China-US Currency Issues Appendices

1. China-US Currency IssuesAppendices Jeffrey Frankel Harpel Professor of Capital Formation & Growth Chinese Leaders in Development ProgramAsh Center, June 8, 2012

2. Appendices • I: What is in China’s interest? • II: Internal balance and external balance • III: What is in the global interest? • IV: Possible inadvertent effects of US pressure • V: Is the US Current account sustainable? • VI: Econometrics of the exchange rate • VII: What determines US Treasury findings regarding “currency manipulation”?

3. Appendix I: 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 • Almost no countries have been forced to appreciate. • Pressure on surplus countries to appreciate will inevitably be less than pressure on deficit countries to depreciate. • It is time to retire 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.

4. Five reasons for China to let RMB appreciate, in its own interest, during 2004-2011 • Overheating of economy, esp. 2007-08, 2010 • 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.

5. 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 back again in 2011; skyrocketing real estate prices.

6. 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)

7. 2. Foreign Exchange Reserves • Excessive: • Though a useful shield against currency crises, • China has enough reserves: $3 by 2011; • & US treasury securities do not pay high returns. • Harder to sterilize the inflow over time.

8. The Balance of Payments ≡ rate of change of foreign exchange reserves (largely $), rose rapidly in China from 2004 on, due to all 3 components: trade balance, Foreign Direct Investment, and portfolio inflows Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008 8

9. FX reserves of the PBoC climbed higher than any central bank in history http://viableopposition.blogspot.com/2012/03/chinas-holdings-of-us-treasuries-what.html

10. Sterilization of foreign reserves:People’sBank of China sells sterilization bonds Data: CEIC Source: Zhang, 2011, Fig.4, p.45.

11. Sterilization of foreign reserves:Decreases in PBoC’s domestic assetsthus offset increases in foreign assets Source: Zhang, 2011,Fig.7, p.47.

12. Further, the PBoC has raised banks’ required reserve ratios Source: Zhang, 2011, Fig.6, p.46.

13. China’s tightening of banks’ lending rates & reserve requirements helped head off rising inflation in 2004, 08, and again in 2011. Fxtimes.com

14. Chinese inflation eased off in 2008-09, but rose again through mid-2011

15. Chinese inflation, once again, began to ease off after mid-2011

16. 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.

17. 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.

18. 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 has been one of those countries that is cheap or undervalued even taking into account Balassa-Samuelson.

19. The Balassa-Samuelson Relationship 2005 Source: Arvind Subramanian, April 2010, “New PPP-Based Estimates of Renminbi Undervaluationand 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 estimate for 2000 (Frankel 2005) = 36%. As recently as 2009 (Chang 2012):25% .

20. Appendix II: Internal&externalbalance Between 2002 and 2007, China crossed from the deflationary side of internal balance (ES: excess supply, recession, unemployment), to the inflationary side (ED: excess demand side, overheating). And again in 2009. =>Moved upward in the “Swan Diagram” => appreciation called for under current conditions. Together with expansion of domestic demand gradually replacing foreign demand, developing neglected sectors: health, education, environment, housing, finance, services General principle: to attain 2 policy targets (internal & external balance), a country needs to use 2 policy instruments (real exchange rate & spending). 20

21. In 2008 & 2010, China was in the overheating + surplus quadrant of the Swan Diagram ED & TB>0 BB: External balance CA=0 Excgange rate E in RMB/$ China 2010 China 2002 ED & TD ES & TB>0 YY: Internal balance Y = Potential ES & TD 21 Spending A

22. Restoring growth, andResolving current account imbalances, in particular, the US CA deficit & China’s surplus, though China’s surpluses have narrowed since 2008. Appendix III:What is in the global interest? 22

23. Current account imbalances are smaller than in 2007, esp. China’s Gavyn Davies, FTblog, May 27 2012

24. Dangers of the longstanding 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 ≈ $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.

25. 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.

26. Appendix IV: Possible inadvertent effects of US pressure on China • 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, the US ability to make demands is diminished. • There is a particular tension between hoping China will continue to buy our Treasury bills, and asking it to stop buying our Treasury bills • i.e., to stop selling RMB / buying $ , • which is what keeps its currency from rising.

