The International Economy magazine (Winter 2013) asks 16 authorities, “Can Changes in Exchange Rate Valuations Affect Trade Imbalances?“   It is referring to the claim in a recent book by Stanford economist Ron McKinnon that pressure on China to let the renminbi appreciate against the dollar is fundamentally misconceived because such a movement in the exchange rate would not reduce China’s trade surplus nor American’s trade deficit.  This is part of an old debate that pre-dates the rise of the China trade problem.  Ron has long claimed that exchange rates don’t determine trade balances because they are “instead” determined by national saving versus investment.   I thought Paul Krugman demolished the argument pretty effectively 25 years ago, with a textbook graph of internal balance versus external balance.   But evidently many still fall for the argument (including some of the experts in the TIE symposium).   So I try again:

Ron McKinnon has made many important contributions to international macroeconomics over the years. But on this issue, he is simply wrong.

It goes without saying that the current account is equal to the difference between national saving and investment. But it does not follow that we should try to improve the current account in the short run by increasing national saving. Under current conditions, that would send the United States back into recession.

The national saving identity is a tautology: it does not in itself imply causation. True, many of the big movements in the U.S. current account deficit can be explained by changes in national saving: the fiscal expansion of the early 1980s, the investment boom of the late 1990s, and the new fiscal expansion of the 2000s. But the important point is that we care about a lot of things besides just external balance (the trade balance and current account). We care at least as much about internal balance (growth, employment, and inflation). To say that an increase in the budget balance and national saving would improve the trade balance does not imply that this would be good policy or that it is the only way to improve the trade balance.

Of course we need to address the budget deficit in the long run, in balanced sensible ways.  But under current circumstances — a still-weak economy, high unemployment, low inflation, rock-bottom interest rates — a reduction in public or private spending would send the economy straight back into recession. That is why the fiscal cliff of January 1, 2013, was such a danger. To observe that the trade balance would have improved if the sharp fiscal contraction had gone fully into effect would have been small consolation for the self-inflicted recession.

The U.S. trade deficit and Chinese trade surplus have diminished and so are today not quite the problems that they were five years ago. But if improving the U.S. trade balance is considered an important goal, then a devaluation or depreciation of the currency is a better tool for the job. (This proposition does not violate the national saving propositions. Nor, on the other hand, does it justify China-bashing.) Because a real devaluation would also raise demand for U.S. products — admittedly with a lag — and thus move us closer to internal balance, it would be a far more appropriate tool for improving the current account under present-day conditions than would cutting national spending or raising taxes.

         A survey of economists is published in the November 2012 issue of Foreign Policy.  One question was whether we thought that the US unemployment rate would dip below 8.0% before the election.   When the FP conducted the poll at the end of the summer, unemployment was 8.1-8.2%.  Now it’s 7.8%.  Only 8% of the respondents said “yes.”   (I was one.  I basically just extrapolated the trend of the last two years.)   

My fellow economists choose defense spending and agricultural subsidies as the two categories of US federal budget that they think the best to cut.  They rate the euro crisis as the greatest threat to the world economy now and are particularly worried about Spain.   

For a slideshow presentation of the results, see “The FP Survey: The Economy.”   Or in a magazine format:  “If we’re ever going to get out of this slump, what will it take?  We asked more than 60 leading economists to tell us.”   

        Also, here is a recent poll from The Economist, asking similar questions of NBER and NABE economists:   “Asking the Experts,” Oct. 6.

