My Blog

March 26, 2008

Scattered throughout this blog are references about the way I view China’s currency regime, why I believe monetary policy is out of control, why I have insisted since 2003 that China’s trade surplus and foreign exchange reserves could only grow, and why I claim that the authorities are increasingly going to have to consider a maxi-revaluation as the only solution to a worsening problem.  I have been asked several times to summarize this argument.  Here is a very brief summary (with apologies to readers of this blog who are tired of all my repetition):

1.        Since at least 2002-2003 China has been caught in a monetary trap.  By tying the value of the RMB to the dollar, and especially by setting it too low, the Chinese authorities ran the risk that in a time of excess global liquidity they would find themselves in the position of excess money inflows leading to excess domestic money expansion, which would be reinforced as domestic money expansion funded rising industrial production, which would cause an increase in the trade surplus and so increase money flows further.  Since global conditions at the time already suggested excess global liquidity, this risk was pretty high.  This is why I argued as far back as 2003-2004 that China’s then-high trade surplus could only rise, and as it rose it would necessarily feed domestic money expansion (the PBoC must create the local money with which to buy all those dollars), which would fund more investment, greater industrial production, and a rising trade surplus.  The key figure to watch is growth in foreign currency reserves.

2.        Because of the self-reinforcing nature of this system, this process must necessarily go on until a very sharp adjustment stops it.  The adjustment could come in the form, as it has in the past to China and other countries, of sharply rising domestic investment (“good” version: massive infrastructure spending; “bad” version: forced corporate investment via rising inventories), rapid debt deflation, a collapse of the banking system into bad debts, a breakdown of sovereign external or domestic credit (from excess fiscal expansion), or out-of-control inflation (which is, of course, one way that the currency can adjust), or it could come as a combination of these factors.  It is possible but unlikely that the adjustment will be benign, and the longer we wait the less likely it is.  This last statement is hard to prove but seems reasonable largely because of historical precedents.

3.        They key to stopping or slowing the process is to stop money inflows into China.  Capital controls erode over time, and after so many decades of capital controls their use is pretty limited in China, especially given the existence of China- or offshore-based transnational family business networks, and China’s size and long borders.  This means the only useful way to address capital inflows is to adjust the currency.

4.        Unfortunately even adjustment is problematic.  A slow adjustment , which we saw from July 2005 to roughly July 2007, means many more years of domestic monetary imbalances, which runs the risk of causing the adjustment, when it finally comes, to be all the more chaotic.

5.        A rapid adjustment, which we have seen since last summer, will only encourage hot money inflows, which will cause the domestic monetary problem to accelerate before it is fixed.  In addition, it is highly likely that a rapid appreciation of the RMB will overshoot whatever the “correct” exchange rate might be.

6.        That leaves only one option: a one-off maxi-revaluation that causes hot money inflows to subside or even reverse.  This may have an adverse impact on China’s trade account, but for reasons I have discussed often I think this impact is less than what many think it will be, and anyway it will happen one way or the other. Nonetheless with Chinese exports having risen, and still rising, so strongly even with the RMB appreciation of the past three years, it seems to me that we would need to see a huge, adverse impact on exports before it slowed export growth to zero, and much of this slowing growth would be absorbed by rising domestic consumption.

7.        The main argument in favor of a maxi-revaluation, however, is not that it will be painless.  The main argument is that the alternatives are much more painful.

8.        How much revaluation?  I leave it to smarter economists to argue about what a “reasonable” or “appropriate” exchange rate is.  My approach is much simpler.  As a former emerging-market bond trader and someone who has spent much of his career watching hot money, investment flows, and investor sentiment, I have tried to estimate what I believe to be the smallest possible revaluation that is nonetheless credible and likely to cause investors, especially speculative investors, to reconsider the direction of the RMB trade.  This wholly unscientific approach suggests to me that we will need a 15-20% revaluation of the RMB.  Notice that this means that even though between inflation and nominal appreciation the RMB has already risen substantially since I first proposed this over one year ago, I still haven’t changed my estimate.  It also means that s smaller revaluation will be a very poor policy choice.