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

28. 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 $ • including a sharp fall of US securities prices. • 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.”

29. 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 2008-2012… • and no crowding out of domestic demand via higher interest rates.

30. Central banks’ reserve holdings The $ share has been on a downward trend since 2000 (also during 1976-1991).

31. The global monetary systemmay move from dollar-based to multiple international reserve currencies • The € could challenge the $. • The SDR is again part of the system. • Gold in 2009 made a comeback as an international reserve too. • Someday the RMB will join the roster with ¥ & ₤. • = a multiple international reserve asset system. SDR

32. Another possible consequence if China allows the exchange rate to become more flexible & market-determined • the RMB could depreciate rather than appreciate, • in response to a slowdown in Chinese growth • especially if: • it were the result of an increase in world oil prices • or were associated with a financial crisis • stemming from real estate or bad bank loans.

33. Especially now that the quarterly overall balance of payments (fx reserve changes) is no longer >> 0 Gavyn Davies, FTblog, May 27 2012

34. Another possible consequence, continued • Indeed, the RMB depreciated in May 2012

35. Increased flexibility,continued • “On 14 April, 2012, the Chinese central bank announced that the band of RMB’s trading prices against the US dollar in the inter-bank spot foreign exchange market is enlarged from ±0.5 per cent to ±1 per cent on each business day. The main purpose was probably to increase the perceived risk of the speculators and thereby decrease ‘hot money’ movements. This enlarged range has, however, not been utilised so far. The largest changes have been of the order of 0.2 per cent.” “Re-pegging the renminbi to a basket: issues and implications” in Asian-Pacific Economic Literature (APEL), May 2012. Heikki Oksanen, University of Helsinki. http://onlinelibrary.wiley.com/doi/10.1111/apel.2012.26.issue-1/issuetoc . 35

36. Prices on Non-Deliverable Forwardsshowing post-2003 speculation on RMB appreciation 36

37. Appendix V:Is the US Current Account sustainable?

38. Economists were (are) split between Ken Rogoff * Maury Obstfeld Larry Summers Martin Feldstein Nouriel Roubini Menzie Chinn Me Lots more Ben Bernanke Ricardo Caballero * Richard Cooper Michael Dooley Pierre-Olivier Gourinchas Alan Greenspan Ricardo Hausmann Lots more those who saw the US deficit as unsustainable, requiring a $ fall, and those who saw (see) no problem. 38 * Some claim that the financial crisis of 2007-09 fits their theories.

39. The events of 2007-09 struck major blows against both interpretations of CA. • Most of us in the unsustainability camp would have predicted that something like the US sub-prime mortgage crisis would cause a big fall in the $. • Instead , the $ strengthened. • Most of those in the sustainability camp had been arguing that the US has uniquely superior assets (corporate governance, securities markets, bank regulation…) • Instead, the crisis showed the US system to suffer serious flaws • of crony capitalism like other countries (Simon Johnson, Ragu Rajan) • or – worse – excessive deregulation (Joe Stiglitz…) • The answer, for the moment: The $ & US Treasury bills still play unique roles in the world monetary system.

40. Critics of the twin deficits view say that the US current account deficit is sustainable. • Global savings glut (Bernanke) • It’s a big world (R. Cooper; Al Greenspan..) • Valuation effects will pay for it (Gourinchas) • US as the World’s Banker (Kindleberger…) • The US offers superior-quality assets (Caballero, Forbes, Quadrini & Rios-Rull, Wei & Wu …) • “Dark Matter” (Hausmann & Sturzenegger) • Bretton Woods II (Dooley, Folkerts-Landau & Garber)

41. Exorbitant Privilege of $ • Among those who argue that the US current account deficit is sustainable are some who believe that the US will continue to enjoy the unique privilege of being able to borrow virtually unlimited amounts in its own currency.