        The world is waiting to see whether China has successfully achieved a soft landing, slowing down the economy from its overheated state of a year ago to a more sustainable rate of growth. Some China-watchers fear it could hit the ground in a crash landing as have other Asian dragons before it. But others, particularly American politicians in this presidential election year, talk only about one thing: the trade balance.
        Here the important message is that long-term forces of adjustment are at work in the Chinese economy.  Foreign perceptions need to be adjusted as well. It is true that not long ago the yuan was substantially undervalued and China’s trade surpluses were very large. But the situation is changing.
        China’s trade surplus peaked at $300 billion in 2008, and has been declining ever since. In fact it even reported a trade deficit in the month of February ($31 billion, its largest deficit since 1998). It is not hard to see what is going on. Ever since the Middle Kingdom rejoined the world economy three decades ago, its trading partners have been snapping up exports of manufacturing goods, because low Chinese wages made them super-competitive on world markets.  It was known as the unbeatable “China price.”  But in recent years, following the laws of economics, relative prices have adjusted to the demand.
        The change can be captured by real exchange rate appreciation. This comprises in part nominal appreciation of the yuan against the dollar, and in part Chinese inflation. Government officials would have been better advised to let more of the real appreciation take the form of nominal appreciation (dollars per RMB). But since they didn’t, it has shown up as inflation instead. (See charts below, which show both nominal and real appreciation, against the dollar or against an index.)
        The natural process was delayed. In the first place, as is well-known, the authorities intervened to keep the exchange virtually fixed against the dollar, in the years 1995-2005 and 2008-2010. In the second place, workers in China’s increasingly productive coastal factories were not paid their full value. The economy has not completed its transition from Mao to market, after all. As a result of these two delaying mechanisms, Chinese continued to undersell the world.
        But then two things happened. First, the yuan was finally allowed to appreciate against the dollar during 2005-08 and 2010-11, by 25% cumulatively [=17% + 8%]. Second, and more importantly, labor shortages began to appear and Chinese workers at last began to win rapid wage increases. Major cities raised their minimum wages sharply over each of the last three years [FT, Jan. 5]: 22% on average in 2010 and 2011 (somewhat less this year, in response to slowing demand: 8.6 % in Beijing, 13% in Shenzhen and Shanghai).  Meanwhile another cost of business, land prices, rose even more rapidly.
        As a result, whereas all signs still pointed to a substantially undervalued yuan as recently as four or five years ago, this is no longer the case. One important measure of undervaluation — a comparison of China’s prices with what is normal given the country’s level of income (the so-called Balassa-Samuelson relationship) – showed the renminbi as undervalued against the dollar by as much as 36% on 2000 data (Frankel, 2005) .  Even after an improvement in the international  price data, Balassa-Samuelson regressions estimated the undervaluation at roughly 30% in 2005  and 25% as recently as 2009.   (Others had other ways of estimating undervaluation; see Goldstein, 2004, and those surveyed by Cline and Williamson, 2008.)   
       The renminbi’s real appreciation against the dollar over the last three years has amounted to 12%, reducing the degree of undervaluation by roughly half, depending on whether one measures it against the dollar or against all countries.  More is to be expected, as Chinese relative wages continue to rise.  In any case, China’s real exchange rate is already closer to this measure of equilibrium than are most countries’ exchange rates (Cheung, Chinn and Fuji, 2010).

      In response to the new high level of costs in the factories of China’s coastal provinces, five types of adjustment are gradually taking place. First, some manufacturing is migrating inland, where wages and land prices are still relatively low. Second, some export operations are shifting to countries like Vietnam and Bangla Desh where wages are lower still. Third, Chinese companies are beginning to automate, substituting capital for labor. Fourth, they are moving into more sophisticated products, following the path blazed earlier by Japan, Korea, and other Asian countries in the “flying geese” formation. Fifth, multinational companies that had in the past moved some stages of their production process out of the US, or out of other high-wage countries, to China are now moving back (”reshoring”). Productivity is still higher in the US, after all. All five of these ways of reallocating resources represent the economic process operating as it should. A sixth seems still to lag behind, despite the consensus in favor of it: expansion of the services sector.
        None of this comes as news to most international observers of China. But many Western politicians (and, to be fair, their constituents) are unable to let go of the syllogism that seemed so unassailable just a decade ago: (1) The Chinese have joined the world economy; (2) their wages are $0.50 an hour; (3) there are a billion of them, and so (4) their exports will rise without limit: Chinese wages will never be bid up in line with the usual textbook laws of economics because the supply labor is infinitely elastic. But it turns out that the laws of economics do eventually apply after all — even in China.

       My next post will recall the precedent of Japan’s trade balance.

[A version of this post was published by Project Syndicate, which has the copyright.]

