials. The Party, concerned about the increasing unrest and riots in the rural areas, has officially changed its emphasis in its next five-year plan from growth maximization to equity. Finally, there are dangerous financial imbalances. Rapid reserve accumulation feeds rapid credit growth, asset price bubbles and overinvestment in the real estate and export sectors, all of which contribute to sectoral imbalances. The authorities have relied on administrative and quantitative controls on credit, rather than on price adjustments such as changes to interest rates, to control overheating. The short-term interest rate was increased by only 27 basis points, in three separate moves, between 2004 and 2006, a risible amount for an economy growing as fast as China. The unwillingness to use the interest rate as a tool of macroeconomic management is in part due to the constraints of the peg. Any increase in interest rate risks generates further capital inflows from abroad, inflows that would add to the liquidity in the system if they are not sterilized. Thus the current RMB peg is generating an unbalanced Chinese economy. China invests too much and consumes too little, and its continental economy is too exposed to the global macroeconomic cycle. Its overall economy is marked by too stark a divide between the prosperous coast, with good transportation, trade and financial links to the world, and the underdeveloped and often under-educated interior and rural regions. (Dunaway, 2006) China’s Need for Currency Flexibility to Control the Economy and Regain Control of Monetary Policy One of the most problematic aspects of the fixed exchange rate regime is that it has led to a dangerous loss of control of monetary and credit policy in China. The resulting overheating of the economy and of financial markets may eventually result in a hard landing. China’s current monetary and exchange rate policy implies a ‘trilemma’ of incompatible policies described by Robert Triffin’s concept of the ‘inconsistent trinity’ in open economies. Triffin observed that policy makers typically have three mutually inconsistent objectives: (a) monetary policy autonomy/independence to stabilize the economy; (b) stable or fixed exchange rates to maintain low inflation and monetary stability and (c) an open capital account to benefit from international capital mobility. The ‘inconsistent trinity’ states that they cannot achieve all three goals at once – they need to choose two and give up the third. If a country wants to maintain a free capital account and stabilize the economy with an independent monetary policy, it cannot have a fixed exchange rate. Conversely, if it wants to maintain a free capital account and have a stable or fixed exchange rate, it cannot have an independent monetary policy. And if a country wants to maintain monetary independence and a fixed exchange rate regime, it needs to surrender capital mobility and adopt capital controls. In some sense, China has chosen the third option by maintaining a semi-peg while attempting to control the economy via interest rate and credit policy. But dealing with large hot money inflows using capital controls creates its own set of problems. China’s capital controls are particularly leaky, hence a lot of hot money still enters the country – $100 billion in 2005 and a little less than that in 2006. Clearly, the ability to both peg and maintain independent monetary policy is challenged. Monetary creation caused by leaky capital controls leads to excessive monetary growth and feeds the overheating of the economy. When a country faces a surge of hot money (and even FDI inflows) and tries to maintain a peg in spite of leaky capital controls, it could try to prevent the appreciation of the currency via full unsterilized foreign exchange intervention. In the case of China, this is not possible because such an intervention would push down domestic interest rates, exacerbating the already overheating economy. China is not able to fully sterilize its intervention either, because it is constrained by the size of its domestic money markets; well-developed and liquid money markets are necessary to issue massive amounts of sterilization bonds. Thus, the sterilization rate has been only 70% of the intervention flows. Partially sterilized intervention and the ensuing liquidity creation implies that China has been forced to reduce domestic interest rates below US rates to lessen the incentive for hot money capital inflows. But these low interest rates are being used at a time when economic overheating instead requires higher interest rates and tighter credit, not lower interest rates and excessive liquidity and credit. As intervention is only partially sterilized and creates excessive liquidity and a credit boom, China has relied on distortionary non-price tools such as direct controls on credit to try to slow the overheating of the economy. But because such administrative controls are themselves leaky and ineffective, the credit, investment and asset bubbles have continued unabated. In 2006, the excessive money creation led to a financial asset bubble: the stock market more than doubled in a year to levels that are inconsistent with economic fundamentals. Thus, with goods inflation still subdued – if rising recently – due to the factors discussed above, the excessive liquidity creation has led to financial asset bubbles. The essential problem that China faces is that it needs an independent monetary policy and much higher interest rates to cool down the economy. But at the same time, as controls are leaky, these higher interest rates would lead to further capital inflows. As a result, the only way to exit the trilemma is to give up on the fixed exchange rate goal. In an overheated economy in which administrative policies to achieve a soft landing have so far proven distortionary and ineffective, moving to a more flexible exchange rate regime is an essential step toward monetary and credit control. An RMB Appreciation is Unlikely to Cause a Japanese-Style Deflation in China One of the arguments made by opponents of revaluation is that a currency move could trigger a deflation in China similar to the one that dogged Japan for most of the 1990s and in the early parts of this decade. Allegedly, the appreciation of the yen in 1985 and again in the late 1980s caused the asset price bubble and its bursting, along with the goods price deflation that plagued Japan in the 1990s. Ronald McKinnon (2003) made the original argument