Currency regime

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Can the RMB be more undervalued today than it was last year?

June 23, 2009 in Currency regime, Trade protection by Michael Pettis | 55 comments

William Cline and John Williamson published on Vox an interesting piece earlier this month June 18), titled \’93Equilibrium Exchange Rates,\’94 in which they try to \’93estimate a set of medium-run fundamental equilibrium exchange rates compatible with moderating external imbalances\’94 for the 30 largest economies. They assume that a sustainable equilibrium trade balance for the US implies a current account deficit of 3% of GDP (this is conservative \’96 I would have thought \’93equilibrium\’94 would have been lower), and try to estimate the amount of currency change needed to get there. They also assume that in general not just the US but all \’93countries should strive to keep imbalances (surpluses and deficits) under 3% of GDP.\’94

Using early June 2009 exchange rates, they find that six countries \’96 most of whom are primarily commodity exporters, not coincidentally \’96 have overvalued exchange rates relative to the dollar (Australia, New Zealand, South Africa, Brazil, Colombia, Mexico), and twelve, mostly in Europe, have currencies that are marginally undervalued. Of the 30 countries, eleven have currencies that are at least 15% undervalued relative to the US dollar. For convenience sake I include their 2008 GDP and rank them by size. These are:

Country

Billions

Undervaluation

Japan

$4,908

18.1%

China

$4,221

40.3%

Switzerland

$491

19.8%

Sweden

$479

15.3%

Taiwan

$392

29.4%

Argentina

$330

18.4%

Thailand

$273

16.7%

Malaysia

$222

33.2%

Hong Kong

$215

27.9%

Singapore

$182

26.3%

Philippines

$169

18.2%

Economists can, and of course will, dispute the methodology and the extent of any perceived under- or over-valuation, but in my opinion the most valuable aspect of these exercises is not that they indicate the \’93correct\’94 exchange rate level, whatever that means, but rather that they can indicate trends or signal interesting anomalies in the aggregate. Two things are noteworthy here, I think.

The first, and most obvious, is that eight of the eleven Asian countries within the top thirty economies (the exceptions are India, Indonesia, and Korea, whose currencies are all undervalued by 4-6%) are on the above list of significantly undervalued currencies, and the list is dominated by them (eight Asians out of eleven countries on the list). This simply suggests the not-exactly-controversial thesis that Asian countries have systematically undervalued their currencies as a strategy to generate employment growth. It also suggests that Asian central banks that worry about the impact of dollar weakness on their reserve holdings are in the funny position of having created the dollar overvaluation at the same time they were actively accumulating those overvalued dollars.

The second noteworthy consequence of their exercise, which I found much more interesting, was a finding that the authors seem to find a little surprising. They say:

The main counterpart to the overvalued dollar is the undervaluation of the Chinese renminbi, along with a few of the smaller Asian currencies. We are somewhat nervous because our estimate (based on the figure of RMB 4.88 to the dollar) of Chinese undervaluation is even larger than it was a year ago (RMB 5.81 to the dollar), despite the fact that the RMB rode the dollar up by 14% in effective terms in the intervening year. It may be that our estimate is now too large because the IMF\’92s projection of the Chinese surplus seems not to have declined despite the RMB\’92s real appreciation, although the fall in commodity prices in the past year has presumably worked in China\’92s favour. But all the other potential biases, notably the way of formulating the Chinese current account target as a substantial surplus rather than the deficit suggested by the FDI inflow, are in the direction of minimising estimated undervaluation. Our analysis is one more piece of evidence that the major macroeconomic imbalance in the world today stems from China\’92s exchange-rate policy.

Leaving aside the fact of their very high estimate of Chinese undervaluation, I think the authors are saying that although the RMB rose 14% from the last time they calculated these equilibrium exchange rates, nonetheless their measure of the adjustment needed to balance trade suggests that the RMB is actually even more undervalued than it had been a year ago.

What\’92s going on? How can a currency that has risen 14% against the dollar finish even more undervalued against the dollar? Part of the answer could be differential productivity growth rates, and since Chinese productivity is growing faster than US productivity it would imply that the RMB should revalue against the dollar just to maintain equilibrium. But of course there is absolutely no way Chinese productivity grew by even a fraction of the amount necessary during that time to explain this anomaly.

But remember in my June 3rd post I argued that we make a mistake when we think only currency and tariff policies can affect trade? There is a whole list of policies that, by directly subsidizing production or by implicitly or explicitly taxing consumption, will necessarily affect the trade account. Could it be that even as the RMB was nominally revaluing, other policies were implicitly \’93devaluing\’94 the RMB \’96 i.e. policies that implicitly increased subsidies to production, and/or taxed consumption \’96 so that the net distortionary impact on trade actually increased? That could explain why a revaluing RMB is nonetheless consistent with an even more undervalued RMB in relative terms.

New lending surges

We are getting reports that June lending numbers are up on May. One of the more bizarre pieces of \’93good news\’94 recently \’96 very popular among the China bulls \’96 were claims that new lending had moderated significantly in the past two months (so don\’92t worry too much about that credit bubble everyone\’92s talking about), but this is true only to the extent that new loans in April and May were compared to the astonishing first quarter numbers. In fact net new lending in April and May was around double the equivalent amounts last year and every year in this decade.

In June, it looks like we are retuning to an upward trajectory. According to an article in the current issue of Caijing:

Commercial bank lending in the first half is expected to hit 6.5 trillion yuan, with new loans in June coming in at about 660 billion yuan, the official Shanghai Securities News reported, citing people close to the matter.
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Chinese banks lent out a record 4.6 trillion yuan in the first quarter to help start stimulus projects; while there has been a slowdown since April, the central bank says its policy remains “moderately loose.” Experts have warned against lending quality, unauthorized loan diversions, and the re-emergence of bad loans, which may cause banks to be more cautious in lending in the second quarter.

Discussing the impact of all this lending Andy Xie weighs in with another thoughtful and worried piece in the current issue of Caijing. He writes:

China’s credit boom has increased bank lending by more than 6 trillion yuan since December. Many analysts think an economic boom will follow in the second half 2009. They will be disappointed. Much of this lending has not been used to support tangible projects but, instead, has been channeled into asset markets.

Many boom forecasters think asset market speculation will lead to spending growth through the wealth effect. But creating a bubble to support an economy brings, at best, a few short-term benefits along with a lot of long-term pain. Moreover, some of this speculation is actually hurting China’s economy by driving asset prices higher.

The current surge in commodity prices, for example, is being fueled by China’s demand for speculative inventory. Damage to the domestic economy is already significant. If lending doesn’t cool soon, this speculative force will transfer even more Chinese cash overseas and trigger long-term stagflation.

He goes on to say:

The international media has been following reports of record commodity imports by China. The surge is being portrayed as reflecting China’s recovering economy. Indeed, the international financial market is portraying China’s perceived recovery as a harbinger for global recovery. It is a major factor pushing up stock prices around the world.

But China’s imports are mostly for speculative inventories. Bank loans were so cheap and easy to get that many commodity distributors used financing for speculation. The first wave of purchases was to arbitrage the difference between spot and futures prices. That was smart. But now that price curves have flattened for most commodities, these imports are based on speculation that prices will increase. Demand from China’s army of speculators is driving up prices, making their expectations self-fulfilling in the short term.

I usually don\’92t quote so much from a single source, but I think Andy Xie\’92s piece is a very good one and well worth reading (there is a lot more). He makes many of the arguments that all of us who worry about China\’92s continuing failure to adapt to the huge adjustment in the global and US economies. His conclusions:

What is happening in the commodity market is glaring proof that China’s lending surge is hurting the country. Even more serious is that it is leading Chinese companies away from real business and further toward asset speculation \’96 virtual business.

\’85Many analysts argue GDP growth follows loan growth, and inflation is a problem only when the economy overheats. This is naive. Borrowed money channeled into speculation leads to inflation. And China may face a lasting employment crisis if private companies don’t expand.

This lending surge proves China’s economic problems can’t be resolved with liquidity. China’s growth model is based on government-led investment and foreign enterprise-led export. As exports grew in the past, the government channeled income into investment to support more export growth. Now that the global economy and China’s exports have collapsed, there will be no income growth to support investment growth. The government’s current investment stimulus is tapping a money pool accumulated from past exports. Eventually, the pool will dry up.

If exports remain weak for several years, China’s only chance for returning to high growth will be to shift demand to the domestic household sector. This would require significant rebalancing of wealth and income. A new growth cycle could start by distributing shares of listed SOEs to Chinese households, creating a virtuous cycle that lasts a decade.

Putting money into speculative investments isn’t totally irrational. It’s better than expanding capacity which, without export customers, would surely lead to losses. Businesses currently lack incentive to invest. But many boom forecasters wrongly assume that recent asset appreciation, fueled by speculation, signaled an end to economic problems. That’s an illusion. The lending surge may have created more problems than it resolved.

Tags: John Williamson, William Cline

Is Governor Zhou a closet Bernanke-ite?

April 8, 2009 in Balance of payments, Currency regime, Money growth, Savings glut by Michael Pettis | 64 comments

I have recently finished reading Martin Wolf\’92s latest book, Fixing Global Finance, and I strongly recommend it for its very clear laying out of the global balance of payments issues behind the global crisis. I should warn my readers that Wolf and I have come to very similar conclusions about the underlying root causes of the crisis \’96 we are both in agreement, for example, about the distorting effect of Asian policies to constrain consumption and boost investment in manufacturing output \’96 but I am mostly impressed by the fact that we come to the same conclusion from such different angles.

Wolf begins with a model based on analyzing the financial architecture of the past forty years and brings to his analysis a very US-centric view of the world, whereas my conceptual model is based on my obsessive reading in the history of financial flows between rich and poor countries and starts with a China-centric view. Somehow we end up in almost exactly the same place, which suggests to me that we may be right or, at the very least, onto something important.

I won\’92t try to summarize the book but I do want to set out two paragraphs in which Wolf explains, far more clearly than I have ever been able to, how it is that reserve accumulation in Asia \’93forced\’94 US households into overconsumption. One of the most common fallacies in popular economic analysis is to assume that countries are somehow analogous to households, and the factors that lead a household to consume \’93beyond its means\’94 are similar to those that cause a country to do so. In that case if the US over-consumed, it is no different than if a stereotypical welfare family maxed out on its credit cards, and while we can fret at the stupidity of the bankers who gave them their credit cards, ultimately the blame for the mess must rest with the innate profligacy of mom and dad.

But this is not true at all when we are talking about overconsumption at a country level. As I have tried to argue many times, the global balance of payments must balance, and significant change in any component of the balance necessarily requires adjustments elsewhere. If Country A enacts trade policies that result in a surging current account surplus, for example, Country B must see its current account deficit surge by the same amount, and the way that happens will reflect a number of factors including the structure of its financial system. Country B could try to resist the growing deficit by engineering a recession and so causing total demand to drop, but this can be very painful for both countries.

Let us assume, then, that a group of countries, perhaps in response to the 1997 crisis, decide that in order to protect themselves from a repeat of that disaster decide to engineer polices aimed at accumulating reserves and limiting external debt. The most obvious way would be to put into place policies that constrain consumption and boost savings (keep wages and interest rates low, limit credit availability to consumers, limit credit availability to small and medium enterprises and especially to the service sector, maintain an undervalued currency, etc.) and direct credit to the investment and manufacturing sector. As a consequence growth in production would exceed growth in consumption and the balance would represent the trade surplus. Trade surpluses, of course, have to be recycled as investment flows (or reserve accumulation) back to the country against which they are running these surpluses. This is not a choice, or even a real lending decision. It is the automatic and necessary consequence of running a trade surplus.

Since the US is the largest and most flexible economy in the world, and since the primary world reserve currency is the dollar (more on this later), in practical terms only the US can be the deficit country for any period of time, and so the surplus countries must accumulate US dollar assets as the obverse of their trade surplus. Martin Wolf explains what happens next:

The rest of the world\’92s capital outflow supports the dollar. At the resulting elevated real exchange rate for the United States, the output of the sectors in the US economy that produce tradable goods and services shrinks, other things being equal. The Federal Reserve cuts interest rates to expand the economy, thereby preventing excessive unemployment. As it does so, a large excess demand for tradable goods and services emerges in the United States. This finally, appears in the trade and current account deficits.

One consequence of all this is that US domestic demand has had to grow faster than real GDP, to ensure that the latter grows in line with potential. The difference between the two is, of course, the increase in the current account deficit, in real terms. With trend growth in GDP between 3 and 3.5 percent a year, domestic demand has to grow even faster. That is precisely what has happened. US real demand (or gross domestic purchases) grew faster than real GDP in 1993 and 1994 and then again every year from 1996 to 2004 inclusive. Cumulatively, between 1993 and 2004 US real GDP grew by 46 percent, while gross domestic purchases rose by 53 percent. That is how the current account deficit emerged. It is also how the United States absorbed the supply of excess capital from abroad.

In the face of a sharp contraction in those sectors of the US economy that compete with Asian manufacturers, in other words, the Federal Reserve must either permit a rise in US unemployment, in which case US consumption will decline and with it imports from Asia will decline too, or it must prevent the rise in unemployment by putting into place monetary policies that are consistent with rapid GDP growth. This argument, by the way, is not at all affected by the very common (and incorrect) argument that the main cause of the US trade deficit with China is the fact that China produces things that the US doesn\’92t want to produce, which I have tried to address in a March 9 blog entry.

Global savings glut

In either case US consumption must grow faster than US GDP, and the choice for the Fed is whether to target a \’93normal\’94 growth in consumption, and permit rising unemployment, or a \’93normal\’94 growth in GDP, and so permit rising indebtedness. The Fed must use US unemployment, in other words, as a tool to prevent Asian trade policies from leading to excess US indebtedness.