Chinese relative prices have risen as much (since 2009) via inflation as via RMB appreciation

(click her for larger image) 

References

     Chang, Gene Hsin, 2008, “Estimation of the Undervaluation of the Chinese Currency by a Non-linear Model,” Asia-Pacific Journal of Accounting & Economics Vol.15, No. 1, April, 29-40.

      Chang, Gene H. , 2012, “Theory and Refinement of the Enhanced-PPP Model for Estimation Equilibrium Exchange Rates — with Estimates for Valuations of Dollar, Yuan and Others”, SSRN abstract=1998477,  Feb. 2.

      Cheung, Yin-wong, Menzie Chinn and Eiji Fuji, 2010, “China’s Current Account and Exchange Rate,” in China’s Growing Role in World Trade, edited by Rob Feenstra and Shang-Jin Wei (University of Chicago Press, 2010).

     Cline, William, and John Williamson, 2008, ‘Estimates of the Equilibrium Exchange Rate of the Renminbi,” in Debating China’s Exchange Rate Policy, edited by M.Goldstein and N.Lardy (Peterson Institute for International Economics), 155-165.  

      Frankel, Jeffrey, 2005, “On the Renminbi,”  CESifo Forum, vol.6, no.3, Autumn (Ifo Institute for Economic Research, Munich): 16-21.

      Subramanian, Arvind, April 2010, “New PPP-Based Estimates of Renminbi Undervaluation and Policy Implications,” PB10-08, Peterson Institute for International Economics.

Emerging markets have performed amazingly well over the last seven years. They have outperformed the advanced industrialized countries in terms of economic growth, debt-to-GDP ratios, and countercyclical fiscal policy.  Many now receive better assessments by rating agencies and financial markets than some of the advanced economies.

As 2012 begins, however, emerging markets may be due for a correction, triggered by a new wave of “risk off” behavior among investors. Will China experience a hard landing? Will a decline in commodity prices hit Latin America? Will the sovereign-debt woes of the European periphery spread to neighbors such as Turkey in a new “Aegean crisis”?

Engorged by large capital inflows, some emerging market countries were in an overheated state a year ago. It is unlikely that the rapid economic growth and high trade deficits that Turkey has experienced in recent years can be sustained. Likewise, high GDP growth rates in Brazil and Argentina over the same period could soon reverse, particularly if global commodity prices fall - not a remote prospect if the Chinese economy falters or global real interest rates were to rise this year. China, for its part, could land hard as its real-estate bubble deflates and the country’s banks are forced to work off their bad loans.

The World Bank has now downgraded economic forecasts for developing countries in 2012 (Global Economic Prospects, Jan.18, 2012).    Brazil’s economic growth, for example, came to a halt in the third quarter of 2011 and is forecast at only 3.4 percent in 2012 …well below the rapid 2010 growth rate of 7.5 percent.  Reflecting a sharp slowdown in the second half of the year in India, South Asia is coming off of a torrid six years, including 9.1 percent growth in 2010.  Regional growth is projected to ease further to 5.8 percent in 2012.

But will economic slowdown turn to financial crash?   Three possible lines of argument support the worry that emerging markets’ performance are fated to suffer dramatically in 2012: empirical, literary, and causal. Each line of argument is admittedly tentative.

The empirical argument is just historically based numerology: emerging-market crises seem to come in 15-year cycles. The international debt crisis surfaced in Mexico in mid-1982, and then spread to the rest of Latin America and beyond. The East Asian crisis erupted 15 years later, in Thailand in mid-1997, and then spread to the rest of the region and beyond. We are now another 15 years down the road. So is 2012 the time for the third round of emerging markets crises?

The hypothesis of regular boom-bust cycles is supported by a long-standing scholarly literature, such as the writings of Carmen Reinhart. But I would appeal to an even older source: the Old Testament - in particular, the story of Joseph, who was called upon by the Pharaoh to interpret a dream about seven fat cows followed by seven skinny cows.

Joseph prophesied that there would come seven years of plenty, with abundant harvests from an overflowing Nile, followed by seven lean years, with famine resulting from drought. His forecast turned out to be accurate. Fortunately the Pharaoh had empowered his technocratic official (Joseph) to save grain in the seven years of plenty, building up sufficient stockpiles to save the Egyptian people from starvation during the bad years. That is a valuable lesson for today’s government officials in industrialized and developing countries alike.

