My Blog

February 20, 2008

In a recent report Jonathan Anderson of UBS explains why he doesn’t think China will adjust the currency via a large one-off revaluation.  As regular readers of my blog know, I have been arguing since early 2007 that there is a high probability that the financial authorities will eventually be forced into a one-off (15-20%) revaluation, although I am uncertain about the timing. 

If they do revalue, they probably won’t want to do it too close to the Olympics because of their low appetite for uncertainty before such an important event, so that leaves them a very short time frame in which to do it – perhaps over the next two months.  However with all the uncertainty over the US economy, and with the new leadership being approved in the next NPC (which begins March 5), I think it is unlikely that they will choose to do it then.  On the other hand, the longer they wait, the worse the monetary and associated imbalances become.

Although I disagree with him, I wanted nonetheless to list Anderson’s arguments because I think his are often the strongest arguments against a revaluation.  I hope I am not violating copyright laws (although if I am, my excuse is, why not? around here everyone else does…), but here are excerpts from Anderson’s piece on why a one-off revaluation does not make sense:

1. It would hurt the wrong people…As we've also discussed numerous times, the problem behind the trade surplus is not overly competitive exports per se ... but rather imports, or more specifically the sharp drop in import demand over the last few years as rising domestic heavy industrial capacity has taken over market share at home and in some cases (e.g., steel) pushed surplus production abroad.
 
In this environment, the optimal solution for the Chinese authorities is to (i) raise costs for overinvested heavy industrial sectors in order to force out marginal players and rekindle import spending, without (ii)
overly penalizing traditional labor-intensive export manufacturers, who are the single largest employer of poor rural migrants.  What's the best way to achieve these aims? The short answer is to let the renminbi strengthen steadily, but not in big discrete jumps.

2. The timing is getting worse. Even if the authorities had been thinking about a one-off move before, it's unlikely they would still be considering it now on the heels of the painful weather-related disruptions in transport and power supply in January and February. Not only will Q1 2008 data point to a visible slowdown at home; most available data have also come off sharply over the past month or two, and the Chinese senior leadership has expressed public concern about the potential impact on mainland exporters. In short, this is not an environment where it would make sense to try an abrupt change of tack on currency policy.

3. …The central bank still has a long way to go before it runs out of options for managing a more gradual scenario…Equally important, FX reserve pressures have been fading over the past six months following the "scare" in the first half of 2007, when inflows jumped sharply (see Chart 2 above). The trade surplus was essentially flat through all of last year on a seasonally adjusted basis and could actually begin to decline in 2008, and as we show below, the strong portfolio capital inflows of a few quarters ago seem to be drying up as domestic equity and property markets fall.

4. No need for emergency inflation fighting. One of the most common arguments in favor of a large up-front revaluation is that the PBoC now needs emergency measures to fight inflation. But this argument makes no sense to us, for the following two reasons. First, as we've stressed continually over the past months, there's no indication whatsoever from the data that current headline inflationary pressures are structural in nature. …As of end-December "core" non-food CPI is perfectly stable; all of the increase in headline CPI in 2007 has come from food, and nearly all of the pressures within food have come from meat and eggs prices alone. This is hardly a picture of widespread, spiralling inflation (the picture may change temporarily in January and February as weather-related shortages lead to price spikes, but this effect should soon fade as well).

And second, there's no rationale behind expectations that renminbi strengthening would help moderate domestic food price increases – for the simple reason that is not a significant importer of food.

5. Fading speculation worries. Another very common argument is that can't successfully pursue a gradual renminbi strategy, since letting the currency appreciate by 8% to 10% per year would bring in a flood of speculative capital and overwhelm the PBC's ability to control the money supply. And in the first half of 2007, it seemed that this was precisely the case: "hot" money was visibly returning to the mainland once again in large amounts, and the central bank was forced to slow down the pace of exchange rate appreciation so as not to encourage further speculation.

However, over the past six months those pressures have faded. As it turns out, the main driver of capital inflows was not exchange rate expectations but rather the booming equity and property markets.

I have a lot of respect for Anderson, and like reading his stuff, although I have to say that I often disagree with his predictions and this is one case where I disagree, largely because I think he misses the main point except at the very end, where he partly addresses it.  Whenever people point out to me all the reasons why a one-off revaluation is a bad idea, I have no disagreement.  It is a bad idea.  If China is forced into a one-off revaluation, it will not be because this is a “good” policy choice that will leave the economy in better shape than it was before the policy was implemented.  It is almost certainly a bad policy choice, but unfortunately the alternatives may all be worse.  By waiting so long on adjusting the currency China has found itself in a trap where it must choose between the least bad options.  I have discussed this often in my blog and don’t want to beat this thing to death, but I do think it is worth making a few points.

