My Blog

April 29, 2008

The global slowdown and the huge uncertainty it has added to the process of evaluating the policy options available to the Chinese authorities could not have come at a worse time.  Exporters are increasingly shrill about the deleterious impact of the rising RMB, although it seems to me that their real problem is partly slowing global growth and partly a domestic trend that is actually very good for China in the medium term – local wages are rising and the former exporting centers of China (i.e. Guangdong province) are shifting rapidly into higher value-added manufacturing and services aimed more at domestic consumption.  Still, a lot of exporters are hurting and the appreciating RMB is an easy target, no matter how often it is pointed out that the RMB has not appreciated at all in trade-weighted terms – it has only really appreciated against the US dollar.

Still, the combination of angry exporters and the fact that, contrary to the expectations of many, a more rapidly rising RMB has not had much impact on reducing inflation, the argument against a too-rapid appreciation of the RMB seems to be gaining ground.

“There've been many calls from the big ministries, especially the Ministry of Commerce, State Administration of Foreign Exchange (SAFE) and National Development and Reform Commission (NDRC),” said a Communist Party official familiar with the decision-making process. “They all believe that the yuan's current rise is too fast.”

This comes from an article in yesterday’s Market News International discussing the fact that in April RMB appreciation has slowed significantly, rising by a modest 0.42% over the month, including today’s 0.24% jump (it closed at 6.9898), compared to its 4.0% appreciation during the first three months of the year.  The article goes on to say: “The government is preparing to step up its intervention in the foreign exchange market to maintain a sharply slower yuan rise against the U.S. dollar, abandoning the policy of recent months to use a stronger currency to fight inflation, government officials and economists told Market News International.”  So what’s going on?

The same old thing.  China’s monetary trap has all but eliminated its policy options.  Slow appreciation didn’t seem to work, and the recent fast appreciation doesn’t seem to work either, so maybe its time to try slow appreciation again.  Unfortunately both policies have resulted in the gradual or more rapid building-up of imbalances to the point where the adjustment is increasingly urgent and increasingly difficult to implement. 

When the authorities began speeding up the rate of appreciation in August and September of last year, the hope was that this would result in lower inflation and a sharp reduction in overinvestment (remember that the pick-up in inflation started at the end of 2006 and the beginning of 2007, long before the pick-up in the rate of RMB appreciation), but I think this hope was based on a misunderstanding of the underlying dynamics.  China’s problem is a monetary problem caused by its currency regime, and the only way to address the problem is either to alter the currency regime so that the PBoC is no longer forced to monetize massive amounts of capital inflows, or to alter the RMB trading level so that the incentive for massive capital inflows is eliminated.  Neither faster appreciation nor slower appreciation will do the trick, since neither resolves the problem that needs resolving.

As early as February of 2007 (and in my June 2007 Far Eastern Economic Review articles), I pointed out that the then-glacial pace of RMB appreciation meant that China would be force to countenance the growing imbalances for much longer than was sustainable.  I also pointed out that any attempt to quicken the pace of appreciation would collapse over the problem of accelerating hot money inflows.  This seems to have happened, and after only six months. 

That is why I argued that they had run out of options.  It was clear that gradual appreciation was storing up massive imbalances that would lead to overheating and inflation, while faster appreciation could not possibly help the fight against inflation because it would actually result in even faster monetary expansion in the short term, which would increase, not decrease, monetary pressures.  The Market News International article goes on to say:

Sources said that the pick-up in the pace of appreciation, which began in early December in the face of rising domestic inflation, has brought with it evidence of rising levels of speculative “hot money,” pouring into China to bet on a further rise in the currency.  It has also led to increased complaints from the export sector -- which has powerful backing from the Ministry of Commerce -- that its margins are being hammered as its competitiveness is eroded by the rising currency. The opposition to the pace of the currency's rise has spilled into the public forum, where a number of influential officials and economists have called on Beijing to take action to counter market expectations about the yuan.

Xia Bin, an prominent government economist with the Development Research Center, an influential think tank under the State Council, became the latest of these when he was quoted on Monday by the official China Securities Journal as saying that the exchange rate can have only a limited impact on the fight against inflation and that expectations need to be stabilized.  “There are so many people saying this -- it's clearly a government signal and there will probably be measures introduced very soon,” said Zhao Xijun, an economist at Beijing's Renmin University.

