Lecture 14:
Problems/Applications
of discretionary policymaking
• Targets & instruments revisited
• Practical difficulties of policymaking
• Managing emerging market inflows
• Appreciate or add to reserves?
• If add to reserves, then sterilize?
• Example of China 2003-2012
Targets & instruments revisited
• When we first showed the need to have
as many independent policy instruments as goals,
monetary & fiscal policy were not independent.
• Now, with capital mobility, they have somewhat
independent effects on external balance,
provided that is defined as BP=0 (rather than TB=0).
• The reason: they have opposite effect on capital flows,
because they have opposite effects on interest rates.
• => Even with a fixed exchange rate, the proper
combination of monetary and fiscal policy can
attain internal & external balance at the same time.
ITF-220 - Prof.J.Frankell
●
TD balanced by KA surplus
●
In theory, there exists a precise mix of monetary & fiscal policy
that will hit both internal balance and BP=0.
Practical difficulties of policymaking
Lags: between the change in a policy instrument
and the response in the economy
Uncertainty with regard to:
• the current position of the economy (“baseline”);
• future disturbances (“shocks”);
• the correct model (e.g., multipliers).
Expectations on the part of the public
Political Constraints
Capital inflows to Emerging Markets
rose rapidly 2003-07,
were set back temporarily in global financial crisis of 2008-09
ITF-220 - Prof.J.Frankell
EmergingMarkets.org
Alternative Ways of Managing Capital Inflows
A.
B.
Allow money to flow in
Sterilized intervention
(can be inflationary)
(can be difficult)
C.
D.
Allow currency to appreciate (lose competitiveness)
Reimpose capital controls
(can impede efficiency)
ITF-220 - Prof.J.Frankell
EM Exchange Market Pressure resumed in 2010
In Latin America, renewed inflows
were reflected mostly as reserve accumulation in Peru,
but as appreciation in Chile & Colombia.
more-managed floating
less-managed floating
Source: GS Global ECS Research
In Asia, Korea & Singapore in 2010 took inflows
mostly in the form of reserves,
while India & Malaysia took them mostly
in the form of currency appreciation.
more-managed floating
less-managed floating
GS Global ECS Research
When EM countries intervene
to prevent appreciation, do they sterilize?
Attempts at sterilization where emerging
markets have faced large inflows:
• In early 1990s, Colombia, Korea, Indonesia and
others tried for a year or two and then gave it up.
• In the past decade, China successfully sterilized for
quite awhile, starting in 2003.
ITF-220 - Prof.J.Frankell
Recall recent example of sterilization
against money inflows: China, 2003-2010
ITF-220 - Prof.J.Frankell
China has mostly taken the BoP surplus as fx reserves.
But it also allowed RMB appreciation (2005-08 & 2011-12).
ITF220 - Professor J.Frankel
Sterilization
foreignreserves
reserves:
Sterilization
ofofforeign
Decreases in PBoC’s domestic assets
offset increases in foreign assets
Source: Zhang, 2011,
Fig.7, p.47.
Also China raised required reserve ratio for banks
Source: Zhang, 2011, Fig.6, p.46.
ITF-220 - Prof.J.Frankell
In 2007-08 China had more trouble
sterilizing the reserve inflow
• PBoC began to have to pay higher domestic interest rates
– and to receive lower interest rate on US T bills
– => “quasi-fiscal deficit” or “negative carry” for central bank.
• Inflation became a serious problem in 2007-08.
– True, global increases in food & energy prices
were much of the explanation.
– But
• Appreciation is a good way to put immediate downward
pressure on local prices of agricultural & mineral commodities.
• Price controls are inefficient and ultimately ineffective.
ITF-220 - Prof.J.Frankell
China tightened
banks’ reserve
requirements &
lending rates.
By 2007, no longer
could hold off
overheating.
But the 2008-09
recession did it instead.
By 2010-11,
inflation was again
accelerating.
