Two days ago I was in Shanghai speaking at a conference organized by a French bank. For some reason I was included in the panel discussing opportunities for Chinese investors in the euro market.
I suspect I was not the right person to have on that panel because my position on the subject is not likely to lead to a stampede of Chinese investments into euro-denominated products. First of all, I don’t think Chinese investors should buy any foreign currency product until the RMB issue has been resolved.With the expected appreciation of the RMB as high as it is, only extremely high-yielding, very risky foreign-currency-denominated assets can be expected to match the returns one can get by simply depositing RMB in a bank account.Why take the risk?
Second, I think the euro is overvalued relative to the dollar, and although we may see more dollar weakness in the short term, my own bet is that the euro will strengthen in the one- or two-year horizon as Europe’s trade deficit continues to swell. Lombard Street Research, a London-based research group and one of my favorites, expects the dollar’s fall to be more of a bungee jump, and they expect the rebound will occur once the markets see the European trade deficit as unsustainable and the euro’s position as precarious. I agree.
Finally, and this is really a much longer-term issue, I am still very skeptical about the survivability of the euro. It seems to me that the strains in the euro zone – especially in countries like Spain, where monetary policy is much too loose, and Italy, where sovereign debt levels are rapidly becoming unsustainable – will put serious pressure on the euro once we end the current liquidity cycle that we have experienced over the past 15-20 year.
I say this because we have some disturbing historical precedence. Currency unions among regions that don’t fulfill the Mundellian rules (including high degrees of capital and labor mobility and free trade) aren’t new.There are plenty of previous examples, but my reading of their histories is that when they are successful they are successful largely during the expansive period of a global liquidity cycle. I cannot think of any that didn’t hit the skids when the liquidity cycle ended. There are many reason why I think this makes sense, and perhaps in some future entry I will discuss why, but suffice it to say that as weaker eastern European countries with their more fragile balance sheets enter the euro the likelihood of a global liquidity contraction playing havoc with the members of the union rises.We still haven’t been seriously tested, and it is only after a really difficult test that we will be able to say with some confidence that the euro experiment has been a success.
Still, in spite of my nay-saying there are some China-related things that are relevant to a discussion of the euro and which I brought up in the conference.The main point, made by many other much smarter people besides me, is that the strength of the euro and other related currencies is significantly affected by the Chinese currency regime (actually by a number of dollar-related currency regimes of which China is the bellwether) because the euro’s strength was caused by the pressure for the dollar to devalue against the currencies of its trading partners, and as long as the RMB and other related currencies were pegged or managed, the full brunt of the adjustment had to occur in currencies where there was no massive central bank intervention – e.g. the euro.
If the US trade deficit is unsustainable, currencies have to realign so that the deficit becomes more manageable, and probably the healthiest way for that to happen is for the dollar to realign against the largest trade surplus countries – after all if trade surpluses do not decline, trade deficits cannot decline either.That means that the brunt of dollar weakness should have occurred against China, Japan, the OPEC countries and other Asian countries who peg to the dollar, to the extent that their trade surpluses decline.Only then can we see a reduction in the US trade deficit that doesn’t occur simply by shifting it elsewhere.
This hasn’t been allowed to happen.The US trade deficit is not disappearing, it is simply being shifted to Europe.I don’t think that can last very long.
On that research group's website, there is an daily note about China's 1st quarter's growth is 16-17%. I cannot read it since I am not a client. I wonder if you can tell us something about their conclusion. Thank you.
By fatbrick - Fri, 18 Apr 2008 05:08:12 GMT
It sounds like an East Asian currency union which have some have proposed would not only be destined to fail on political terms, but also economic terms. Most countries would be afraid to allow too much labor mobility with China. Similarly, a currency zone including just China, Hong Kong, Macau, and Taiwan would fail for the same reasons.
By orgulous - Fri, 18 Apr 2008 08:01:07 GMT
Prof. Pettis:
Thank you for another good read. I would add that, anecdotally, it seems like the Europeans are less tolerant of the idea of persistent large trade deficits with China (as another reason for pressure on the euro/rmb).
orgulous:
Care to expound on "Similarly, a currency zone including just China, Hong Kong, Macau, and Taiwan would fail for the same reasons." I'm not sure that this group has the same pressures as melange of European states or a broad East Asian regime.