Unfortunately I am still willing to bet that a slowing pace of appreciation will not stop hot money inflows anywhere close to the extent necessary.  At best, I suspect, slower appreciation will slow capital inflows marginally while lengthening the period during which the imbalance can grow, although even then inflows may actually pick up speed initially if the PBoC steps up intervention to limit the RMB’s rise.  At worst it will signal to the market that with the PBoC so clearly running out of options, the probability of a maxi-revaluation will have increased so significantly that it makes more sense than ever to bet on the RMB.  In fact I suspect it will be the latter.  Let’s watch the hot money proxies closely over the next few months.

At any rate in neither case will inflation slow down.  I expect inflation will continue to rise because of the already-huge growth in money.  As it does, the lack of policy options will become clearer than ever, and those people at the PBoC and related agencies who understand how serious the monetary imbalances are will see their arguments in favor of a sharp adjustment much strengthened.    I hope this happens quickly.

Unfortunately the authorities still have one or two more tricks they might try.  For example, according to Market News International, “The official said that capital controls will also be introduced to stem the inflows of hot money.”  Capital controls?  Hmmm.

I am pretty pessimistic about the usefulness of capital controls in such a large country with such active and porous borders.  Increased capital controls are likely mainly to distort economic activity (how do you distinguish between legitimate trade and FDI transactions and hot-money-related transactions without significantly increasing the cost of monitoring?) while increasing the opportunities for corruption, without seriously reducing hot money inflows for more than a few months – which is all it will take for people to figure out how to get around the new rules.  After all China has had capital controls basically since 1949, and the empirical evidence suggests that capital controls become eroded over time as alternative channels develop.  Can anyone doubt whether Chinese businesses, with extended family networks abroad, have figured out how to evade capital controls?

By the way and on a very related topic, some of my blog readers might remember in March when I quoted one of my former Tsinghua students, now a VP at a large investment bank, who told me about a sign he had seen at his golf club in Shenzhen saying that, according to SAFE, as of April 1 Shenzhen golf clubs would no longer be able to accept Hong Kong dollars as payment for their services. A few days ago he sent me another message:  “Remember I told you about the banning of the use of HKDs in Shenzhen golf clubs?  Ha ha I again used HKD today to pay. No problem.”

Meanwhile, and making it all the less likely that more moderate appreciation will eliminate hot money incentives, the drumbeat for a maxi-revaluation is steadily rising.  According to yesterday’s Bloomberg:

China may revalue the yuan by 10 to 15 percent in the coming months as policy makers seek to temper inflation close to an 11-year high, according to Frank Gong, head of China research at JPMorgan Chase & Co.  The currency's 16 percent gain since the last revaluation of 2.1 percent on July 21, 2005 has failed to curb import prices, and attracted funds seeking to take advantage of continued yuan gains which have flooded the economy with excess cash… The chances of a one-off adjustment are higher than the 10 to 20 percent odds previously forecast, wrote Gong in the note published yesterday. He was unavailable for comment today.

The authorities are really in a tough position, and I am certainly glad I am not the one forced to make the decision about what to do.  The wrong decision, or even the right decision at the wrong time, could be a real career buster.  I think for political reason the authorities need to try every alternative policy option before they can develop a very wide consensus that none of them work.  Unfortunately the longer they wait the more difficult the adjustment will be. 

I am curious to see the trade data for the next few months.  If export growth slows, as I expect, and if inflation picks up, as I also expect, what is there left for them to try?  By the way I heard one recent projection of 8.4% CPI inflation for April.  If true, it implies an annualized rate of inflation for the first four months of 2008 of 9.5%.  I suspect that April CPI inflation may actually be higher, but if it is 8.4% this will certainly provide some relief, since it implies no real month-on-month inflation for April.

Comments (13) for "Is RMB appreciation slowing?"

Hi Prof. Pettis, This may sound like a silly idea, but what are your thoughts on the odds and effects that a maxi-revaluation of the RMB DOWNWARD instead of the expected upwards direction would have? It seems to me, a layman, to have some interesting effects. #1 the hot-money speculators take it in the shorts, and the PRC government teaches these speculators a lesson. #2 the Chinese stock market would probably rally. #3 exporters would be happy. etc etc. From what I understand, this would also have some pretty strong negative consequenses. What if, say, a 25% downwards revaluation were followed by a 75% upwards revaluation months or a few years later? It seems that in the current situation, where a command-driven economy is 'contaminated' by outside market-driven economies (the hot-money speculation on RMB rise being a great example) the only option the command-driven economy has is to do the unexpected, otherwise speculators from outside the control of the government will always have the upper hand. By David Geise - 4/29/2008 2:38 AM