Fxtimes.com
China’s housing prices took off again in 2013.
Rate of increase of housing prices
in 4 major Chinese cities (year-on-year)
Source: Gwynn Guilford — Sept. 6, 2013
16
End of Lecture 15:
Problems/Applications
of discretionary policymaking
Appendix 1: Examples of sterilization of inflows,
from the early-1990s
(1) Central bank sells sterilization bonds during period of sterilization
ITF-220 - Prof.J.Frankell
Examples of sterilization of inflows, early-1990s
(2) Interest rates are high during period of sterilization, fall thereafter.
ITF-220 - Prof.J.Frankell
Examples of sterilization of inflows, early-1990s
(3) Reserves rise rapidly during sterilization period; slow down thereafter
ITF-220 - Prof.J.Frankell
Appendix 2: Five reasons China warranted a more
flexible exchange rate regime, in its own interest
• Overheating of economy in 2007-08: …=> appreciation
– Wasn’t relevant in 2009 slowdown. But was again in 2010-12.
• Excessive reserves ($3 ½ trillion as of 2014)
– Though a useful shield against currency crises, by now China has enough reserves
– Harder to sterilize the inflow over time.
• Attaining internal and external balance.
– To attain both, need 2 policy instruments.
– In a large country like China, the expenditure-switching policy
should be the exchange rate.
– Along with expenditure-increasing policies (2009).
• Avoiding crash:
– Experience 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.
• RMB undervalued, judged by Balassa-Samuelson relationship.
ITF-220 - Prof.J.Frankell
Longer-run perspective:
Balassa-Samuelson relationship
• Prices of goods & services in China are low
– not just low judged by Absolute PPP (.23 relative to the US),
– but also low by standards of Balassa-Samuelson relationship
estimated across countries (which predicts .36).
• The RMB is undervalued in this specific sense.
– 2000 estimate was 35%
• before 2007 statistical revisions by IPC project.
– Now undervaluation estimate more like 15%.
ITF-220 - Prof.J.Frankell
Estimation of B-S relationship for 2000
• For every 1% increase in real income/capita (relative to US),
prices increase .4% (relative).
• China’s estimated residual is .15
– Using revised ICP stats.
– Subramanian (2008).
Fitted values
CHN
logRER00
.370385
CHN
Frankel (2006)
118 countries, PWT
-2.15096
6.17768
10.6917
ITF-220 loginc00
- Prof.J.Frankell
Real appreciation
• The RMB’s real appreciation against the $
from 2009 to 2012 amounted to 12%,
• reducing the degree of undervaluation by roughly half,
• depending on whether one measures it against the $
or against all currencies.
• More is expected, as China’s relative wages continue to rise.
• In any case, China’s real exchange rate is already closer to
this measure of equilibrium than are most countries’
exchange rates (Cheung, Chinn & Fuji, 2010).
China Adjusts, 2009-12
• Various measures suggest that China has achieved a
major share of the needed trade adjustment since 2009:
• Its trade surplus peaked at $300 billion in 2008,
and declined thereafter.
• Substantial real appreciation of the RMB
has brought it closer to equilibrium.
– Some nominal appreciation +
– Some price inflation and, especially, wage increases.
Adjustment of relative prices
• The famous “China price”:
– Ever since China rejoined the world economy
3 decades ago, its trading partners have been snapping up
exports of manufacturing goods,
– because low Chinese wages made them
super-competitive on world markets.
• But in recent years, relative prices have adjusted
– following the laws of market economics.
Adjustment of relative prices, continued
• The change in relative prices is reflected
as real exchange rate appreciation.
– This comprises, in part, nominal appreciation
– and, in part, Chinese inflation.
– Government officials would have been better advised
to let more of the real appreciation take the form
of nominal appreciation ($ per RMB).
– But since they didn’t, it showed up as inflation instead.
– See charts below:
• appreciation, against the $ and other currencies.