For emerging markets, the first phase of seven years of plentiful capital flows occurred in 1975-1981, with the recycling of petrodollars in the form of loans to developing countries.  The international debt crisis that began in Mexico in 1982 was the catalyst for the seven lean years, known in Latin America as the “lost decade.” The turnaround year, 1989, was marked by the first issue of Brady bonds, which helped write down the debt overhang and put a line under the crisis.

The second cycle of seven fat years was the period of record capital flows to emerging markets in 1990-1996.  Following the 1997 “sudden stop” in East Asia came seven years of capital drought. The third cycle of inflows, often identified as a “carry trade,” came in 2004-2011 and persisted even through the global financial crisis. If history repeats itself, it is now time for a third sudden stop of capital flows to emerging markets.

Are a couple of data points and a biblical parable enough to take the hypothesis of a 15-year cycle seriously?  We need some sort of causal theory that could explain such periodicity to international capital flows.

Here is a possibility: 15 years is how long it takes for individual loan officers and hedge-fund traders to be promoted out of their jobs. Today’s young crop of asset pickers knows that there was a crisis in Turkey in 2001, but they did not experience it first hand. They think that perhaps this time is different.  

If emerging markets crash in 2012, remember where you heard it first - in ancient Egypt.

[This article was published in Project Syndicate, which holds the copyright.]

All of a sudden, the renminbi is being touted as the next big international currency.   Just in the last year or two, the Chinese currency has begun to internationalize along a number of dimensions.   RMB bank desposits are now available in Hong Kong.  A RMB bond market has grown rapidly there as well, with the issuers including major multinationals such as McDonald’s.   Some of China’s international trade is now invoiced in the currency.  Foreign central banks have been able to hold RMB since August 2010, with Malaysia going first. 

Some are now claiming that the renminbi could overtake the dollar for the number one slot in the international currency rankings within a decade (especially Subramanian 2011a, p.19; 2011b).   The basis of this prediction is, first, the likelihood that the Chinese economy will surpass the US economy in size and, second, the historical precedent when the dollar overtook the pound sterling as the number one international currency during the period after World War I.   

It used to be thought that international currency status was subject to much inertia (e.g., Krugman, 1984).  There was said to have been a long lag between the date when the US economy had passed the UK economy with respect to size (1872, by the criterion of GNP) and the time when the dollar had passed the pound (1946, by the criterion of shares in central banks’ holdings of reserves). 

The “new view,” represented in particular by Eichengreen (2011) and Eichengreen and Flandreau (2010), is that the lag was in fact rather short.  It took until World War I for the dollar to fulfill the criteria of an international currency.  Furthermore, the date when the dollar is said to have challenged the pound in importance has now been moved up to the mid-1920s.   The first point is right. If trade is the measure of size, the US first caught up with the UK during World War I.  The US did not even have a permanent central bank until 1913.  The other important criteria came soon thereafter:  creditor status for the country; the perceived prospects for the currency to remain strong in value; and deep, liquid, open financial markets.  (I have discussed the criteria in earlier papers.  Chinn and Frankel, 2007, evaluate them econometrically and give further references.)  The second point seems a matter of whether or not one wants to distinguish between the concept of “coming to rival” / “catching up with”  the pound (1920s) versus the phenomenon of definitively “pulling ahead” / “displacing” the pound (1945).  Under either interpretation, the dollar’s initial rise as an international currency was indeed rapid, once the conditions were in place. 

The dollar is one of three national currencies to have attained international status during the 20th century.  The other two were the yen and the mark, which became major international currencies after the breakup of the Bretton Woods system in 1971-73.  (The euro, of course, did so after 1999.)  In the early 1990s, both were spoken of as potential rivals of the dollar for the number one slot.  It is easy to forget it now, because Japan’s relative role has diminished since then and the mark has been superseded.  In retrospect, the two currencies’ shares in central bank reserves peaked as the 1990s began.