Prof. Pettis: Certainly, the one-off revaluation of the RMB might convince the hot money that the low hanging fruit is gone. What happens in the fourth option - the RMB is convertible? The maxi-revaluation is still a pseudo-peg, right? David Geise: Interesting idea, but what happens to inflation and the gross imbalances if you devalue the RMB (which is already effectively being devalued against most currencies)? By matt - 4/29/2008 5:41 AM

If the objective was to punish the hot money speculators, then a devaluation will certainly do the trick. In fact a change in trend from gradual revaluation will do the trick too,no need for massive adjustment. Hot money flows where there is easy money to be made. Unless the money can find a profitable place to park once it reaches an RMB account, I dare say the notion of shifting foreign currencies into RMB for an uncertain 8% growth is not exactly for the faint hearted. With the Chinese stock market clearly in a bear phase, and property market going nowhere, there is little parking spaces for hot money speculators. Remember also RMB is not freely convertibile. When the music stops, and eventually it WILL stop (remember how the world was sure of 'not if but when' Japan would overtake the US as world #1 economy back in 1990?), make sure the exit door is nearby, as it will be jam-packed with everyone who wants to get out at the same time. As of now, the biggest challenge that occupies the minds of those inpower is how to create enough jobs for the 20odd million new job seekers who turn 18 each year. Inflation is of course an important issue, but nothing compared to 20million frustrated, idealistic young adults. Any maxi-revaluation will not take place until and unless that someone to push the button is empowered with a political mandate to do so, as Volcker after Burns. Until we see a Burns equivalent in China gets sacrificed, we wont see a China Volcker do a maxi-revaluation. If gradual revaluation since 2005 has not worked, maybe it is time to switch to gradual devaluation. That may be the path of least resistance for China. By Kheng - 4/29/2008 1:18 PM

However maybe the hot money is coming into China because of credit concerns with the US, and it's going to be rather insensitive to the exchange rate. By Twofish - 4/29/2008 2:30 PM

Also, I really don't see them pushing the button until non-food inflation is higher than it currently seems to be. Pettis: The wrong decision, or even the right decision at the wrong time, could be a real career buster. I don't think that people are that worried about their careers. It's being on the wrong end of an angry mob that concerns people. By Twofish - 4/29/2008 2:32 PM

With local exporters howling about plunging margins, inflation recently reaching for double digits, a hard-won reputation for both refusing to devaluate and a grudging reluctance to revaluate, China is on the very edge of a new paradigm for them: They are now so tied to the American economy that as the U.S. sneezes China will catch the cold. China has disproved the business cycle for an entire generation; but the cycle is an inexorable fact of economics. Frankly, China is overdue for a correction, and the weakening American economy might just be the precipitating event. They have managed a boom; let's see if their institutions are prepared for the test of a modern bust. Only unemployment is going to bring down that growing inflation; does China have a central banker as intellectually honest as Paul Volcker, deliberately creating a recession to bring inflation under control? By a Duoist - 4/29/2008 5:25 PM

I do not know how you define generation, Duoist. But in 1990s, there were several very serious downturns in Chinese economy. Another issue, maybe China does not need a max-revaluation but a one-off inflation: the price had been kept low for too long. When employment is closer to its full level, it is time that the growth showed up at price tags. By fatbrick - 4/29/2008 9:04 PM

Its crucial to keep in mind the single most important factor underlying all Chinese decisions and the greatest source of fear for those in power: employment. When you have credible officials like Zheng Jingping telegraphing that the government will relax its "tight" monetary policy if growth slips below 9 percent, all these peripheral questions are automatically answered. By kevinfischer2002 - 4/29/2008 9:31 PM

I am not sure I would want to manage monetary policy just for the purpose of punishing speculators. A devaluation would simply make all the current imbalances much worse while almost certainly starting a trade war with Europe and the US. It would also mean a deteriorating terms of trade for China. That is almost certainly a non-starter now. Kheng, you may or may not be right about whether people bringing money into China are being foolish, but from the PBoC's point of view that is irrelevant. What matters is that they ARE bringing huge amounts of money into China (or at least that seems to be the case) and this makes the management of monetary policy nearly impossible. From my point of view that is the key consideration. Fatbrick is right about serious downturns. One of the strange things I keep hearing again and again is that people have been predicting downturns in China for 30 years and it has never happened. It has happened at least three times very seriously. By Michael Pettis - 4/30/2008 2:55 PM