This whole argument in favor of a maxi-revaluation depends crucially on the assumption that foreign exchange inflows will continue to accumulate at extraordinary levels until the adjustment is made.  This is the bet I made four years ago – I argued that reserves would surge.  Of course like everyone else I seriously underestimated just how much it would surge.  The key argument against continued rapid appreciation is of course the incentive this creates for speculative inflows. 

I have already argued many times that I believe speculative inflows are a serious problem.  Logan Wright, of Stone & McCarthy, has probably done the best work in trying to understand what is happening with foreign currency flows in China.  He has a new two-part paper that examines this.  I strongly urge anyone interested to read his papers (and get on his mailing list), but to summarize his newest paper, I will quote the opening paragraph:

Our analysis indicates that hot money inflows, which we estimate at $81-147 billion in 2007, were less volatile than the data initially indicated throughout last year and have likely increased in recent months, driven by faster appreciation of the yuan against the dollar. The implications of these findings are that current trends in foreign exchange reserve growth and foreign currency lending growth are likely to continue, even if the central bank enacts new restrictions on short-term foreign debt. In addition, some evidence points to the central bank continuing to use the daily central parity as a policy tool, rather than a channel permitting greater market influence over the yuan's value.

Comments (5) for "China's monetary trap"

Michael, I think you leave out the most important part of the story. What to do after the revaluation 1) fix the exchange rate again 2) Letit go freely or 3) continue some kind of managed float. I guess your idea is to leave it to the market moer or less directly. But if so why should we talk about a revaluation at all. Why not speak in favour of releasing market forces tomorrow, and then let us see whether we will get +5% or +15%, or -5%. If we have had large speculative inflows recently, the rate 7,00 may already be "just about right". We do not know e.g how much the trade surplus may be overstated due to overpricing between Chinese subsidiaries and foreign parent companies. We also do not know how much other capital would be repatriated out of China immediately after the one-way bet disappears. So, I share your analysis, but should not the conclusion be another. To let the peg go? By Stefan, Tallinn - 3/25/2008 11:43 PM

Actually after a revaluation I would recommend fixing the currency wiithin a very narrow band (either against the dollar or against a well-defined basket) and then widening that band over time until it was effectively irrelevant. The PBoC could continue intervening to minimize volatility in the beginning, but eventually it would focus on domestic monetary management. By Michael Pettis - 3/26/2008 11:45 AM

What if there is a sharp outflow of speculative money after an one-off revaluation given the leaky capital controls? By Andy - 3/26/2008 1:22 PM

Is there any way you could direct me to Logan Wright's 2 part paper? or his mailing list for that matter. I got lots of hits through google, but none led me to the treasure chest. Much appreciated By lccheh - 3/27/2008 7:36 AM

I agree that events have conspired to make the renminbi's current pace of appreciation untenable, hence the increasing likelihood of a growth shocking 'maxi-revaluation'. However, the latest data show that the trade surplus is coming down, albeit still at high levels, the Feb number was particulary low at around 8bn, less than half the 22bn they usually post. In a way, the slowdown in the US and Europe could be exactly what the chinese authorities need at this time to cool their economy. It is unclear to me the extent to which they will be able to compensate with FAI because of most of it is concentrated into real estate development which is likely to be contained because of a slowdown in coastal prices as well as manufacturing which is geared to exports. Re the latter rising labor costs are decimating exporter margins, so I expect a deterioration in the ROIs and retained earnings of the exporters that have been contributing to FAI growth. I also think that inflation is mostly a food/supply shock phenomenon as opposed to the money supply driven runaway inflation of the mid 90s. The difference today is that the PBoC has not only sterilized the majority of the fx reserves, but also prevented the remnants of the unsterilized reserves from drowning money supply by curbing loan growth. That is the mechanism through which contamination happens and it is under control. Money supply growth is only 17% vs 40% back in the 90s. Of course, inflation whether from food or money growth is still a problem, since its 35% of expenditures. But I think that they will ride it out and it will tick down once we anniversary some of the initial spikes up. So just another perspective on things, their economy might just 'muddle through' long enough to avoid a spectacular revaluation. By SS - 3/28/2008 3:16 AM