My Blog

October 1, 2008

The holiday week continues to limit information and policy-making, and of course the Chinese stock markets are closed, but there were nonetheless two interesting articles, one in the Chinese press and one from abroad, worth noting.  The first was a very long article in today’s Xinhua called “The rise of the yuan – where now for China’s currency?” in which the author, Zhu Yifan interviewed a number of economists on prospects for the RMB.

After going through the benefits a rising RMB has had for Chinese consumers and the costs to exporters, the article shifts gears and refers to the currency regime as a structural part of China’s problem:

The reverberations of the rapid appreciation of the yuan are deep and complicated. The change was not as simple as a boost in buying power or a squeezed trade surplus. Behind it lies a shift in the country's overall economic strategy, driven by recognition that the current export structure won't support economic development the way it used to.

“China's currency had been kept in an undervalued state since the 1997 Asian Financial Crisis, and the government in effect used it to finance the imports and exports sector at the cost of its non-trading industries,” says Professor Pan Yingli, of the Shanghai Jiao Tong University management school.  A large profit margin was then created between low production costs paid in undervalued yuan, and the high revenues reaped by selling these products to international clients.

This brought prosperity for the country, but took a heavy toll with high pollution and energy consumption. Too much labor-intensive industry with low-efficiency and little added value stretched supply by demanding evermore manufacturing materials, which pushed up upstream prices. The heavy reliance on overseas markets was detrimental to the establishment of an overall balanced industrial structure in China.  It also created a persistent gap between the well-developed coastal east, which thrived by trading with the outside, and the poor central and western regions in China.

“The structural conflict has accumulated to a stage that demands a solution,” says Pan.  “Strengthening the yuan is the rational choice as it helps stabilize inflation and leads to the optimization of industrial structure.”

The article then goes on to point out that the strategy to accelerate the RMB’s appreciation foundered, as should only have been expected, on the issue of speculative hot money inflows, which have poured into the country in the last year.  It quotes Liu Yuhui, researcher with Chinese Academy of Social Sciences, as warning that losing control of capital inflows would ultimately cause policy-makers to lose control of the underlying macro-economy – something which, I believe, has already happened.

I am not sure where the article was ultimately headed – it concludes:

Given the complexity of the situation, opinion is divided over whether the appreciation will continue, or whether there will be a one-off appreciation to end the uncertainty. Guesses are made at the so-called ceiling of the yuan. Central bank governor Zhou Xiaochuan says China would gradually expand the elasticity of the exchange rate, sending out the signal that Beijing would let the yuan fluctuate rather than rise unilaterally.

The fast appreciation of the yuan in the first half might not continue, and the concern over possible fallback of foreign trade could weigh against continuous further appreciation, says Peng Xingyun, of the Chinese Academy of Social Sciences.  “There are many factors in the market that affect supply and demand, which, if changed, would sway the exchange rates,” says Peng.

Still, I think this article was the strongest example of a recent spate of articles I have noticed reopening the debate over the RMB.  In the past month or so we have seen a sharp decline in the rate of appreciation of the currency, and I think there is a big debate with policymakers on one hand arguing that with a slowing world economy and declining export growth this is the wrong time to be raising the value of the RMB, and on the other hand recognizing that China needs desperately to rebalance its economy away from export orientation and, just as desperately, needs to regain control of its own monetary policy.

The only thing I can add to the debate is the fear that policymakers waited way too long to resolve this debate, and I think in particular the last year of massive inflows has probably undermined the financial system to the point where it is very vulnerable to shocks.  In a sense, they’re damned if they do and damned if they don’t.  Maintaining the value of the currency continues the unbalance, speeding up the appreciation re-ignites speculative inflows, and even my once-favored response – a one-off revaluation – is now a very risky strategy that could provide the shock needed to cause the banking system to unravel.

Add to the mix the second article I found interesting today.  John Thornhill has a piece in today’s Financial Times about the developing political and economic strains between China and Europe.  I have argued for a long time that as long as China maintained its currency regime it forced a trade deficit onto the rest of the world, which for the most part meant the US.  However as the dollar weakened versus the euro in response to the strains associated with the US trade deficit, it shifted China’s trade surplus from the US to Europe, something which I never believed could last very long.  Europe simply doesn’t have the labor and financial flexibility and has too many “old” industries for it to be able to accept a sustained trade deficit with China.

China’s astonishing economic rise over the past three decades has unsettled many countries and regions, but perhaps nowhere more than Europe, which in some respects still regards itself as the centre of the world.  For a while, Europe’s politicians and business leaders marvelled at China’s economic dynamism and applauded its successes in reducing mass poverty. Alarmed at US unilateralism at the time of the Iraq war, leaders such as Jacques Chirac of France and Gerhard Schröder of Germany even held out the prospect of a fully-fledged strategic partnership with the growing power. The European Union has been steadily developing an extensive – and largely positive – dialogue with China over a vast range of subjects spanning economics and trade, the role of the United Nations, counter-terrorism, cultural exchanges, Iran, North Korea, Darfur and Burma.