All this would have been bad enough if it hadn\’92t been for the need for the US to finance a very unpopular war, the Iraq invasion, in the way that unpopular wars have traditionally been financed \’96 irresponsibly, through borrowing and money creation rather than taxes (remember that the Vietnam War was also associated with a credit bubble in the US). Asian policies, according to this view, definitely helped create the monetary distortions, but we must remember that there were plenty of bad domestic policies compounding the problem.

At any rate for the Fed to use US unemployment as a tool to prevent Asian trade policies from leading to excess US indebtedness is obviously politically very difficult, and it is also obvious that for the past ten year the Fed chose excess indebtedness. Since the 1997 crisis we have seen both household savings and the US trade deficit break out of their normal ranges and either collapse (household savings) or surge (trade deficit). This is a necessary consequence of the process that Wolf describes.

In that light, as U.S. fiscal spending surges in response to the crisis, increased attention will be placed on the way that U.S. fiscal spending leaks out through the current account to boost employment in China and elsewhere. And just as the Chinese complain bitterly, and rightly, that the West outsources polluting activity to China via the trade account, the U.S. will complain, as Martin Wolf pointed out in a March 31 editorial in the Financial Times, that China is outsourcing fiscal indebtedness to the U.S., also via the trade account. Surplus countries, he argues, \’93relied on the private sectors of deficit countries to do their irresponsible borrowing for them.\’94 In response to the contraction in the borrowing among US households, the U.S. government, in other words, is currently choosing to borrow and spend the proceeds in order to generate job growth in the U.S. as well as in China. This can\’92t go on forever.

All of this is, of course, a variation on Ben Bernanke\’92s \’93global savings glut\’94 hypothesis, and as everybody knows, Beijing wholly rejects this hypothesis as an explanation for the current global imbalances. For Chinese policymakers, the cause of the crisis lays firmly and totally within US monetary and financial policies (or lack thereof), and absolutely no blame can be apportioned to Asian trade policies.

Or is this really Beijing\’92s view? The extraordinary thing to me is that while Beijing has insisted almost desperately that any attempt to apportion blame to China is completely dishonest, they have nonetheless more or less welcomed Bernanke\’92s hypothesis, perhaps without realizing it, through the back door. I say this because the widely-discussed essay by PBoC Governor Zhou last week, in which he assailed the reserve status of the US dollar as being the main cause of global imbalances, is as far as I can tell nothing more than Ben Bernanke\’92s hypothesis viewed from a slightly different angle.

Why? Because Governor Zhou makes the claim that the reserve status of the US dollar gives the US an unfair advantage in that it can borrow nearly unlimited amounts simply as consequences of the need for foreign countries to accept dollars as reserves and for the purpose of international trade and investment. Of course he is almost certainly right, and he is just as certainly not the first person to make this claim. I think it was De Gaulle\’92s favorite economist, Jacques Rueff, who first discussed this \’93exorbitant privilege\’94 as far back as the 1960s (NB: Martin Wolf corrects me — it was Valery Giscard D’Estaing who first said it — but I leave the mistake, and the correction, because it is one so commonly made).

But remember that if we make the very simple (and necessary) assumption that the ability of a country to run current account deficits is constrained mainly by a country\’92s ability to finance those deficits, then the ability to borrow unlimited amounts also means the ability to run unlimited trade deficits. It was the reserve status of the dollar that permitted the US to run the massive trade deficits it has during the past decade.

Had the US dollar not been the reserve currency of choice (in other words had Asian trade surplus countries not recycled their trade surpluses into purchases of US government bonds), the dollar would have had to decline against world currencies as a consequence of the rising deficit \’96 Asian currencies too, and not just European \’96 and the US trade deficit would have stabilized at much lower levels. This is also another way of saying, as Martin Wolf\’92s piece directly implies, that the Fed would not have had to choose between unemployment and indebtedness and that the binge borrowing that characterized US household behavior would have been much, much lower.

The world loves dollars because the US seems to love deficits

In fact I would go further. Because of the dollar\’92s reserve status, only the US could have possibly run the deficits necessary to absorb the huge surpluses that Asian trade policies were generating. Without the dollar\’92s status as a reserve currency, the Asian development model that stresses expanding production while constraining consumption \’96 which among other things results in trade surpluses and net investment abroad (which of course is the same thing) \’96 would have either required another reserve currency, or it would have failed.

Could there have been another reserve currency \’96 and could it be that the dollar\’92s \’93exorbitant privilege\’94 is something that Washington has enforced? Yes and no. The US economy comprises about one-quarter of the world\’92s economy and one-third of the rich-country economies. In principle it would have been very easy for any country to accumulate reserves of other rich countries \’96 nearly all of whose currencies are easily convertible \’96 so that there is no reason why the dollar portion of all developing-country central bank reserves might not have exceeded roughly one-third of the total, instead of the two-thirds or more that it currently occupies. Another third could be euros, and the rest a combination of the currencies of Japan, the UK, Switzerland, Canada, Australia, South Korea, and so on.

But it can\’92t just rest there. When a central bank chooses which currency to buy, unlike when you or I make our own portfolio decision, it is also determining the direction of net trade flows. Those other countries would have had to match the investment surplus (net inflows on the capital account) with an equally large current account deficit. If China had followed this balanced policy of reserve accumulation, in other words, the only thing that could possibly have stopped them, and a very big impediment it would have been, was the political or economic willingness and ability of those countries to run the corresponding trade deficits with China.

That, of course, is the problem. Given their much more limited economic flexibility and their less ebullient financial systems, those other countries probably would have never been able to sustain the necessary levels of trade deficit, and they would have almost certainly moved aggressively against China to limit the development of unfavorable trade balances. China, in other words, chose to hold US dollars not because the US government has somehow enforced reserve status on the US dollar and denied it to other currencies (Washington could never have prevented China from buying euros or yen or anything else), but simply because no other country is able to run deficits of the necessary magnitude.

The argument, then, that the dollar\’92s status as the reserve currency and brings an exorbitant privilege is simply the other side of Ben Bernanke\’92s savings-glut coin. Without the dollar\’92s reserve status, the global savings glut would have never occurred, or rather it would have never resolved itself in the way it did, and Asian development models aimed at engineering trade surpluses would have had to fail.

So is Governor Zhou a closet Bernanke-ite? He would probably be surprised at this question, and even more surprised at my answer, I think, but I cannot see how you can separate the two arguments \’96 his on the perils of the dollar\’92s dominant reserve currency status and Bernanke\’92s on the impact of high Asian savings on the US balance of payments. He and Bernanke agree fundamentally on the roots of the imbalance.

By the way, the model I have been using to explain the imbalances also addresses another contentious question between the US and China which I did not really think about until I read a fascinating short piece by MIT\’92s Simon Johnson on his blog, more in reference to Europe but relevant nonetheless. China, as we know, is very worried that the US will resort to monetary policy rather than fiscal policy to address collapsing demand in the US. The former hurts China (supposedly because it might cause an erosion in the value of the dollars the PBoC holds), whereas the latter helps by slowing the contraction in US net demand and giving China more time to adjust its overcapacity problem.

It turns out that there may be another reason, even more powerful, and as soon as I read this paragraph by Johnson I had one of those \’93Aha!\’94 moments that means I am going to have think much more seriously about the implications:

Remember this. If you run an expansionary fiscal policy (building bridges), I have an incentive to free ride (selling you BMWs) and not engage in a similar fiscal stimulus. But if you run an expansionary monetary policy, your exchange rate will tend to depreciate, putting pressure on my exporters and I\’92ll be pushed – by BMW-type producers – towards providing a parallel monetary stimulus.

This may be why monetary rather than fiscal stimulus makes sense for the US, and less sense for trade surplus countries. It prevents, or at least reduces, the leaking-out of employment generation effects of US borrowing and spending.

The other China

Talking about BMWs, my argument, of course, is not so much about China and the US as it is about trade surplus and trade deficit countries. In that light there was a very interesting article in Monday\’92s Financial Times about the difficulties Germany is facing in adjusting to the changes in the global balance. Many people assumed that Germany, which was in a very \’93strong\’94 position (high savings, large trade surplus, low debt \’96 which are all more or less the same thing, really), would weather the crisis easily, but of course it should have been self-evident that a crisis that affects the deficit sides of the global balance of payments must also affect, by the same amount, the surplus sides:

The risk is that \’96 like Japan in the 1990s \’96 Germany faces a \’93lost decade\’94, or a protracted period of economic malaise as it waits for the global economic tides to turn and struggles to find domestically generated sources of growth. \’93I am convinced it is going to be a slow recovery,\’94 says Mr Staake. \’93Who is going to be buying anything?\’94

This downfall is all the more galling because, even a year ago, the country could have expected to weather the global economic storms. There was no danger of a housing crash; prices had been flat for a decade. Consumers had saved; companies had not increased leverage dramatically. \’93From a structural point of view, this recession should never have happened,\’94 says Commerzbank\’92s Mr Kr\’e4mer.

With hindsight, however, Germany was a sitting target after the collapse of Lehman Brothers investment bank in mid-September. Its exports were equivalent to more than 47 per cent of GDP last year \’96 compared with less than 20 per cent in Japan and about 13 per cent in the US. Its industrial base is skewed towards producing machinery and equipment \’96 \’93investment goods\’94 account for more than 40 per cent of its exports \’96 and towards emerging European and Asian economies.

While the crisis was focused on US housing and capital markets, Germany was unaffected. But after Lehman\’92s failure paralysed banks, and confidence nosedived globally, companies around the world shelved investment plans \’96 leaving German factories turning out goods nobody wanted to buy. Industrial production in January was more than 20 per cent lower than a year before; overseas orders for investment goods had almost halved.

\’93Who is going to buy anything?\’94 Good question, and one that must be answered by policymakers planning to export their way out of the crisis.

I especially love the statement \’93From a structural point of view, this recession should never have happened.\’94 One of my standard complaints about most economists, especially those who focus on a single country or group of countries, is that they ignore balance-sheet and balance-of-payments effects. Of course it should have been obvious that a crisis in the deficit countries would affect the surplus countries \’96 in fact it should have been obvious that the impact on the latter should have been worse.

Meanwhile, and as a continuing part of how the crisis will evolve, there is an interesting article in today\’92s Bloomberg about one of the ways in which the Chinese fiscal response to the crisis risks making the imbalance, and China\’92s long-term adjustment, worse.

China\’92s shipbuilding industry may be about to get a bailout — from its customers. The government may force state-owned shipping groups to buy more vessels as foreign carriers scrap orders, according to Steve Man, an HSBC Holdings Plc analyst in Hong Kong. That risks increasing costs and overcapacity among shipping lines grappling with a collapse in global trade.

\’93They \’91encourage,\’92 but my thinking is it\’92s more of a directive,\’94 said Man. \’93It hurts every player in the industry and creates excess capacity that will take longer to absorb after an upturn.\’94

As I have argued many times, the constraints of the Chinese development model and limitations in the financial system mean that it will be very hard for China to shift its behavior quickly enough to match the possible adjustment in the US and elsewhere. Bailing out the ship-building industry is one way in which Beijing\’92s fiscal reaction \’96 while understandable from an employment point of view \’96 may exacerbate the adjustment. Washington\’92s bailing-out of the automobile industry is the same sort of mistake, I think, but in the US case it is much easier to justify. The US must reduce its net consumption, and if boosting production is economically inefficient in the long term, at least it fits within the overall adjustment in the short term. This is not the case with China \’96 it should be boosting consumption directly, and not indirectly by boosting capacity.

There is a lot more I wanted to discuss today, but this blog entry is getting to be way too long. But just one quick thing, yesterday I was having coffee with some visiting friends from Goldman when one of them received a notice that there were credible rumors on the March increase in new loans. We had all been expecting a very big March number \’96 between RMB 1.3 and RMB 1.6 trillion.

It turns out that the true number may have been an astonishing RMB 1.9 trillion.

That means that for the first three months of the year we have had loan increases of RMB1.6 trillion, RMB 1.1 trillion, and RMB 1.9 trillion. This amounts to RMB 4.6 trillion for the first quarter of 2009, compared to RMB 4.5 trillion for all of 2008. Notice to my students: learn more about how to resolve and restructure bad loans. This will be a great career option for you over the next few years.

Tags: Exorbitant privilege, Zhou Xiaochuan

The dollar must be replaced \’96 yet again

March 24, 2009 in Currency regime, Financial crisis, Global liquidity, PBoC by Michael Pettis | 23 comments

Beijing music and art

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Things have been so busy that I haven\’92t been posting as much as I would like. \’a0Besides my increased writing commitments and the constant barrage of news, I would like to mention that over the past weekend we completed the second annual festival of experimental and avant garde music, featuring the best Chinese composers and performers from all over the country, and several of my regular blog readers attended \’96 thanks for that, even though this blog is no longer available inside the Chinese firewall. \’a0

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Twenty hours of music over two days is not always easy, especially when some of the music is \’93challenging,\’94 to say the least, but I am pleased to say that this festival has become the premier event in China for new and experimental music and the turnout was larger than expected and very enthusiastic. \’a0So far we don\’92t seem to have been affected by the economic crisis. \’a0In particular performances by Mamur, Li Jiahong and Li Tieqiao, Shouwang\’92s White Ensemble and a number of others were exceptionally good. \’a0We\’92re all still exhausted, but already I have been getting urgent enquires about our plans for next year.

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While on the subject of art I should note that the People\’92s Daily had an article today on difficulties facing the Chinese art market.

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The global economic meltdown has hit the city’s art exhibition industry, with several big international events attracting less funds than before or even being postponed, exhibition organizers said.