Duoist: They are now so tied to the American economy that as the U.S. sneezes China will catch the cold. This isn't the case. China's economic growth has been overwhelming domestic, and it's business cycles aren't in synch with the United States. Which is why pegging to the US dollar is not a good idea. Pettis: It has happened at least three times very seriously. And the one that keeps people in Beijing up worrying at nights is the one that happened in 1989. However I'm actually rather optimistic that things won't get nearly that bad this time, because the policy tools available to deal with macroeconomic adjustment are far stronger than they were in 1989, 1993, and 1998. Also taking a page from Krugman. China economic expansion since 1978 is not difficult to explain. Basically after about 150 years of economic and political mismanagement, China got to the point where there wasn't anything holding down growth, at which point productivity was so low that there was nowhere to go but up, and up very quickly. By Twofish - 5/1/2008 12:12 PM

I mentioned Japan as an example of how a trend can get seriously entrenched with genuinely positive economic conditions to substantiate and further foster that trend way past its fundamentals. A more recent example is Nasdaq rising from 750 in 1995 to 5132 in 2000. Nikkei rose from 6000 points in 1982 to over 40000 point in 1989. At the peak, I read media report calculating how the land the Imperial Palace occupies in Tokyo was worth more than the state of California, and Japanese were taking out mortgages with 100 years tenure. When the tide eventually turned, Nikkei went on a correction which initially hit a major bottom of 15000 in 1992, and subsequently below 10000 in 2003. I don’t know Nikkei’s PE ratio at its peak, but I recall $SSEC PE ratio around 80 at its peak last October. At its peak in 2001 Cisco carried a PE ratio of 100x (ballpark figure). I recall some celebratory coverage on TV highlighting Cisco with the largest market cap in the world then, not unlike the recent media coverage of PetroChina being the first trillion dollar company. Enough investors were convinced we were entering a new millennium witnessing the birth of an internet-based NEW economy, thus justifying higher Nasdaq PE. Some even questioned if Warren Buffet was out of touch as he didn’t own a single tech stock in his portfolio. It is only in hindsight that we knew chasing Nikkei stocks was a bad idea in 1990. Likewise, those who bought USD to chase Nasdaq stocks in 2001 believed both USD and Nasdaq were powering higher. History has plenty of examples to show how late comers tend to get seriously hurt chasing a trend as a one way bet. For RMB, the added exit complication is its convertibility. Interestingly, Nikkei took 7 years to grow 600%, only to give back 75% of that rise in 2 years. Nasdaq took 5 years to rise 584%, only to give back 92% of that rise in 2 years. $SSEC took less than 2 ½ years to grow 514%, only to give back 60% of that rise in 6 months. To-date $SSEC has recovered 24% from its bottom in 6 trading days. Hesitant recovery but the trend appears up. By Kheng - 5/1/2008 2:30 PM

Twofish, 1989, 1993, 1998, 2003. That is an average interval of 5 years. Next in line, 2008? 1989 and 2003 were serious, so hopefully 2008 is minor. By Kheng - 5/1/2008 2:36 PM

Professor Pettis, I m new reader of your blog. Interesting and very insightful articles. I agree with u that currency regime needs to be fixed ultimately and is currently causing liquidity problem chinese government is facing, however it's not the only cause. i believe you should at least look at the credit growth in banking systems for the past many years (i think the banking system is going to face big challenges if corporate earning growth slows down in the coming years. u probably agree that despite all the effort of state-bailout of bad debt, bank IPO, etc., the banking system is still so primitive. how many chinese banks analyze credit risk properly today?). it appears to me that foreseeable goal of the government is to achieve a relative "stable" market exchange rate of rmb, maybe a "dirty float", something like singapore dollar. nevertheless, the key is how to achieve it, without causing much political, social and economical conflicts. so far, it appears that the government has accepted that the path would take some time, maybe more or less one year (look at what rmb is trading on offshore NDF market). i think one-off reval doesn't fit the criteria. whether other means would achieve those objectives, the government needs to weigh it carefully. Increase in foreign capital inflow is inevitable at this stage. as for many, it's risk-free investment, 10%-12% p.a. hedged on NDF plus interest rate carry. A "gradualism" approach would mean that the government needs to suck it up one way or another. Tighter policy control and scruitiny on FDI and other means of inflow is definitely an option, the only problem is how good it can be implemented. Your view? Also, it would be great if you can write something about how chinese bank lend. i think it is a very interesting topic. i learnt from my chinese bank friends that basically regardless the interest rate is 13% or 3%, banks stick to the same group of customers, even though some, in risk sense, may not even be good customers. there may be many chinese versions of subprime lending.. -Ken By Ken - 5/3/2008 12:10 AM