However, as the world’s centre of economic gravity slips inexorably eastwards, the perception appears to be spreading among European voters that China’s rise is as much of a curse as a blessing. As China has regained its reputation as the workshop of the world, it has seemingly sucked manufacturing plants and jobs out of Europe and flooded the EU with cheap manufactured imports. The EU’s trade deficit with China has recently been rising by an estimated €15m an hour.

The article quotes Eberhard Sandschneider, director of the German Council on Foreign Relations, as saying “Europe has switched from China hype to China angst.”  He adds: “The popular view is that the Chinese are stealing our jobs.”

Anti-China feeling has been rising sharply in Europe and I think this seriously limits China’s room for maneuvering, especially on the RMB.  I just saw an interview with Steve Roach, the chairman of Morgan Stanley Asia, and he is convinced that the dollar is due for more weakness against the euro.  I am not sure I agree, but any dollar weakness is going to cause real problems between China and Europe since dollar weakness also means RMB weakness.

China is going to be forced somehow to adjust just its monetary policies just when everything on the external front has gone wrong.  This won’t be easy.  We should all hope the recession associated with the US financial crisis is very, very mild.

Comments (14) for "The currency debate re-ignit...

Michael -- hasn't Europe already accepted a sustained rise in its trade deficit with China? Last I checked, its deficit with China (EU-25) was comparable to the United States deficit with China. The question is whether or not that deficit continues to widen -- while the US-Chinese bilateral deficit with China seems to have peaked, at least temporarily, Europe's deficit hasn't -- at least not yet. By bsetser - 10/1/2008 11:26 PM

Brad, Europe's trade deficit with China has certainly gotten pretty big recently, and that is why, I think, all the anti-China noise has been intensifying this year. I don't see this thing going on for several years, as it did (and does) with the US. By Michael Pettis - 10/2/2008 2:32 PM

May I concur with what Michael is saying. The noise is not specifically anti-China. The Tibet issue is out. But certainly an anti-low-quality-industrial-goods-at-dumped-prices political campaign could arise any time here locally in France. Sarkozy is definitely in a posture to try save what can still be saved in terms of local industries. By François - 10/2/2008 5:19 PM

Fat Brick: "Communists were the most successful and brilliant revolutionists ever in Chinese history. Even they cannot avoid some disasters in their later years." My dear, Fat Brick, these words seem very much like the words of Edgar Snow. Of course, who would not enjoy reading Edgar Snow. And, who would not have a great deal of respect for what this party has accomplished in China. Maybe the problem is that the Edgar Snow type of Communism got off track around the early 1960's. And has already fallen by the wayside. If you are a stalwart communist, than there are STILL many that will applaud your way of thinking. But, please, just give us a communism without authoritarianism. A communism which puts the rights of people before the government. And a communism that incorporates democracy as its guiding principle. Some people are so rigid in their ideology that they can not entertain conflicting ideas. If, Francois, you are not one of these, then you might want to spend some time with Chomsky before he kicks the bucket. He is getting old, unfortunately. Don't know, but you might be able to find Chomsky, still, at MIT. By . - 10/3/2008 5:39 AM

The Blogger: "anti-China noise has been intensifying this year" And with very good reason. 1. The system is so very corrupt. 2. The local environment has been so significantly degraded, ongoing, as it has been for hundreds of years. 3. There is NO good rule of law. 4. Despite the recent optimistic Pew report, still, the kids think they live in a cesspool where there is no hope to get out, unless they are able to find some way to travel to Canada, USA, Australia, or Mars. Basically, ideology aside, the kids growing up in China today are Fkd. Yes, Fkd. For one thing, the overpopulation problem screws them before they are even born. (just take a look at the demographics, 30 years from now.) Then, the lousy Government screws them over, a second time. If they don't die of getting shot in Tiananmen, then they might die of drinking tainted milk before the age of 2. Also, the greatest travesty is that MOST people in tune believe that their aspirations for a similar life to what they see on American TV will eventually come to fruition, which is totally not reasonable. Basically, one could think of this argument logically. How many of you idiots on this blog would like to trade your citizenship for a Red Chinese Passport? And, then maybe live your life in Qinghai? Yeah, Man. You Pseudo Lovers of China. You GREAT so called F'ing FRIENDS of China. Put your citizenship on the line! You guys are wimps. You guys are not Friends of China. You idiots are just wimps. Basically, almost everyone on this blog would NOT trade their place in their home country to be FORCED to live in this place called CHINA..........FOREVER. BUT, if anyone on this blog is willing to give up his/her citizenship to make a life in China, then let everyone know about this decision. We need to know who you are. So that we can send you care packages from the free world, such as encrypted copies of the WSJ and the NY Times, and the FT. Now, pls, may I have a 蚂蚁上树 for my usual midnight snack? Thank you. By 蚂蚁上树 - 10/3/2008 6:55 AM

