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Crouching Renminbi, Hidden Yuan

Infuriating as the Bush smear operation is, it's still worth considering some substantive questions around here as John Quiggin does today writing about the US trade deficit. The one thing everyone agrees on is that the current situation is unsustainable, so it will not be sustained. But how will it end? I'm surprised that John doesn't really address the China factor in this regard. The contemporary US trade deficit situation is unusual, in part, because a very large and growing proportion of it is a deficit with a country (the PRC) whose currency is pegged to the dollar. As a result, the automatic stabilizer of currency depreciation followed by fewer China-to-US exports and more US-to-China exports doesn't kick into effect. At the same time, the Chinese government is (and has been for some time) engaged in purchases of US Treasury bonds that seem to be justified more on geopolitical terms than by conventional investment criteria. This helps shelter the US from what the textbook says the ill effects of an unsustainable dual-deficit path should be.

In light of all that, perhaps the question is less how long can the USA sustain the current path, then how long China can stay on its path, and how (or why) might the PRC government decide to change course.

August 22, 2004 | Permalink

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Matthew Yglesias mentions something that I've thought about a lot lately -- the fact that the Chinese government is one of the largest financiers of the US debt through its purchases of Treasury bonds. As Matt notes, Chinese investment in [Read More]

Tracked on Aug 22, 2004 10:32:58 PM

Comments

My understanding is that China will soon stopping pegging the Yuan to the dollar. Is that off? If I were Uncle Sam, I'd relax the rules against purchasing the Yuan seeing how it is seriously undervalued.

Posted by: Jacob | Aug 22, 2004 12:49:38 PM

The out for America is a slow but steady disengagement of manufacturing out sourcing, and the build up of completely custom on demand local production. The reality is that thanks to technology advancement a miniscule popultaion can now produce the goods for the vast majority of consumers. Furhter no entrenched maufacturer has any advantage whatsoever over funded and educated up and comers. Right now monopolies exist based on knowledge of setting up distributed manufacturing processes, but even this is a transient lock-up.

Central production is now completely unnecessary, goods, services, and energy can now be produced absolutely locally, and transported absolutely anywhere. Even the super store concept is a barrier to the flow of retail,as it is now more practical to assemble the store itself dyanmically than maintain it. This of course implies that land values cannot be maintained since relative geo-graphy is no longer a guarantee to anything. So forsure the suburban housing markets, particularly in heavily internally managed areas, should expect to free up some capital to the rest of the economy.

Since the late nineties the nation has been sitting on the verge a completely new era of commerce, production and employment. Whether its news, film or movie distribution, energy produciton and transmission, or countless other projects the future is very bright. Except of course for the old monopoly holders that see nothing but downside, who of course financed this administration and are now toting up the costs of their mistakes.

China and Japan continue to fund us because we are the only viable market in the world, and in the process they speed up the growth of their own internals. In the case of Japan it prevents the monopoly reckonings that we face, in the case of China it lets them get a larger section of society to American levels of comfort. We have not directly threatened either China or Japan's long term interests so they continue to support us. However the minute we do, the game is over. Had the Iraq mess gone more to our favor you could have expected China to make more economic noise.

The situation is still salvagable, but the longer we ignore it the more likely the mountain becomes unclimbable. Four more years of ignorance and mismanagement could force a global show down. A policy of engagement will of course be widley accepted by the world economic community, and lead to a managed easing of problems as well as a dramatic shift in economic activity.

Posted by: patience | Aug 22, 2004 1:46:54 PM


China keeps saying that its goal is to eventually move to a more flexible exchange rate, but it has not, to my knowledge, said when it will do so. I suspect that China is more likely to repeg to the dollar at a higher rate/ use the occasion to shift to pegging to basket of currencies than simply to start floating.

As for Matt's question of how long China can stay on this path, a few points:

a) It is not just China. Almost all Asian economies, even those that don't formally peg, have intervened to limit appreciation against the dollar, and thereby appreciation v. china (the yuan or renminbi). Japan's intervention in q1 was enormous, and provided more financing to the US than the reserve accumulation associated with China's peg. Right now, it would not surprise me if Asia was providing the US with less financing (comparatively speaking) and oil exporters were providing more. Watch Russia's reserve accumulation.
b) There is no upper bound on how many reserves a country can accumulate ... but reserve accumulation still has costs. When the Bank of China buys dollars from its exporters, it sells renminbi. That adds to the money supply. It then has to sell renminbi T-bills or something similar to reduce the money supply (sterilization). But there are limits to how much China can do this, its financial markets are not big enough for perfect sterilization on this scale. Consequently, barring perfect sterilization, reserve accumulation translates into inflation, and for the true wonks, inflation in the context of a fixed exchange rate leads to a real currency appreciation over time. The problem is that this natural mechanism of adjustment is slow.
c) The Bank of China is also taking on a fair amount of financial risk by buying and holding more and more dollar denominated assets (all those treasury bills), even though it must be projecting that the reniminbi eventually will rise in value v. the dollar (the value of dollar assets value goes down, in chinese currency terms, in the event of revaluation). The carry -- the interest rates china gets on its t-bills -- is not enough to offset this risk, imho. There is an argument that the Bank of China does not care about the risks of financial losses -- what matters to them is that a rapidly growing export sector is absorbing labor/ spurring china's development. But it is still a risk.

