China-US Currency Issues

1. China-USCurrency Issues Jeffrey Frankel Harpel Professor Revised from CLD Program, June 8, 2010;CHINA FUTURE LEADERS, 10 a.m., Bell Hall, January 17, 2011

2. Topics to be covered (I) Historical timeline of exchange rate diplomacy (II) What is in China’s interest? (III) What is in the interest of the US & Rest of World? (IV) Shifting power relationships • Appendices: • U.S. Treasury biannual reports on currency manipulation • The current account imbalances • The internationalization of the RMB • Technical appendices

3. Historical timeline “I have listened to both sides of this debate. Here is what I think. I think those who call for a fixed exchange rate are right in the short run. And those who call for a floating exchange rate are right in the long run.How long is the short run, you ask? You must understand. China is 8000 years old. So when I say, short run, it could be 100 years.”-- Li Ruogu, Deputy Governor, People’s Bank of China, Dalian, May 2004

4. Historical timeline of currency diplomacy • 1973: End of Bretton Woods era. • Major currencies switch from fixed to floating. The rest keep their pegs. • 1977: IMF members agree that each shall “avoid manipulatingexchange rates … in order to prevent effective balance of payments adjustment or to gain an unfair competitive advantage over other members.” [Principle (A) of the “1977 Decision on Surveillance over Exchange Rate Policies,” and Sect.1, Clause 3, of Article IV amended in 1978.] • In practice, the IMF almost never pressures countries to revalue their currencies upward; • It just pressures deficit countries to devalue. • 1983-84: ¥/$ Agreement. 1985: Plaza Accord. • Japan, US & others cooperate to bring down overvalued $, esp. vs. ¥ • 1987-89: • Louvre Agreement: $ depreciation halted. • Big bubbles in Japan’s equity & real estate markets, • followed by crash, & severe Japanese stagnation in 1990s.

5. Timeline, continued • 1988:The Omnibus Trade & Competitiveness Actmandates the US Treasury report to Congress biannually on whether trading partners were manipulating currencies. • Section 3004 requires the Treasury to “consider whether countries manipulate the rate of exchange between their currency and the US $for purposes of preventing effective balance of payments adjustments or gaining unfair competitive advantage in international trade.'' • The US must hold talks with governments deemed to be breaking rules. • In the first Reports to Congress on International Economics & Exchange Rate Policy, Korea & Taiwan PoC were found to be guilty of manipulation, • while Singapore & Hong Kong SAR “got off with a warning.” • China was named in early 1990s.

6. Timeline, continued: Exchange rate • Jan. 1994: China devalues its official rate, • unifying its dual exchange rate system. • 1997-98: East Asia crisis. • China wins plaudits for keeping RMB (“yuan”’) fixed • while all its neighbors are devaluing. • 1995-2005: China continues to peg • for 10 years • at 8.28 RMB/$.

7. Timeline, continued: US pressure • Oct. 2003: Treasury Secretary Snow begins to “browbeat” China to allow appreciation. • Treasury Report: RMB merits concern & talks • Speculators in financial markets start to bet appreciation. • as reflected in either capital flows (see Prasad & Wei) • or non-deliverable forward price (see appendix graph). • Feb. 2005: Senators Schumer & Graham propose first of bills to impose (WTO-illegal) tariffs of 27.5 % against all Chinese goods if China does not substantially revalue its currency. • Subsequent versions, by Baucus-Grassley and others substitute the phrase “currency misalignment” in place of “unfair manipulation” to ease standard of proof.

8. Timeline, continued: China’s macroeconomy • 2004-07:Rapid growth puts China into Excess Demand. • 2005-06:Despite large balance of payments surpluses, PBoC sterilization of reserve inflows prevents excessive money growth & inflation. • 2007-08:Sterilization finally falters:Money becomes excessive. • Inflation becomes a serious concern. • Shanghai stock market experiences a bubble. • Mid-2008 – early 2009:Worst of the global recession hits. • China loses 26% of exports • Growth slows; danger of overheating disappears. • Mid-2009 – 2011:China resumes very rapid growth • in response to domestic demand stimulus + renewed exports • China is now a major engine of growth in world economy. • Danger of overheating returns: esp. real estate bubble.

9. Timeline, continued: Exchange rate • 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. • 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, • because € does.

10. The magnitude of daily movements vs. $ increased in the spring of 2006,

11. Timeline, continued: Exchange rate • May 2008: Chinese leaders hear exporter complaints of competitiveness difficulties. • Mid-2008-April 2010: yuan re-pegs ≈ $ 6.84 RMB/$ • ≈ 20% stronger, vs. $, than 2005.

12. The RMB rose against the $ for 2 years, but returned to peg in mid-2008 $/RMB €/RMB €/$

13. Timeline,continued • 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.

14. 2009: Chinese warnings • Premier Wen worries US T bills may lose value.Urges the US to keep its deficitat an “appropriate size” to ensure the “basic stability” of the $(again on 11/10/09). • PBoC Gov. Zhou, proposes replacing $ as international currency, with the SDR (March 09). SDR

15. Timeline, continued2010 • Winter 2010: Pressure mounts -- • International pressure on Beijing to appreciate; • Congressional pressure on US Treasury to find China guilty of currency manipulation in its biannual report due April 15. • But Chinese say they will never bow to pressure.

16. April 2010 -- Collision is averted: • Treasury postpones manipulation report. • June 19 – PBoC announces it will “increase the renminbi’s exchange-rate flexibility,” • though subsequent appreciation is small. • So both sides save face • for the moment.

17. September 27 – Brazil Finance Minister Mantega warns of “Currency Wars”: • Each country intervenes to push its currency down • in effort to gain trade advantage, • collectively futile. • November 8, G20 Summit in Seoul -- • China criticizes US Fed’s monetary easing (“QE2”) as an example of currency wars.