Clearly China cannot go back to the old days of a pegged exchange rate or the painfully slow appreciation it experienced until last summer.  That leaves only two more options – the current strategy of much more rapid appreciation, or a one-off revaluation.  There are such serious problems with the rapid appreciation option that in my opinion by a process of elimination we are left with the last one.  What are the problems?  At least three, I think:

1.        The current appreciation strategy postpones the resolution of the monetary problem for perhaps another two years, during which time the imbalances caused by explosive money growth can only get much worse.  Another two years of this kind of reserve growth is almost certainly a terrible idea.  As it is, China’s monetary regime should have been altered in 2003 or 2004, and because it wasn’t, we have spent the last three years with explosive monetary growth.  By October of last year all the gradualist ideology and wishful thinking in the world (and there has been a lot of both) could not prevent the economic authorities from recognizing that China had built serious imbalances thanks to its out-of-control monetary policy, and if these weren’t addressed there was a risk of a very sharp adjustment.  That is why the October Economic Conference resulted in the abrupt policy shift.  It is hard to imagine that another two years of this can be anything but disastrous fro China.

2.        Anderson disagrees, but there is some evidences that hot money inflows are indeed high and likely to rise, although masked partly by complexities in the way the PBoC accounts for reserve accumulation and by over- and under-invoicing in the trade accounts.  The trader in me finds it hard to believe, in any case, that a low-risk 10-14% return in dollars for bringing money into China will not cause large speculative inflows, even if there are capital controls.  If it takes another two years to get to where we want to go, the impact could be hundreds of billions of dollars of additional monetary expansion because of speculative inflows.  This is the opposite of what we need.

3.        Finally, and this is a problem that almost no one to my knowledge has discussed, but there is serious a problem with the end game that needs to be addressed before we get there.  A gradual appreciation, unlike a one-off revaluation, creates no credible signal that we have reached the upper limit of the appreciation path.  If the RMB appreciates for two years at 8-10%, how do investors and speculators know when we have reached the "correct" level and stop speculating on additional appreciation?  In past cases, sustained currency appreciation develops its own momentum, and often a currency will switch from heavily undervalued to heavily overvalued (Japan in the 1980s?).  This could well happen in China, and it would cause a whole new set of problems that would be very difficult to control.

Notice that none of my reasons for a one-off revaluation are positive reasons.  I came to the conclusion that China would be forced into this policy only because I was forced to conclude that every other policy would fail.  In other words it is only by a process of elimination that I arrived at this conclusion.  That doesn’t mean, of course, that the financial authorities will necessarily come to the same conclusion I did, but it does suggest, at least to me, that if they don’t, China’s financial system and near-term economic prospects face some very ugly adjustments.  A one-off revaluation is a bad idea, but everything else is worse.

Comments (15) for "Should we expect a one-off j...

What does Anderson mean when he says: "Equally important, FX reserve pressures have been fading over the past six months following the "scare" in the first half of 2007, when inflows jumped sharply." By TR - 2/19/2008 7:08 PM

I think he is saying that the growth rate of reserves has declined from its early 2007 peak. While this is true, I do not think we should overstate its importance. Reserves have been growing at alarmingly high rates at least since 2005. Since then, the growth rate has accelerated sharply. Remember when the $247 billion (in 2006) seemed like a monstrously high number? This year if correctly counted reserves grew by over $500 billion. Even if the growth rate slows down, and even if it becomes negative, we have a long ways to go before we get back to "monstrous". At any rate excess monetary growth is not just a flow problem, it is also a stock problem. If this year or next reserves were to grow by whatever the "right" growth rate is for an economy the size of China's, it would still not resolve China's monetary imbalances because the PBoC would have to undo previous years of excess growth. By Michael Pettis - 2/19/2008 7:25 PM