For those who are seriously interested, my friend Nouriel Roubini has a web page (www.stern.nyu.edu/globalmacro) with tons of links on this topic/ debate.

Brad Setser

Posted by: bsetser | Aug 22, 2004 1:50:07 PM

bsetser--thanks; your explanation is the best I've seen of these issues.

Posted by: liberal | Aug 22, 2004 2:03:13 PM

I was going to make some of the same points as Brad, but he made them better, so let me only append one.

It's not merely that the Bank of China may not "care" about losses; it's entirely possible that the Bank of China, which isn't exactly completely independent of the government of China, may think of these losses as a particularly cheap export subsidy, and one that doesn't run afoul of free trade in the direct sense....

My guess, by the way, is that eventually, the rapidly growing Chinese middle class is going to want American consumer goods to be cheaper....

Posted by: howard | Aug 22, 2004 2:32:31 PM

Jacob: China has to move 500 million people from the farms to the cities. They're not going to change their policy for at least a couple of decades.

Also, I don't think the Bank of China's too worried about the risk of holding t-bonds, since those t-bond purchases are essentially free; all China is doing to buy those things is printing Yuan. I bet the (virtual) ink is still wet when the transaction takes place.

Posted by: Kimmitt | Aug 22, 2004 3:12:51 PM

Indirectly OT, my newspaper (business section) this morning reviewed a book by Philip Longman:The Empty Cradle. This is about the decline in rate-of-population growth worldwide, especially in the developed countries, but also China, India, Brazil,etc. Women are having fewer children then they would even like, due to education, long work hours, available housing, etc. An opportunity cost problem, where women lose real money per child raised.

But it was a small side note that interested me. Besides the usually mentioned problem of supporting older populations, the main problem mentioned of the population bust was the decline in elite consumers. Productivity, resources, GDP, investment, education were only relevant to a healthy economy to the degree they help create people who buy cellphones, DVD players, and gourmet vegetables.

Now maybe this is as old as Marx, but it struck as weird and kinda backwards that we educate our youth not so they can become productive workers but so that they may become frivolous consumers.
I suspect it also pertains to global trade balance and credit problems discussed in MY's post. Markets,markets,markets. I question the whole damn system.

Posted by: bob mcmanus | Aug 22, 2004 3:26:32 PM

Might the PRC change course as the price of oil goes up?

Posted by: janeboatler | Aug 22, 2004 3:33:19 PM


I would bet against rising oil prices as a short-term trigger for a renminbi revaluation. no doubt, china's import bill is rising because of higher oil prices (and strong commodity prices more generally). But the latest US trade data suggests that China's surplus with the US is also rising significantly. The two may well balance each other out - and, in a sense, if higher oil imports reduce the pace of china's reserve accumulation, it only reduces pressure for China to change.

Howard, I would personally would not bank on pressure from chinese consumers prompting change; pressure usually comes when consumers lose something that they are used to (in the us, cheap gas) rather than when they are denied the opportunity to ever know they are missing something. Plus, China imports capital goods and raw materials, and the US does not really specialize in producing consumer goods for the $1000-2000 per capita income market. I doubt this pattern would change much even if china revalued the renminbi -- china will import more, but maybe not consumer goods made in the usa.

My bets for potential sources of pressure that will force some form of change in the current US t-bills for chinese goods trade:

a) Pressure from frictions created in the U.S. as resources move from sectors (and regions) that produce goods that compete against chinese goods (pressure that will only grow, since I suspect that China increasingly cannot grow its exports at its current pace primarily by taking market share away from other asian producers, increasingly it will be moving into sectors -- say furniture and autoparts -- with substantial us production) to sectors and regions that benefit from the export of US t-bills (i.e. interest rate sensitive sectors, such as housing).

b) Pressure from financial markets. Last year central banks provided roughly half of the total financing needed for the us trade deficit, and private markets the other half. the US trade deficit is rising, both because of oil and because us non-oil imports are also growing strongly. If private investors from abroad cease to be willing to finance their current share of the us trade deficit at current us interest rates (afterall, there are riks associated with lending in dollars to a country to country with a large trade deficit and a foreign debt to GDP ratio that is likely to be almost 30% by the end of the year), foreign central banks have to be willing to step up the amount of financing they provide or the dollar has to start sliding agains someone/ us interest rates have to rise to attract more private financing, slowing the us economy. Keeping the status quo might require more, not less, central bank financing of us deficits, and the problems of sterilization/ taking on more financial risk only get bigger. At some point, something will give.