18. Jan. 2011: Preparations for Obama-Hu summit • Jan.14: Geithner notes that -- including higher China’s inflation -- RMB is appreciating at 10% per year. • That suggests US lower priority on the currency issue • Vs. IPR, North Korea & other issues.

19. Appreciation + inflation WSJ 1/22/11

20. 5% nominal appreciation per annum + 5% inflation differential≈ 10% real appreciation per annum September-December 2010 Global Macro Monitor Data sources: The Economist, BLS, CEIC, Thomson Reuters

21. (II) From China’s viewpoint, • 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 • Few countries have been forced to appreciate. • Pressure on surplus countries to appreciate will inevitably be less than pressure on deficit countries to depreciate. • I support retiring 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.

22. What is in China’s interest? • My view: mutually-beneficial bargain, between equals • As part of G-20 process • E.g., 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.

23. Five reasons China should let RMB appreciate, in its own interest • Overheating of economy • Reserves are excessive. • It gets harder to sterilize the inflow over time. • 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. • Avoiding future crashes. • RMB undervalued, judged by Balassa-Samuelson relationship.

24. 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.

25. 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)

26. 2. Foreign Exchange Reserves • Excessive: • Though a useful shield against currency crises, • China has enough reserves: $2 ½ trillionby April 2010; • & US treasury securities do not pay high returns. • Harder to sterilize the inflow over time.

27. Foreign exchange reserves held by the People’s Bank of China are approaching $3 trillion in 2011. New York Times Jan 12, 2011

28. The Chinese money supply has almost doubled in the last 3 years, contributing to a rapid growth aggregate demand as reflected in nominal GDP New York Times Jan 12, 2011

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

30. Attempts to sterilize reserve inflow: Successful sterilization in China: 2005-06 High reserve growth =>steadymoney offset by cuts indomestic credit While reserves (NFA) rose rapidly, the growth of the monetary base was kept to the growth of the real economy – even reduced in 2005-06. were remarkably successful in 2005-06.

31. In 2007-08 China began to have 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 priceswere 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.

32. Sterilization faltered in 2007 & 2008 Monetary baseaccelerated Growth of China’smonetary base,& its components Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008

33. China’s CPI accelerated in 2007-08Inflation 2002 to 2008 Q1 Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008

34. Inflation is once again accelerating

35. 3. Need a flexible exchange rate to attain internal & externalbalance • 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.

36. 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.

37. 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.

38. The Balassa-Samuelson Relationship 2005 Source: Arvind Subramanian, April 2010, “New PPP-Based Estimates of Renminbi Undervaluation and 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%.

39. Solving the problem of current account imbalances, in particular, the US CA deficit & China’s surplus. Both have widened, on long-term trends. (III) What is in the global interest? 39

40. The US trade & current account balances have been on a downward path for 50 years.They “improved” sharply in 2008-09, falling by half; but this reversal was temporary, due to US recession, Trade & current accounts, in $ billions per quarter

41. Dangers of the U.S. trade deficit • Shorter-term dangers: • Protectionist legislation • A possible hard landing for the $. • Long-term dangers: • Dependence on foreign investors • US net debt to RoW now ≈ $3 trillion, • and rising. • Will lower our children’s standard of living. • When the US cuts its deficit, that will mean the rest of the world losing its surplus • The longer adjustment is postponed, the harder it will be.

42. Policies to reduce the US CA deficit • Reduce the US budget deficit over time, • thus raising national saving. • After all, this is where the deficits originated. • Depreciate the $ more. • Better to do it in a controlled way • than in a sudden free-fall. • The $ already depreciated a lot against the € • & other currencies • from 2002 to 2007. • Who is left? • The RMB is conspicuous as the one major currency that is still undervalued against the dollar.

43. (IV) Changing power relationships • It has never worked well for the US to make a dozen different demands on China, • IPR, human rights, help on N.Korea, Iran… • when we only have one carrot/stick: • keeping our markets open. • As the world’s largest debtor, with China our primary creditor, our ability to make demands is diminished. • There is a particular tension between hoping China will continue to buy our Treasury bills, while asking it to stop buying our Treasury bills • i.e., to stop buying $ / selling RMB, • which is what keeps its currency from rising.

44. Be careful what you wish for. You might get it ! $2½

45. If China gave US politicians what they say they want... • we might regret it. • if it included reserve shift out of T bills, to match switch in basket weights from $. • we could have a hard landing for the $. • Skeptics argue China will not sell T bills • because, as the largest holder, it would be the biggest loser when the $ depreciated. • Financial market fears that China might stop buying US T bills could send the $ down in themselves. • If the $ is falling, China will not want to be the only one left “holding the bag.”

46. If China gave US politicians what they say they want... • For US output & employment to rise, • we would first need other Asian currencies to appreciate along with RMB. • Otherwise, fall in US bilateral trade deficit with China would be offset by rise in US bilateral deficit with other cheap-labor countries. • It also depends on excess capacity in US economy • as 2008-2011… • and no crowding out of domestic demand via higher interest rates.

47. Appendices • Bi-Annual US Treasury reports on currency manipulation • Is the US Current account sustainable? • The 2003 start of RMB speculation • Internal & external balance • The internationalization of the RMB Technical appendices

48. Appendix 1: Analysis of the Treasury Department’s biannualReport to Congress on International Economics and Exchange Rate Policy -- Frankel & Wei (2007)

49. Two hypotheses regarding determinants of US Treasury decisions whether partnersare 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 .

50. Timeline, continued • Those countries named as manipulators, or given warnings, have always been Asian. • What political economy determines Treasury findings? • Econometric analysis: • Domestic political variables are as important as global manipulation criteria.