The current RMB phenomenon differs in an interesting way from the historical circumstances of the rise of the three earlier currencies.  The Chinese government is actively promoting the international use of its currency.   Neither Germany nor Japan, nor even the US, did that, at least not at first.   In all three cases, export interests, who stood to lose competitiveness if international demand for the currency were to rise, were much stronger than the financial sector, which might have supported internationalization.  One would expect the same fears of a stronger currency and its effects on manufacturing exports to dominate the calculations in China.

In the case of the mark and yen after 1973, internationalization came despite the reluctance of the German and Japanese governments.  In the case of the United States after 1914, a tiny elite promoted internationalization of the dollar despite the indifference or hostility to such a project in the nation at large.  These individuals, led by Benjamin Strong, the first president of the New York Fed, were the same ones who had conspired in 1910 to establish the Federal Reserve in the first place.

It is not yet clear that China’s new enthusiasm for internationalizing its currency includes a willingness to end financial repression in the domestic financial system, remove cross-border capital controls, and allow the RMB to appreciate, thus helping to shift the economy away from its export-dependence.  Perhaps a small elite will be able to accomplish these things, in the way that Strong did a century earlier.  But so far the government is only promoting international use of the RMB offshore, walled off from the domestic financial system.  That will not be enough to do it.

[This RIETI perspectives note summarizes the argument in "Historical Precedents for the Internationalization of the RMB," a paper that I have written for a workshop directed by Sebastian Mallaby, for the Council on Foreign Relations and the China Development Research Foundation.]

 Comments can be posted at the version on the Vox site or Seeking Alpha.

References

Chinn, Menzie, and Jeffrey Frankel , 2007, “Will the Euro Eventually Surpass the Dollar as Leading International Reserve Currency?” in  G7 Current Account Imbalances: Sustainability and Adjustment, edited by Richard Clarida (University of Chicago Press).  

Eichengreen, Barry, 2011, Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International Monetary System (Oxford University Press).

Eichengreen, Barry, and Marc Flandreau, 2010, “The Federal Reserve, the Bank of England and the Rise of the Dollar as an International Currency, 1914-39,” BIS WP no. 328, Nov.

Eichengreen, Barry, and Jeffrey Frankel, 1996, “The SDR, Reserve Currencies, and the Future of the International Monetary System” in The Future of the SDR in Light of Changes in the International Financial System, edited by M.Mussa, J.Boughton, and P.Isard (International Monetary Fund).

Krugman, Paul, 1984, “The International Role of the Dollar: Theory and Prospect,” in Exchange Rate Theory and Practice, edited by J.Bilson and R.Marston (University of Chicago Press), 261-78.

Subramanian, Arvind, 2011a, “Renminbi Rules: The Conditional Imminence of the Reserve Currency Transition,” (Petersen Institute for International Economics), September. 

Subramanian, Arvind, 2011b , Eclipse: Living in the Shadow of China’s Economic Dominance (Petersen Institute for International Economics), September. 

The current visit of Secretary Tim Geithner to Beijing once again shines the spotlight on the Renminbi (RMB) and on demands by US politicians that the People’s Bank of China (the country’s central bank) abandon the peg to the dollar.  

Throughout the period 2003-2008, I, as some others, have thought that demands from American politicians of both parties that China loosen the dollar link have been misguided in a number of particulars.    They were misguided in thinking that an appreciation of the RMB would, alone, do much to boost US output or employment.  The demands were especially misguided in putting such high priority on the entire exchange rate issue, given that we need China’s help on more important things, such as preventing a nuclear-armed North Korea.   But my arguments during this period might reasonably have been viewed by non-wonks as quibbles.   After all, I did agree, along with a majority of other economists, that an increase in the flexibility of China’s exchange rate would be a good thing.

Now, in 2009, the situation has changed in some important ways.   Continued demands from American congressmen that China should stop intervening in foreign exchange market to keep the RMB fixed against the dollar have become especially foolish.  This is because of two developments over the last year.   

