Asia/Pacific: The Wrong Case for RMB Revaluation
[A good post by Andy Xie - Mish]
morganstanley.com
Andy Xie (Hong Kong)
The US government has developed what appears to me to be an obsession over China’s currency peg. It began with the wrong conviction -- in my view -- that a significant currency appreciation by China would solve the US trade deficit problems. It has evolved into a power play for some US politicians; China’s so-called intransigence is increasingly viewed as a challenge to US power that should be pushed back.
The big and rising trade deficit of the US has aroused concerns among its business leaders, policy thinkers, and politicians. There is a widespread belief that the US must do something about its trade deficit. But do what?
The initial consensus among some of America’s leaders is to place blame elsewhere. China has the biggest trade surplus with the US, and its currency is pegged to the dollar. Many have jumped to the simplistic conclusion that China’s peg is the problem, believing that, when the peg is removed, the US trade deficit will decline sharply.
I think that such judgment is clouded. China’s currency peg may be many things, but it is not causing the US trade deficit. Cheaper Chinese goods decrease the US trade deficit by shifting imports from the higher-cost economies to China. This is why East Asia’s shares in the US import or trade deficits have declined sharply and consistently in the past ten years, even though China’s shares have increased consistently.
A significant appreciation by China would increase the US trade deficit by making imports more expensive. It could decrease the US trade deficit only if production were moved from China to the US. This is farfetched, in my view. China’s wages are 5% of those of the US. No conceivable revaluation by China would make this possible.
A more subtle explanation for the US position is that China’s revaluation would allow other currencies to adjust. The dollar could adjust sufficiently to correct the US trade balance. I see two problems with this view. First, competitive devaluation works if an economy has huge overcapacity. The US economy is running at capacity. Why would a competitive devaluation increase its output? Second, Japan and others have favored a Chinese revaluation as a substitute for their own currency appreciation. Hence, if China were to move its currency, other major economies would likely keep their currencies down.
The US economy is fully employed and is experiencing big and rising trade deficits. It is clear to me that the US economy is experiencing excessive demand stimulus, i.e., the Federal Reserve has kept the real interest rate too low. The case for keeping the real interest rate low is a low inflation rate. I would argue that globalization has brought down the equilibrium inflation rate. Hence, the Fed should not keep the real interest rate low because the nominal inflation rate is still low.
The real interest rate in the US is likely to rise in 2006, I believe. [Real interest rates will rise but not in the manner people expect. It will be because of DEFLATION that real intererst rates will rise - Mish] The Fed is still raising interest rates and is likely to take the Fed funds rate to 3.5% before yearend. The oil exporters that have experienced rapid rises in trade surpluses may have repaired their balance sheets sufficiently and could embark on spending the extra income from higher oil prices. When this happens, the US bond yield would rise. Hence, the real interest rate in both the short and long ends would increase. US consumption could cool, and the US trade deficit could decline substantially in 2006, in my view.
The US does have a competitiveness problem, I believe. The Fed, in my view, has done a huge disservice to the US economy by covering up its competitiveness problem with excessive stimulus. It has turned a structural weakness into a massive trade deficit. Hence, America’s leaders, in my view, have focused on the wrong variable -- the trade balance -- and blame America’s trading partners for the US problems. If the US economy weakens significantly next year, which I believe it will, US politicians could become even more agitated about China. This, however, would be focusing on the wrong issue.
China’s currency peg to the dollar reflects its two weaknesses. First, its financial system is not market-based and accumulates bad debts. Without the peg, China could become a poor version of Japan, with a strong currency, deflation, and low growth. With a massive overhang of surplus labor, China could get trapped in a deflationary equilibrium.
Second, China’s economic system does not create globally competitive companies and relies on export processing for growth. Hence, the export-processing companies have a major voice in China’s currency policy. Because the US is their major market, they prefer a dollar peg.
Between the two, the financial sector is a bigger problem. Because the financial system overfunds fixed investment, the returns on capital are low. Hence, China’s investment boom needs a bubble to keep going. In the current case, the property bubble keeps up the profit expectation, and the expectation of an Rmb revaluation keeps liquidity plentiful. Because China’s investment boom is based on unrealistic profit expectations, if the currency is revalued substantially, it could, I believe, cause liquidity to dry up and the economy to have a hard landing.
China should reform its financial system sufficiently before floating its currency, in my view. The minimum condition should be floating the four state banks. At least, this would be a commitment to a market-based financial system. China should also wait for the economy to cool down. With the economy so overheated, a sudden change in the currency could spawn a chain reaction that could cause a hard landing.
[Bingo - Mish] |
