China, the US, and Currency Issues

Jeffrey Frankel

Harpel Professor, Harvard University

Chinese Future Leaders, January 29, 2010

Topics to be addressed

• The US twin deficits

• Alternative theories

• The call on China to appreciate the RMB.

• What is in China’s interest?

• What is China’s actual exchange rate policy?

• Shifting power relationships

API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University

US external deficits have shown a negative trendin the long run (1960-2007)

temporarily interrupted in recessions of 1980, 1990, 2001, & 2008.

Previously CA>TB, due to intl. investment earnings. Now reversed.

Figure 17.6U.S. Trade Balance and Current Account Balance, 1960-2007

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1.00

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1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

Balance on goods and services expressed asa share of GDP

Current account balance expressed as a shareof GDP

.

percent of GDP

Sources: Department of Commerce (Bureau of Economic Analysis)

Trade & current accounts, in $ billions per quarter

The US deficits improved in 2008-09, but this will again be a temporary reversal,

attributable to the US recession

(=> import quantities ↓ & oil prices ↓)

Dangers of the U.S. trade deficit

• Shorter-term dangers: – Protectionist legislation,

• including scapegoating China– Rising dependence on foreign investors – Hard landing for the $.

• Long-term dangers: – US net debt to RoW now ≈ $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.

Policies to reduce the US deficit

• Reduce the US budget deficit over time,– thus raising national saving.– After all, the current account deficit originated

in the budget deficit (“twin deficits”).

• Depreciate the $ more.– Better to do it in a controlled way

• than in a sudden free-fall.– The $ has already depreciated a lot against the €

• & other currencies.– Who is left?– The RMB is conspicuous as the major currency

that is still undervalued against the dollar.

Critics of the twin deficits view say that the US current account deficit is sustainable.

1. Global savings glut (Bernanke)

2. It’s a big world (R. Cooper; Al Greenspan..) 3. Valuation effects will pay for it (Gourinchas)

4. US as the World’s Banker (Kindleberger…)

5. 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)

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.

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 !

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.

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.

There is no reason to expect better today:

1) Capital mobilityis 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.

Central banks’ reserve holdings Frankel & Chinn (2007) estimated effects of country size, market depth, ability to hold value, and network effects

Simulation suggests € could overtake $ by 2022.

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75 80 85 90 95 00 05 10 15 20 25 30 35 40

USD

DEM

EUR

When will the day of reckoning come?

• Not in 2008: In the short run, the financial crisis caused a flight to quality which evidently still meant a flight to US $.

• Chinese warnings in 2009 may have marked a turning point:

– Premier Wen worried US T bills will lose value.On Nov. 10 he urged the US to keep its deficit at an “appropriate size” to ensure the “basic stability” of the $.

– PBoC Gov. Zhou in March proposed replacing $ as international currency, with the SDR.

The global monetary systemmay 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 ¥ & ₤.

• = a multiple international reserve asset system.

• 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 inevitablybe less than pressure on deficit countries to depreciate.– In my view, 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.

• China should do what is in its own long-term interest.

From China’s viewpoint,

• This does not preclude mutually-beneficial bargains, between equals– E.g., China agrees that:

• its exchange rate is part of the problem,• it will cooperate to lower the RMB/$ rate in a gradual matter,• and it won’t dump US treasury bills.

– In exchange, US agrees that: • its low national saving deficit is part of the problem, • it will cooperate to reduce the budget deficit,• and it won’t close off the US market to Chinese goods.

• But a bargain isn’t even necessary;– It is in China’s own interest to begin appreciating the RMB.

What is in China’s interest?

Five reasons China should let RMB appreciate, in its own interest

1. Overheating of economy

2. Reserves 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.

1. Overheating of economy:• Bottlenecks. Pace of economic growth is outrunning:

– raw material supplies– physical infrastructure– environmental capacity– level of sophistication of financial system.–

• Stock market bubble.•

• Inflation 6-7% in 2007 => price controls

shortages and social unrest.

• All of the above was suspended in late 2008,– due to sharp loss of exports in global recession.– But it is back again now.

Attempts at “sterilization,” to insulate domestic economy from the inflows

• Sterilization is defined as offsettingof international reserve inflowsso as to prevent them from showing updomestically as excessive money growth & inflation.

• For awhile PBoC successfully … until 2007-08.– The usual limitations are finally showed up:

• Prolongation of capital inflows• Quasi- fiscal deficit• Failure to sterilize• Rising inflation

2. Foreign ExchangeReserves

• Excessive:– Though a useful shield against currency crises, – China has enough reserves: $2 ½ trillion by Jan.2010;

– & US treasury securities do not pay high returns.

• Harder to sterilize the inflow over time.

Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008

Components of China’s rising balance of payments and the evolution of foreign exchange reserves

While reserves (NFA) rose rapidly, the growth of the monetary basewas kept to the growth of the real economy – even reduced in 2005-06.

Successful sterilization in China: 2005-06Attempts to sterilize reserve inflow:

In 2005-06 China was remarkably successful.

In 2007-08 China had more trouble sterilizing the reserve inflow

• PBoC began to pay higher interest rate domestically, & receive lower interest rate on US T bills => quasi-fiscal deficit.

• Inflation became a serious problem.– True, global increases in food & energy prices

were much of the explanation.– But

• China’s overly rapid growth itself contributes.• Appreciation is a good way to put immediate downward

pressure on local prices of farm & energy commodities.• Price controls are inefficient and ultimately ineffective.

Sterilization faltered in 2007 & 2008

Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008

Growth of China’smonetary base,

& its components

China’s CPI accelerates in 2007-08

Inflation 2002 to 2008 Q1

Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008

3. Need a flexible exchange rate to attain internal and 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” (E≡RMB/$)– => 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).