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The article goes on to discuss difficulties facing the 798 Art District in Beijing \’93a center featuring primarily non-government-funded art events, where many shows were cancelled.\’94

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I am not totally sympathetic because it seems to me that the commercial art scene here was simply part of the late stage credit bubble, and the young artists I like best were never really able to participate.\’a0 But it is a nonetheless interesting story because historically art bubbles have always been part of the bubble cycle.

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On that topic, I thought I would make a quick, and perhaps a little snide, reference to an article in last month\’92s New York Times about the Chinese art market.\’a0 About a year ago I had dinner with a group of people which included a couple of gallery owners specializing in contemporary Chinese art.\’a0 Not surprisingly, they were ebullient about the seemingly inexorable rise of Chinese contemporary art prices, and perhaps also not surprisingly, I was enough of a wet blanket to argue that we were soon going to see a total collapse in art prices.\’a0

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Why?\’a0 Because every serious financial bubble in history was, towards its later stages, accompanied with an even more ferocious bubble in art prices, and when the bubble burst, art prices were among those worst hit (I refrained from adding that although there are a number of young Chinese underground artists whose works I really love \’96 stand up, Cult Youth Collective \’96 for the most part I was very unimpressed with the commercial stuff getting most of the attention).

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Needless to say most of the dinner guests were politely skeptical, and my pointing out the examples of the Japanese art market in the 1980s and the Arab art market in the 1970s \’96 two markets that people don’t talk about much anymore, it seems \’96 didn’t make much difference.\’a0 One month later I read in one of the British newspapers that some well-known London-based art dealer had announced that prices in the art market had reached a level that represented long-term artistic value, and would not be affected by the crisis (art prices have reached a stable plateau? I hope he was otherwise as good an art dealer as Irving Fisher was an economist).\’a0

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So what does the New York Times article say?

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A global financial crisis has wiped out vast amounts of personal wealth, prompting a plunge in art prices. Suddenly bereft of visitors, galleries are laying off staff members, and the collectors who patronized them now worry that their art investments may prove a colossal folly.\’a0 \’93It\’92s been a long, cold winter,\’94 said Zoe Butt, director of international programs at Long March Space, which is closing two of its three Beijing galleries. \’93The era of Chinese contemporary art commanding such high prices is over.\’94\’a0

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…Globally, the recent rise in Chinese artists\’92 fortunes was unparalleled. Only one Chinese artist \’97 Zao Wouki, a traditional painter who lives in France \’97 ranked among the Top 10 best-selling living artists in 2004, according to Artprice.com, which tracks auction sales. (He ranked ninth.) But by 2007, 5 of the 10 best-selling living artists at auction were Chinese-born, led by Zhang Xiaogang, who trailed only Gerhard Richter and Damien Hirst. That year, Mr. Zhang\’92s auction sales totaled $56 million, according to Artprice.com. Many collectors were seduced by the numbers. \’93For people who got into the market three years ago, I feel sorry for them,\’94 said Fabien Fryns, who runs F2 Gallery in Beijing.

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When people say that it isn’t easy to know if we were in the midst of a bubble, I can only respond that when, in just three years, the number of Chinese artists in the top ten living best-sellers zooms from one to five, it must be obvious that we are in a particularly frothy bubble.\’a0 No matter how rapidly talent and access to collectors improve, the quality of an art scene simply cannot adjust at anywhere near that speed.\’a0 I am sure even Renaissance Florence under Cosimo de Medici’s very wise patronage took much longer than three years to move so far up the artist-income scale.

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A new reserve currency

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But back to less exalted things.\’a0 The number one topic of conversation right not seems to be an essay posted in both English and Chinese on the PBoC\’92s website by PBoC Governor Zhou Xiaochuan.\’a0 In it Governor Zhou argues that the world needs a new and better reserve currency, one not dominated by a single country, and that it is in the best interest of the world that this reserve currency be created by a body like the IMF. \’a0Funnily enough for all the attention the essay received I saw no mention of it on either Xinhua or the People\’92s Daily.\’a0

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We have heard these kinds of arguments many times before over the course of the 20th century, and usually in response to a global balance of payments crisis. \’a0Is there anything new about this proposal?\’a0 Some commentators saw this essay as a purely political move.\’a0 Jamil Anderlini of the Financial Times, for example, had this to report:

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China\’92s central bank on Monday proposed replacing the US dollar as the international reserve currency with a new global system controlled by the International Monetary Fund.\’a0 In an essay posted on the People\’92s Bank of China\’92s website, Zhou Xiaochuan, the central bank\’92s governor, said the goal would be to create a reserve currency \’93that is disconnected from individual nations and is able to remain stable in the long run, thus removing the inherent deficiencies caused by using credit-based national currencies\’94.

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Analysts said the proposal was an indication of Beijing\’92s fears that actions being taken to save the domestic US economy would have a negative impact on China.\’a0 \’93This is a clear sign that China, as the largest holder of US dollar financial assets, is concerned about the potential inflationary risk of the US Federal Reserve printing money,\’94 said Qu Hongbin, chief China economist for HSBC.

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Although Mr Zhou did not mention the US dollar, the essay gave a pointed critique of the current dollar-dominated monetary system.

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Others were more intrigued by the theoretical implications of the essay.\’a0 A number of people including Columbia University\’92s Joseph Stiglitz, are supportive of the idea, arguing that the status of the US dollar as the world\’92s reserve currency creates unnecessary problems for both the US and the rest of the world.\’a0

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Most importantly for the US it means that it is very difficult for the Fed to manage domestic monetary policy because the US financial system must accommodate not only conditions in the US but also distortions introduced by the use of the US dollar as a reserve currency, and these distortions can be massive.\’a0 The most obvious example is the way over the past decade systematic industrial policies mainly in China and East Asia aimed at running trade surpluses and the accumulation of reserves meant that the US economy and its financial and monetary systems were forced to adjust in ways that created large and serious imbalances, which only now are we resolving. \’a0

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But although I think the world would be better off if there were an active alternative to the US dollar, I can\’92t help but think all this flurry of talk is a waste of time and driven mainly by political considerations almost wholly divorced from any understanding of exactly what a reserve currency is and how its status is achieved. \’a0Every decade or so there are calls for the replacement of the US dollar with a more international reserve \’93currency\’94 but they always lead exactly nowhere, and I can\’92t think of any reason why this time will be different. \’a0On the contrary, one of my working assumptions is that with the end of the global liquidity cycle the value of liquidity will be higher than ever. \’a0New currencies and currency unions thrive during the liquidity cycle. \’a0They almost never survive the end of the cycle.\’a0

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Perhaps Governor Zhou has much more faith than I do in the role policymakers have in creating reserve status \’96 as if you could fill a few boxes, make a political decision, and then simply create a new, widely used reserve currency.\’a0 But the fact is that excessive reliance on the US dollar was not a policy decision. \’a0If the world truly wants a more \’93balanced\’94 reserve currency system there are, after all, many currencies that could have functioned alongside the US dollar, but investors, central banks, and international traders seem to have had little interest in acquiring a \’93balanced\’94 portfolio of reserve currencies.\’a0

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For one thing liquidity is key, and I think not even the euro \’96 and certainly not SDRs or alternatives to the SDR \’96 can ever hope to achieve anything like the level of liquidity implicit in the US dollar market.\’a0 For another thing, for a currency to achieve reserve status there must be some systematic way of delivering the currency to central banks and other players who want to acquire it, and the US does so by its ability and willingness to run persistent trade deficits.\’a0 How will the IMF or whoever controls the SDR create and assign reserves?

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More specifically, if the SDR is indeed a true reserve currency, and not simply an accounting entry that allows central banks to pretend that they are not holding dollars but whose value ultimately rests on its convertibility to the US dollar, who will determine the global money supply and how do we prevent this from becoming a horribly politicized process?\’a0 After all the Fed has an interest in seeing stability in the value and use of the dollar, and so it can be counted on more or less to act in the best interest of the reserve currency, but why should anyone care about the value of the SDR over the long term and, more importantly, how can prudent behavior be enforced?\’a0 More worryingly, if Europe has had so much trouble managing monetary policy among a group of neighboring countries with fairly similar social and economic conditions, how do we manage monetary policy on a global scale?

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Perhaps the SDR is a covert way of getting back to something resembling the gold standard by creating a fiat currency with very strict rules about its expansion.\’a0 If that is the case, the SDR almost certainly won\’92t last long.\’a0 Since we\’92ve gone off the gold standard we have forgotten how brutal and unforgiving gold-standard discipline can be, and I think it was Barry Eichengreem who argued in Golden Fetters that the gold standard could only work in a society in which the poor and the weak have little political power, the voting franchise is limited, and the impact of monetary policies on underlying economic conditions was not widely understood.

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Unemployment

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All this talk of new currencies and new financial architecture is obviously aimed at the upcoming G20 meetings.\’a0 I very much doubt anything useful will come of the meeting except for diplomatically restrained name-calling, and I am currently writing a piece to be published by the Carnegie Endowment (who I recently joined), which I hope to have by the end of this week, discussing some of the issues the participants are going to face.

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Bu away from the world of high finance I thought I would mention two things.\’a0 The first is an article in last week\’92s Xinhua on hiring prospects.

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The latest report by major job service provider Manpower indicates that hiring prospects in China may continue to drop by a “considerable 10 percent” in the second quarter as the global financial crisis began to affect the real economy. \’a0The report, based on a survey which covered 4,149 employers across the country, showed that the eastern job markets were experiencing the weakest hiring climate in four years.

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The next article, on the same topic, is from today\’92s People\’92s Daily. It focuses specifically on the job outlook for college graduates. \’a0Last week I read an article \’96 also in People\’92s Daily, I think, but I can no longer find it \’96 in which it was claimed that the share of Guangdong students graduating in 2009 who already have job offers was less than half of the share last year at this time.\’a0 Today\’92s article seems to confirm this:

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In an unfortunate reversal of fortune, more than 70 percent of upcoming graduates have yet to secure a job.\’a0 “Normally about 70 percent of graduates have job offers in March, but now the situation is completely upside down,” Wu Xiaohui, senior campus recruitment consultant with Shanghai Foreign Service Co Ltd (SFSC), told China Daily yesterday.

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The article goes on to say:

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According to another survey by SFSC, about 55 percent of the city’s 104 multinational corporations didn’t intend to recruit new staff this year amid the deepening recession.\’a0 Among those who plan to hire, half will recruit fewer than 10 people, compared with an average of 50 to 100 people in previous years.

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Along with this gloomy outlook the World Bank last week cut its growth forecast for China.\’a0 When they cut their forecast last year, I said they would revise it downward at least one more time.\’a0 Perhaps this time will be the last downwards revision for 2009, but if it is, expect a series of downward revisions for 2010.\’a0 This is from last week\’92s Xinhua:

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The World Bank (WB) has cut its forecast for China’s 2009 economic growth yet again — this time to 6.5 percent from 7.5 percent, it said here Wednesday. \’a0\’a0This is the second cut the bank has made for China’s 2009 gross domestic product (GDP) growth forecast. Last November its prediction stood at 9.2 percent.

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This came after the bank lowered its forecast for the 2009 world economy, which was expected to decline 1.5 percent from 2008. In November, the WB forecast the world economy would grow 1 percent this year.

Tags: Art bubble

Banker? Or Grocer?

March 16, 2009 in Banks, Currency regime, NPLs by Michael Pettis | 12 comments

Replenishing bank capital

One of the students in Peking University’s Guanghua Students Monetary Policy Committee, a group for which I am an advisor, put together last week a summary of plans to raise capital adequacy ratios for Chinese banks.\’a0 I thought it would be useful to reproduce his numbers.\’a0 According to him, Shenzhen Development Bank, Everbright, China Merchant Bank and CCB have recently issued RMB 83.2 billion ($12.2 billion) in subordinated debt.\’a0 Minsheng Bank, ICBC, Industrial Bank and BoC plan to issue an additional RMB 243 billion ($35.5 billion) of subordinated debt. \’a0Minsheng is also planning to issue RMB 1 billion in shares.\’a0

At the same time in December the CBRC required that the big five banks raise their loan loss provisions from 100% to 130% of the loans in the bottom three of the five credit categories.\’a0 Off the top of my head I think the second category \’96 \’93special mention\’94 loans \’96 comprises roughly three times as many loans as the bottom three categories combined, and many analysts assume that anywhere from one-half to all should properly be classified as doubtful or impaired. \’a0Given the huge growth in lending and lax lending standards during the past few years (during what had to be a great time to be a banker), I think skepticism about the quality of bank portfolios is very much in order.

Policymakers are assuring everyone that the banking system is healthy, as policymakers everywhere always do.\’a0 I, of course, have my doubts, so I think it is very prudent that while they praise the banking system on one hand the authorities are making banks take on more capital and larger loan loss provisions. \’a0I think it is extremely unlikely that we don\’92t see a surge in NPLs over the next two years.\’a0 This is particularly likely since credit expansion for February turned out to be RMB1.1 trillion, three to four times the amount of new lending last February which, when combined with last month’s RMB1.6 trillion, means than net new loans for the first two months of this year are significantly more than half of net new lending in 2008.\’a0 Of course it might be pointed out that most of this new lending is to state-sponsored projects and was strongly “encouraged” by policymakers, so it is likely to come with explicit or implicit guarantees, but in the case of a surge inNPLs I suspect that banks will nonetheless be forced to take losses before the government itself steps in.