(Apologies for the length of this, it is a topic that interests me greatly)

Brad Setser

Posted by: bsetser | Aug 22, 2004 5:00:14 PM


I would bet against rising oil prices as a short-term trigger for a renminbi revaluation. no doubt, china's import bill is rising because of higher oil prices (and strong commodity prices more generally). But the latest US trade data suggests that China's surplus with the US is also rising significantly. The two may well balance each other out - and, in a sense, if higher oil imports reduce the pace of china's reserve accumulation, it only reduces pressure for China to change.

Howard, I would personally would not bank on pressure from chinese consumers prompting change; pressure usually comes when consumers lose something that they are used to (in the us, cheap gas) rather than when they are denied the opportunity to ever know they are missing something. Plus, China imports capital goods and raw materials, and the US does not really specialize in producing consumer goods for the $1000-2000 per capita income market. I doubt this pattern would change much even if china revalued the renminbi -- china will import more, but maybe not consumer goods made in the usa.

My bets for potential sources of pressure that will force some form of change in the current US t-bills for chinese goods trade:

a) Pressure from frictions created in the U.S. as resources move from sectors (and regions) that produce goods that compete against chinese goods (pressure that will only grow, since I suspect that China increasingly cannot grow its exports at its current pace primarily by taking market share away from other asian producers, increasingly it will be moving into sectors -- say furniture and autoparts -- with substantial us production) to sectors and regions that benefit from the export of US t-bills (i.e. interest rate sensitive sectors, such as housing).

b) Pressure from financial markets. Last year central banks provided roughly half of the total financing needed for the us trade deficit, and private markets the other half. the US trade deficit is rising, both because of oil and because us non-oil imports are also growing strongly. If private investors from abroad cease to be willing to finance their current share of the us trade deficit at current us interest rates (afterall, there are riks associated with lending in dollars to a country to country with a large trade deficit and a foreign debt to GDP ratio that is likely to be almost 30% by the end of the year), foreign central banks have to be willing to step up the amount of financing they provide or the dollar has to start sliding agains someone/ us interest rates have to rise to attract more private financing, slowing the us economy. Keeping the status quo might require more, not less, central bank financing of us deficits, and the problems of sterilization/ taking on more financial risk only get bigger. At some point, something will give.

(Apologies for the length of this, it is a topic that interests me greatly)

Brad Setser

Posted by: bsetser | Aug 22, 2004 5:01:03 PM

Very interesting stuff Brad.
A question if you please:
What would a change look like? What would have to happen for the U.S. trade deficit to stop expanding so rapidly?

Posted by: WillieStyle | Aug 22, 2004 5:27:34 PM

You guys are pretty high powered((I mean it); but I think when the credit expansion here becomes untenable this bangs or whimpers. Best regards.

Posted by: mauberly | Aug 22, 2004 5:35:24 PM

You're talking about China like it's a separate economy, but to a significant degree it's now a part of the US economy. US companies move factories to China all the time, big companies like Ford. They don't want the dollar to fall against yuan, it'll make their products less competitive.

Imagine that you just spent hundreds of millions moving your assembly lines to China and suddenly the exchange rate changes so that cars you build there cost 50% more than you expected. Bummer. No, the yuan/dollar rate is not a plot of evil Communists, it's a sort of "Animal Farm" arrangement between their pigs and our -- well, and our pigs.

Posted by: abb1 | Aug 22, 2004 6:20:25 PM

Brad, you certainly may well be correct, and i'm not banking of chinese consumers making a difference tomorrow, but my bet is that chinese consumers are like every other consumer in the world: they want american popular culture. And they want it cheaper than the supported dollar value allows it to be.

Now, might that pressure be years off? Absolutely. Might it never happen? Conceivably. Might other pressures result in economic dislocations of other kinds? unquestionably. It's just such a large consumer market that i can't help but speculate on it as a countervailing force to the export-focussed chinese approach.

Posted by: howard | Aug 22, 2004 6:36:07 PM

"In light of all that, perhaps the question is less how long can the USA sustain the current path, then how long China can stay on its path, and how (or why) might the PRC government decide to change course."

There has already been speculation (in the Washington Post, I believe) that the Chinese government just might be keeping this up until the US is so dependent on China to save it from the economic consequences of its own deficit that China can blackmail us into letting it reoccupy Taiwan.