First of all, it's not clear at all that the current round of inflation is due to PBC monetary policy over the last several years. Personally, I think that the global economy changed in a major way in mid-2007 (and the economy is always changing) and that triggered the current burst of inflation. The trouble with reason 3) is that it applies to a one-off reval as much as it does a gradual one. If the PBC where to suddenly reval by 15%, how does anyone know that this will be the last reval? Historically, one-off revals never seem to work, because it's hard to say to currency speculators "you've forced our hand once, but this will be the last time." The revals at the end of Bretton Woods I, suggest that a "one-time" reval is just a signal to pour money in to create another reval. There is no way that the PBC can credibly revalue and peg, because the value of the RMB is outside of the control of the PBC, and is the result of relative policies between the PBC and the Federal Reserve. What the "correct" exchange rate is after the reval depends on Fed policy and the only way of maintaining stable exchange rates is to have the PBC and Fed coordinate policy, and I don't see that happening since the Fed is going to be driven mainly by domestic pressures. It's pointless for the PBC to give a signal, because the PBC can signal all it wants that it doesn't want to revalue any more, and then the Fed can cut interest rates by a half point and the PBC has to allow the currency to adjust. Finance problems do not get "resolved." Monetary policy and finance are dynamic systems, and the solutions of today invariably become the problems of tomorrow. By Twofish - 2/19/2008 9:04 PM

" If the RMB appreciates for two years at 8-10%, how do investors and speculators know when we have reached the "correct" level and stop speculating on additional appreciation?" When Fed cut 125bps in 2 weeks, people are speculating that there is another 100bps or 150bps ahead. Now U.S. headline inflation rate is 4%, the expectation for further rate cut is weakened. It will be the same to RMB. If the food price is controlled and inflation rate begin to fall, or export number shrink, all these signals will be clear to investors and speculators that RMB reaches its peak, at least at the moment. By fatbrick - 2/20/2008 7:27 AM

the reserve growth slows down, one possible reason is the USD might go to the China investment corp, another possible reason is SAFE is cutting foreign debt quota of onshore banks aggressively, so some chinese banks are buying USDCNY spot to get USD Cash. By Ali - 2/20/2008 9:08 AM

the key disadvantage of one-off 10% reval and 10% rise in 2-3 quarters are lack of flexibility. Basically by doing maxi- reval, free macro put options are thrown away, real economic agents also have little time to adjust to the sudden tightening monetary conditions and this might cause havoc in production, employment and financial market. The only time monetary authority do Maxi-move are in times of crisis and historically, they are doing more massive easing through maxi-devaluation or rate cut. By isaac - 2/20/2008 9:09 AM

Twofish, you are right: credible signalling is going to be very difficult. The point, however, is not to arrive at a "correct" rate that balances interest rate differentials or even trade differentials, but rather to stop the furious money inflow. I would argue that a jump and a peg would go some way to slowing and maybe even reversing capital inflows, especially as it might then create incentives for wealthy Chinese savers to begin using QDII to diversify their portfolios. Rapid appreciation will almost certainly accomplish the opposite effect. Remember, the point is not to push China into a perfect currency position. It is enough simply to push China into a better one. By the way the PBoC can reinforce the impact of signalling by various market operations -- eg selling RMB calls to speculators betting on another revaluation. Fatbrick, you say "If the food price is controlled and inflation rate begin to fall, or export number shrink", there will be no upward pressure on the RMB. Of course you are right, but that is like saying that if the US fiscal deficit declines there is no need to increase fiscal discipline. That statement is undoubtedly true, but unless we are very lucky and tax receipts suddenly and unexpectedly surge we should not expect the deficit to decline until there is greater fiscal discipline. I don't think the conditions you mention will occur until the currency regime has been adjusted. That is, in my opinion, precisely why we need to adjust the currency regime -- to alter those conditons. If they can change by themselves, then of course there is no need to alter. By Michael Pettis - 2/20/2008 11:44 AM

I hate to repeat myself. But I still firmly believe the different theory about the inflation in China. Thus, I come up with different conclusion and policy implication. Anyway, I guess that we will see the result in 3 months. By fatbrick - 2/20/2008 12:04 PM

among original reasons officials insist against Rmb appreciation, there is one implicit distrust or doubt regarding robustness of China banking and financial system amid economic downturn. Improvement of NPL, rising asset prices are probabaly result of Rmb expectation, excessive liquidity. Therefore, many consider or probabaly still consider undervalued Rmb key lynchpin of financial stability. Put to extreme, if Rmb is put to fair level, how much further capital inflow you expect or capital flight will result considering the very expensive China asset prices, poor legal protection of property rights? I agree with fatbrick, Rmb appreciation is for anti-inflation and painful for government, for this purpose oneoff reval is too extreme. By isaac - 2/20/2008 12:27 PM