42. When does the “privilege” become “exorbitant?” • if it accrues solely because of size & history, without the US having done anything to earn the benefit by virtuous policies such as budget discipline, price stability & a stable exchange rate. • Since 1973, the US has racked up $10 trillion in debt and the $ has experienced a 30% loss in value compared to other major currencies. • It seems unlikely that macroeconomic policy discipline is what has earned the US its privilege !

43. The “Bretton Woods II” hypothesis • Dooley, Folkerts-Landau, & Garber (2003) : • today’s system is a new Bretton Woods, • with Asia playing the role that Europe played in the 1960s—buying up $ to prevent their own currencies from appreciating. • More provocatively: China is piling up dollars not because of myopic mercantilism, but as part of an export-led development strategy that is rational given China’s need to import workable systems of finance & corporate governance.

44. There is no reason to expect better today: • Capital mobilityis much higher now than in the 1960s. • The US can no longer necessarily rely on support of foreign central banks: • neither on economic grounds(they are not now, as they were then, organized into a cooperative framework where each agrees explicitly to hold $ if the others do), • nor on political grounds(China & OPEC are not the staunch allies the US had in the 1960s). 3) A possible rival currency to the $ exists.

45. My own view on “Bretton Woods II”: • The 1960s analogy is indeed apt, • but we are closer to 1971 than to 1944 or 1958. • Why did the BW system collapse in 1971? • The Triffin dilemma could have taken decades to work itself out. • But the Johnson & Nixon administrations accelerated the processby fiscal & monetary expansion (driven by the Vietnam War & Arthur Burns, respectively). • These policies produced: declining external balances, $ devaluation, & the end of Bretton Woods.

46. AppendixVI: ExchangeRateEconometricsEstimating the weights • A problem made-to-order for OLS regression. • Regress % changes in value of RMB against % changes in values of candidate currencies. • Δ log RMBt = c + α Δlog $t + β1Δlog € t + β2 Δlog ¥t + … • The coefficients are the basket weights. • Can impose α + Σ β j = 1. F& Wei (2007), Frankel (2009)

47. Does the Balassa-Samuelson relationship have predictive power? • Typically across countries, gaps are corrected halfway, on average, over subsequent decade. • => 3-4 % real appreciation on average per year, including effect of further growth differential. • Correction could take the form of either inflation or nominal appreciation, but appreciation is preferable.

48. Referencesfor statistical estimates of RMB undervaluation • Chang, Gene Hsin, 2008, “Estimation of the Undervaluation of the Chinese Currency by a Non-linear Model,” Asia-Pacific Journal of Accounting & Economics Vol.15, No. 1, April, 29-40. • Chang, Gene H. , 2012, “Theory and Refinement of the Enhanced-PPP Model for Estimation Equilibrium Exchange Rates --- with Estimates for Valuations of Dollar, Yuan and Others”, SSRN abstract=1998477, Feb. 2. • Cheung, Yin-wong, Menzie Chinn and Eiji Fuji, 2010, “China’s Current Account and Exchange Rate,” in China’s Growing Role in World Trade, Rob Feenstra & Shang-Jin Wei, eds. (U.Chicago Press, 2010). • Cline, William, and John Williamson, 2008, ‘Estimates of the Equilibrium Exchange Rate of the Renminbi,” in Debating China's Exchange Rate Policy, edited by M.Goldstein and N.Lardy (Peterson Institute for International Economics), 155-165.   • Frankel, Jeffrey, 2005, “On the Renminbi,”CESifoForum, vol.6, no.3, Autumn (Ifo Institute for Economic Research, Munich): 16-21. • Subramanian, Arvind, April 2010, “New PPP-Based Estimates of Renminbi Undervaluation and Policy Implications,” PB10-08, Peterson Institute for International Economics.

49. Appendix VII: Analysis of the U.S.Treasury’s biannualReport to Congress on International Economics and Exchange Rate Policy -- Frankel & Wei (2007)

50. Two hypotheses regarding determinants of US Treasury decisions whether partnersare manipulating currencies: • (1) Legitimate economic variables • the partner’s overall current account/GDP, • Additions to its foreign exchange reserves, • 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 .