Good news out of China

But why is it good news?  In March I had this to say about China’s yuan peg:

Deflation was my fear for China in late 2008 and 2009, but I agree that that danger is now past.  The Balassa-Samuelson effect would allow China to appreciate the real yuan, and even maintain a large CA surplus.  Indeed I predict they will allow some appreciation later this year.

Yes, I know it’s in bad taste to quote oneself.  And no, I’m not trying to say “I told you so.”  (Many people predicted that yuan appreciation would resume sometime this year.)  Rather I wanted to emphasize the right reasons for letting the yuan appreciate.

Some have argued (and by “some” I obviously mean Paul Krugman) that the weak yuan was hurting the US economy by reducing aggregate demand.  I have argued against that view, instead suggesting that China should adjust the yuan as necessary to meet their domestic macroeconomic goals, which include keeping inflation low.  Inflation in China has recently been rising, and the Chinese government has resorted to administrative controls to slow things down.  These controls seemed to hurt Chinese stocks, which have done poorly this year.

Here is an AP new report on the market reaction to the Chinese announcement:

Beijing’s announcement on Saturday affects markets because China currently keeps the yuan artificially low to boost exports. That helps China sells products to the U.S. and Europe on the cheap, but also makes it difficult for its own consumers to buy foreign goods.

An appreciation in the yuan would help balance out growth across China’s economy and is considered a boost for U.S. and European manufacturers and exporters. The main market impact — a weakening of the dollar — could also help make the U.S. economy more competitive.

Finally, by letting the currency rise, the threat of inflation to China should be reduced, easing investors’ worries that interest rates could be hiked to cool off the economy.

“Market players saw the announcement as a sign that Chinese authorities are confident in China’s economic growth,” said Kazuhiro Takahashi, equity strategist at Daiwa SMBC Securities Co. Ltd.

However, experts also noted that any reform to China’s currency policy would be gradual.

This announcement discusses several reasons why markets appear to have responded positively to the Chinese announcement.  The first part of the quotation describes what might be termed the “terms of trade” argument.  Trade is (supposedly) a zero sum game and thus if the yuan goes up then the US and other countries gain business and China loses business.  The second part of the quotation is more in line with the “macroeconomic stability” argument that I alluded to earlier.  I suggested that China should appreciate the yuan if and only if it was in China’s interest to do so.  How can we tell who’s right?  One approach would be to look at the various market reactions:

In Asia, Japan’s benchmark Nikkei 225 stock index ended 242.99 points, or 2.4 percent, higher at 10,238.01 — a one-month high close. South Korea’s Kospi rose 1.6 percent to 1,739.68, and Australia’s S&P/ASX 200 added 1.3 percent to 4,612.60.

Hong Kong’s Hang Seng index climbed 3.1 percent to 20,905.91, while China’s Shanghai Composite Index added 2.8 percent to 2,583.91. Benchmarks in Singapore and Taiwan also advanced.

Of the 11 Asia/Pacific markets listed in Yahoo.com, only Hong Kong rose by more than the Chinese stock market.  Many Hong Kong companies have invested heavily in China, and those investments will become more valuable in HK$ terms as the yuan appreciates.  But the big gainers were the Chinese stock investors.  A higher yuan will restrain inflation and reduce pressure on the Chinese government to use crude monetary tools to crack down on real estate speculation.  But shouldn’t the Chinese government crack down on their wildly overheated investment sector?  As Zhou Enlai might have said “It’s too soon to tell.”

I’ll do a post on Chinese real estate in the near future.  (For those who don’t know, the Zhou comment was in response to a questioner who asked him about the impact of the French Revolution.)


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16 Responses to “Good news out of China”

  1. Gravatar of StatsGuy StatsGuy
    21. June 2010 at 08:37

    BTW, few have argued that trade is truly zero sum, but rather that Chinese currency controls can be mercantilist (and they start to look zero sum because of this). A lot of people have been calling Chinese policy mercantilist for a long time, but it seems that someone from Chicago has just built a model to describe it. So it must be real. 🙂

    BTW, here is an excerpt from Pettis on June 15, before the announcement. [Also, let me suggest that this also provides an example of how monetary policy and bank regulation are not separable.]

    “Two months ago University of Chicago economist, Robert Aliber, came to speak at my central banking seminar at the Guanghua School of Peking University. In a fascinating discussion he explained that in fact there was another possible resolution of the imbalances caused by relatively rapid productivity growth in the tradable goods sector.

    He pointed out that if the nominal exchange rate is not allowed to rise, policymakers can still contain inflation by what economists call financial repression, made possible by their control over the banking system in countries where banks completely dominate the financial system. In the Chinese context, financial repression exists because the vast bulk of Chinese savings is in the form of bank deposits, and the deposit rate is set at extremely low levels.

