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Friday, September 8, 2006

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Today's debate about the yuan

In his "Economic Scene" column for the New York Times, Tyler Cowen makes a counterintuitive argument:

Contrary to popular opinion, China may be good for our trade balance. American consumers seem determined to spend money, and Chinese businessmen have made the bill cheaper.

It is not the case that China is simply draining the United States of money. Most of the growth in Chinese exports to the United States has come from switching manufacturing and assembly from other, more expensive, Asian countries. In 1985, China, Japan, Hong Kong, Taiwan and South Korea accounted for 52.3 percent of America’s trade deficit. By 2005, this percentage had fallen to 40.9 percent, in part because of cost savings from buying Chinese....

The Chinese keep the yuan low, relative to the dollar, by buying up United States Treasury securities; as of early 2006, the Chinese central bank held up to $470 billion in Treasury securities. This huge accumulation of relatively low-yielding assets is the investment strategy of risk-averse bureaucrats, but it may bring longer-term benefits. Those assets can someday be sold or otherwise transferred to underdiversified Chinese financial institutions. The accumulation gives the Chinese a stake in American prosperity and signals that the Chinese are committed to long-term participation in the global economy. On the American side, the Treasury market is more liquid and the budget deficit can be financed at lower cost.

The yuan should not, as matters stand, float freely with free capital movements. Large quantities of Chinese savings, currently restricted to the domestic currency, would probably flee the country, worsening the serious solvency problems at Chinese banks. The Chinese must first clean up their banking system before they can have free capital markets. Contrary to the conventional wisdom, a market-determined value for the yuan might well be lower than today’s exchange rate, not higher....

Revaluation advocates claim that the Chinese need a stronger currency to prevent their economy from “overheating.” China may indeed not be stable. But it is unlikely that the United States government can successfully micromanage another country of 1.3 billion people into a soft landing. Chinese economic data is very poor and Americans do not have a good record in advising transition economies. The Chinese recipe for economic growth, which encouraged exports, seems to be working, although it ran counter to efforts by American economists and policy makers to promote the privatization of state-owned companies.

The climb of the Chinese economy out of Communism and into prosperity has brought the world, and the United States, a free lunch. Consumer goods of many kinds are cheaper and the Chinese are likely to generate many scientific and technical innovations. Steering the value of the Chinese currency — from Washington — is unlikely to increase those gains. The United States should not be spending its international political capital on yuan revaluation, which is at best a nonevent.

This column has caused something of a ripple in the economics portion of the blogosphere. See Greg Mankiw for a supportive post.

For more critical takes see Brad DeLong and particularly Brad Setser (Cowen responds to Setser here).

I had to write about this issue in a white paper for U.S. Trade Strategy, so a few quick thoughts on the matter:

1) Debating about what happens to the yuan if China liberalizes its capital markets is pretty much a red herring at this point, because it's not happening anytime soon. I lean towards Tyler's view that the yuan would likely fall, because the amount of Chinese savings that would leave would dwarf the amount of investment capital that would flow in (one of the scarier facts about the Chinese economy is that to my knowledge no one has any idea of how to gauge the efficiency of recent Chinese investments). Again, though, it's a red herring.

2) The debate boils down to whether you believe a small shift in the trade balance, which would be caused by a small revaluation of the yuan, is worth the large amounts of political and diplomatic capital required to get China to move. The Brads think the answer is yes, because any nudge towards reducing global imbalances is a good thing, and such a reduction would prevent U.S. overinvestment in nontradables. Tyler thinks that U.S.policymakers should swallow a dose of humble pie and recognize that given the current domestic political economy of China, us nudging them to devalue might make sense in theory but not practice.

On this point I'm moe sympathetic to the Brads, but in the end concur with Tyler that no poicy wonks have been willing to acknowledge the downsides of a devaluation gone wrong. Those scare me just as much as the long-term imbalances.

I fully expect my readers to weigh in on the matter.

posted by Dan on 09.08.06 at 08:39 AM

Comments:

We are working on a post about this topic. Just a heads up that your trackback function does not seem to be working.

Good job on picking this up so quickly and bringing the arguements together here! Would welcome your input as well.

posted by: Dan on 09.08.06 at 08:39 AM [permalink]

Dan -- I think the question is not so much whether portfolio and bank flows out of China would dwarf portfolio and bank flows into China as whether the net portfolio and bank flows would dwarf China's $250b (@10% of GDP) surplus in China's basic balance (current account + net FDI flows). Technically, portfolio flows count in the basic balance, but in China's case, they are usually considered hot money.

