China-US Currency Issues
Appendices
Jeffrey Frankel
Harpel Professor of Capital Formation & Growth
Chinese Leaders in Development Program
Ash Center, June 8, 2012
Appendices
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•
•
•
•
•
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I: What is in China’s interest?
II: Internal balance and external balance
III: What is in the global interest?
IV: Possible inadvertent effects of US pressure
V: Is the US Current account sustainable?
VI: Econometrics of the exchange rate
VII: What determines US Treasury findings
regarding “currency manipulation”?
Appendix I: From China’s viewpoint,
• Countries should have the right to fix
their exchange rate if they want to.
• True, the IMF Articles of Agreement
and the US Omnibus Trade Act of 1988
call for action in the event that a country
is “unfairly manipulating its currency”.
• But
– Almost no countries have been forced to appreciate.
– Pressure on surplus countries to appreciate will inevitably
be less than pressure on deficit countries to depreciate.
– It is time to retire the language of “manipulation.”
• Usually, it is hard to say when a currency is undervalued.
• Don’t cheapen the language that is appropriate to WTO rules.
3
• China should do what is in its own long-term interest.
Five reasons for China to let RMB appreciate,
in its own interest, during 2004-2011
1. Overheating of economy, esp. 2007-08, 2010
2. Reserves are excessive.
– It gets harder to sterilize the inflow over time.
3. Attaining internal and external balance.
– To attain both, need 2 policy instruments.
– In a large country like China,
expenditure-switching policy should be the exchange rate.
4. Avoiding future crashes.
5. RMB undervalued, judged by
Balassa-Samuelson relationship.
4
1. Overheating of economy:
• Bottlenecks.
Pace of economic growth is outrunning:
– raw material supplies, and
– labor supply in coastal provinces
– Also:
– physical infrastructure
– environmental capacity
– level of sophistication of financial system.
• Asset bubbles.
– Shanghai stock market bubble in 2007.
• Inflation 6-7% in 2007
=> price controls => shortages & social unrest.
• All of the above was suspended in late 2008,
– due to global recession.
– But back again in 2011; skyrocketing real estate prices.
5
Attempts at “sterilization,” to insulate
domestic economy from the inflows
• Sterilization is defined as offsetting
of international reserve inflows,
so as to prevent them from showing up
domestically as excessive money growth & inflation.
• For awhile PBoC successfully sterilized…
– until 2007-08.
– The usual limitations finally showed up:
•
•
•
•
Prolongation of capital inflows <= self-equilibrating mechanism shut off.
Quasi-fiscal deficit: gap between domestic interest rates & US T bill rate
Failure to sterilize: money supply rising faster than income
6
Rising inflation (admittedly due not only to rising money supply)
2. Foreign Exchange Reserves
•
Excessive:
– Though a useful shield against currency crises,
– China has enough reserves: $3 by 2011;
– & US treasury securities do not pay high returns.
•
Harder to sterilize
the inflow over time.
7
The Balance of Payments
≡ rate of change of foreign exchange reserves (largely $),
rose rapidly in China from 2004 on, due to all 3 components:
trade balance, Foreign Direct Investment, and portfolio inflows
Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008
8
FX reserves of the PBoC climbed
higher than any central bank in history
http://viableopposition.blogspot.com/2012/03/chinas-holdings-of-us-treasuries-what.html
Sterilization of foreign reserves:
People’s Bank of China sells sterilization bonds
Data: CEIC
Source: Zhang, 2011, Fig.4, p.45.
Sterilization of foreign reserves:
Decreases in PBoC’s domestic assets
thus offset increases in foreign assets
Source: Zhang, 2011, Fig.7, p.47.
Further, the PBoC has raised
banks’ required reserve ratios
Source: Zhang, 2011, Fig.6, p.46.
China’s
tightening of
banks’ lending
rates & reserve
requirements
helped head off
rising inflation
in 2004, 08, and
again in 2011.
Fxtimes.com
Chinese inflation eased off in 200809, but rose again through mid-2011
Chinese inflation, once again,
began to ease off after mid-2011
3. Need a flexible exchange rate to
attain internal & external balance
• Internal balance ≡
demand neither too low (recession) nor too high (overheating).
• External balance ≡ appropriate balance of payments.