    This has the effect of transferring large amounts of income away from net savers, which for the most part consists of Chinese households, and in favor of net users of capital. Net users, of course, consist primarily of large, capital intensive businesses, real estate developers, infrastructure investors and local and central governments, including the People’s Bank of China, the largest net borrower of renminbi in China. Net savers are forced into subsidizing net users, in other words.

    The consequence is that monetary growth is channeled not into household demand but rather into the production of more goods, and the inflationary impact of monetary expansion is muted. Financial repression is an alternative to currency appreciation or inflation.

    The cost of low interest rates

    But according to Aliber’s model, financial repression has a cost. It leads to overinvestment, asset bubbles, and rising excess capacity. By keeping the cost of capital in China very low – perhaps as much as 5-8% below a rate that would impose a fair distribution of the benefits of economic growth between savers and users of capital – it results in a surge in investment which, allied with large-scale socialization of credit risk, can lead at first to a rapid increase in economically viable investment but ultimately, if left unchecked, results in capital continuing to pour into investment long after its returns are uneconomical.

    I think it is pretty clear that during the last few years, and perhaps even longer, we have migrated into a state where the correctly valued costs of Chinese investment in infrastructure, real estate development, manufacturing capacity, and government spending, exceed the economic benefits.”

  2. Gravatar of Jon Jon
    21. June 2010 at 08:49

    Yes, I was thinking how clever the Chinese were this morning. They do something they need to do–want to do–and tell us they are doing it for us and have accomodated us.

  3. Gravatar of Ed Dolan Ed Dolan
    21. June 2010 at 09:21

    Two points. First, Scott is completely right that the Chinese announcement is driven by domestic needs, mainly, the need to use currency appreciation to control domestic inflation. However, it is not clear that we can expect much early appreciation of the yuan relative to the dollar. The reason is that the yuan has already appreciated something like 12% against the euro, which, taking into account that the EU is an even bigger trading partner for China than the US, means there has already been a substantial, inflation-damping, real trade weighted appreciation even before the new announcement.

    Second point, StatsGuy is absolutely right to focus on the negative consequences of using financial repression to control inflation. To underline this point, take a look at a 2006 study by the McKinsey Global Institute (http://www.mckinsey.com/mgi/publications/china_capital/index.asp), which found that China’s incremental capital to output ratio was not only higher than India’s, Japan’s, or Koreas, but was actually rising. Their data only went thru 2003, but the investment binge in the last two years resulting from the investment-intensive Chinese stimulus package could only have reinforced the trend of the ICOR. So China is killing its own goose with its currency peg.

  4. Gravatar of scott sumner scott sumner
    21. June 2010 at 09:24

    Statsguy, The problem with the term ‘mercantilism’ is that it is used in two very different ways, that have nothing in common.

    1. Protectionism
    2. High savings rates.

    China obviously fits the second definition, as does free trading Hong Kong and Singapore.

    Another problem is confusion between nominal and real exchange rates. China’s real rate will appreciate regardless of what they do with their nominal rate.

    I agree with Aliber that a modest currency appreciation is better than financial repression. That’s why I think the Chinese did the right thing. But of course this won’t entirely solve the problem, it will just make the economy a bit less distorted.

    Jon, Good point.

  5. Gravatar of scott sumner scott sumner
    21. June 2010 at 09:26

    Ed, I agree that the yuan won’t appreciate very much in the short run, and indeed I think that’s one reason why Chinese stocks responded so strongly. They are putting the correct policy into effect, but not overdoing it.

  6. Gravatar of StatsGuy StatsGuy
    21. June 2010 at 11:08

    ssumner:

    “The problem with the term ‘mercantilism’ is that it is used in two very different ways, that have nothing in common.”

    While they are very different, they do have a lot in common. But first, it’s important to note that the real comparison is:

    1) Trade Barriers
    2) Forced Savings + Capital Controls

    Thus, we should differentiate between Singapore, and China where forced savings with capital controls in which we get excess _export-focused_ supply, which results in unsustainably cheap imports to the US that are paid for by taking savings from poor Chinese households.

    The key is the inability of Chinese households to invest outside China (unlike Singapore), which gets translated into capital investment subsidies inside china that are financed by a de facto tax on (forced) savings. THAT is not merely a social choice about savings vs. consumption… THAT is protectionism. Moreover, the consumption disincentives are concentrated in imports due to the undervalued currency.

    But the next question is – so what? How is this different from a general increase in supply, which may cause painful short-term US adjustments but is better in the long term?