Depending on your estimate of the current net inflow of portfolio/ bank flows now (I would say @ $50b over the past four quarters, but the total is sensitive to your assumptions and it has been declining as US rates rose and Chinese rates stayed low), the needed net swing to push the RMB down is around $300b -- from a net inflow of $50b to a net outflow of $250b. i am by no means a big fan of china's bankings system (tho bad investments financed by banks are usually more of a problem for taxpayers than depositors), but i find that kind of swing inplausible.

posted by: brad setser on 09.08.06 at 08:39 AM [permalink]

p.s. I think you meant revaluation rather than devaluation ... the US certainly doesn't want a weaker RMB. That may explain how liberals (soros) are end doing better as currency traders than liberatarians ...

posted by: brad setser on 09.08.06 at 08:39 AM [permalink]

Well my reasons for being a stiff WRT with china are multifold.
The last smirk on my face was when in my local italian american festival held every year on my streetcorner is when I see a guy selling fake sharpie markers.
Inorder to determine these were fake requited some
work but in the past I had seen several fakes where a cursory inspection proved they were fake, such as a MOKITA branded drill where 'o' would be an 'a' in the front packaging and be a knockoff of a MAKITA packaging except on the reverse side where an actual address with Mokita tools would be given....
This practice is very common with chinese products.
A more sinister practice were the sharpie markers which were not sharpie but were being sold as sharpie markers.

The reason I say this WRT dollars is 2 folds
Many Chineese banks have overstated the amount of there US$ holdings to their chinese owners.
This is very problamatic as many chinese stockholders have complained...
they dont know what overseas holding does a chinese owned company holds

2nd fold is as an American i dont want to see falsely branded products in america, I dont care what is the norm elsewhere.
If the marker is poor i'll blame sharpie not the person who sold it to me....

How does it add to Yuan revaluation you may ask?
How do i trust the chinese with a closed authoritarian system who have been given a near western european power status in the current system....
Frankly i dont... And i choose my investments quite carefuly.

posted by: Vulcan on 09.08.06 at 08:39 AM [permalink]

At this point, isn't it a question of belling the cat?

The chinese are in a position to do pretty much whatever they want, and we aren't in a position to stop them. We could ask them pretty pretty please for a revaluation, and they might choose to do it in exchange for concessions that might be even worse.

If we want to do something effective, our choices are limited to:

1. Reduce imports, reduce american standards of living to the point that we don't need to devalue. (Also we could reduce our trade deficit by 40%? half? by getting out of iraq.) There would be big international implications of such a choice, but no need to consider them -- I can't imagine any Uncle Sugar politician making that choice before January 2009, and by then the situation will have changed considerably.

2. Military action. Everybody now sees that there are limits to the US military, but still we can defeat any navy in a blue ocean, and we can defeat any army in the world provided we have six months to a year to preposition supplies. There might be some way to leverage from that.

3. Nukes. We might have more than half the world's nukes by now. Probably between the USA and israel we have more than half. Maybe we could do some kind of nuclear blackmail?

4. Maybe we can bluff and the chinese won't know we're bluffing?

Is there some other possibility, some way we can keep the chinese from doing whatever they want?

If we have a bust hand and have to fold, then all our discussion about the china problem turns into a question of how we can adapt to minimise the damage of whatever they do. For that we'd do better to start out with "What if china does this, or that, or this other thing? How can we respond?". Arguing about reasons why the chinese can't do this or that or the other thing is only arguing that we shouldn't make those plans.

People who're powerless naturally make arguments about why the powerful can't do what we fear. I remember people explaining why Greenspan couldn't keep dropping interest rates. It turned out he could and he did. Then when we got to the bottom where he really couldn't drop them further without paying people to take the money, there were lots of arguments why he couldn't raise rates. But he did. Before iraq I heard arguments that Bush wasn't really going to invade. It would be a quagmire, we'd lose international standing, all kinds of things. The claim was that he was just bluffing Saddam so Saddam would back down. Then it turned out he wouldn't let Saddam back down, he invaded regardless. All the reasons he couldn't do it have come back to bite us, but he did it anyway.

I don't understand china. You don't understand china. Nobody understands china. Probably nobody in china understands china. Eventually we will get some outcomes that somebody predicted, and they will think this validates their opinions. It doesn't really. Talking about why china can't do this or that serves no purpose except to reduce our anxiety levels.

posted by: J Thomas on 09.08.06 at 08:39 AM [permalink]