Not that anyone needs any further encouragement to optimism, on this blog, where China is concerned. But, if anyone really wants to be optimistic about China, then perhaps the best book to read would be that written by Dr. Peter Navarro, Berkeley, “The China Wars”. This book spells out the many reasons why China is the sole beneficent major country in the world which will have the power and strength to be a stabilizing factor, for the next generation. The book extrapolates on the reasons for China's recent success, including lauding the people in China's government which have, in a contrarian way, used their influence to further and build on China's many resources. It is evident, the well validated optimism in this book, if any one were to wish to read a more lucid and optimistic account of China's past and recent history, including optimism for China in the near future, that one could not recommend this book, highly enough. This book is being studied in China by scholars at major universities. (Actually, a true fact.) The only problem with the book is that it appeals, mostly, maybe only, to people whose interest is extremely focused on China, and so therefore may not garner the wider readership that this fine book deserves. This is neither and endorsement nor an advertisement for selling the book. Steal it if you can. I think there is a downloadable copy using the ed2k p2p amule utility. But, this is just an audio book. The main point is that this book proves the China optimists correct in a very logical and unambiguous way. One can not help to bend to Navarros' conclusions when he predicts a much more optimistic outcome for China in the near future that most scholars now see. Steal the book if you can. But read it, we must. By Betty Holmes - 10/3/2008 12:04 PM

Maybe I missed this scenario in your analysis, but it seems you may have left one out: That an economic collapse in the US negates the Chinese government's concerns about an appreciating yuan's impact on exports. Obviously, if exports take a large dive, then the damage to the sector of the economy would already be done. You might ask "If exports sink, why would the yuan appreciate?" And that brings me to my point: is it realistically forseeable that large investors would see the yuan as an undervalued asset in one of the world's largest economies, with a high domestic savings rate, massive aggregate deposits, and a budget surplus by a government that is extremely stable. i.e., is there a scenario where large investors would forsake the dollar for the yuan, out of a flight to safety? Domestic consumption would be the engine of the economy, China's purchasing power would skyrocket, and that combination of purchasing power and size would produce a tsunami of foreign investment...by the Chinese, scooping up undervalued assets across the globe. It would be something akin to America in the years immediately after WWII, when the rest of the world's economies were devastated by war, and the dollar became the reserve currency. OK, I've stuck my chin out, please educate me on why that scenario can't happen... By Zach - 10/3/2008 7:26 PM

Zach, in spite of a lot of excited comment about the decline of the US (vastly exaggerated) and the rise of China (also exaggerated, although less so), there is still a huge almost insurmountable gap between the two, and it is very unlikely, at least in our lifetimes, that a flight to safety will involve capital leaving the US and going to China. Aside from the fact that China has capital controls, so making it hard for money to enter and leave, it also has a very weak financial system and a very small capacity to tolerate capital inflows that are even a small fraction of the capital inflows to the US. At any rate if the current financial crisis is what inspires theories of capital outflow from the US, we haven’t yet seen f China itself can escape the adverse impacts – something which I very much doubt. By Michael Pettis - 10/3/2008 7:39 PM

Thanks Michael, I really appreciate you taking time out to educate me there... By Zach - 10/4/2008 12:29 AM

I don't think that China will economically surpass the United States in my lifetime, but just because you are number one doesn't mean that you do everything right, and have no reason to listen to people who are number #15 and that they have nothing useful to offer you. (And vice versa.) The United States will not economically decline, but the era, which started with the collapse of the Soviet Union, in which the United States could offer economic and political advice and ideas and expect and even demand that those ideas be accepted uncritically is over. Also the United States will over the next few years be trying to figure out what *is* it's economic model, and China has some experience in that area. How well or badly China holds up over the next few months is going to have a huge impact on the US debate about things like how should the US regulate the mega-banks or the degree to which the US should or shouldn't hold onto the equity stakes it gets as a result of the bailout. You can have an exchange in which China sends over economic policy advisers, and the US sends over food inspectors. As far as currency policy, I think it is *FAR* too premature to talk about what the PBC should do. We are entering a new economic era in which the currency dynamics are very poorly understood. The PBC's goal for the next month should be to do the minimal necessary to avoid a crisis, and then try to understand what is going on in the world. By Twofish - 10/6/2008 12:03 AM

Pettis: But, please, just give us a communism without authoritarianism. I really don't see how you can do this. The trouble is that if the state is the only employer then it has the means to be very intrusive on your personal life. In your typical communist system, If the state wants you to work as an engineer and you want to grow daisies, then what do you do if the state is the only employer? One fundamental question is how does a society allocate resources and decide who does what, and if you leave those decisions completely in the hands of the state, then authoritarianism because inevitable. If you create markets and a legal system. this diffuses power in a way that makes the state less intrusive. By Twofish - 10/6/2008 12:09 AM

Twofish, I don't think the "But, please, just give us a communism without authoritarianism" was from me. By Michael Pettis - 10/6/2008 6:32 PM

i need help i have a speech debate on wheather america and south america should have a single currency...HELP need facts..thanks !!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!! dancing_alainna@yahoo.com By needhelp2222 - 11/18/2008 12:21 AM

i'm pro By needhelp2222 - 11/18/2008 12:22 AM