China is now in the overheating + surplus quadrant of the Swan Diagram

Exchange rate E

in R

MB

/$

YY:Internal balance

Y = Potential

ED & TD

ES & TD

ES & TB>0

China2010

BB:External balance

CA=0

China2002

ED & TB>0

Spending A

4. Avoiding future crashes

Experience of other emerging markets (1994-2002) 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.

5. Longer-run perspective:Balassa-Samuelson relationship

• Prices of goods & services in China are low– not just low relative to the United States (.23)

– but also low by standards of Balassa-Samuelson relationship estimated across countries (which predicts .36).

– before Dec. 2007 statistical revisions by IPC project

• In this specific sense, the yuan was undervalued by an estimated 35% in 2000

– and is by at least as much today.– But wouldn’t imply need for sudden change of this size.

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).

loginc00

Fitted values logRER00 CHN

6.17768 10.6917

-2.15096

.370385

CHN

Frankel (2006)118 countries, PWT

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.

What about China’s currency reform announced in July 2005?

• China did not fully do what it announced, – i.e., basket peg (with cumulatable +/- .3% band).– Statistical estimates

(Frankel & Wei, 2007; Frankel, 2009; Frankel & Xie, 2010):

• PBoC kept RMB very close to the $ in 2005-2006.• Subsequently, some appreciation in 2007-08

– But not against the implicit basket,

– only against $, as other currencies in basket (€) appreciated against $.

• Nowhere near floating

• More recently, since mid-2008,– the RMB has again been closely linked to the $.

If China gave US politicians what they say they want...

• We might regret it.– if it included reserve shift

to match switch in basket weights.

• US TB & employment wouldn’t rise much– fall in US bilateral trade deficit with China

would be offset by rise in US bilateral deficit with other cheap-labor countries,

• but US interest rates would likely rise.– possible hard landing for the $.

Lesson: Be careful what you wish for. You might get it !

$2½

http://ksghome.harvard.edu/~jfrankel/index.htm

Appendix 1: The decade 2001-2010Appendix 2: Looking forward

• An analogy with the 1980s & 1990s.

• In 80s, the US was said to be in decline– The “hollowing out” of manufacturing.– Paul Kennedy’s The Rise and Fall of the Great Powers.

• Japan was thought a juggernaut, taking over the world economy.– Ezra Vogel’s Japan as Number One– Chalmers Johnson’s MITI and the Japanese Miracle, etc.

Japan (and the Asian NIEs) were said to have a superior model of capitalism

• “Asian values”• Long horizons• Keiretsu / chaebol• Low cost of capital• Relationship banking• Government guidance• Pro-saving financial system• Lifetime employment (in the case of Japan)

• Firms maximize size (capacity or market share)

As soon as the 1990s started,1980s assumptions were proven wrong

• The US triumphed militarily in the Gulf War (1991).

• The US triumphed politically with the fall of the Soviet Union (1991).

• The Japanese model burst, – along with its land-stock-market bubble (1990) – and economy (1991-…) .

And as the 1990s progressed,

• the US experienced the longest economic expansion of its history;

• America was declared to have a New Economy.

• Currency crises hit Korea, and Southeast Asian countries in 1997-98.

• And Asians were told to emulate the US model, especially its financial system:– corporate governance, accounting standards, – consumer finance, innovative products,– securities markets, rating agencies, and– Anglo-American style banking (market-oriented & arms-length)

But as soon as the 2000s started,the 1990s assumptions were proven wrong

• Bursting of the US dot-com bubble (2000).

• Failure of US electoral institutions (Nov.2000).

• Failures of Sept.11 (2001) & US response (Iraq, Guantanamo)

• Failure of US corporate governance in scandals of Enron, etc. (2001).

• Decade of flat median income and rising debt.

Financial crisis (2007-2009)

• Bursting of US housing bubble (2006)

• inevitably led to sub-prime mortgage crisis (2007).

• Less predictably, failures of US financial system led to disappearance of liquidity (2008)

• and the 2nd recession of the decade, – the worst since the 1930s.– The rest of the world followed.

Who got pieces of it right, beforehand?

• Krugman: If a Depression can happen in Japan, it can happen in any modern economy.

• Rajan: Failures of corporate governance.• BIS (Borio & White): Too-easy credit, via asset

prices, leads to crises -- with no inflation in between.• Shiller: US housing price bubble.• Gramlich: Homeowners are taking

mortgages that they can’t repay.• Rogoff: “This Time Is Not Different.”• Roubini: The recession will be severe.

The US has lost its claim as an exclusive model for others to emulate

The desirable principles haven’t changed, only the claim that the US uniquely embodies them– Open democracy, rule of law– Competition in goods markets– Corporate governance focused

on long-term shareholder value, • not executives’ options prices• nor empire-building.

– Government intervention to address market failure• E.g., tax pollution (don’t subsidize fossil fuels). • Supervise banks, under rules (don’t take them over).

Looking forward: The US is in a hole

• Adroit monetary & fiscal management has succeeded in limiting the length & severity of the recession.– The turning point was

probably early summer, 2009– => we have avoided the mistakes of

• the Depression, • or Japan’s lost decades.

• But the long-term fiscal outlook – already bad – has gotten worse.

The same with other major industrialized economies.

A remarkable role-reversal:

• Debt/GDP of the top 20 rich countries (≈ 80%) is already twice that of the top 20 emerging markets;• and rising rapidly. • By 2014 (at ≈ 120%), it could be triple.

One of the most important developments of 2009:

the G-20supplanted

the G-7

• Finally giving some representation to large emerging market countries,

– after years of failed attempts in the IMF & elsewhere

• We have much to talk about in 2010:– Economics: exit strategy, CA imbalances, financial reform– Other: A new treaty to address Global Climate Change