Aside from loan and capital-raising figures other numbers are not looking too positive.\’a0 The wholesale price index came out today, with wholesale prices falling 6.0% year on year.\’a0 Part of this was caused by falling crude and commodity prices, but there is enough left over to make me continue wondering about underlying liquidity conditions.\’a0 Logan Wright told me Saturday that he expects to see very low, or even negative, reserve accumulation over the quarter, and regular readers of my blog know that\’a0I consider reserve accumulation to be the strongest indicator of underlying monetary conditions in China.
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Manufacturing output for the first two months of the year was up 3.8% from the same period last year, which was well below already low projections (because of the moving Spring Festival holidays it doesn’t make much sense to compare individual months in the first quarter).\’a0 Much of what little growth occurred was powered by a surge in concrete production and, to a lesser extent, by a sharp increase in vehicle sales.\’a0 The optimists would say that this shows that the government stimulus is working.\’a0 Pessimists would argue that the increase in auto sales may well be short-lived because it surged largely after a cut in taxes, and there are persistent rumors of a significant increase in car purchases by government-related entities.\’a0\’a0 In both cases the\’a0 growth in sales might then be seen as anticipated purchases that take will have trouble persisting.

Likewise pessimists would also argue that the surge in concrete production is not evidence that the stimulus is having an effect but rather evidence\’a0 that people believe that it will have an effect, and so are building inventory in anticipation (the same is probably true of the recent surge in steel production and inventory levels).\’a0 This is good news if the stimulus actually does have a big impact on demand, since rising inventory prevents bottlenecks, but of course bad news if the stimulus turns out to be weaker than expected, in which case the need to work off inventory will slow future production to below actual usage.\’a0

Aside from high loan growth numbers and low growth in manufacturing output, retail sales figures also came out last week. \’a0 According to an article in Thursday’s South China Morning Post:\’a0

Growth in retail sales slowed to 15.9 per cent over January and February from December\’92s 17.4 per cent growth and 22 per cent in October, the statistics bureau said.\’a0 \’93It seems clear the domestic demand is slowing in China, and this could be happening at a faster pace than the sales data suggest,\’94 said Moody\’92s Economy.com analyst Sherman Chan in a report. \’93Having households pull back on spending is exactly what China does not need.\’94

Beijing is trying to prod consumers to spend more with measures that include subsidizing appliance purchases for rural families. But families save heavily for education, health care and other expenses, and analysts say they are unlikely to spend more on consumer goods until Beijing creates a social safety net to ease such burdens.\’a0 A market research company, DDMA, said a February survey found 45 per cent of those polled had cut back on spending, down from 7 per cent in January.\’a0

Xinhua put a different spin on the numbers in an article the next day:\’a0

China’s retail sales grew 15.2 percent in the first two months to 2 trillion yuan (293.8 billion U.S. dollars), the National Bureau of Statistics (NBS) said Thursday.\’a0 The figure, although lower than the 20-percent-plus increase a year earlier, was encouraging, analysts said.

Retail sales growth in January and February was equal to or even higher than last year adjusted for inflation, said Zhuang Jian, senior economist with Asian Development Bank.\’a0 The consumer price index (CPI), a major gauge of inflation, hit a 12-year high of 8.7 percent in February 2008 but fell 1.6 percent in the same month this year.\’a0 “Domestic consumption has remained stable so far, despite the economic slowdown,” he added.\’a0\’a0

I think Xinhua’s interpretation is probably closer to the mark but in either case it seems, not surprisingly, that household consumption is almost certainly declining.\’a0 Remember that retail sales are not a great indicator of household consumption in China because they include lots of other things, including government consumption.\’a0 In addition I should add thatCICC , one of China’s three leading investment banks, came out with a report on March 11 which I cannot excerpt but which basically advised caution about the retail sales figures and the outlook for household consumption.

A difficult transition

On a very different subject, two days ago I received a very interesting and intelligent email from one of my readers, a student who I believe is from the South\’a0of China (I am guessing this because he mentioned his plan to set up a business in Guangxi) although I am not sure if he is currently at Peking University or at another school.\’a0 He has allowed me to reprint his email, although I am not sure whether he is comfortable with my using his name, so I will reprint part of his letter while leaving out his name and any private references.\’a0 I have edited the letter slightly to make it follow the format that I use in this blog:

Being a student and a loyal reader of your blog, you have all but convinced me that China should continue to allow its currency to appreciate, for China and the world’s sake. This is in spite of the fact that my family runs an export business and appreciation of the currency will most definitely affect our business in a negative way.\’a0 In light of the global financial crisis, the big theme in China is how to increase domestic spending and gradually make the export oriented businesses more domestic-dependent. And I always tell myself that the appreciation of the RMB will help because imports will be cheaper and that will directly increase the purchasing power of Chinese consumers.\’a0

Today, I went shopping with my girlfriend at Carrefour and I was trying to find some evidences to support my theory. Today we bought about RMB100 of food, typical of the things that we would need for the next 2-3 days.\’a0 Roughly, I would say we bought RMB30 worth of meat (chicken and pork), RMB40 worth of fish, RMB20 of milk/dairy and RMB10 of shampoo.\’a0 Then I try to determine how much the Chinese consumers would save if the exchange rate was changed.\’a0 Here is what I realize:\’a0

All RMB 100 of food are made right here in China. Even the RMB10 foreign brand shampoo is made by a factory in Shanghai. So, I thought, what would happen if the dollar to RMB exchange rate becomes 1:4? Well, the cost of making these items wouldn’t decrease that much because most of the components that go into producing these items are not imported and would stay pretty much the same. (Please correct me if I am wrong in this assumption.)

However, if the exchange rate suddenly becomes 1:4, a lot of Chinese exporters, including my family’s juice business, which actually has a good margin compared to other labor intensive industries, will go out of business.\’a0\’a0

In addition, perhaps now it would make economic sense for western companies to import their products (beef, fish, milk, shampoo) into China (of course assuming that the tariffs stay the same) and domestic consumers would buy imported goods because they are better quality and may now be cheaper. \’a0

So this also adds additional pressure to the manufacturers. furthermore, perhaps now P&G would in this new exchange rate environment consider producing its shampoo in the U.S., because relatively speaking, P&G’s cost of production in the U.S. would have gone down.So China gets hurt in a multiple of ways as a result of China revaluing its currency:\’a0

1. Export companies go out of business.

2. Domestic companies get more competition from foreign companies and are forced to cut prices and maybe wages.

3. Foreign companies will have less incentive to invest and do production in China.

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The benefit is that Chinese consumers will buy more imported goods, but I am not even sure if the consumers will get more purchasing power as a whole because as in our shopping experience, almost all of the things that I buy are made locally, so the prices wouldn’t really drop. (I can see in the case of luxury goods, i.e. LV, or Gucci, where they would be come sufficiently cheaper if the exchange rate re-values.)\’a0

\’a0So in conclusion, on the one hand, based on PPP or Big Mac index, I get the impression that the RMB is greatly undervalued (i.e. 1 Big Mac in US is $4, and 1 Big Mac in China is RMB 12-15). Yet, if the RMB were to really go up in value, the economy would definitely be hurt in many ways.

What is wrong and what can we do?\’a0\’a0

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This is a great letter because (aside from the fact that it shows why I enjoy teaching here so much, given the intelligence and thoughtfulness of so many of the students I meet) it indicates in a very concrete way how complex the policy decisions are and how difficult the transition process is likely to be.
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The first thing I would bring up is the issue of the effect of revaluation on the food purchased at Carrefour.\’a0 Of course it is true that the cost to make those Chinese-made goods would not decline in RMB terms except to the extent that they included foreign components (which may be more than many realize, since much of the fertilizer used by Chinese farmers comes from abroad, as does the oil they use to transport their products to Carrefour), but that does not necessarily mean that their cost to the consumer would not decline.\’a0 All of these things can be manufactured abroad, and it may be that Malaysian chickens, Australian milk or the same shampoo manufactured in Vietnam would become so much cheaper that either Chinese consumers would begin to buy more foreign food, or Chinese producers would have to lower their costs or improve their quality to compete.\’a0 This directly benefits Chinese consumers.\’a0

Of course it might hurt Chinese farmers and producers, and this is why the transition becomes difficult.\’a0 In a very abstract way we can argue that whatever pain the farmers feel is less than the gains other Chinese enjoy.\’a0 Cheaper food for Chinese consumers means that they have more money leftover to go to restaurants, buy books, or get haircuts, and so Chinese businesses that supply these services will benefit.\’a0\’a0

In an even more abstract sense we can argue that China does some things relatively better than other countries, and some things relatively worse \’96 that is, the specific conditions in China, including its infrastructure, labor markets, educational systems, and so on mean that Chinese can do some things more productively and efficiently and other things less so.\’a0 By allowing the RMB to appreciate (or by otherwise relaxing constraints that affect the relationship between production and consumption), Chinese businesses and producers will be forced to concentrate on the things they can do more productively and efficiently than others, while leaving others to do the things they don\’92t do so well.\’a0\’a0

This increases the total economic well-being of China and the countries with which it trades, and so at least in principle every country can become a little better off.\’a0 Remember that if China buys more from abroad, that doesn\’92t mean that Chinese producers must sell less.\’a0 Whatever money China exports to pay for those imports represents a net increase in either 1)foreign buying of things that Chinese producers are good at making or 2)foreign investment in China, which increases the productivity of Chinese workers.\’a0 Both of these are good for China\’92s economic prospects and both result in rising employment.\’a0

But there is no getting around the fact that the process will be painful in the short term, as the student writing the letter has pointed out.\’a0 Although in the long run China and Chinese workers and consumers will almost certainly be better off as China makes the transition to a more balanced and domestic-driven economy, there are nonetheless short term costs.\’a0 Resources and labor will not be smoothly reallocated from exporters to domestic service producers and manufacturers who serve the local markets.\’a0 What usually happens is that, to use the very dry jargon of economists, these resources and labor will be \’93freed up\’94 as exporters go bankrupt or downsize.\’a0\’a0

As economic conditions change, and as exporting becomes less profitable, businesses aimed at local consumers will take advantage of newly available assets, resources and labor to begin operating, and gradually China will once again reach more or less full employment with a very different economic structure.\’a0 But of course remember that at first, domestic demand (and domestic employment) will actually decline as workers lose their jobs.\’a0 This is where the government can and should play an important role, for example by boosting domestic consumption as much as possible so that it quickly becomes profitable for Chinese companies to target the domestic market.\’a0

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Allowing and even encouraging this transition may therefore seem like a bad idea for China, but as the global crisis shows, it will be impossible for a large economy like China’s to continue depending so much on the export sector and on foreign investment.\’a0 It must make the transition, and the later it does so the more difficult it will be.\’a0
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\’a0When the US made a similar transition 200 years ago, after the panic of 1797 when the Bank of England suspended gold payments, and when the US Quasi-War with France and the Napoleonic Wars in Europe decimated the US export trade, it did so over at least two very difficult decades, and after sharp rise in unemployment in the early years.\’a0 Eventually the whole country shifted its economic structure and, needless to say, the shift turned out to be crucial for the subsequent success of the US economy.\’a0\’a0
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Japan was forced to confront the failure of its own export-led model in the late 1980s and early 1990s, and, as everyone knows, the process has not been easy. \’a0Of course it would have been better for the US and Japan if they had try to adjust earlier, when global trading conditions were optimal, but like China in the past decade, it is hard to make an adjustment when things seem to be going so well.\’a0 It almost always takes a crisis to force the change, even though this makes the process of change that much more difficult.

By the way although much of the above is a fairly standard exposition on how free trade benefits everyone, I am not necessarily a believer in unfettered free trade for China.\’a0 Remember that under conditions of free trade and no currency intervention Chinese businesses and producers will be forced to concentrate on the things they can do better than others, while leaving others to do the things they don\’92t do so well.\’a0 This of course benefits the whole world in the short term, but China may not be happy over the long term with its comparative advantages.\’a0 It might find that cheap labor and low technological skills are not the kinds of advantages it wants to enjoy.

In that case a very strong argument can be made that selective protection can alter the relative advantages China has by encouraging innovation and development in areas in which China now has a relative disadvantage.\’a0 I won\’92t say much more about this (which is anyway likely to be highly controversial) except to note that as far as I have been able to determine from the historical evidence, with exception of a few very small trading nations, every technologically and socially advanced country since the British in the 17th and 18th centuries did so behind trade and other barriers aimed explicitly at altering the country\’92s technological and commercial position.\’a0

Much of this theory is beautifully summarized and implemented in Alexander Hamilton\’92s writings, and it is worth noting that the US, unlike its largely free-trading counterparts in Latin America, had the highest import tariffs of any major country for most of the 19th Century.\’a0 The risk of this kind of protectionist policy of course is when trade protection is allied with attempts to foster national champions, which almost always results in the worst of both worlds.\’a0 Competition breeds innovation, and state-supported national champions are almost always global losers.\’a0

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Before closing I should switch the subject and mention that Canada’s Globe and Mail had an article Friday about my insistence that a very wide-spread claim — that China is Washington’s banker — is based on a misunderstanding of the reserve accumulation process, and that it is probably more useful to think of China as a shop that sells to the US and accumulates IOUs, rather than as its banker.\’a0 You can find the article here.\’a0 Banker’s lend discretionary money, whereas grocers only accept IOUs from important clients on purchases from the store.\’a0 It is an important distinction, I think.