• General principle: to attain both policy targets,
a country needs to use 2 policy instruments.
• For a country as large as China, one of those policy
instruments should be the exchange rate.
• To reduce BoP surplus without causing higher unemployment,
China needs both
– currency appreciation, and
– expansion of domestic demand
• gradually replacing foreign demand,
• developing neglected sectors:
health, education, environment, housing, finance, & services.
16
4. Avoiding future crashes
Experience of other emerging markets
suggests it is better to exit from a peg in
good times, when the BoP is strong, than
to wait until the currency is under attack.
Introducing some flexibility
now, even though not ready
for free floating.
17
5. Longer-run perspective:
Balassa-Samuelson relationship
• Prices of goods & services in China are low
– compared at the nominal exchange rate.
– Of course they are a fraction of those in the U.S.: < ¼ .
– This is to be expected:
explained by the Balassa-Samuelson effect,
• which says that low-income countries have lower price levels.
• As countries’ real income grows, their currencies experience real
appreciation: approx. .3% for every 1 % in income per capita.
– But China has been one of those countries that is cheap or
undervalued even taking into account Balassa-Samuelson.
18
1
The Balassa-Samuelson Relationship
-1
-.5
0
.5
2005
-3
-2
-1
0
1
Log of Real Per capita GDP (PPP)
2
coef = .23367193, (robust) se = .01978263, t = 11.81
Source: Arvind Subramanian, April 2010,
“New PPP-Based Estimates of Renminbi Undervaluationand Policy Implications,” PB10-08, Peterson Institute for International Economics
Undervaluation of RMB in the regression estimated above = 26%.
Estimated undervaluation averaging across four such estimates = 31%.
Compare to estimate for 2000 (Frankel 2005) = 36%.
As recently as 2009 (Chang 2012): 25% .
19
Appendix II: Internal & external balance
• Between 2002 and 2007, China crossed from the deflationary
side of internal balance (ES: excess supply, recession,
unemployment), to the inflationary side (ED: excess demand
side, overheating). And again in 2009.
– =>Moved upward in the “Swan Diagram”
– => appreciation called for under current conditions.
– Together with expansion of domestic demand
• gradually replacing foreign demand,
• developing neglected sectors:
health, education, environment, housing, finance, services
• General principle: to attain 2 policy targets
(internal & external balance), a country
needs to use 2 policy instruments
(real exchange rate & spending).
20
In 2008 & 2010, China was in the
overheating + surplus quadrant of the
Swan Diagram
ED & TB>0
Excgange rate E
in RMB/$
BB:
External balance
CA=0
China
2010
ES & TB>0
ED & TD
China
2002
ES & TD
Spending A
YY:
Internal balance
Y = Potential
21
Appendix III:
What is in the global interest?
Restoring growth, and
Resolving current account imbalances,
• in particular, the US CA deficit
• & China’s surplus,
• though China’s surpluses
have narrowed since 2008.
22
22
Current account imbalances are smaller
than in 2007, esp. China’s
Gavyn Davies, FTblog, May 27 2012
Dangers of the longstanding U.S. trade deficit
• Shorter-term dangers:
– Protectionist legislation
– A possible hard landing for the $.
• Long-term dangers:
– Dependence on foreign investors
– US net debt to RoW ≈ $3 trillion,
• and rising.
• Will lower our children’s standard of living.
– When the US cuts its deficit,
that will mean the rest of
the world losing its surplus
• The longer adjustment is postponed, the harder it will be.
24
Policies to reduce the US CA deficit
• Reduce the US budget deficit over time,
– thus raising national saving.
– After all, this is where the deficits originated.
• Depreciate the $ more.
– Better to do it in a controlled way
• than in a sudden free-fall.
– The $ already depreciated a lot against the €
• & other currencies
• from 2002 to 2007.
– Who is left?
– The RMB is conspicuous as the one major currency
that is still undervalued against the dollar.
25
Appendix IV: Possible inadvertent
effects of US pressure on China
• It has never worked well for the US to make
a dozen different demands on China,
– IPR, human rights, help on N.Korea, Iran…
– when we only have one carrot /stick:
• keeping our markets open.
• As the world’s largest debtor, with China our primary creditor,
the US ability to make demands is diminished.