    Pettis goes further and argues this has repercussions associated with excess investment (bubbles, overcapacity). If one believes that we are observing subsidized export overcapacity (courtesy of forced savings and constrained options for saved money), but that the overcapacity is NOT functional (aka, it truly is too much for the external world economy to reasonably absorb, particularly without Chinese imports picking up), then it would have a _non-functional_ negative effect on US jobs by putting US labor out of work “temporarily” until the excess capacity resolved. In an environment of tight credit, “temporary” becomes “permanent” very quickly. This sort of whipsaw is costly.

  7. Gravatar of thruth thruth
    21. June 2010 at 13:06

    Statsguy: what’s the argument for investment subsidies (in this case forced savings) creating a bubble? The best I can come up with is that the principals of state mandated savings vehicles aren’t discriminating about their investments and will happily fund ponzi schemes. Is that the argument?

  8. Gravatar of david david
    21. June 2010 at 17:33

    @Statsguy

    To nitpick, Singapore also has forced savings and during its earlier development similarly used the funds to subsidize internal investment by its state-owned enterprises. High savings account contributions then crowds out local household investment overseas anyway.

    (Singapore today allows its people to invest their CPF savings, but of course it is no longer a developing country).

  9. Gravatar of david david
    21. June 2010 at 17:56

    @scott

    On a tangent: I stumbled across this 1983 article that takes a similar stance to what I have previously argued in your comments. It is oddly prescient about modern Singapore (see the conclusions on pp761-762 – the pursuit of privatization as an end in itself, the increasing separation of the state from ‘heartlanders’ as the government today calls them, and the predicted changes in Singapore’s privatization campaign – the social safety net grew dramatically to replace state-managed job security), although its unsubtle opposition to Reagan and Thatcher may have been misguided.

  10. Gravatar of StatsGuy StatsGuy
    21. June 2010 at 18:55

    @David

    Please note that I in no way argued that forced savings, or indeed classic mercantilism, isn’t an effective strategy to accelerate early industrialization (though one that, eventually, a country must transition away from). That’s a tough argument, on both sides. And we, the United States, which aggressively used mercantilist mechanisms to protect early markets and built a huge trade surplus going into the 20th century, don’t have much room to criticize here. I’m merely arguing that China’s policies are indeed mercantilist.

    @Thruth

    This is Pettis’ argument:

    “But according to Aliber’s model, financial repression has a cost. It leads to overinvestment, asset bubbles, and rising excess capacity. By keeping the cost of capital in China very low – perhaps as much as 5-8% below a rate that would impose a fair distribution of the benefits of economic growth between savers and users of capital – it results in a surge in investment which, allied with large-scale socialization of credit risk, can lead at first to a rapid increase in economically viable investment but ultimately, if left unchecked, results in capital continuing to pour into investment long after its returns are uneconomical.

    I think it is pretty clear that during the last few years, and perhaps even longer, we have migrated into a state where the correctly valued costs of Chinese investment in infrastructure, real estate development, manufacturing capacity, and government spending, exceed the economic benefits.”

    I don’t think Pettis is arguing against any forced domestic savings at all, merely the scale of it. 0.6% to 0.7% of world gdp in export surplus, from an economy totalling only 8% of the world GDP, sustained by an economy with massive externally targeted investment dependency.

  11. Gravatar of thruth thruth
    22. June 2010 at 04:41

    @Statsguy: I guess I missed the bit about “allied with large-scale socialization of credit risk”. That indeed sounds like he is talking about some sort of principal agent problem. (Fannie and Fredie’s underpricing of credit risk and incentives to go for broke may be a good analogy here.) Do we know anything about how the Chinese state is directing its domestic investments?

  12. Gravatar of scott sumner scott sumner
    22. June 2010 at 05:34

    Statsguy, The inability of the Chinese to invest outside China tends to make their trade surplus smaller, ceteris paribus. So I don’t see the similarity to mercantilism. If they removed those barriers, China’s surplus might be even more than 0.6% of world GDP. BTW, over the past 12 months China’s trade surplus is much smaller than Germany’s and even smaller than Russia’s (a country with 1/10th China’s population.)

    Many people forget that import trade barriers reduce exports. So if mercantilism is defined as policies that boost exports, then import trade barriers are not mercantilist.

    I don’t think China’s external policies create bubbles, rather any bubbles are caused by a politicized banking system that makes loans as political favors, not on a cost/benefit basis.

    I have doubts about the entire “bubble” theory of China’s economy, which I think confuse many separate issues.

    David, I agree that there are similarities between forced saving and China’s strategy, although Statsguy’s also right that China’s capital account is less open than Singapore.

    Statsguy, I see the debate over mercantilism as slightly distorted.

    1. The US ran trade deficits during much of the 19th century, as it was developing. When it became the world’s biggest economy (around 1900?) it began running surpluses. Obviously this is totally different from China.