about the negative effects of the appreciation of the yen, and now warns that China could suffer the same fate. McKinnon argues that global rebalancing can instead fully occur via ‘expenditure reduction’ policies. In particular, a reduction in the United States budget deficit can moot the need for the ‘expenditure switching’ affects of changes in nominal and real exchange rates. His view is based, in part, on his long-standing argument that a regime of global fixed exchange rates among major advanced economies is ideal. From this standpoint, currency adjustments are destabilizing rather than stabilizing. In his view, countries with fast productivity growth will indeed experience an appreciation of the equilibrium and actual real exchange rate. But he argues that this real appreciation – the increase in the relative price of domestic versus foreign goods – can be achieved via domestic inflation rather than a nominal appreciation of the currency. Stephen Roach, the chief global economist at Morgan Stanley, recently expressed a similar opinion: This is not the first time that Washington has tried to browbeat a major US trading partner into submission by using the blunt instrument of currency appreciation as the ‘remedy’ for a trade imbalance. Repeatedly during the 1980s, when the US was in the midst of its first external crisis – a current account deficit that peaked at a then-unheard of 3.4% share of GDP – Washington pounded on Japan to let the yen rise. After all, the bilateral deficit with Japan was the biggest piece of the then gaping US multilateral trade deficit. The theory was if Japan repriced its ‘unfair’ competitive advantage, all would be well for an unbalanced world. Unfortunately, the Japanese heeded this advice, and the yen/ dollar cross rate soared from 254 in early 1985 to an intraday peak of 79 in the spring of 1995. Sadly, Japan’s ‘endaka’ (strong yen) was a major factor behind its subsequent undoing – fueling the mother of all asset bubbles in equities and property that ended with a sickening collapse into a protracted post-bubble deflation. Politics never cease to amaze me, but I am incredulous that a mere 20 years later, America is offering the Chinese the same bad advice that took Japan down a road of unmitigated macro disaster. Fortunately, saner minds have prevailed in Beijing. (Roach 2006). China has already had a long decade of high productivity growth with essentially fixed nominal exchange rates. As its equilibrium real exchange rate has now appreciated, an orderly adjustment of the actual real exchange rate toward the equilibrium one requires a nominal exchange rate adjustment as well. Otherwise, the real appreciation will eventually occur via a politically disruptive increase in inflation. When China experienced high inflation in the early to mid-1990s, the real economy experienced a hard landing and sharply slower growth in the late 1990s. Hence the McKinnon solution of higher inflation as a way of achieving real appreciation understates the risks of inflation in China. One should also note that the Balassa–Samuelson effect implies that Chinese inflation will, over the medium to long run, be higher than the inflation rate of more advanced economies, as pointed out by Jeffrey Frankel (2004). In fact, if productivity growth in traded-goods sectors outpaces that of non-traded goods, the ensuing increase in nominal wages in the traded sector will increase the costs of production and prices of non-traded goods faster than those of traded goods. Hence, McKinnon and Roach are correct in stressing the important role that US fiscal adjustment can play in supporting an orderly global rebalancing. But their view that such rebalancing does not require any exchange rate adjustment in China is at odds with over 30 years of experience with flexible exchange rates. This experience shows that exchange rate flexibility has helped undo exchange rate misalignments that do occur from time to time. Conclusion The current effective peg to the United States dollar prevents the pursuit of the independent monetary and credit policy that China needs to control its overheated economy. The policies of partially sterilized foreign exchange intervention and administrative controls are ineffective in controlling the credit boom. The accumulation of foreign reserves, now in excess of a staggering $1 trillion, will eventually lead to massive capital losses when the required currency adjustment occurs. Delaying this necessary currency adjustment will only increase such eventual capital losses as the stock of reserves will be higher and the required appreciation greater if such unavoidable appreciation is further delayed. Given its high productivity growth, the Chinese economy can thrive and grow in a more sustained and balanced manner by letting its currency appreciate at a faster rate over time. The current economic overheating and the real appreciation of the equilibrium exchange rate deriving from high growth would eventually induce high inflation in the absence of a nominal exchange rate appreciation. Thus, such appreciation is required to prevent a costly increase in inflation. An orderly reduction of global current account imbalances requires changes in economic policies in both deficit (US) and surplus (China) countries. And the exchange rate, together with appropriate expenditure policies, is an effective complementary tool for an orderly adjustment of excessive trade imbalances. Experience suggests that the expenditure switching effects of changes in real exchange rates are necessary and effective in modifying the demand for exports and imports and trade balances. China has worked hard to shed, for its own long-run economic benefit, market-distorting policies over the last two decades, but some of the most important relative prices are still controlled by the government. Fixed exchange rates, one of the relics of a command economy, lead to excessive allocation of resources to the traded export sector and too little to imports and consumption. The nominal and real cost of capital is also controlled, leading to excessively cheap credit and too many investments with low returns. The allocation of savings to investment is still heavily influenced by the government in ways that are becoming increasingly distortive. And the relative price of land is distorted by land-use policies encouraging too much housing investment, leading to a housing bubble that could burst and cause real economic damage. Read More