• There is a particular tension between hoping China
will continue to buy our Treasury bills,
and asking it to stop buying our Treasury bills
– i.e., to stop selling RMB / buying $ ,
• which is what keeps its currency from rising.
26
Be careful what you wish for. You might get it !
$2½
27
If China gave US politicians
what they say they want...
• we might regret it.
– if it included reserve shift out of T bills,
to match switch in basket weights from $.
– we could have a hard landing for the $
– including a sharp fall of US securities prices.
• Skeptics argue China will not sell T bills
– because, as the largest holder,
it would be the biggest loser when the $ depreciated.
• Financial market fears that China might stop buying
US T bills could send the $ down in themselves.
• If the $ is falling, China will not want
to be the only one left “holding the bag.”
28
If China gave US politicians
what they say they want...
• For US output & employment to rise,
– we would first need other Asian
currencies to appreciate along with RMB.
• Otherwise, fall in US bilateral trade deficit
with China would be offset by rise in US bilateral deficit
with other cheap-labor countries.
– It also depends on excess capacity in US economy
• as 2008-2012…
• and no crowding out of domestic demand via higher interest rates.
29
Central banks’ reserve holdings
The $ share has been on a downward trend since 2000
(also during 1976-1991).
80
USD share
75
USD + 0.6 Unalloc.
share (COFER)
70
65
60
55
50
45
65
70
75
80
85
90
95
00
05
10
30
The global monetary system
may move from dollar-based
to multiple international reserve currencies
•
The € could challenge the $.
•
The SDR is again part of the system.
•
Gold in 2009 made a comeback
as an international reserve too.
•
Someday the RMB will
join the roster with ¥ & ₤.
•
31
= a multiple international reserve asset system.
Another possible consequence
if China allows the exchange rate
to become more flexible & market-determined
• the RMB could depreciate rather than appreciate,
– in response to a slowdown in Chinese growth
• especially if:
– it were the result of an increase in world oil prices
– or were associated with a financial crisis
» stemming from real estate or bad bank loans.
Especially now that the quarterly
overall balance of payments
(fx reserve changes) is no longer >> 0
Another possible consequence,
continued
• Indeed, the RMB depreciated in May 2012
Increased flexibility,
continued
• “On 14 April, 2012, the Chinese central bank announced
that the band of RMB’s trading prices against the US
dollar in the inter-bank spot foreign exchange market is
enlarged from ±0.5 per cent to ±1 per cent on each
business day. The main purpose was probably to
increase the perceived risk of the speculators and
thereby decrease ‘hot money’ movements. This enlarged
range has, however, not been utilised so far. The largest
changes have been of the order of 0.2 per cent.”
“Re-pegging the renminbi to a basket: issues and implications” in Asian-Pacific Economic Literature (APEL), May 2012.
Heikki Oksanen, University of Helsinki. http://onlinelibrary.wiley.com/doi/10.1111/apel.2012.26.issue-1/issuetoc .
35
Prices on Non-Deliverable Forwards
showing post-2003 speculation on RMB appreciation
7.6
7.8
8
8.2
8.4
Spot and Forward Rates of USD/RMB
04/07/03 10/15/03
12/31/04 07/22/05
01/08/07
date
spot
3-month
1-month
12-month
36
• Appendix V:
Is the US Current Account
sustainable?
37
Economists were (are) split between
those who saw the US deficit as
unsustainable, requiring a $ fall,
•
•
•
•
•
•
•
•
Ken Rogoff *
Maury Obstfeld
Larry Summers
Martin Feldstein
Nouriel Roubini
Menzie Chinn
Me
Lots more
and those who saw
(see) no problem.
•
•
•
•
•
Ben Bernanke
Ricardo Caballero *
Richard Cooper
Michael Dooley
Pierre-Olivier
Gourinchas
• Alan Greenspan
• Ricardo Hausmann
• Lots more
38
* Some claim that the financial crisis of 2007-09 fits their theories.
38
The events of 2007-09 struck major
blows against both interpretations of CA.
• Most of us in the unsustainability camp would have
predicted that something like the US sub-prime
mortgage crisis would cause a big fall in the $.
– Instead , the $ strengthened.