Posted by: Bruce Moomaw | Aug 22, 2004 7:21:59 PM


abb1. your assessment of ford (and GE's) interests are right, but unless they are willing to borrow in renminbi, sell the reniminbi for dollars and then invest in the US (this is a hypothetical -- chinese controls make this trade difficult), then they need the bank of china to support the current exchange rate. someone has to lend to the US to keep the US exchange rate as it is now; right now, that someone is to a large extent Asian central banks, not GE and ford. To the extent that GE and Ford are raising funds in the US to invest in china, their actions are putting pressure on the dollar to depreciate and the renminbi to appreciate. The Bank of China is fighting that, and thus building reserves -- effectively buying up the dollars GE is bringing into the China and then lending it back to the US (and more specifically to the US government).

What would it take for the US trade deficit to stop expanding? In my view, two things. One. East Asian currencies need to strengthen against the dollar, making our exports more competitive their (and reducing the incentive to import from East Asia/ shift production there). The dollar has fallen against the Euro, but not against most fast growing Asian economies. That means East Asian central banks have to stop intervening and let their currencies strengthen. How the US can encourage that to happen is a huge question -- as abb1 noted, that change is not in the short-run interest of all parts of the US economy. Two. Either the pace of growth in US consumption has to slow (reducing growth in US imports) or the pace of growth in world demand (consumption and investment) has to accelerate. In broad terms, US consumption has been growing faster than US income (because we are borrowing to support current consumption, led by our government), while the world's income has been growing faster that its consumption. Part of the gap between the rest of the world's income and its consumption shows up in the form of higher reserves in the bank of china and bank of japan. they save. we then borrow from them to consume. The result is a growing trade defict. To end the deficit, that all has to reverse itself. We have to save a bit more and spend a bit less, so we need to borrow a bit less from the world.

It would be nice if strong export growth supported our economy as the pace of US consumption growth slows -- it is better for the US and the world is the trade deficit closes because of growing us exports, not falling imports. As a counterpart to the changes in the US, therefore, the world needs to spend a bit more and save a bit less, with higher demand growth abroad supporting our exports and their production as the pace of the growth in their exports to the US slows a bit. Sorry if that is both a bit wonky and rather macro. Can try to be more concrete, but it is far easier to state what has to happen in broad terms than to figure out precisely how it will happen or when it will happen. In my view, a $500 billion trade deficit cannot be closed overnight or without rather significant changes in the pattern of global growth.

p.s. lower oil would help, but it is not enough.

Brad

Posted by: bsetser | Aug 22, 2004 7:23:16 PM

bruce, while we're on the subject, given that the bush administration treats costs in iraq as the marginal cost on the budget, i think it's fair to assume that we are borrowing from china to pay for our iraqi adventure.

Which would be amusing if it weren't so perverse....

Posted by: howard | Aug 22, 2004 9:07:27 PM

Interesting stuff. Brad should start a macro econ blog.

Posted by: nona | Aug 22, 2004 9:52:14 PM

...but my bet is that chinese consumers are like every other consumer in the world: they want american popular culture. Howard
Agreed with everything you said, except this! Whilst it may still be largely true, it's a trend that is slipping fast. I'll try and find the site with the stats, but worldwide consumer loyalty to US products is steadily falling. Coke, Hollywood, Nike, McDonalds, NBA basketball; the lot.
Case in point - who's the most popular sports person in the world? David Beckham, by a factor of 100...

Posted by: floopmeister | Aug 23, 2004 12:26:13 AM

Howard talks about how the Chinese middle class is going to want more American consumer goods in the future.
What American consumer goods?
Aren't more and more of them being made in China, Howard?

Posted by: steverino | Aug 23, 2004 12:54:02 AM

Thank you for posting about this.

Could this be part of a plan of economic warfare on china's part?

Could they at some point let the dollar sink while they keep the renminbi stable? The dollar would obviously not be a good reserve currency, the renminbi might.

Companies that thought they were outsourcing might find they can no longer afford the outsourced services. The chinese etc companies would have to find new clients to outsource to them. Which might not be hard to do....

If the USA can't afford to import much oil, could we afford military ventures?

Who would be the superpower in that case?

Posted by: J Thomas | Aug 23, 2004 2:48:30 PM

JThomas- The USSR successfully maintained a superpowered military for years, despite humongous economic woes. The U.S. could easily do the same for like 50 years...

"Never underestimate the power of the system"

Posted by: pete | Aug 23, 2004 7:34:55 PM

Pete, the USSR was an oil exporter during that time, not an oil importer.

Posted by: J Thomas | Aug 25, 2004 12:30:28 AM

Also, the USSR didn't allow its citizens to wrack up immense private debts through easy credit...

Posted by: floopmeister | Aug 25, 2004 3:14:24 AM

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