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Tags: Subordinated debt

Trade, CPI and other numbers came in this week

March 11, 2009 in Currency regime, Exports and imports, Inflation, PBoC, Policy, Trade protection by Michael Pettis | 51 comments

Deflation and debt
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On Monday CPI and PPI numbers for February came out. CPI was down 1.6% year and year and PPI was down 4.5%, in line with or slightly below expectations and, according to Bloomberg, the highest rate of deflation among the 78 countries they follow. Some of this may be caused by one-off factors, especially declining food prices, and most of the press and analyst commentary suggested as much, but the figures are still too hazy to say with any certainty whether or not deflation is likely to become a problem. Qi Jingmi, an economist with the State Information Centre, a government think-tank, was quoted in an article in the South China Morning Post as saying “I worry about PPI. The sharp fall in PPI shows that the financial crisis is gradually spreading to the real economy.”
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The PBoC’s Governor Zhou has already promised that China will do whatever it takes to prevent deflation, although at this point it is hard to find anyone who believes in the 4% target inflation for 2009. According to an article Friday in Bloomberg he said that \’93We would rather be faster and heavy-handed if it can prevent confidence slumping during the financial crisis.\’94 The article goes on:
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Chinese central bank Governor Zhou Xiaochuan pledged \’93fast and heavy-handed\’94 policies to restore confidence and prevent the global financial crisis from deepening the nation\’92s economic slump. \’93If we act slowly and less decisively, we\’92re likely to see what happened in other countries: a slide in confidence,\’94 Zhou said at briefing in Beijing. The central bank has \’93ample room\’94 to fine-tune monetary policy after a record surge in lending in January, he said.

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I continue to be very skeptical about the actual amount of control the PBoC has over monetary policy. Until last summer despite PBoC intentions to run “prudent” or “tight” monetary policies all the evidence suggested out-of-control money growth, and since then their promises to expand aggressively have been at least somewhat undermined by evidence of monetary contraction. I am convinced that given the currency regime, net foreign inflows or outflows more than other factors determine underlying money in the system, and since the PBoC has very little control over the net flows, and so little control over the rate at which it is forced to monetize those flows, monetary conditions are at least as likely to reflect external conditions as domestic policy.
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That is why what interests me most about the inflation numbers is what they suggest about monetary conditions — a subject on which it is very hard to get complete data and for which we often need to draw inferences from other parts of the economy. In that light, it is worth noting that the money-versus-pork debate seems to have died down since last summer with the decline of inflation at year-end, but I suspect it is going to revive soon enough, as I discussed in one of my entries in December. For example, a Bloomberg article on Monday had this to say:
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China isn\’92t yet facing \’93typical\’94 deflation, where falling prices are accompanied by shrinking loans and money supply and an economic recession, central bank vice governor Yi Gang said, according to the state-run Xinhua News Agency. The central bank has \’93sufficient\’94 policy tools to combat deflation, Yi said, without elaborating.

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Maybe it is indeed true that falling prices are not accompanied by shrinking loans and money supply, but it seems to me that we can’t really say for sure. We think we know that loans aren’t shrinking because loan growth numbers in the official banking sector pretty clearly show rapid loan growth, but as I have written many times before, much of January’s loan growth represented either balance sheet rearrangements or other forms of loan growth that don’t represent real credit growth to the economy (and by now that is a pretty widely accepted interpretation of the January numbers, although many bank analysts continue to talk up the loan growth as effective).
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In addition, there is still anecdotal evidence that the informal banking sector is having difficulty expanding and even that their balance sheets may actually be shrinking. Real credit in China, in other words, is expanding much more slowly than the headline numbers suggest and may even be contracting. We don’t really know. For those who care, the current issue of Forbes has a very interesting article by Gady Epstein on one part of the shadowy credit market in China.
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By the way I assume that Vice Governor Yi is indirectly referring to Irving Fischer’s debt-deflation thesis. But in my opinion, and if I read Fischer correctly, the risk for China is not a financial collapse induced by excess and unstable leverage. In spite of the haziness of the debt accounts I really don’t think China has the amount and kind of leverage that is likely to lead to a collapse in asset prices (although my one caveat is that we don’t really know the relationship between asset collateral and debt in the informal banking sector). The risk instead — and a highly probable risk although the timing is a little hazy — is that China will see many years of sub-par growth as it works off its addiction to excess capacity and makes the tough and slow transition to a domestic-led economy. I think Nick Lardy’s warning of a “long landing” rather than a “hard landing” is what we should expect. I am only guessing here, and haven’t really worked it out, but perhaps monetary reflation, which I think would have been Fischer’s proposal for the US today, is not likely to be of much help to China.
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Trade figures are out
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Meanwhile, and back to the real world, February trade numbers were released today. As I guess pretty much anyone who reads my blog would know, the export numbers were terrible. Exports plunged 25.7% in February year on year, even though this year February did not include the Spring Festival holidays, and so was substantially longer than February 2008. The foreign press seems mostly to think that the sharp decline in exports came as a huge surprise to most experts, while the Chinese press seems to think it was largely expected (the SSE Composite declined on the news, but only by 0.9%). I have always believed that the fact exports were dropping much more rapidly in the rest of Asia than in China was clearly not sustainable, and that it was just a question of (very little) time before we began to see Chinese exports hit much more sharply. I do not believe the process is over.
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According to an article in today’s Xinhua:
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China’s exports plummeted 25.7 percent year-on-year in February, the fourth straight monthly decline, as global demand shrank, the General Administration of Customs said Wednesday. Exports contracted to 64.90 billion U.S. dollars, while imports slumped 24.1 percent to 60.05 billion U.S. dollars. The sharp declines reflected weakening external demand, which would persist throughout the year as the global recession deepened, said Zhang Junsheng, an economics professor at the University of International Business and Economics. “These huge falls were inevitable, given the global downturn,” he said.

…Exports of labor-intensive products contracted more moderately than total exports, reflecting the government’s moves to raise export rebates starting last July, the agency said. Garment and accessory exports fell 11 percent to 14.62 billion U.S. dollars, while those of toys sank 17.1 percent to 850 million U.S. dollars.

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I have heard several times reference to the fact that the increase in export rebates has helped the textile sector, although I would have guessed that this wouldn’t be something policymakers would want to advertise to the outside world. Along that line I think we are going to see a lot more pressure on policymakers somehow to “deal” with the problems in the export sector. On Monday Commerce Minister Chen Deming announced a cut in export taxes. According to an article in Tuesday’s Financial Times:
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China will reduce export taxes to zero and give more financial support to exporters as it tries to increase its share of global trade in the current crisis, the country’s commerce minister announced on Monday. China would “use all possible measures to ensure the stable growth of our exports and prevent a large drop in external demand”, Chen Deming said in an interview published by a Communist party newspaper. “We should increase our share of the global market… We must transform ourselves from a big export nation to a strong export nation,” he continued.

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It’s probably not a good idea to announce a drive to increase China’s share of the global export market, especially since for the last several months, while the world has suffered a collapse in demand, China’s share of exports has risen dramatically, but this may have been said primarily for domestic consumption. Yesterday Chen spoke again about trade. According to an article in People’s Daily:
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China’s foreign trade faces grim times in the coming months, Commerce Minister Chen Deming said yesterday even as the government tries to take steps to boost trade.

…Chen said the government would support exporters, in particular those of electronic goods and machines that account for 57 percent of the country’s exports. The government has raised export rebate rates and will expand the coverage of export credit insurance and encourage financial institutions to offer export credit services to boost exports, he said.

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The pressure to fix the export sector is clearly rising. My friend Isaac Meng was quoted later on in the same People’s Daily article explaining why policymakers are taking a decision which is not likely to make already-difficult global trade relations much easier:
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“Global trade and demand [are] collapsing and so are the currencies of many of China’s competitors and customers,” said Isaac Meng, an economist with BNP Paribas. “This is putting huge pressure on China’s export industries and the government to push all the buttons to boost the economy.”

At a press conference on Friday Zhou Xiaochuan, the central bank governor, refused to rule out a devaluation in China’s currency, the renminbi. “If you can tell us clearly what is going to happen [in the countries where the financial crisis started], it would be easier for us to tell you what measures we will take,” Mr Zhou said when asked directly whether he would rule out a devaluation of the renminbi.

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In a sign of how contentious the debate has gotten within China, the trade worriers put in a counterclaim. This from a Bloomberg article:
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China should let the yuan rise 3 percent against the dollar in 2009 to deter capital outflows and help the country make overseas acquisitions, said Wang Jian, a researcher affiliated with the nation\’92s top planning agency. China\’92s foreign-exchange reserves grew by the least in more than four years in the fourth quarter as sliding exports prompted traders to step up bets on yuan depreciation. People\’92s Bank of China Governor Zhou Xiaochuan pledged last week to maintain yuan stability as investors pull money out of emerging- market assets because of slowing global economic growth.

\’93A weaker currency will prompt massive amounts of foreign capital to flee the country,\’94 said Wang, secretary general of the China Society of Macroeconomics, a Beijing-based research institute under the National Development and Reform Commission that advises the government. \’93It won\’92t help exports. Foreign consumers still won\’92t have enough money to buy.\’94 At least $1 trillion of \’93hot money\’94 may have entered China, Wang estimated, as the yuan gained 21 percent against the dollar since the central bank ended a fixed exchange rate in July 2005. Depreciation would risk spurring a sudden exit of those funds, causing turmoil in the financial system, he said in an interview yesterday.

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I think hot money flows are one of the potentially destabilizing factors we need most to worry about because the PBoC’s currency regime means that monetary conditions, as I discuss in the first half of this entry, are largely determined by net inflows or outflows. In that light it is worth noting that while imports in February were also very bad — they dropped 24.1% year on year — the February trade surplus was much, much lower than for any month in a long time. China’s trade surplus for February was $4.8 billion, lower than the $7 billion rumor I mentioned a few days ago and much lower than the roughly $34 billion average monthly surpluses of the past six months (and $39.1 billion for January).
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This may be a very good thing for China as it goes into the G20 meeting, since it takes a little of the sting out of China’s growing export of overcapacity, but one month of “good” numbers after a long series of absolutely awful numbers won’t mean much, and we need to figure out more about the composition of imports. In particular I am interested in seeing whether imports include a lot of one-off rebuilding of commodity reserves. By the way with last month’s “low” trade surplus, some people are arguing that the era of massive monthly surpluses are over. This is from MarketWatch:
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“The bigger shock figure was the decline in the trade surplus to $4.8 billion as exports fell faster than imports,” said [Royal Bank of Scotland's chief China economist, Ben] Simpfendorfer. “February’s trade surplus typically falls because of seasonally strong commodity imports and seasonally weak consumer exports,” he said. “So, the decline in the trade surplus will likely be reversed next month. Nonetheless, the surplus will not bounce back above a $20 billion monthly rate this year.”

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Trade and industrial policies
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I hope Simpfendorfer is right. The Washington Post seems very worried about the trade-policy outlook. In an article titled “US to Toughen its Stance on Trade,” it warns that US policy seems increasingly dissatisfied with global trade and says that “the Obama administration is aggressively reworking U.S. trade policy to more strongly emphasize domestic and social issues.” Today’s New York Times also had a worried editorial on President Obama’s trade agenda, which included the following:
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Trade will play an important role in the world\’92s eventual recovery, transmitting economic growth from one country to the next. Protectionism leads to further protectionism, and yielding to its temptation could unleash destructive trade wars that would crush any chance of recovery. Unfortunately, few politicians are willing to tell their constituents that unpopular truth. Instead, governments are succumbing to protectionism\’92s dangerous lure. In recent months, Russia has jacked up import barriers on cars, farm machinery and other products. The European Union has reintroduced subsidies on dairy products. Europe, India and Brazil raised tariffs on imported steel.

Protectionism is also taking subtler forms, like Britain\’92s requirement that bailed-out banks favor domestic lending. The United States is not immune. The stimulus bill had a \’93Buy America\’94 provision, and it made it more difficult for companies receiving stimulus dollars to hire foreign workers under the H-1B visa program. President Obama\’92s choice for United States trade representative, Ron Kirk, appears ambivalent about the value of free trade. As part of his confirmation hearings this week, Mr. Kirk testified that he would work to expand trade but also argued \’93that not all Americans are winning from it and that our trading partners are not always playing by the rules.\’94

…If ever there was a need for collective action \’97 on fiscal stimuli, monetary policy, aid to the developing world, fighting protectionism \’97 it is now. A place to start the rethinking is China and how to encourage increased domestic consumption and investment in China and other cash-rich Asian countries so they can start pulling the world out of recession.

China\’92s leaders, in particular, need to understand that export-led growth no longer works for them or for the world. The United States will have more influence if it stops beating on Beijing for its foreign-exchange policy and engages China\’92s leaders as partners, not rivals. Vigorous trade will help the world recover. For that to happen, the United States will have to provide strong leadership and a clear commitment to fighting protectionism. Any sign of ambivalence from Washington will only make things worse.

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The whole debate over trade is going to be framed within US and European discussions about fiscal stimuli since it is not at all clear that Chinese policymakers are contributing much more than some fairly smug, and perhaps hypocritical, statements about how everyone must embrace free trade. But the US and European discussions don’t seem particularly positive right now. According to today’s Financial Times:
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Disagreements between the European Union and the US over how to combat the global recession widened on Tuesday as EU governments made clear they had little appetite for piling up more debt to fight the collapse in output and jobs. Finance ministers from the 27-nation bloc insisted in Brussels that it was doing enough to support world demand and did not need at present to adopt another fiscal stimulus plan, as Washington is urging.

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I hesitate to enter these very deep waters, but I think the Europeans, at least as described in this article, might be right. There is a real need for an adjustment in consumption in the US, and I don’t think it makes sense for the US to attempt to replace excess household consumption with excess government consumption. One way or the other the US, along with China and most other countries that have contributed to one side or the other of the global imbalances, is going to have to accept a demand contraction.
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Trade friction is an issue that will not easily go away. Not all the information released this week was bad, however. Some was good and some was neutral — by which I mean it could be read either as bad or good depending on your economic model. According to an article in today’s Bloomberg:
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China\’92s investment spending surged as the nation poured money into roads, railways and power grids to counter a plunge in exports, which a separate report showed fell by a record in February. Urban fixed-asset investment climbed a more-than-estimated 26.5 percent in January and February combined to 1.03 trillion yuan ($150 billion) from a year earlier, the statistics bureau said today in Beijing.

