The Renminbi The Case for revaluation

The Context 2004: China’s economy is on the overheating side of internal balance appreciation would help ease inflationary pressure To achieve both internal balance and external balance China needs to adjust its real exchange rate China’s current FOREX is adequate to shield it against currencies crises and U.S treasury securities do not pay a high return. It is increasingly difficult to sterilize the inflow over time. A large economy like China can achieve adjustment in the real exchange rate via flexibility in the nominal exchange rate more easily than via price flexibility. From a longer-run perspective, prices of goods and services in China are low by the standards of a Balassa-Samuelson relationship estimated across countries. The yuan is undervalued by approximately 35%. The hybrid basket-band-crawl regime seems to argue for a dollar peg with only a 2.1% revaluation. 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.

Context, continued Econometric estimation of true regime reveals: $ link did not even begin to loosen until 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. May 2008: Chinese leaders hear exporter complaints of competitiveness difficulties. Mid-2008-April 2010: yuan repegs ≈ $ 6.84 RMB/$ ≈ 20% stronger, vs. $, than Oct 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.

THE RMB ROSE AGAINST THE $ FOR 2 YEARS, BUT RETURNED TO PEG IN MID $/RMB €/RMB €/$

Two hypotheses regarding determinants of US Treasury decisions whether partners are 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.

EXPLAINING FINDINGS OF TREASURY DEPARTMENT BIANNUAL REPORT TO CONGRESS ON INT.EC. & EXCHANGE RATE POLICY 7 All countries 15 Asian economies Excluding oil exporters US bilateral TB -0.92*** -0.99*** Partner’s 0.014*** 0.028** CA/GDP Partner’s Real -0.18*** -0.23** Exchange Rate Change in reserves/GDP US unem ** 0.08** ployment *** statistically significant at 99% level

THE MAGNITUDE OF DAILY MOVEMENTS VS. $ INCREASED IN THE SPRING2006 8

COMPLAINTS: TREASURY & OTHER US 9

CHINA’S VIEW 10 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.

China’s Interest: Sino, US duo  mutually-beneficial bargain, between equals  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.

12 FIVE REASONS CHINA SHOULD LET RMB APPRECIATE, IN ITS OWN INTEREST 1.Overheating of economy 2.Reserves are excessive. It gets harder to sterilize the inflow over time. 3.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. 4.Avoiding future crashes. 5.RMB undervalued, judged by Balassa-Samuelson relationship.

13 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 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.

14 ATTEMPTS AT “STERILIZATION,” TO INSULATE DOMESTIC ECONOMY FROM THE INFLOWS Sterilization is defined as offsetting of international reserve inflows, so as to prevent them from showing up domestically as excessive money growth & inflation. For awhile PBoC successfully sterilized… until 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)

15 2. FOREIGN EXCHANGE RESERVES Excessive: Though a useful shield against currency crises, China has enough reserves: $2 ½ trillion by April 2010; & US treasury securities do not pay high returns. Harder to sterilize the inflow over time.

16 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

ATTEMPTS TO STERILIZE RESERVE INFLOW: 17 While reserves (NFA) rose rapidly, the growth of the monetary base was kept to the growth of the real economy – even reduced in Successful sterilization in China: High reserve growth offset by cuts in domestic credit => steady money

18 IN 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 prices were 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.

STERILIZATION FALTERED IN 2007 & Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008 Monetary base accelerated Growth of China’s monetary base, & its components

CHINA’S CPI ACCELERATED IN INFLATION 2002 TO 2008 Q1 20 Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008

21 3. NEED A FLEXIBLE EXCHANGE RATE TO ATTAIN INTERNAL & EXTERNAL BALANCE 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.

22 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.

23 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.

24 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%. The Balassa-Samuelson Relationship Balassa-Samuelson relationship 2005