    2. Some East Asian countries that were often considered “mercantilist” (such as Korea) often subsidized exports. But the export subsidies roughly offset the impact of their import tariffs, leaving trade relatively open. Not surprisingly, Korea was a trading nation, not an autarky.

    3. Free trading Singapore and HK grew fast just like Taiwan and Korea, suggesting that any differences in trade polices were much less important than the commonalities among the 4 tigers.

    4. In the 19th century the US was not as protectionist as is often claimed. The average tariff rate is misleading for two reasons—many goods had no tariff, and there were no non-tariff barriers (which are now the biggest problem.) We were a trading nation with a trade deficit–not at all mercantilist.

    BTW, in PPP terms, China is probably 15% of world GDP.

  13. Gravatar of david david
    23. June 2010 at 13:39

    Korea didn’t just subsidize exports; it resisted foreign direct investment and played its own elaborate currency games.

    As for Singapore and Hong Kong, well, I think I have argued before that there are good reasons to doubt careless classifications of either as ‘free trade’. Both certainly welcomed foreign investment, but both worked their own domestic economy very carefully, and this detail is easy to miss in a small city. Imagine a hypothetical developing country that neither subsidizes exports nor taxes imports nor applies capital controls. But it subsidizes technical and professional education for designated industries, and constructs industrial parks with government-funded infrastructure most suitable for industries producing things that happen to currently most purchased in the (currently) richer developed states, and sets specific land zoning requirements that encourage certain industries but not others. It presents a fair playing field to private-sector domestic and foreign investment, but it expands the (necessarily domestic) public sector dramatically, again in selected industries. And, of course, forced savings. Is this still ‘free trade’?

    (apropos of nothing: I’m not sure whether this got missed, since you usually write individual replies).

  14. Gravatar of scott sumner scott sumner
    24. June 2010 at 07:05

    David; You asked;

    “Imagine a hypothetical developing country that neither subsidizes exports nor taxes imports nor applies capital controls. But it subsidizes technical and professional education for designated industries, and constructs industrial parks with government-funded infrastructure most suitable for industries producing things that happen to currently most purchased in the (currently) richer developed states, and sets specific land zoning requirements that encourage certain industries but not others. It presents a fair playing field to private-sector domestic and foreign investment, but it expands the (necessarily domestic) public sector dramatically, again in selected industries. And, of course, forced savings. Is this still ‘free trade’?”

    Yes.

    I’d recommend Krugman’s book “Pop internationalism” which exposes myths about “level playing fields.”

    Regarding Singapore, It is much more free market than in 1983, and ranks number 2 in the world in every survey that I have seen. If you find a survey that suggests a different ranking, I’ll take a look. We have 100,000s of regulations in America, and also sorts of special industrial parks with tax favors, etc., and yet we are considered a fairly free market economy. I am not at all impressed when people cite individual actions taken by the Singapore government. We do the same things here. It’s a question of how free market Singapore is relative to other countries, and the answer is that it is relatively free market. I am no expert on Singapore, but I have read an entire book on their economy, and I have been there, so I feel I know something about it. They have very low taxes, low government spending, few trade barriers, good property rights, good control of externalities, low levels of corruption, etc.

  15. Gravatar of david david
    24. June 2010 at 14:38

    Ah… I think you may misunderstand. No, I’m not trying to argue for some populist antiglobalization measure; I’m just trying to emphasize the facts on the ground elsewhere (I spent more than a decade in Singapore and have, yes, read books about it and its domestic policies).

    Policies in areas that are regarded as macroeconomically unimportant for large countries can have a dramatic impact in small countries. Tax favors and industrial parks would hardly alter US macroeconomic statistics. Tax favors and industrial parks can alter the whole structural balance of a city-state (which may very well only have one industrial park).

    And naïvely counting regulations seems, well, naïve. Singapore grants itself a few wide and expansive powers. The US grants itself many heavily restricted powers. The US and Singapore don’t “do the same thing” – or let me know when the US begins planning land use for the entire country based on industrial policy! Or is this one policy unimportant because it is only one policy vs. the US devolving land planning to innumerable state and city authorities?

  16. Gravatar of ssumner ssumner
    25. June 2010 at 12:06

    david, I agree that there is an apples and oranges issue here. I believe that the land use policies may well be some of the least efficient parts of the Singapore policy regime. They are certainly very inefficient in HK. In any case, I have no interest in defending “Singapore” as a country, but rather aspects of their system that I like. These include very low taxes, high savings, budget surpluses, open capital markets, flexible payroll tax rates, health savings accounts, fully-funded pensions, free trade, taxes on externalities, self-insurance for unemployment, etc.

    My hunch is that their housing and land use policies hurt living standards there, but I can’t say for sure.

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