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The fact that fixed asset investment surged might suggest that the fiscal stimulus plan is having an effect and will counteract to some extent the slowdown in other parts of the economy. A worrier (me) would be very nervous however that the stimulus ended up worsening the overcapacity problem, in which case any benefit would be more than paid for next year. More unambiguously good news involved February car sales, which are up substantially and suggest that some government policies are getting consumers to go back to buying cars, although this was accompanied by bad numbers on car exports.
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The mainland\’92s sales of domestically made vehicles surged 25 per cent in February from a year earlier, as a tax cut for small cars and other measures helped revive the market, an industry group said on Wednesday. February\’92s sales totalled 827,600 units, up 12 per cent from the 735,000 sold in January, the China Association of Automobile Manufacturers said in a report posted on its website. Production in February totalled 807,900 units, up about 23 per cent from the year before, it said.

…However, despite the apparent rebound in China\’92s own car market, a slump in demand is crimping sales overseas: exports in January fell 33.5 per cent from a year earlier, to US$2.66 billion, the group said. The impact was most severe for domestic-brand cars, with January exports falling 64 per cent from a year earlier to 16,300 units, it said. Imports of vehicles also took a hit amid the deepening economic downturn, falling 20.3 per cent from a year earlier in January to US$1.73 billion, it said.

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Finally before closing, and for an indication of rationality that sometimes seems to be missing from foreign expectations about China, few analysts in China seem to buy the idea so popular in the West that somehow Chinese policies may be enough to pull the world out of its economic crisis. Tuesday’s People’s Daily had a long article on the subject. Among other things it said:
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A China-driven recovery of world economy is “unrealistic”, economists said amid hope, after the world’s attention was drawn to China’s annual parliament session, that the country’s stimulus plan would help the whole world out of the recession.

…Economists said they believe China would be able to keep its growth at about 8 percent this year, a growth rate long believed to be minimum to create enough jobs and maintain social stability. However, they said it is wild wish to count on the country alone to fuel the global recovery, as China’s economy accounted for only five percent of the world’s total.

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To pin hope of the global recovery only on China is similar to charging a colt with an overwhelmingly big carriage and hoping it to drag the cart along, they said. Beijing-based economist Wang Xiaoguang warned that actually China’s influence is very “limited.” He said China’s stimulus package might help store up some investors’ confidence in world economy, but “China alone could not revive the world.”

Tags: Art, Irving Fischer

Should China Devalue the Yuan?

February 15, 2009 in Balance of payments, Currency regime, Exports and imports, Trade protection by Michael Pettis | 35 comments

As I reported in last Thursday\’92s blog entry, last week the research institute associated with China’s Ministry of Finance published a report on its website arguing that China’s central bank should “actively guide” the yuan\’92s exchange rate and devalue the currency to about 6.93 against the US dollar. The purpose of depreciating, the report said, was to help maintain economic growth and bolster employment

An exchange rate of 6.93 implies a depreciation of 1.5%. This is not much of a big deal and unlikely to make much of a difference in Chinese export prices, so I wonder why they would even say this except as a trial balloon. It is not just the research institute that has been making the devaluation argument. Although a number of officials have publicly called for stability in the exchange rate, within China there has been a heated debate about the country’s currency strategy, with several prominent commentators and economists arguing that China needs to devalue the yuan, by substantially more than 1.5%, so as to help Chinese manufacturers achieve greater competitiveness in the global export markets.

I think this kind of talk shows how mutually incompatible China\’92s two policy objectives are in the short term. First, China wants to boost domestic employment by boosting investment and helping restore manufacturing profitability. Second, China is under pressure, and this will almost certainly increase, to reduce its export of overcapacity, and China must address this pressure before it leads to worsening trade friction.

These policy goals might not seem mutually contradictory on the surface, but I would argue that this is only because policymakers \’96 and many commentators, it seems \’96 are failing to distinguish between total demand and net demand. Global demand is contracting, so anything that China does to boost total domestic demand is good for the world, right?

Not necessarily. Domestically, any increase in total demand will have positive implications for employment, but globally the world needs increases in net demand \’96 that is, consumption minus production. Since China provides negative net demand to the world (it runs a trade surplus), what the world needs from China as global demand contracts is a reduction in the amount of negative net demand China provides.

China can boost total demand by boosting manufacturing \’96 every worker not fired is a worker able to consume more \’96 but boosting manufacturing also boosts Chinese production. If it increases production relative to consumption, then China is actually reducing net demand, even while it is increasing total demand. That this is happening, by the way, shows up in the rising trade surplus.

In that light devaluing the currency would be a mistake. Although it might make Chinese manufacturing exports seem more competitive in the near term, there are at least two sets of problems with devaluing the yuan. First, as should be very apparent, the slowdown in China’s exports is not a function of rising domestic costs but rather caused by declining global demand. With imports contracting rapidly, it is a mathematical necessity that countries like China that export excess capacity will, in the aggregate, be forced to export less. The fact that China’s exports have contracted by much less than most of its Asian trading neighbors suggests that in fact China has suffered much less than the average Asian exporter from the contraction in global demand, which makes the argument that China is losing export competitiveness hard to sustain. In that case devaluing the currency would almost certainly set off competitive devaluations.

Some in China are arguing that other Asian countries are already devaluing, so by devaluing China would simply be keeping up, but this argument is a weak one. With Chinese exports declining by less than other Asian countries, and the Chinese trade surplus rising, it will be hard, as I point out above, to argue that China has lost trade competitiveness.

More importantly China is the third largest economy in the world and has the largest trade surplus in the history of the world. It cannot act as if it were a Vietnam, whose economy is small enough that devaluation would only have a slightly negative impact on the global balance. China must understand the impact of its actions on the global, which necessarily must constrain its behavior.

This is because with global demand contracting, any attempt by China to force more overcapacity onto a struggling world \’96 i.e. reducing net demand even further \’96 will require an even sharper contraction in manufacturing among its trade partners. China’s trade surplus is the measure of the amount of overcapacity, or negative net demand, it is exporting into the global economy, and January’s astonishingly high trade surplus of $39 billion, the second highest on record, caps a six month period during which China’s already record-breaking trade surpluses have surged. But with global demand contracting, any increase in China’s trade surplus requires that manufacturers in the rest of the world on average must cut production and fire workers by more than the amount implied by the global contraction in demand.

This will almost certainly lead to widespread claims that China is playing unfairly. Already China is in serious trade disputes with India and Indonesia, and with protectionist sentiment on the rise in the US, Europe, and the rest of the world, this is not the time to create more protectionist fury. A devaluation of the yuan, however small, would be seen as China\’92s answer to the Smoot-Hawley tariff increase, the notorious bill passed by the US Congress in 1930 that put the nail in the coffin of international trade (and a great example of the US failure to understand in 1930 that, like China today, it was too big to ignore the global impact of its domestic policies). In that case devaluation would almost certainly lead to an increase in trade friction.

In the 1930s, Smoot-Hawley had that very effect, and as the country with the world’s largest trade surplus in the 1920s, the US found itself, ironically, as the greatest victim of the contraction in world trade it did most to sponsor. As I have argued many times in a world of contracting demand, it is countries with excess capacity or negative net demand \’96 the trade surplus countries \’96 who are most vulnerable to a collapse in international trade. Even more than the US in the 1930s, China would suffer enormously from trade war.

The second set of arguments against devaluation involves a little longer term thinking, and so might easily be ignored in the panic of the crisis, but China\’92s economy must make the transition from export orientation to reliance on its domestic market. The process is never easy. To devalue the currency now would mean failing to take advantage of the shift that is already taking place and would push the economy in the wrong direction \’96 that of further constraining already-too-low domestic demand, while increasing the importance of the export sector in the Chinese economy. The difficult transition from export reliance to reliance on domestic consumption is not a problem that can be evaded, and postponing it will only make the transition worse.

As counterintuitive as it may seem, I think China should actually continue revaluing the yuan, but before doing so it must reach an explicit agreement that in exchange for revaluing, its trade partners will maintain open markets for China\’92s exports. This is key, and on Wednesday I think I will have a piece in the Financial Times that tries to make this point very explicitly. A trade war would force China to adjust quickly, and I think that would be socially disastrous for China, and at any rate given the structure of the country\’92s financial system and development model it cannot make the transition quickly.

As the world\’92s leading provider of excess capacity, China cannot avoid a difficult adjustment in a world of collapsing global demand. The goal of policymakers must be to slow the necessary adjustment over several years by negotiating an orderly decline in global trade imbalances. This requires cooperation, not devaluation. Sunday\’92s softer G7 communiqu\’e9 which, according to an article in today\’92s the Financial Times, \’93adopted milder language than recently regarding China\’92s handling of its currency,\’94 is a welcome step towards more civil discourse, but it should not mask the risk of rising protectionism. Among themselves the G7 can be as diplomatic as they like, but governments respond to domestic pressure, and nothing creates pressure like rising unemployment. Japan\’92s awful 2008 Q4 GDP numbers (down an astonishing 12.7% on an annualized basis) shows just how heavy that pressure will be.

I am off to Washington DC later today to testify before the US-China Commission and meet a bunch of friends in Treasury and State. On Saturday I will try to write about what I hear there.

Tags: Net demand

There are monetary echoes from the 1930s too

January 21, 2009 in Balance sheets, Currency regime, Hot money, PBoC, Reserves by Michael Pettis | 29 comments

I have been on the road for the past few (and next ten) days, in part because of Spring Festival, so I haven’t been able to post as much as I normally do, but I was asked to write an article for a Chinese magazine, which I recently finished, on comparisons between today and the beginning of the 1930s.\’a0\’a0 As the recognition grows around the world of the similarities between China in 2008 and the US in 1929, it is worth considering why the Great Depression in the US was so severe and what lessons China should draw from it.\’a0 I and a few others have discussed one of the similarities so many times and in so many different places that I think by now the whole issue of the trade impact of US overcapacity in the 1920s and 1930s and how it relates to China today is pretty widely recognized.

But there is more.\’a0 I just finished rereading Barry Eichengreen’s Golden Fetters, a book on monetary conditions in the 1920s and 1930s (and in my opinion one of the great books of financial history).\’a0 One of the points he makes \’96 in fact it is probably the main point of the book \’96 is the way currency policies (i.e. adherence to the gold standard) sharply constrained the ability of policymakers to deal effectively with the monetary consequences of the 1929-31 crisis.\’a0 It wasn’t until various affected countries escaped from their monetary handcuffs and rejected gold that monetary policy became flexible enough to permit them to loosen sufficiently to counteract the banking collapse that accompanied the crisis.\’a0 Eichengreen makes the point often and forcefully that there was a strong positive correlation between the speed with which countries went off the gold standard and the mildness of the subsequent economic crisis.

As an aside I would add my impressionistic sense that countries that ran large balance of payments surpluses (most obviously the US, but there were others too) were in the strongest position to hang on to gold, and so were the last to go off gold.\’a0 They were also the ones most harmed by the 1930s crisis.\’a0 I am not sure if this is primarily because of the monetary straitjacket or because most countries with strong balance of payments positions were also countries with large trade surpluses, and so they suffered most from a contraction in global demand and a collapse in international trade, but I suspect that the two are very closely linked.

Let me summarize my view of the key conditions in the 1920s and 1930s that shed light on current conditions.\’a0 Besides the standard impact of the 1929 crash on consumer confidence, domestic consumption, and the cost of capital, economists generally speak of two factors that compounded the difficulties facing the US economy:

The first I have discussed many times.\’a0 Throughout the 1920s, the US created significant industrial overcapacity, which it was able to export even as massive foreign borrowing in the US markets financed those exports.\’a0 However just when the 1929 crash caused US consumption to decline, it also eliminated foreign financing for the trade deficit countries.\’a0 As international trade collapsed \’96 especially after the US tried to force the adjustment abroad by the passage of import tariffs \’96 domestic demand was not nearly high enough to absorb everything US factories produced, and the US was forced to resolve its overcapacity problem domestically.\’a0 It could have done so by increasing domestic government demand, as Keynes advised, but although the US was in a very strong position fiscally, it failed to take advantage of this strength and barely expanded government spending.\’a0 This ensured that overcapacity would not be resolved by rising government demand but rather by factory closings and rising unemployment.\’a0 Of course the passage of Smoot-Hawley and other mercantilist acts, by inviting retaliation, made the process much more difficult.

To make matters worse, excess money expansion caused by the massive accumulation of reserves in the 1920s had led to over-investment and risky lending.\’a0 The stock market crash set off the process of deleveraging that always signals the end of a liquidity boom, and banks, financing companies and securities firms saw their balance sheets contract.\’a0 When the Federal Reserve failed to accommodate the sudden collapse in money supply as banks cut lending in response to the crisis, the resulting money contraction in the US converted a sharp economic slowdown into a disaster.\’a0 According to Milton Friedman (and I think most other economists) this was the biggest policy blunder that ensured that the crisis would be so devastating.

Compared to the US in 1929 China fares better on some measures, but not all.\’a0 The first and most obvious is the scale of China\’92s overcapacity problem.\’a0 China\’92s trade surplus, the cleanest measure of overcapacity, is of the same magnitude as that of the US in 1929 \’96 roughly 0.5% of global GDP \’96 but its economy is less than one-fifth the relative size of the US in 1929.\’a0 Resolving the overcapacity problem will be much more difficult for China, especially if the world descends into trade friction and if international trade contracts.\’a0 For that reason China must be at the forefront of trade liberalization and avoid the mistake the US made in 1930 of trying to increase its export competitiveness and reduce domestic demand for foreign goods.\’a0 In that direction lays trade friction, which would have a devastating impact on Chinese businesses.