The first development: in mid-2008, the top leaders in China decided to abandon the policy they had followed in 2007 – which had consisted of the long-desired evolution away from  the dollar peg and the placing of a substantial weight on the euro.  They changed horses in mid-stream:    After mid-2008 they returned to their old policy  of a fairly close peg to the dollar (similar to 2005-06).   Evidently the motivation for the return to the dollar was complaints from Chinese exporters who had lost competitiveness in 2007 as the euro and therefore the new basket appreciated against the dollar.  (Barry Naughton, 2008, gives a glimpse inside politburo politics.)  

Why, then, are American congressmen wrong to complain that the return of the dollar link has given American firms an additional price disadvantage in world markets?   The first reason on the list is that over the last year, the euro (surprisingly) depreciated against the dollar.  In other words, at precisely the moment when the RMB jumped back on the dollar horse, the dollar horse and the euro horse changed directions vis-à-vis each other.  If the Chinese authorities had kept the (loose) basket policy of 2007 instead of switching back to the dollar peg in 2008, the value of the RMB would be lower today, not higher, and dollar-based producers would be at a more of a competitive disadvantage, not less.

The second development is that, in early 2009, the stratospheric rate of rise of China’s foreign exchange reserves fell abruptly.  In some months, the PBoC actually lost reserves.   This means that an increase in exchange rate flexibility – in the extreme case, a move to floating – under current conditions might not result in an appreciation of the RMB, and might even result in a depreciation.  Again, that does not correspond to what the congressmen actually want, nor to the public opinion that they represent.

In the near future, we could see a return of substantial surpluses on China’s overall balance of payments and a return of the 38-year trend dollar depreciation.   In that case, intervention would once again imply suppressing RMB appreciation against the dollar.  But that leads us to the third point.

The third development, this spring, is the appearance in the dollar’s garden of the first “red shoots.”   Red as in deficits and red as in China.   For decades, the United States has been able to count on foreigner investors, and in a pinch foreign central banks more specifically, to buy dollars to finance US current account deficits.   In recent years, the PBoC has been the lead facilitator, piling up $2 trillion in reserves, most of it in dollars (the estimate is 70%).  Many argued that the United States could continue to enjoy this “exorbitant privilege” indefinitely.   But during the past two months we have seen the first signals that this might not continue forever.   The possibility that rating agencies might eventually downgrade US debt is in the air, and US longer-term interest rates have finally begun to rise. 

The most telling warning shots have come from Chinese officials.   Premier Wen in April expressed worry that US Treasury securities would lose value in the future;  that required an unprecedented public assurance from President Obama.   Then PBoC Governor Zhou in May proposed replacing the dollar as an international currency, with the SDR.   Another official told Americans that his countrymen “hate” having to hold a currency that they believe will lose value in the future as it has in the past.  Interpreted separately and literally, each of these statements raises interesting economic questions worthy of extended discussion.  Taken together, they constitute a simple wake-up call for oblivious Americans.   The message is that we are heavily and increasingly dependent on China to buy our treasury securities, at a time when big budget deficits lie in America’s recent past (the big debt that Obama inherited from George W. Bush), in America’s present (the record budget deficits caused by the current recession), and in America’s future (rising medical costs and the retirement of the baby boomers), .   If they and other Asian and commodity-exporting countries stop buying our treasuries, the result would almost certainly be a hard landing for the dollar.  I define a dollar hard landing as the combination of a big fall in its value together with a big increase in US interest rates.  The outcome might be stagflation.

As a general proposition, it is somewhat obtuse to make strident demands on one’s biggest creditor without taking any consideration of the change in the power relationship that debtor status entails.   It is especially obtuse to make the demand that the Chinese stop buying dollars, at the same time as we depend on them continuing to buy dollars to finance our deficits.    But demanding that they stop buying dollars is precisely what we have been doing for six years, every time we respond to trade concerns by demanding that they stop intervening to prevent the RMB from rising.

Fortunately, Secretary Geithner’s April decision not to declare China guilty of unfair currency manipulation, in Treasury’s semi-annual report, suggests that he understands the subtleties of the situation.   Now if those congressmen would just learn some economics…

[Any readers wishing to post comments are referred to the RGE Monitor version or Seeking Alpha version of this post.]

Tags: basket, China, dollar, exchange rate regime, renminbi, Schumer-Graham, ShangJin Wei, yuan
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