Response to “Inflation first, appreciation second”
By Michael Pettis
Geng Xiao of the Brookings Institute has written a piece called “Inflation first, appreciation second” to which Dan Berg alerted me.He has asked me to comment on it.You can find it at http://www3.brookings.edu/papers/2007/0730_china_xiao.aspx.
Mr. Xiao argues that China should not revalue its currency because the Chinese trade “imbalance” is caused by a faster reduction in hidden transactions costs on the export side relative to the import side.For him, “Low wage is neither the single factor nor even the most important factor pushing the advance of China’s export competitiveness”. Transaction costs on imports must be reduced in order to achieve balance, and faster currency appreciation will not help, but may hinder, China’s transition.
I agree with his comment about low wages not being the main cause of the trade imbalance, but disagree with his overall argument.My response to Dan is the following:
Dan,
Thanks a lot for your comments. I read Geng Xiao's piece and there are three big things with which I disagree very strongly.
1.The RMB is the root cause of the trade imbalance, in my opinion, but not for the reasons he and many others think. It is not because of relative price or wage differentials but because of the monetary impact of the currency regime.In a way, this is what happened in the US in the 1920s and Japan in the 1980s – the combination of very high trade surpluses and capital account surpluses caused massive overinvestment and a stock market bubble, which ultimately weakened the banking system. That left both countries vulnerable to a balance sheet crisis, and is leaving China vulnerable to the same thing, in my opinion.Until the inflows are reversed (and it seems only a significant revaluation can do that), China is condemned to an excessive monetary expansion which feeds the trade surplus by feeding overinvestment.
2.Xiao argues that a combination of 4% inflation and 4% appreciation will cause the necessary adjustment in 15 years, and he recommends achieving these two inflation/appreciation goals as the appropriate policy for the PBoC.I had a similar discussion in early 1998 with a friend who later became governor of the Brazilian central bank.At the time I had argued that the combination of an unstable balance sheet and an overvalued pegged currency would force a painful devaluation onto Brazil. Since the government’s balance sheet was progressively getting more unstable (primarily caused by the high and rising amount of short-term government debt needed to defend the currency), thus causing the cost of a currency shock to rise, the sooner the central bank engineered a devaluation, the less painful it would be.
My friend agreed that these weaknesses did indeed exist, but argued that since Brazil’s inflation was substantially lower than that of he US, the currency would adjust gradually anyway over five to seven years, and so a forced devaluation would be unnecessary. He agreed with me, however, that there was no guarantee that Brazil had enough time to adjust, and that there was a real risk that external conditions would force an ugly adjustment much earlier. That is what in fact happened.The Russian crisis created the shock that broke the Brazilian currency in January 1999.
Perhaps China has 15 peaceful and stable years in which to adjust, but I would not bet on it.In the meantime, overinvestment will keep adding to balance sheet weaknesses.
3.Xiao also suggests that China can choose a 4% inflation rate and stick to it.I would not be nearly as optimistic.If Chinese inflation is a monetary phenomenon, the PBoC will not be able to choose an inflation target while the money base is growing so explosively. Look how frantically they are now trying to bring inflation down.Is it likely that they can manage a smooth 4% inflation for 15 years?
Xiao suggested that other countries suggest to China to have inflation instead of appreciation. He is looking at it from a Chinese economist's point of view, and not from a foreign politician's point of view.
No foreign politician can get away with suggesting China to increase inflation without getting the wrath from China for interfering with Chinese internal affairs. However, exchange rate is not an internal affair, and China won't dare suggest that is internal affair. Therefore, complaints from China against such suggestion are much easier to explain away to your local constituents, as well as showing that you are doing something to address the concerns of your local constituents.
However, pleasing your local constituents is not something the Chinese government can understand, as the Chinese people need no pleasing from the government. It is the government that needs pleasing.
By Bill - 12/22/2007 2:50 AM
Bill: However, pleasing your local constituents is not something the Chinese government can understand, as the Chinese people need no pleasing from the government. It is the government that needs pleasing
This is a common view but it is incorrect. The Chinese government is actually quite responsive to public opinion, and it recognizes the need to be responsive in order to avoid another Tiananmen, which everyone, including the Chinese government, wants to avoid.
I'm not sure why 4% inflation + 4% appreciation is preferable to 8% appreciation. Appreciation is something that the PBC can control without too much difficulty whereas inflation involves lots of factors that are outside the control of the PBC. My objections to a maxi-reval are that there would likely be unexpected things happening, but having an inflation target is likely to have even more weird things happening.
In any case, inflation is now above the target, and its not clear to me what Xiao thinks China should do about that.
Inflation is now paramount risk to China, asset bubble risk is probabaly caused by same factor driving inflaiton.
Government now is putting inflation as No.1 objectives and pulling all strings simultaneously. Even aggressive move such as Maxi Rmb revaluation is seriously studied for pro-cons.
Michael Pettis is a professor at Peking University's Guanghua School of Management, where he specializes in Chinese financial markets. He has also taught, from 2002 to 2004, at Tsinghua University’s School of Economics and Management and, from 1992 to 2001, at Columbia University’s Graduate School of Business. He is a member of the board of directors of ABC-CA Fund Management Co., a Sino-French joint venture based in Shanghai.
Pettis has worked on Wall Street in trading, capital markets, and corporate finance since 1987, when he joined the Sovereign Debt trading team at Manufacturers Hanover (now JP Morgan). Most recently, from 1996 to 2001, Pettis worked at Bear Stearns, where he was Managing Director-Principal heading the Latin American Capital Markets and the Liability Management groups. He has also worked as a partner in a merchant banking boutique that specialized in securitizing Latin American assets and at Credit Suisse First Boston, where he headed the emerging markets trading team. Besides trading and capital markets, Pettis has been involved in sovereign advisory work, including for the Mexican government on the privatization of its banking system, the Republic of Macedonia on the restructuring of its international bank debt, and the South Korean Ministry of Finance on the restructuring of the country’s commercial bank debt.
Pettis is a member of the Institute of Latin American Studies Advisory Board at Columbia University as well as the Dean’s Advisory Board at the School of Public and International Affairs. He is the author of several books, including The Volatility Machine: Emerging Economies and the Threat of Financial Collapse (Oxford University Press, 2001). He received an MBA in Finance in 1984 and an MIA in Development Economics in 1981, both from Columbia University.
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Comments (3) for "Response to “Inflation first...
January, 2008