The Global Credit Crisis and Chinas Exchange Rate Ronald McKinnon Brian Lee Yi David Wang Stanford University Singapore Economic Review Conference August 6-8, 2009

Advantages of Stabilizing Yuan/Dollar Rate A Potted History 1995 to 2004 fixed rate nominal anchor: 8.28 Y/$ [McKinnon & Schnabl, Jan 2009] July 2005 to July 2008, one-way bet on RMB appreciation: hot money inflows, buildup of official exchange reserves, loss of monetary control, disrupt forward exchange market [Wang 2009] July 2008 to Nov. 2008, unwinding of dollar carry trade with sharp apprec.of $ effective ex rate, (Lee 2009), Y/$ rate reset at 6.83 through to present 2009, monetary control regained with a massive expansion of bank credit to support fiscal stimulus for offsetting sharp fall in exports

Source: FRB Figure 1: Chinas monetary policy and the yuan/dollar rate ( )

Source: IMF and The Peoples Bank of China Figure 2: Foreign Reserves of China, Japan, Germany, and U.S. ( )

Figure 6: Bilateral Trade Balances of Japan and China versus the United States (percent of U.S. GDP, 1955 – 2008/1) Source: Kenichi Ohno, BEA

U.S Mercantile Pressure, I. Acute Japan Bashing, 1978 to Episodic trade disputes steel, autos, color televisions, machine tools, semi conductors - Resolution: Japan imposes voluntary export restraints and allows yen appreciation -Yen/dollar rate appreciates episodically from 360 in August 1971 to peak at 80 in April 1995, when U.S. announced a strong dollar policy Japan financial system destabilized: bubble economy followed by a deflationary slump and low interest liquidity trap in 1990s (McKinnon-Ohno,1997)

U.S. Mercantile Pressure, II. China Bashing: 2000 to ? -China surpasses Japan in 2000 as having the biggest bilateral trade surplus with the U.S -Unlike Japan, export surge is across the board in low value added manufactures. Focus is primarily on appreciating the Renminbi: -Schumer-Graham bill of March 2005 for a 27.5% tariff on U.S. imports from China unless RMB appreciates (withdrawn October 2006, but new threat in 2007) -Section 3004 of U.S. Public Law : U.S. Secretary of Treasury must report twice a year on whether countries with trade surpluses are manipulating their currencies. Timothy Geitners congressional testimony January 2009 RMB rises by 2.1% on July , and begins slow upward crawl

One way bet: RMB appreciation July 2005 to July 2008 Hot money flows into China No private capital outflows to finance Chinas huge trade surplus (McK & Sch 2009) Huge buildup of official exchange reserves: government sole international intermediary Massive sterilization: sale of central bank bonds, increases in reserve requirements of com banks Direct restraints on domestic bank credit Still loss of monetary control with domestic inflationary pressure added to foreign

Chinas Foreign Exchange Reserves Source: UBS

Source: EIU Figure 3: Chinas Consumer Price Indices (Growth rate: % yoy)

Figure 4: Renminbi and Dollar Exchange Rate Movements ( ) Source: IFS and BIS July2008 NominalRateDollarYuan EffectiveRateoftheRenminbi EffectiveRateoftheU.S.dollar Unwinding of Carry Trades

Source: globalfinancialdata.com Note: The commodity price index does not contain crude oil. Figure 5: Commodity Price Indices (Jan 2002 =100)

Figure 8: Unwinding the yen and dollar carry trades (effective exchange rates, 2006=100) Source: BIS

Source: Brian Lee (2009) Table 1: Returns on carry trades ( ) Note: (a) For funding in dollars, the return is the average for Brazil, Mexico, and Canada. (b) For funding in yen, the return is the average for Australia, Korea, and New Zealand. (c) Trough to peak for the yens effective multilateral exchange rate. Caution: The unwinding of the carry trades in 2008 may not fully explain these exchange rate appreciations.

Dollar carry trade unwinds and accidental stabilization of the RMB since July 2008 Credit crunch summer and fall of 2008 dries up short-term finance for dollar, yen, and commodity carry trades Surprise dollar appreciation, July to Nov 2008, of approx 20% against all currencies except the Japanese yen with a general fall in commodity prices. PBC stops gradual (and predictable) appreciation of RMB, and stabilizes at 6.83 yuan/dollar. Hot money inflows stop, some private outflows, minimal increases in official exchange reserves. PBC regains monetary control Massive domestic credit expansion: cuts in reserves required of commercial banks while lifting credit ceilings, reductions in deposit and loan interest rates Domestic spending largely offsets collapse in exports

Source: China Customs Statistics Information Figure 9: Chinas Nominal Trade (in billions of U.S. dollar, monthly)

Source: UBS Figure 10: Chinas interest rates (%)

Source: UBS Figure 11: Chinas New loans to non-financial institutions (RMB bn)

Source: UBS Figure 12: Chinas M2 and Bank Lending (Growth rate: % yoy)

Loans for 15 large U.S. banks Source: Wall Street Journal

Source: SCB M2 growth around the world

Violation of interest parity conditions and breakdown of Chinas forward market mid 2007 to mid 2008 Open Interest Parity (OIP): E(S) = i t (yuan) – i t (dollars), where S = yuan/dollar Covered Interest Parity (CIP): f t = i t (yuan) – i t (dollars) where f = (F – S)/S is forward premium on dollars OIP breaks down when the interest differential is less than expected appreciation because of fall in US rates CIP breaks down when SAFE had to impose controls on financial capital inflows, i.e., borrowing in dollars Result: Chinas exporters cant cover dollar earnings forward, thus tightening credit constraint

Source: Datastream. Note: OIP is Open Interest Parity. Figure 13: Interest Differentials versus Percentage Changes in the Yuan/Dollar Exchange Rate ( )

Source: Wang (2009) Figure 14: Forward Rate vs. Forward Rate from Covered Interest Parity (yuan/dollar,6 month)

Source: Wang (2009) Figure 15: Percentage Deviation From Covered Interest Parity (yuan/dollar, by maturity)

Reducing Chinas Saving-Investment Surplus Increase share of household disposable income in GDP in order to increase private consumption reduce personal income and sales taxes increase government transfer payments increase dividend payouts from enterprises Increase government social expenditures. Stimulate household spending increase consumer credit abolish one-child policy? Objectives (1) Reduce Chinas trade surplus (2) Counter cyclical downturn in China and rest of the world Caveat: Stabilize exchange rate (Mundell-Fleming)

Figure 16: Investment, Savings and Current Account of China (as a percent of GDP) Source: EIU

Source: UBS Figure 17: Chinas Labor Income and Operating Surplus (Share in GDP(%))

Source: UBS Table 2: Chinas Economic Positions in 1997 and 2007 Note: The NPL ratio is 2.8% for four largest commercial banks, Dec 2008.

Conclusion:Countering the Global Cyclical Downturn in New U.S. fiscal stimulus is problematic: weak domestic financial institutions, and trade deficit would increase China now a big actor on the world stage with stronger public finances and much stronger banking system To stimulate the U.S. and world economies, the primary fiscal stimulus should be in China and other surplus Asian economiesand possibly Germany. Nov 2008, China announces a half trillion dollar fiscal stimulusnow supported by rapid bank credit expansion U.S. quid pro quo: No more China bashing on exchange rate, or through antidumping duties, and other policies