The Renminbi - Dollar Issue

1. The Renminbi -Dollar Issue Jeffrey Frankel Harpel Professor Spring Exercise, April 23, 2010

2. Topics to be covered (I) Historical timeline of exchange rate diplomacy (II) What is in China’s interest? (III) What is in the US & RoW interest? (IV) Shifting power relationships • Addendum: The current account imbalances

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 United States dollar 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. Analysis of the Treasury Department’s biannualReport to Congress on International Economics and Exchange Rate Policy -- Frankel & Wei (2007)

7. 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 .

8. 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 .

9. 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:

10. Explaining findings of Treasury Department biannualReport to Congress on Int.Ec. & Exchange Rate Policy   All countries 15 Asian economies Excluding oil exporters US bilateral TB -0.92*** -0.99*** 0.06550.1548 Partner’s 0.014*** 0.028** CA/GDP 0.002 0.007 Partner’s Real -0.18*** -0.23** Exchange Rate 0.0291 0.1115 Change in 0.003 -0.012 reserves/GDP 0.003 0.009 US unem- 0.022** 0.08** ployment0.010 0.037 *** statistically significant at 99% level

11. Findings suggest the domestic US variablesaffect the Treasury decision more than the legitimate global manipulation criteria: • weak role for partner reserve accumulation, • very high significance of bilateral balance, • significance of US unemployment, and • significant (borderline) extra effect of unemployment in election years.

12. Implication If the IMF were interpreting Article IV, rather than the Treasury interpreting the 1988 US law, • the criterion of consistent uni-directional forex intervention would receive more emphasis, • and US-specific variables such as the bilateral trade balance would not appear at all.

13. Some sympathy for the Treasury • It walks a fine line. • An additional finding: Treasury is eager not to single out one country for unique opprobrium. • No single country is left exposed on its own. • the top-ranked country is less likely to be named than if it had some other country to hide behind, while • the 2nd- & 3rd-ranked countries are more likely to be moved up, to give the leader company.

14. 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/$.

15. Timeline, continued:US pressure • Oct. 2003: Treasury Secretary Snow begins to “browbeat” China to allow appreciation. • Report: RMB merits concern & talks • Speculators in financial markets start to bet appreciation. • as reflected in either capital flows (residual; see Prasad & Wei) • or non-deliverable forwards (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.

16. Timeline, continued:China’s macroeconomy • 2004- :Rapid growth puts China into Excess Demand condition. • 2005-06:Despite large balance of payments surpluses, PBoC sterilization of reserve inflows prevents excessive money growth & inflation. • 2007-08:Sterilization finally falters: Money growth 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 rate slows down; danger of overheating disappears. • Mid-2009 – mid-2010:China resumes blistering 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. asset market bubbles.

17. 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. • Econometric 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, • But only because € does.

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

19. Estimating 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)

20. Has US pressure pushed the pace of increased flexibility? • We searched an electronic database of news reports (FACTIVA/NewsPlus) , recording the number of US news reports of US officials asking China to speed up RMB flexibility/revaluation. • Two separate time series on the cumulative numbers of complaints • from US Treasury and • from officials of other government agencies (e.g. the White House, Congress and Fed)

21. Complaints: Treasury & other US

22. We added # complaints as a regressor (Table 19) • No evidence that U.S. official complaints are associated with RMB appreciation relative to the currency basket. • There is evidence that cumulative complaints are associated with a reduction in the RMB’s weight on the US dollar.

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

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

25. 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.

26. 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

27. 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. • US-China relations deteriorate • on other fronts as well.

28. April 1-9: Collision is averted at the last minute -- or at least postponed • April 1: China announces Hu Jintao trip to DC • to attend April 12-13 summit. • April 2: Beijing hints it may adjust pegging policy • if visit goes smoothly. • April 3: Treasury announces manipulation report postponed • from mid-April deadline, • probably until the summer: • after Strategic & Economic Dialogue in May, • & G-20 Summit meeting in June. • Implication – The two governments must have come to a face-saving understanding. • April 9: Geithner makes surprise stop in Beijing.

29. (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 • 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.

30. What is in China’s interest? • My view: mutually-beneficial bargain, between equals • 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.

31. 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.

32. 1. Overheating of economy: • Bottlenecks. Pace of economic growth is outrunning: • raw material supplies, and • labor supply in coastal provinces • 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.

33. 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)

34. 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.

35. The Balance of Payments ≡ rate of change of foreign exchange reserves rose rapidly over last decade Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008

36. The Balance of Payments rose rapidly in China over past decade, due to all 3 components: trade balance, Foreign Direct Investment, and portfolio inflows Source: Prasad & Sorkin

37. Not only has the level of fx reserves risen,but the rate of change(BoP surplus)shows acceleration Source: Prasad & Sorkin

38. 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.

39. In 2007-08 China had 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.

40. 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

41. In 2008, domestic Chinese interest rates when above US T bill rates=> quasi fiscal deficit Source: Prasad & Sorkin

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

43. 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.

44. 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.

45. 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.

46. 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%.

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. The conclusion – that it would be in China’s interest to allow RMB to appreciate -- • has long been shared by top economic officials in China, it is believed. • But the decision is a political one: • It is a matter of Hu and Wen !

49. Solving the problem of current account imbalances, in particular, the US CA deficit & China’s surplus. Both have widened, on long-term trends. Imbalances narrowed sharply in 2009; the US deficit fell by almost ½ ; China’s CA surplus fell by almost ½. Its trade surplus actually dipped to 0 in March 2010. Problem solved? The imbalances will now resume widening. (III) What is in the global interest? 49

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