Perhaps not nearly as strong as the US in 1930, China is nonetheless in a reasonably strong position fiscally \’96 although municipal reliance on land sales for revenues, contingent liabilities in the banking system and in provincial and municipal borrowing, and overall lack of transparency, make it difficult to judge.\’a0 More importantly, however, there is widespread recognition among policymakers, unlike in the 1930s, that rapid and forceful fiscal expansion is key to creating new demand.\’a0 Unfortunately it is not yet clear exactly how aggressively the Chinese government will expand fiscally and whether it will do so fast enough to replace declining US and European imports.

The second point may be the more important.\’a0 Like the US in the 1920s China experienced a huge run-up in central bank reserves and, as the inevitable counterpart, low interest rates and excessive money supply growth.\’a0 When this happens the financial system often responds by taking on excessive credit risk and over-investing.\’a0 Given the complexity of the China\’92s formal and informal banking systems and the lack of transparency, it is difficult to know how vulnerable the banking sector is, but it is clearly something about which to worry.\’a0 Warren Buffett once quipped that you can never know who is swimming naked until the tide goes down.\’a0 The tide is receding and we are about to see how many naked bankers there are.

How the PBoC will respond to any signs of sharp money contraction is probably the most important question to answer and also the most difficult.\’a0 On the optimists’ side the mistakes made by the US central bank in the 1930s have been so widely discussed that there is no question that Chinese policymakers understand the risk.\’a0 The PBoC will undoubtedly do all in their power to counteract any monetary or credit contraction.

But things are not so easy.\’a0 In the 1930s as long as the US was on the gold standard, it had limited flexibility in dealing with domestic monetary management.\’a0 This is one of Eichengreen’s key points.\’a0 Once the US got off the gold standard in 1933 it was able to pursue a wholly independent monetary policy, but its failure to counteract the initial credit contraction was a blunder with huge implications, and one from which it was only able to recover after tremendous pain.\’a0 Certainly the PBoC would not make the same choice this time around, would it?

But can it choose differently?\’a0 Unfortunately the PBoC is not as free to manage domestic monetary policy as the Fed was after 1933 because its primary obligation is to manage the foreign exchange value of the currency.\’a0 This means that a crucial aspect of monetary policy in China is determined largely by net inflows or outflows on the trade and capital account.

The PBoC has other tools: most importantly its influence on credit creation (I am skeptical about the usefulness of open market operations) which it can expand partly by reducing the minimum reserve requirement for banks and partly by moral suasion within the banking system, but I am not sure how effective this is likely to be.\’a0 Remember that much of the credit expansion from previous years seems to have migrated off the balance sheets of commercial banks (including into the informal sector) when the PBoC tried to constrain credit growth.\’a0 In my opinion when underlying monetary conditions are consistent with rapid credit expansion there, is little the regulators can do to prevent this from happening.\’a0 At best they can decide whether it happens in the regulated parts of the system or whether it simply migrates to other areas.

The reverse is also likely to be true.\’a0\’a0 Attempts by the PBoC and other policy-makers to force banks to expand credit may result in higher loan growth reported on bank balance sheets, but overall credit growth within the economy is likely to be much less.\’a0 If the underlying money supply is consistent with contracting credit, the system will most likely see contracting credit (and I am saying nothing about the possibility that much of the formal credit expansion reported by the banks will consist of empty lending into future NPLs).

With international trade falling, it is probably only a question of time before China\’92s trade surplus begins to shrink sharply (although a number of commentators who I respect a lot, including Brad Setser, might disagree with me on this), and as I wrote last week there is mounting evidence that some of the hot money that poured into China one year ago is now starting to leave.\’a0 This suggests that China may begin to see rapid contraction of foreign currency holdings and, with it, a contracting domestic money supply.

This may be the biggest unexpected risk China faces.\’a0 We must remember that as long as the main task of monetary policy is to set the value of the RMB in foreign currency\’a0 terms, the PBoC has limited ability to manage the domestic money supply.\’a0 If net outflows are large in 2009, the PBoC may be forced to preside over a monetary contraction, and this would be exacerbated if there were problems in the banking system that caused formal and informal banks to cut lending.\’a0 This would undoubtedly worsen China\’92s difficult economic adjustment to the problem of overcapacity.\’a0 It is vitally important that Chinese policymakers recognize the monetary constraints under which they work and prepare contingency plans.\’a0 China can learn a lot from the mistakes of US policy in the 1930s.

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By the way whenever I say that money outflows could become a problem for China, inevitably someone rushes in to pour scorn on the idea that China is vulnerable to a 1997-style Asian crisis.\’a0\’a0 I agree it isn’t, and I will repeat (again) that this is not and never has been the point of my concern about hot money outflows.\’a0\’a0 China does not have a currency mismatch risk worth bothering about.\’a0 The reason to worry about hot money outflow is that it has a domestic monetary impact.

Tags: Eichengreen

Monetary conditions might exacerbate the Chinese adjustment

January 15, 2009 in Currency regime, Hot money, Informal banks, PBoC by Michael Pettis | 37 comments

I think if I were an economic policymaker in China I would be spending most of my time thinking about the money supply and how it works. There is a small but growing possibility that Chinese monetary conditions are going to go wrong at exactly the wrong time, and policymakers will need to have a well-thought out and vigorous plan to address it if it happens.

It has become pretty clear that the huge amount of hot money that poured into China last year and earlier this year is beginning to reverse itself pretty sharply. According to a PBoC release yesterday, China’s foreign exchange reserves increased to $1.946 trillion at the end of 2008, up from $1.906 trillion at the end of September. Here is what Logan Wright, of Stone & McCarthy, said in a release earlier today:

The Q4 2008 foreign exchange reserve data, released yesterday, indicate that China’s six-year liquidity cycle may be coming to an end, triggered by limited expectations of further yuan appreciation alongside a rapid downturn in both the domestic property market and global consumption of Chinese exports. Despite a record-high quarterly trade surplus of $114.3 billion and additional sources of capital inflow, China’s foreign exchange reserves rose by only $40.4 billion in the fourth quarter. This suggests that China saw significant levels of capital outflows during the fourth quarter, which we estimate totaled around $120-140 billion. Valuation adjustments may explain the decline in headline reserve levels in October (by $25.9 billion), but they cannot explain the entirety of the slowdown in reserve growth during the fourth quarter.
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It has become harder than ever to figure out exactly what is going on with central bank reserves \’96 and of course just when we need clarity most \’96 so there is a lot of variation in all of our estimates about the different components of the adjustments in reserves, but Logan is one of the most careful of the PBoC watchers and his estimates on hot money outflow fall into line with my own and most of the other credible estimates I have seen. For example Mark Williams of Capital Economics said in a release yesterday that \’93hot outflows may have amounted to well over $100bn last quarter, equivalent to around 8% of Q4 GDP,\’94 and Stephen Green at Standard Chartered said in another release yesterday that he calculated the \’93unexplained\’94 amount of reserve changes to be about $110 billion, although at least part of that may be accounted for by a lag in trade payments.

Remember that there are two reasons for hot money to leave China \’96 one on which most of us have focused, and another, which may be more important but which hasn\’92t received the attention it deserves. The first is the expected excess return for bringing money into China or taking it out \’96 basically the RMB deposit rate plus the expected appreciation of the RMB less the equivalent US dollar deposit rate. When there were tremendous expectations for RMB appreciation, money poured into China, and now that those expectations are evaporating, or even going negative (i.e. there is some concern that the RMB may depreciate), it is likely to leave.

The second reason for hot money flows, not as widely discussed but at least as important, is the perception of risk, especially of the financial system. Remember that whether any given level of expected appreciation results in outflows or inflows depends also on the expected risk. As risk rises, it will take a lager expected return to encourage inflows. As China\’92s economy contracts, and as local businesses become increasingly worried about the potential for the current crisis to lead to deeper problems, including problems with the banking system, there is an increasing incentive for wealthy Chinese businessmen to take money put of the country.

For much of 2007 and early 2008 I argued that Chinese monetary policy had locked the country into a dangerously pro-cyclical trap, and unless the PBoC engineered a one-off revaluation that would stop hot money inflows, there was a real risk of incurring destabilizing capital inflows and outflows. When things were going well and the country\’92s economy was booming, hot money would pour into the country, unleashing a credit bubble and exacerbating the problem of overheating and overcapacity.

Once conditions turned around, however, I worried that hot money outflows would have exactly the opposite impact, causing a contraction in the money supply that would lead to credit contraction and an even sharper economic slowdown. This is always the great danger of hot money \’96 when things are going well it pushes the economy into overheating, while squeezing the economy just as things start to get bad.

Needless to say, the PBoC did not revalue the RMB or otherwise move quickly enough to control the torrent of hot money inflow, and now they may be forced to deal with the accompanying but opposite problem. As conditions deteriorate, hot money outflows will become a real monetary drag.

This is not to say that these outflows are creating a problem for China right now. On the contrary, with outflows more or less matching current account and FDI inflows, the net impact is that for the first time in several years the PBoC finally has some apparent control over domestic monetary policy.

What worries me and some of my other PBoC-watching friends is the implication of this reversal on future monetary conditions in China. The outflows are almost certainly likely to cause contraction in credit \’96 especially in the informal banking sector, where much of the hot money inflow may have hidden \’96 and one can make a very plausible argument that outflows, and the attendant credit contraction, may exacerbate the slowdown in the economy.

If it does, and in so doing increases the perception of riskiness in China, it may create further strong incentives for local business owners to take money out of the country. China, in other words, has locked itself into a highly pro-cyclical monetary policy, and one of the key points to remember about highly pro-cyclical systems is that it is very hard to predict exactly where they are going, but it is a pretty safe to predict that whatever they do they will go to extremes (as if to confirm my worry about exacerbating tendencies, I see that China\’92s National Bureau of Statistics has just revised upward China\’92s sizzling 2007 growth rate of 11.9% to 13.0%).

To extend this a little further, it is worth remembering that there were at least three important factors that caused the severity of the Great Depression in the US. First, the US had to deal with a substantial industrial overcapacity problem just as the European countries that absorbed US overcapacity by running trade deficits with the US saw the financing of these deficits interrupted. I have written about this several times in the past few weeks so I won\’92t discuss it further.

Second, the US did not expand fiscally nearly enough to counteract the decline in domestic and foreign demand for US production. I know that this is a controversial point and I don\’92t want to get into a debate about the efficacy of fiscal expansion, but as I see it the US would have been better off if the government had followed Keynes\’92 advice and expanded more quickly. Third, the US experienced a severe monetary contraction as some banks either collapsed, others sharply contracted their lending, and depositors and businesses hoarded cash. The Fed should have accommodated this contraction by relaxing monetary conditions but failed to do so. According to Milton Friedman this may have been the single biggest cause of the severity of the contraction.

So where does that leave China? The overcapacity adjustment in China may be much larger than the one faced by the US \’96 with 40% of global GDP the US had to absorb a trade surplus of roughly the same magnitude as China, which accounts for only 7% of global GDP. On the fiscal side I think China will definitely expand much more aggressively than the US did in the 1930s (how could it not?) but of course there are real questions about how much real expansion there is, how it is going to be financed, and how much of it will simply be wasted or turn into NPLs. Most importantly, can China expand enough to make up for the contraction in US and European demand (the two economies are more than six times the size of China)?

The US experience in the Great Depression suggests that among the things we should be most worried about in China is underlying monetary conditions. If hot money outflows accelerate and, as is likely to happen, the trade and FDI surpluses drop sharply, we could start to see some large monthly net outflows, and it shouldn\’92t come as a surprise if large outflows increase the perception of risk and so encourage further large outflows. Remember that outflows mean dollars sold by the PBoC in exchange for RMB, which represents a contraction in the base money supply. If China is forced to experience a sharp monetary contraction on top of its economic adjustment, things could easily get out of hand.

A sharp monetary contraction, as I see it, basically means a sharp contraction in credit. Could we see this, and can the PBoC take steps to counteract it? Here is what the South China Morning Post had to say in an article two days ago

Yuan-denominated loans granted by mainland banks grew a robust 19 per cent last month from a year earlier, suggesting lenders are heeding Beijing’s calls to stimulate the economy. Mainland banks extended 740 billion yuan (HK$839.31 billion) in loans in December, the biggest monthly rise since January last year, the Shanghai Securities News reported yesterday.

The new loans started to rise from about 300 billion yuan monthly in most of last year to 476.9 billion yuan in November when the central government unveiled a 4 trillion yuan fiscal stimulus package and encouraged banks to help funding the toll road, railway, port and other projects under the scheme. \’93Bank lending has been a key indicator. It’s crucial to China’s economy-boosting efforts. The December figure shows the needed credit expansion is on the way,\’94 said Peng Wensheng, an economist with Barclays Capital Research.

I am not sure I agree with Peng Wensheng. We are not seeing credit expansion so much as a growth in RMB-denominated loans in the formal banking system. Perhaps this is a good proxy for credit in China, but I suspect it isn\’92t. First, much of the growth has come in the form of a sharp increase in bill discounting, and I am not sure whether this might not include a lot of double counting. I have also heard whispers that companies are turning to short-term credit not for investment purposes but rather because of serious cashflow problems. If so, this might be the worst sort of credit expansion.

And second, it is not clear what is happening to off-balance sheet transactions \’96 which may be in the process of being shifted back on balance sheets to meet credit targets with no real expansion in credit \’96 or, more importantly, to the informal banking sector. The anecdotal evidence is that the latter is contracting sharply, which is consistent with the idea of hot money outflows.

Whether credit is indeed expanding or in fact contracting is, to me, still an open question, and I would argue that circumstantial evidence \’96 the collapse in inflation, the open disgruntlement among banks about pressure to meet credit expansion targets, hot money outflows \’96 suggest that it is contracting.

