The Renminbi The Case for revaluation

The Context•2004: China’s economy is on the overheating side of internal balance

appreciation would help ease inflationary pressure

•To achieve both internal balance and external balance China needs to adjust its real exchange rate•China’s current FOREX is adequate to shield it against currencies crises and U.S treasury securities do not pay a high return.•It is increasingly difficult to sterilize the inflow over time.• A large economy like China can achieve adjustment in the real exchange rate via flexibility in the nominal exchange rate more easily than via price flexibility.• From a longer-run perspective, prices of goods and services in China are low by the standards of a Balassa-Samuelson relationship estimated across countries. •The yuan is undervalued by approximately 35%. • The hybrid basket-band-crawl regime seems to argue for a dollar peg with only a 2.1% revaluation. •July 2005: China announces a new policy,

Immediate 2.1 % revaluation, Followed by “managed float”: controlled appreciation, supposedly against an unspecified basket of currencies.But, as often, de jure exchange rate regime ≠ de facto.

Context , continued

•Econometric estimation of true regime reveals:$ link did not even begin to loosen until 2006.By 2007, implicit basket had shifted some weight onto other currencies, especially the €. RMB appreciates against the $ from 2006 to 2008,

But only because € does.•May 2008: Chinese leaders hear exporter complaints of competitiveness difficulties.Mid-2008-April 2010: yuan repegs ≈ $ 6.84 RMB/$

≈ 20% stronger, vs. $, than 2005.•Oct. 2006 -- IMF Article IV consultation finds RMB “undervalued.”

•2007: US Treasury temporarily passes hot potato of exchange rate complaints to IMF,

which gets mandate for exchange rate “surveillance.”

•2008: Though financial crisis originates in US, “flight to quality” temporarily raises demand for $.

•2009: Chinese leaders, for the first time, express concerns that their vast holdings of US treasury bills may not be well-invested.

Pres. Obama & Secy. Geithner seek to reassure.

THE RMB ROSE AGAINST THE $ FOR 2 YEARS, BUT RETURNED TO PEG IN MID-2008

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Exchange rates, Jan. 2005 - March 2010

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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 .

EXPLAINING FINDINGS OF TREASURY DEPARTMENT BIANNUALREPORT TO CONGRESS ON INT.EC. & EXCHANGE RATE POLICY

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All countries 15 Asian economies Excluding oil exporters

US bilateral TB -0.92*** -0.99*** 0.0655 0.1548

Partner’s 0.014*** 0.028**CA/GDP 0.002 0.007

Partner’s Real -0.18*** -0.23** Exchange Rate 0.0291 0.1115

Change in 0.003 -0.012reserves/GDP 0.003 0.009

US unem- 0.022** 0.08** ployment 0.010 0.037

*** statistically significant at 99% level

THE MAGNITUDE OF DAILY MOVEMENTS VS. $ INCREASED IN THE SPRING2006

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-.00

20

.002

.004

ln(c

ny)-

ln(c

ny[_

n-1]

)

01 Jul 05 01 Jan 06 01 Jul 06 01 Jan 07date

Changes in CNY per USD over Time: 07/22/05-1/8/2007

COMPLAINTS: TREASURY & OTHER US

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05

1015

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01 Jul 05 01 Jan 06 01 Jul 06 01 Jan 07date

cumulative non-treasury report cumulative treasury report

Time plots of cumulative US Treasury and Non-Treasury Complaints

CHINA’S VIEW

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• 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.• 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.

China’s Interest: Sino, US duomutually-beneficial bargain, between equals

China agrees that: its exchange rate is part of the problem, it will cooperate to lower the RMB/$ rate in a gradual manner, and of course it won’t dump US treasury bills.

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

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

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FIVE REASONS CHINA SHOULD LET RMB APPRECIATE, IN ITS OWN INTEREST

1. Overheating of economy

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.

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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 it is back again now; skyrocketing real estate prices.

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ATTEMPTS AT “STERILIZATION,” TO INSULATE DOMESTIC ECONOMY FROM THE INFLOWS

• Sterilization is defined as offsettingof international reserve inflows,so as to prevent them from showing updomestically 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

• Rising inflation (admittedly due not only to rising money supply)

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2. FOREIGN EXCHANGE RESERVES

• Excessive:

• Though a useful shield against currency crises,

• China has enough reserves: $2 ½ trillion by April 2010;

• & US treasury securities do not pay high returns.

• Harder to sterilize the inflow over time.

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The Balance of Payments≡ rate of change of foreign exchange reserves (largely $),

rose rapidly in China over past decade,due to all 3 components:

trade balance, Foreign Direct Investment, and portfolio inflows

ATTEMPTS TO STERILIZE RESERVE INFLOW:

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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: 2005-06

High reserve growth

offset by cuts indomestic credit

=> steady money

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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 contributed.• 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

19Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008

Monetary baseaccelerated

Growth of China’smonetary base,

& its components

CHINA’S CPI ACCELERATED IN 2007-08

INFLATION 2002 TO 2008 Q1

20Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008

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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.

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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.

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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 is one of those countries that is cheap or undervalued even taking into account Balassa-Samuelson.

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-1-.

50

.51

Lo

g o

f P

rice L

evel

-3 -2 -1 0 1 2Log of Real Per capita GDP (PPP)

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 Frankel (2005) estimate for 2000 = 36%.

The Balassa-Samuelson Relationship200 5 Balassa-Samuelson relationship 2005