• Most of those in the sustainability camp had been
arguing that the US has uniquely superior assets
(corporate governance, securities markets, bank regulation…)
– Instead, the crisis showed the US system to suffer serious
flaws
• of crony capitalism like other countries (Simon Johnson, Ragu Rajan)
• or – worse – excessive deregulation (Joe Stiglitz…)
• The answer, for the moment: The $ & US Treasury bills
39
still play unique roles in the world monetary system.
Critics of the twin deficits view say that the
US current account deficit is sustainable.
1.
2.
3.
4.
5.
Global savings glut (Bernanke)
It’s a big world (R. Cooper; Al Greenspan..)
Valuation effects will pay for it (Gourinchas)
US as the World’s Banker (Kindleberger…)
The US offers superior-quality assets
(Caballero, Forbes, Quadrini & Rios-Rull, Wei & Wu …)
6. “Dark Matter” (Hausmann & Sturzenegger)
7. Bretton Woods II
(Dooley, Folkerts-Landau & Garber)
40
Exorbitant Privilege of $
• Among those who argue that the US
current account deficit is sustainable
are some who believe that the US will
continue to enjoy the unique privilege
of being able to borrow virtually unlimited
amounts in its own currency.
41
When does the “privilege” become “exorbitant?”
•
if it accrues solely because of size & history,
without the US having done anything to earn
the benefit by virtuous policies such as budget
discipline, price stability & a stable exchange rate.
•
Since 1973, the US has racked up $10 trillion
in debt and the $ has experienced a 30% loss
in value compared to other major currencies.
•
It seems unlikely that macroeconomic policy
discipline is what has earned the US its privilege !
42
The “Bretton Woods II”
hypothesis
• Dooley, Folkerts-Landau, & Garber (2003) :
– today’s system is a new Bretton Woods,
• with Asia playing the role that Europe played
in the 1960s—buying up $ to prevent
their own currencies from appreciating.
– More provocatively:
China is piling up dollars
not because of myopic mercantilism,
but as part of an export-led development strategy
that is rational given China’s need to import workable
systems of finance & corporate governance.
43
There is no reason to expect better today:
1) Capital mobility
is much higher now than in the 1960s.
2) The US can no longer necessarily rely
on support of foreign central banks:
• neither on economic grounds
(they are not now, as they were then,
organized into a cooperative framework where
each agrees explicitly to hold $ if the others do),
• nor on political grounds
(China & OPEC are not the staunch allies
the US had in the 1960s).
3) A possible rival currency to the $ exists.
44
My own view on “Bretton Woods II”:
•
•
The 1960s analogy is indeed apt,
but we are closer to 1971 than to 1944 or 1958.
•
Why did the BW system collapse in 1971?
•
The Triffin dilemma could have taken decades
to work itself out.
•
But the Johnson & Nixon
administrations accelerated
the process by fiscal & monetary expansion
(driven by the Vietnam War & Arthur Burns, respectively).
•
These policies produced: declining external balances,
$ devaluation, & the end of Bretton Woods.
45
Appendix VI: Exchange Rate Econometrics
Estimating the weights
• A problem made-to-order for OLS regression.
• Regress % changes in value of RMB against
% changes in values of candidate currencies.
• Δ log RMBt =
c + α Δlog $t + β1Δlog € t
+ β2 Δlog ¥t + …
• The coefficients are the basket weights.
• Can impose α + Σ β j = 1.
F& Wei (2007), Frankel (2009)
46
Does the Balassa-Samuelson
relationship have predictive power?
 Typically across countries, gaps are corrected
halfway, on average, over subsequent decade.
 => 3-4 % real appreciation on average per year,
including effect of further growth differential
.
 Correction could take the form of either inflation or
nominal appreciation, but appreciation is preferable.
47
References
for statistical estimates of RMB undervaluation
• Chang, Gene Hsin, 2008, “Estimation of the Undervaluation of the
Chinese Currency by a Non-linear Model,” Asia-Pacific Journal of
Accounting & Economics Vol.15, No. 1, April, 29-40.
• Chang, Gene H. , 2012, “Theory and Refinement of the EnhancedPPP Model for Estimation Equilibrium Exchange Rates --- with
Estimates for Valuations of Dollar, Yuan and Others”, SSRN
abstract=1998477, Feb. 2.
• Cheung, Yin-wong, Menzie Chinn and Eiji Fuji, 2010, “China’s Current
Account and Exchange Rate,” in China’s Growing Role in World
Trade, Rob Feenstra & Shang-Jin Wei, eds. (U.Chicago Press, 2010).