Frankly I am not sure where all of these musings lead, and I need to do a lot more thinking about the subject, but I worry that for reasons beyond the PBoC\’92s control we may see a much sharper monetary contraction in China than expected, especially if hot money outflows increase, and this could seriously exacerbate the downturn just as it did in the US in the 1930s. Can the PBoC accommodate this by relaxing? I don\’92t think so. Remember that I have argued for years that the PBoC has little to no real control over domestic monetary conditions as long as it retains the straitjacket of the currency regime. It should have gotten out years ago, or at least reduced the strength of its pro-cyclical impact by revaluing sharply before hot money flooded into the economy, but I am not sure it can easily adjust in the midst of a crisis. Perhaps they should anyway consider what the impact would be of either loosening the band considerably, or even floating.

Is China experiencing dollar outflows?

December 3, 2008 in Currency regime, Hot money, Trade protection by Michael Pettis | 19 comments

The government was actively buying stocks today and as a result, not surprisingly, the market surged on hopes that they are serious about putting an end to the bear market. After declining yesterday by 0.3%, the SSE Composite jumped 76 points today to close the day at its high of 1965, up 4.0%. Central Huijin, a subsidiary of the CIC, increased its stake in China Construction Bank, as it said it would do last September. If this is sustained, it may help relieve a little of the gloom, but it is not clear to me that the rally has stronger legs than previous government-inspired rallies.
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More interestingly, the dollar market today was acting strangely. Since late yesterday there have been no bid-offers on dollars, until the PBoC came in late in the day to sell dollars (the PBoC is normally a buyer of dollars). This suggests that capital outflows, at least for this week, have outpaced current account inflows, although we don\’92t want to read too much into this as of yet. January\’92s 4th Quarter PBoC numbers should prove very interesting as we wade through the increasingly difficult-to-interpret numbers to estimate hot money behavior.
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As far as I can piece together today\’92s currency-market activity from conversations with some of my former students, now trading, and my friend Logan Wright, at Stone & McCarthy, the market has been very short of dollars in recent days as corporations over the past three days have been net buyers from banks. Since banks are not allowed to be net short, there were rumors that they had reached their dollar limits yesterday and were refusing to post prices for fear of being lifted.
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Why have corporations been buying dollars? Part of the reason seems to be the NDFs in Singapore are pricing in a depreciation of the RMB, and corporations who can get around the capital control rules are finding it profitable to buy dollars in China and sell them in the NDF market. This is a great arbitrage if you can do it. But part of it may simply reflect the fact that talk of currency depreciation has increased in recent weeks, and until today the RMB has been depreciating. Today the central parity appreciated by 0.0025 to 6.8501, although the RMB closed the day at the weak end of the 0.5% band.
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It is not irrelevant that Secretary Paulson will be here tomorrow for two days as part of the Strategic Economic Dialogue. His call for a stronger RMB yesterday signals that the currency is still likely to be at the heart of the debate. There has been more and more talk over the past few days about the possibility of RMB depreciation, and of course President Hu\’92s comments on Sunday about China losing its competitive edge strengthened the talk, but until there has been no real reason to think that there has been a policy shift.
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Still, the possibility that pro-depreciation constituencies in China may yet gain the upper hand in the debate is very worrying. At first depreciation might seem like an obvious policy move \’96 if export growth is slowing, and if unemployment pressures are rising, why not engineer demand expansion by increasing foreign demand for Chinese goods? After all, the outlook is increasingly grim. A \’93Blue Paper\’94 by the prestigious Chinese academy of Social Science forecast GDP growth for next year at 9.3% \’96 insanely optimistic, I think \’96 but they did list some of the problems facing China. According to today\’92s Xinhua:
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The Blue Paper also notes that housing prices will fall dramatically in a short period of time, and subsequently enter a rather long adjustment period in 2009. Economists from CASS believe the real estate industry will be bogged down throughout 2009 as demand weakens under high prices and the global financial crisis. Homebuyers and investors will be more prudent in their activities. Suppliers will also experience a chilly season next year as some small and medium-sized enterprises with limited capital are forced to leave the market.

Risks will increase as some homebuyers become unable to pay their mortgages and some builders will not be able to pay workers to complete projects. On the country’s employment front, the Paper adds that one million college graduates will be unable to find jobs by the end of 2008, a problem that will be exacerbated when more people may lose their jobs in 2009 as more than five million new graduates begin seeking employment the same year.

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But remember that Chinese overcapacity is part of the global problem, and as interesting as they may seem at first, capacity-boosting measures only make the global imbalance worse. Yesterday Vice Premier Wang Qing made a speech on the subject in which he both called for consumption enhancing moves as well as export-enhancing moves. An article in Xinhua reported:
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Chinese Vice Premier Wang Qishan has called for more concrete measures to tap China’s domestic consumption potential to sustain economic growth. External demand for Chinese goods has fallen markedly amid the global financial crisis, while domestic consumption power also fell, Wang told recent meetings on foreign and domestic trade.

\’85The vice premier urged a reduction of burdens for businesses, help for them in getting finance and promotion of mergers and acquisitions. He also called for more measures to optimize the export structure and explore new markets to offset the negative impact on the export sector of the global economic slowdown

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That last paragraph worries me if it indicates the direction of policy. I really do believe that we are on the brink of a very ugly period for trade relations, and anyone in China who thinks that trade conflicts will not be devastating for China does not understand China\’92s role within the global balance of payments. This is not the time to try to strengthen exports at the expense of trading partners without a significantly larger increase in imports.
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On that note, the EU Observer had the following piece earlier this week:
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EU-China relations usually revolve around trade, with the EU buying \’80231 billion worth of goods from China last year and exporting \’8072 billion in return. But human rights concerns came to the fore during the Beijing Olympics, when scores of EU leaders stayed away from the opening ceremony after Chinese troops shot Tibetan protestors.

China is also unhappy that the EU continues to uphold an arms export embargo dating back to the 1989 Tiananmen square massacre. The latest summit and death penalty row could play into the hands of European leaders keen to restrict the flow of Chinese imports during the EU’s economic downturn, experts warn.

\’93Protectionist sentiment toward China in Europe has been growing for a while,\’94 Center for European Reform analyst Katinka Barysch wrote in the Wall Street Journal. \’93Anti-China sentiment is on the rise in Germany …Even in traditionally liberal Britain, people who see China as an economic threat outnumber those who see it as an opportunity by four to one.\’92

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The meetings between the Dalai Lama and European leaders is once again inflaming passions both in China and in Europe, and this is not the kind of atmosphere in which trade disputes are easy to resolve. There is (yet again) a movement afoot in China to boycott French goods, but I am not sure countries running large current account surpluses should be talking about boycotting countries who are running deficits with them.
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This kind of talk can easily backfire. An interruption of the trade relationship between the two countries is actually likely at the macro level to be good for France in the short term (or, in what amounts to the same thing, it is easy enough politically to make the argument), and bad for China in both the short and long term. Remember, for France any interruption of international trade means they need to increase production to meet domestic demand. That means hiring workers. For China it means reducing its ability to export overcapacity, and this usually means closing down factories. I know, I know, France is not necessarily likely to produce at home what China sells, but in this world, finding a new supplier is a lot easier than finding a new customer.
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At any rate this evening rumors have been swirling through the markets that November’s exports have declined year on year by 7%. One of my former students, now a currency trader in Shanghai, just told me this. I have no idea if it is true, but it gives a sense of how nervous markets are.

Tags: Dalai Lama, USD/CNY

China isn’t losing its competitive edge

December 1, 2008 in Consumption and production, Currency regime, Policy, Trade protection by Michael Pettis | 12 comments

The stock market had a decent day today, with the SSE Composite rising 1.25% to close at 1895. Bad news about manufacturing was overshadowed by an announcement that the government will expand a plan to subsidize household appliance purchases by farmers. That helped appliance manufacturers, who led the market up. I suspect that we will see an increasingly worried government propose more of these consumption-boosting measures, although for now there is not enough information to gauge how effective these will be.
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The release of the proposal to boost consumption by helping farmers buy appliances came on the back of a string of related proposals by government officials. According to Friday\’92s South China Morning Post:
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Zhang Ping, the director of the National Development and Reform Commission, yesterday gave a bleak outlook for the world’s fourth-biggest economy, a day after the central bank cut interest rates by the biggest margin in 11 years. \’94The global financial crisis has not bottomed out yet and the impact is deepening in China,\’94 Mr Zhang told a briefing. \’93Some domestic economic indicators point to an accelerated slowdown in November.\’94

The government might cut interest rates and lower banks’ reserve requirements further, National Bureau of Statistics officials, led by spokesman Li Xiaochao, wrote on the Ministry of Finance’s website. The government might also raise the threshold for personal income taxes to exempt more people and further stabilise the yuan, the officials said.

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Any such measure is good news, although as I have written often in earlier posts, the sheer size of the global adjustment will make it very difficult for China to create sufficient domestic expansion. Meanwhile news from the manufacturers continues to get grimmer. Today two separate Purchasing Managers\’92 Index numbers were released, one by the China Federation of Logistics and Purchasing (the \’93official\’94 one) and one by CLSA. Both of them showed record contractions in export orders, output and new orders, suggesting that manufacturing is contacting at a faster pace than most expected. On a slightly more positive note, Dong Tao of Credit Suisse thinks we \’93may be getting close to a bottom in this cycle, cushioned by orders from government projects and the near ending of inventory de-stocking.\’94
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The most interesting news recently, however, was related to a speech President Hu made yesterday at the weekend\’92s Politburo meeting. According to today\’92s People\’92s Daily, besides warning \’93that the global financial turmoil will make it harder for China to maintain the pace of its economic development in the near future\’94, he said, in a widely noted comment, that \’93with the spread of the global financial crisis, China is losing its competitive edge in the world market as international demand is reduced.\’94
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What exactly does this mean? It is worth noting that this has come in the context of recent RMB weakness. According to a Bloomberg piece today, \’93China\’92s yuan fell by the most in seven weeks, three days before U.S. Treasury Secretary Henry Paulson visits Beijing for trade talks, on speculation the central bank wants to weaken the currency to spur the economy.\’94 Meanwhile calls for depreciation of the RMB are getting more common, and more and more commentators are beginning to wonder if we might not see a conscious strategy of RMB depreciation.
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Several people have pointed out that even with the RMB\’92s weakness against the dollar, the surge in the dollar against the euro has meant that the RMB has strengthened on a trade-weighted basis. This may be true, but it seems to me that the meaningful exchange rate is the dollar/RMB rate (most of Asia is effectively dollar bloc), and the dollar/euro exchange rate does little more than determine how the trade deficit shifts between the US and Europe.
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So to get back to President Hu, what exactly does it mean that China is losing its competitive edge? China has better infrastructure than most developing countries, and it has never been strong in technological or management innovation, and its financial system has always been poor at allocating capital, so which \’93edge\’94 is China losing? If this means that labor costs are getting too high, this comment is worrying because actually I think rising wages are necessary to China\’92s long-term adjustment (whether they will have the much-needed short-term effect in increasing consumption is doubtful). I hope this isn\’92t a prelude to constraining wage increases.
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But I think the biggest worry is that this may be a hint that the RMB has appreciated too much. The one thing that China absolutely cannot afford to do, in my opinion, is to fix its \’93competitive edge\’94 by lowering comparative costs via RMB depreciation. Maureen Fan of the Washington Post asked me last night what I thought of this comment, and my response was:
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Chinese exports aren’t being priced out of the market. The problem is a contraction in global demand, and all export economies are going to lose sales. If China tries to \’93regain\’94 competitive edge by subsidizing exports \’96 for example, by depreciating the currency \’96 that could make global conditions worse by increasing overcapacity, when what we really need is to increase global demand.

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I have written about this a lot in previous postings, so I won\’92t rehash all my arguments, but the problem China is facing is not that its exports are less competitive but rather that the US economy has to shift towards higher household savings, and the inevitable corollary is a significant reduction in household consumption. This means that the US imports must decline (and European imports are likely to decline too, by the way), or to put it another way, that foreign exports to the US (and Europe) must decline. If China tries to maintain its export growth in the face of contracting global demand, it inevitably means that someone else must bear more than 100% of the full cost of the necessary adjustment, and I find it hard to believe that other countries, especially net importing countries, will accept this with much good grace.
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Currency depreciation \’96 even failure to continue appreciating the currency \’96 along with any other export-boosting measures, will almost certainly lead to a significant rise in trade tensions, and as I have argued many times before, a trade war will hurt current-account surplus countries far more than it will hurt deficit countries. In fact as I see it (and will write in a future entry) this crisis will come in two stages. In the first stage, countries with excess debt-fueled consumption get hit, and as a consequence they are forced to cut consumption and raise savings.
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In the second stage, countries with excess debt-fueled production get hit as they fail to accommodate their excess production to the cut in global consumption. Countries like China should be wary about production-boosting measures (Smoot-Hawley-with-Chinese-characteristics, I call them) and should focus largely on consumption-boosting measures. The more they do, the less the chance of international trade constraint and the faster they get through the crisis \’96 but make no mistake, this will not be an easy process no matter what they do.

Tags: Competitive edge

« Older entries

Currency regime

Can the RMB be more undervalued today than it was last year?

Is Governor Zhou a closet Bernanke-ite?

The dollar must be replaced \’96 yet again

Banker? Or Grocer?

Trade, CPI and other numbers came in this week

Should China Devalue the Yuan?

There are monetary echoes from the 1930s too

Monetary conditions might exacerbate the Chinese adjustment

Is China experiencing dollar outflows?

China isn’t losing its competitive edge

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