I agree that the shock to the banking system might indeed be too great to handle, and as long as their is some uncertainty about it, the authorities will be reluctant to risk it. On the other hand the current monetary imbalances are almost certainly leading to bad banking pratice and potentially weakening balance sheets. The authorities have to balance these two uncertainties, although I agree with you that the bias will always be towards avoiding dramatic action. More to the point, however, if inflation surges or if the continuing high trade suprlus leads to escalating tensions with the US and Europe, the governement may be forced into doing something that they wouldn't otherwise want to do. The question is not whether a maxi-revaluation is a bad idea. Of course it is, but it is possible (and perhaps even likely)that we find oursleves in a position where not doing it is even worse. By Michael Pettis - 2/20/2008 12:41 PM

Professor Pettis, I wonder if at times you feel a little frustrated with the debate. As I understand it, your argument has been consistent and very clear: A maxi-revaluation will be a very risky, unpleasant policy for China, but nonetheless because of their slowness to address their monetary imbalances the financial authorities may be forced into a maxi-revaluation because the alternative will be worse. But whenever someone disagrees with you, they argue that the authorities will not maxi-revalue because it will be risky and unpleasant. This is not an argument against your position. It seems to me that logically they should be arguing instead that China will not find itself in a position where they will have no better alternative. Have I summarized correctly? By Francois L. - 2/20/2008 1:28 PM

Francois, with your admirable French logic you have boiled my position down to its essence: A one-off revaluation is unquestionably a bad policy choice, but it may well be that the leadership has engineered itself into a position where, absent some very good luck, the alternative will be worse. Of course even if I am right it doesn’t follow that they will choose the one-off revaluation. For political reasons, or because of poorly identified accountability, or even because of their inability to move away from the gradualist policies which they value so highly (and which may have gotten them into this mess), they may very well stick with the alternative, but the consequences would then be very worrisome. However I am not at all frustrated by the debate. If I were 100% certain that I am correct, perhaps I would be, but I am not. I welcome any challenge or confirmation of my views because the issue is very complex. By Michael Pettis - 2/20/2008 2:22 PM

I'm agnostic as to whether or not a maxi-reval is a good thing or not. The important thing at this point is that the currency is depegged which means that the Chinese government has the ability to conduct independent monetary policy. Also it's not quite either or. The PBC could appreciate the RMB 15% over one day, one week, one month, or one year. A lot of this really depends on how bad hot money inflows really are, and I think that PBC probably has better information on that than we do. One thing that makes me suspect that perhaps there hasn't been an influx of hot money is that the SAFE's first instinct is usually to tighten capital controls, and there hasn't been an announcement that I've seen that currency regulations will be strictly enforced. By Twofish - 2/20/2008 3:56 PM

Twofish, read today's entry on hot money. I try to address just that. By the way the currency is not depegged -- it is simply pegged to a new number every day -- and of course China has not regained the ability to control independent monetary policy, unless you believe they are buying huge amounts of dollars every month because they feel the urgent need to add to reserves. I think it is more correct to assume they are buying dollars because they have no choice as long as they maintain the currency at a specified value, and so they have no control (or very little) over domestic monetary policy. By Michael Pettis - 2/20/2008 4:06 PM

<<I think he is saying that the growth rate of reserves has declined from its early 2007 peak. While this is true, I do not think we should overstate its importance. Reserves have been growing at alarmingly high rates at least since 2005. Since then, the growth rate has accelerated sharply. Remember when the $247 billion (in 2006) seemed like a monstrously high number?>> The growth of reserves is only appearing to decline, I think, because the headline reserves have shrunk but the "true" reserves probably are still growing. Michael, you've got the answer to this conundrum right on your blog (in December). The largest banks, since August, have been asked to set aside foreign currency instead of yuan for the required reserve rate increases. This has been knocking $20 billion a month off headline foreign reserves ($40 billion in December when RRR went up twice as much as usual). However these reserves are all hedged (or whatever) to guarantee that the commercial banks don't suffer losses from currency fluctuations. Thus, effectively, the foreign exchange reserves should be about $140 billion higher. When you add in this $20 billion a month (as Logan Wright has in his paper), all of a sudden you get much more normal seeming #s for increases in hot-money inflows, showing marked increases. Of course all this becomes hard to tease out for end of year because you've got the CIC fund shifting probably going on in there. But I think Michael's bottom-line reality is important to focus on: What's the expected appreciation in RMB this year? 6 percent? What does the ultra-safe bank account in China fetch these days annually? 4 percent? That's an easy 10 percent for the smart money in the U.S. that surely knows that (not to imply that it's easy to park money in a Chinese bank but that this indicates your baseline expectations on "investing" if you're from the U.S.). By Chinawatcher - 2/20/2008 4:25 PM