Appreciation versus the US $, 2005-12
1.5
1.4
CNY/USD,
2005M06=1
1.3
real
1.2
nominal
1.1
1.0
The RMB rose against the $ during 2006-08,
but temporarily returned to peg in mid-2008.
0.9
2005
2006
2007
2008
2009
2010
2011
Appreciation vs. index of currencies, 2005-12
1.35
1.30
CNY Index,
2005M06=1
1.25
1.20
Real value
of CNY
1.15
Value
of CNY
1.10
1.05
1.00
0.95
2005
2006
2007
2008
2009
2010
2011
China’s trade balance
The surplus peaked in 2007, and then fell.
Source: Reserve Bank of Australia (June 2013)
China runs a deficit in primary products, offset by a surplus in manufactures.
China’s trade balance
The bilateral surplus with the United States
is as big as ever – which has no economic importance,
but is politically sensitive.
31
The natural adjustment process was delayed.
• 1st, because the authorities intervened to keep the
exchange virtually fixed against the dollar, in the
years 1995-2005 and 2008-2010.
• 2nd, workers in China’s increasingly productive
coastal factories were not paid their full value.
– The economy has not completed its transition
from Mao to market, after all.
• As a result of these two delaying mechanisms,
Chinese continued to undersell the world.
But then two things happened.
• 1st, the yuan was finally allowed to appreciate
against the $ during 2005-08 & 2010-11,
by 25% cumulatively
• =17% + 8%.
• Though less against other currencies.
• 2nd, labor shortages began to appear =>
China’s workers at last won rapid wage hikes.
– Major cities raised their minimum wages
sharply over each of the last 3 years:
• 22% on average in 2010 & 2011;
• Meanwhile another cost of business,
land prices, have risen even more rapidly.
Chinese wages have been rising
Source: “China’s wage inflation,” Aug. 28, 2013
34
Real appreciation
• The RMB’s real appreciation against the $
from 2009 to 2012 amounted to 12%,
• reducing the degree of undervaluation by roughly half,
• depending on whether one measures it against the $
or against all currencies.
• More is expected, as China’s relative wages continue to rise.
• In any case, China’s real exchange rate is already closer to
this measure of equilibrium than are most countries’
exchange rates (Cheung, Chinn & Fuji, 2010).
5 types of adjustment are gradually taking place in
response to the new high level of costs
in the factories of China’s coastal provinces:
• 1st, some manufacturing is migrating inland,
– where wages & land prices are still relatively low.
• 2nd, export operations are shifting to Vietnam or Bangla Desh
– where wages are lower still.
• 3rd, Chinese companies are beginning to automate,
– substituting capital for labor.
• 4th, they are moving into more sophisticated products,
– following the path blazed earlier by Japan, Korea, & other Asian tigers
• in the “flying geese” formation.
• 5th, multinational companies that had in the past moved some stages
of their production process to China, out of the US or out of other
high-wage countries, are now moving back.
• All five of these ways of reallocating resources
represent the economic process operating as it
should.
• None of this comes as news
to most observers of China.
• Many Western politicians are unable
to let go of the syllogism that seemed
so unassailable just a decade ago:
– (1) The Chinese have joined the world economy;
– (2) their wages are $0.50 an hour;
– (3) there are a billion of them, and so
– (4) their exports will rise without limit:
“Chinese wages will never be bid up in line
with the usual textbook laws of economics
because the supply labor is infinitely elastic.”
• But it turns out that the laws of economics do eventually
apply after all -- even in China.
Expansion of the services sector.
This 6th dimension of adjustment still lags behind,
• despite the consensus in favor of it.
• China has had great success in manufacturing
– especially via exports.
• Now it needs to help the other side of the economy catch
up: services, via domestic demand
– Retail, education, environmental quality,
– health care, pensions, social safety net.
• Some of this could be done via government spending
– especially with the economy in slowdown in 2014,
– as China did in 2009; but that was mostly heavy investment.