My Blog

December 3, 2007

MON 3 DEC 2007

The value of the RMB does matter to the trade balance (2) By Michael Pettis

I think these arguments are sometimes overstated but largely correct.  The direct impact of an appreciation of the RMB on foreign appetite for Chinese goods is likely to be fairly small, and so should not affect export volumes.

 

But while Chinese authorities and foreign supporters of the currency regime use this argument to explain why foreigners should not push China to raise the value of its clearly undervalued currency, they often justify China’s resistance to letting the currency appreciate faster by citing the adverse unemployment consequences of a subsequent collapse in exports.  These two arguments cannot both be true, although of course it is unfair to discredit either argument simply because some of their proponents are inconsistent.  I am convinced, however, by the first argument – an RMB appreciation is not likely to have enough of a pricing impact significantly to change foreign demand for Chinese exports, unless the appreciation were very substantial.

 

But that doesn’t mean that the value of the RMB not matter to China’s trade balance.  It does, and a faster appreciation will reduce the trade surplus.  The reason will not have to do so much with the impact of RMB appreciation on foreign appetite for Chinese goods, but rather because of the impact of a faster appreciation on China’s domestic monetary policy.

 

When a country produces more than it consumes, it must run a trade surplus, and the greater the gap between production and consumption, the greater the trade surplus.  Here is where China has found itself caught in a monetary trap. For many years China has been a large net recipient of foreign direct investment.  Since at least the early part of the decade it has also been a net recipient of speculative inflows.  When these are combined with China’s trade surplus, the net result is that in China there is a large and growing excess supply of dollars relative to RMB.

 

When that happens, of course, the market normally adjusts by forcing down the price of the dollar against the RMB, until demand for dollars balances supply.  But China’s central bank, the PBoC, does not allow movement in the dollar value of the RMB.  Every day it sets the price of the dollar (or, more correctly, it sets the narrow band within which the dollar trades).  Still, supply and demand must balance, and the PBoC ensures this balance by offering to buy or sell whatever amount of RMB is necessary to force the market to clear at the desired exchange rate.

 

Given the growing net excess supply of dollars at desired exchange rates, the PBoC is forced to supply the domestic economy with more and more RMB in order to absorb the net dollar inflow.  China’s monetary policy, in other words, is largely determined not by the needs of the domestic economy but by the net supply of dollars, and as that supply grows, China’s money base expands.  In the past four years, as China dragged its heels on revaluing the RMB, the supply of excess dollars went from a river to a flood (you can measure the net supply of dollars by counting the increase in PBoC reserves).

 

Why does this matter for the balance of trade?  Because as the PBoC flooded the market with RMB (and with central bank bills, used in a largely ineffective attempt to mop up the flood of currency), this had a number of secondary consequences.  Rapid money expansion led to rapid credit expansion and rapid growth in fixed asset investment, which forced Chinese industrial production to soar.  As Chinese production soared – much faster than Chinese consumption, which was hobbled by a high and rising savings rate driven in part by the social insecurities associated with China’s rapid social and economic transformation – the gap between what the country produces and what it consumes soared with it, and so China’s trade surplus grew to astonishing levels (and will grow more in the coming months).

 

Of course this only served to reinforce the problem.  A growing trade surplus increased the supply of dollars relative to demand.  It also encouraged speculative inflows from investors who had money abroad (mainly it seems from Hong Kong, Taiwan and the mainland) looking to take advantage of the asset price frenzies unleashed by money growth as well as by the certainty that China would have to increase the value of RMB, thus making any RMB investment, even something so boring as putting money in the banks and earning negative real rates of interest, very juicy by international standards.

 

The process is circular and highly self-reinforcing.  All of this money inflow creates conditions for more money inflow, until some adjustment finally stops the process.  China is caught in a monetary trap in which rising trade surpluses force an expansion in the money supply, which forces a rising trade surplus. 

 

Until the mechanism that links the two is broken or substantially modified, there is very little China can do to slow the process down, and nothing it can do to stop it.  Four years of increasingly desperate measures – raising bank reserve rates, raising interest rates, allowing a slight appreciation in the currency, enforcing or creating new administrative measures, moral suasion, jawboning, and sterilization – have done nothing to reverse money growth.  In fact in the past three years the monetary process has accelerated by nearly every measure.

 

Ultimately China must do something that reduces and even reverses monetary inflows.  One way might be to engineer a large enough revaluation of the RMB so that speculative inflows reverse themselves and imports grow.  A second way might be to wait for a financial or economic crisis significantly large enough to cause capital outflows.  A third way, which is currently the preferred approach, may be slowly to try to climb out of the trap by repairing the financial system and allowing the RMB to crawl upward a little faster – and pray that the country can climb faster than the trap deepens.

 

My own belief is that the third way brings with it a high probability of failure, and the longer we wait for the real adjustment the more likely the second way becomes – a soaring money supply increases the risks of overproduction, asset bubbles, and bad loans in the banking system.  I would argue that the best solution for China is the first of the three ways I suggested, a rapid increase in the value of the RMB – in fact a one-off maxi-revaluation that would forestall speculative inflows – and although there are significant risks and costs associated with that path, they are less costly than the alternatives.

 

Ultimately China’s currency policy does matter to its balance of trade with the world, but perhaps not in the obvious way.