• Cline, William, and John Williamson, 2008, ‘Estimates of the
Equilibrium Exchange Rate of the Renminbi,” in Debating China's
Exchange Rate Policy, edited by M.Goldstein and N.Lardy (Peterson
Institute for International Economics), 155-165.
• Frankel, Jeffrey, 2005, “On the Renminbi,” CESifo Forum, vol.6, no.3,
Autumn (Ifo Institute for Economic Research, Munich): 16-21.
• Subramanian, Arvind, April 2010, “New PPP-Based Estimates of
Renminbi Undervaluation and Policy Implications,” PB10-08, Peterson
Institute for International Economics.
Appendix VII: Analysis of
the U.S. Treasury’s biannual
Report to Congress on
International Economics and
Exchange Rate Policy
-- Frankel & Wei (2007)
49
Two hypotheses regarding determinants of
US Treasury decisions whether partners
are manipulating currencies:
• (1) Legitimate economic variables
– the partner’s overall current account/GDP,
– Additions to its foreign exchange reserves,
– the real overvaluation of its currency;
vs.
• (2) Variables suggestive of domestic
American political expediency
– the bilateral trade balance,
– US unemployment,
– an election year dummy .
50
Two hypotheses regarding determinants of
US Treasury decisions whether partners
are manipulating currencies:
• (1) Legitimate economic variables
– the partner’s overall current account/GDP,
– its reserve changes,
– the real overvaluation of its currency;
vs.
• (2) Variables suggestive of domestic
American political expediency
– the bilateral trade balance,
– US unemployment,
– an election year dummy .
51
–Those countries named as manipulators, or
given warnings, have always been Asian.
–What political economy determines
Treasury findings?
• Econometric analysis:
• Domestic political variables are
as important as global manipulation criteria.
52
Explaining findings of Treasury Department biannual
Report to Congress on Int. Ec. & Exchange Rate Policy
All countries
Excluding oil exporters
US bilateral TB
-0.92***
0.07
-0.99***
0.15
Partner’s
0.014***
CA/GDP
0.002
Partner’s Real
-0.18***
Exchange Rate 0.03
Change in
0.003
reserves/GDP
0.003
US unemployment
15 Asian economies
0.022**
0.010
0.028**
0.007
-0.23**
0.11
-0.012
0.009
0.08**
0.037
53
*** statistically significant at 99% level
Findings suggest the domestic US variables
affect the Treasury decision
as much as the legitimate global manipulation criteria:
•
•
•
•
weak role for partner reserve accumulation,
very high significance of bilateral balance,
significance of US unemployment, and
significant (borderline) extra effect of
unemployment in election years.
54
Implication
If the IMF were interpreting Article IV, rather
than the Treasury interpreting the 1988 US law,
– the criterion of consistent uni-directional forex
intervention would receive more emphasis,
– and US-specific variables such as the bilateral
trade balance would not appear at all.
55
Some sympathy for the Treasury
• It walks a fine line.
• An additional finding:
Treasury is eager not to single out one
country for unique opprobrium.
– No single country is left exposed on its own.
• the top-ranked country is less likely to be named than
if it had some other country to hide behind, while
• the 2nd- & 3rd-ranked countries are more likely to be
moved up, to give the leader company.
56
Has US pressure pushed the pace
of increased flexibility?
• We (Frankel & Wei, 2007) searched an electronic
database of news reports , recording the number
of US news reports of US officials asking China
to speed up RMB flexibility/revaluation.
(FACTIVA/NewsPlus)
• Two separate time series on the cumulative
numbers of complaints
– from US Treasury and
– from officials of other government agencies
» Esp. the White House, Congress & Fed.
57
Complaints: Treasury & other US
0
5
10
15
20
Time plots of cumulative US Treasury and Non-Treasury Complaints
01 Jul 05
01 Jan 06
01 Jul 06
01 Jan 07
date
cumulative non-treasury report
cumulative treasury report
58
We added # complaints as a regressor
(Table 19)
• No evidence that U.S. official complaints
are associated with RMB appreciation
relative to the currency basket.
• There was evidence that cumulative
complaints were associated with a
reduction in the RMB’s weight on the US $.
59