Fatbrick, I haven't read the research report yet (I am not a client and so I only see the reports long after they come out), but my understanding is that they took the official RMB-based GDP figures and deflated it with the official CPI inflation numbers, and came out with a much higher real growth rate than the one claimed by the government. Their conclusion is that either CPI understates real inflation significantly or real GDP growth is much higher. Their methodology seems plausible and we know that there have been problems in the official numbers, so there is a big question mark over everything.
Matt, I think the argument that Europe is likely to be less tolerant of high trade deficits is reasonable, and one which I believe too. Europe has a less flexible financial system and labor structure, and they haven't made as much of the difficult shift out of lower value-added industries as has the US.
This suggests that financing a large trade deficit over long periods of time will be riskier and that the employment consequences of a large trade deficit with countries like China will be worse. I agree with Orgolous that a currency union between mainland China, Taiwan and HK will be very difficult because there is limited capital and labor flexibility and, given the differences in relative size, a currency union would mean that Taiwan and HK would simply import Chinese monetary policy, which is barely appropriate for the mainland and very inappropriate for those two, very different, economies. Currency unions reduce hedging costs but also reduce flexibility. In this case I think the latter far outweighs the former.
By Michael Pettis - Sat, 19 Apr 2008 00:47:31 GMT
Concerning Europe remember that when single individuals in Russia become rich, they fee it is much more secure for them to move their money out of Russia into e.g Europa - where all public institutions feel more reliable in terms of granting those rich people their ownership rights. I think we could see Chinese private money leave China for the same reason. As far as I understand private individual cannot even own land in China.
The trigger of a massive outflow of hot money from China, and a downward pressure on the RMB could happen when trade-balance figures start to shock markets on the downside. I understand March was a step in that direction, and I think there will be more.
By Stefan, Tallinn - Sat, 19 Apr 2008 01:57:24 GMT
China may be the country where many people liked to make money. It may not be the country where those people want to keep their money.
By Stefan, Tallinn - Sat, 19 Apr 2008 02:00:41 GMT
I do not have access to the Lombard St research report either, but on the basis of Michael's brief description, it seems the same type of point I made about inflation, money stock and asset prices in the previous post applies here. The cpi may not be representative of the mix of transactions involved in GDP, in which case it is not appropriate to deflate GDP using the cpi. In particular, if input prices (including both raw materials and labour) are rising and output prices are not (ie margins are falling - next post), deflating GDP by cpi will increase "real" GDP - incorrectly.
After Taiwan's presidential election, some people are talking about the concept of "Chung-Hua-Yuan" (a common currency for mainland, hongkong, and taiwan).
What do you think about this idea?
By Wenqing Liou - Sun, 20 Apr 2008 04:30:10 GMT
In regard to what you mention under 'Second', the latest EU-15 trade balance numbers published by 'Eurostat ' show that their trade deficit of EUR 11 Bn in January swung into a surplus of EUR 0.8 Bn in February with exports growing by 13%, and imports rising 11%.
Michael Pettis is a professor at Peking University's Guanghua School of Management, where he specializes in Chinese financial markets. He has also taught, from 2002 to 2004, at Tsinghua University’s School of Economics and Management and, from 1992 to 2001, at Columbia University’s Graduate School of Business. He is a member of the board of directors of ABC-CA Fund Management Co., a Sino-French joint venture based in Shanghai.
Pettis has worked on Wall Street in trading, capital markets, and corporate finance since 1987, when he joined the Sovereign Debt trading team at Manufacturers Hanover (now JP Morgan). Most recently, from 1996 to 2001, Pettis worked at Bear Stearns, where he was Managing Director-Principal heading the Latin American Capital Markets and the Liability Management groups. He has also worked as a partner in a merchant banking boutique that specialized in securitizing Latin American assets and at Credit Suisse First Boston, where he headed the emerging markets trading team. Besides trading and capital markets, Pettis has been involved in sovereign advisory work, including for the Mexican government on the privatization of its banking system, the Republic of Macedonia on the restructuring of its international bank debt, and the South Korean Ministry of Finance on the restructuring of the country’s commercial bank debt.
Pettis is a member of the Institute of Latin American Studies Advisory Board at Columbia University as well as the Dean’s Advisory Board at the School of Public and International Affairs. He is the author of several books, including The Volatility Machine: Emerging Economies and the Threat of Financial Collapse (Oxford University Press, 2001). He received an MBA in Finance in 1984 and an MIA in Development Economics in 1981, both from Columbia University.
Subscribe to this Site
Comments 
- Fri, 18 Apr 2008 12:50:11 GMT
August, 2007