Chinese Currency: Considerations in Revaluing the Renminbi

In a recent report, Jonathan Anderson of UBS explains why he doesn’t think China will adjust the currency via a large one-off revaluation. As regular readers of my blog know, I have been arguing since early 2007 that there is a high probability that the financial authorities will eventually be forced into a one-off (15-20%) revaluation, although I am uncertain about the timing.

If they do revalue, they probably won’t want to do it too close to the Olympics because of their low appetite for uncertainty before such an important event, so that leaves them a very short time frame in which to do it – perhaps over the next two months. However with all the uncertainty over the US economy, and with the new leadership being approved in the next NPC (which begins March 5), I think it is unlikely that they will choose to do it then. On the other hand, the longer they wait, the worse the monetary and associated imbalances become.

Although I disagree with him, I wanted nonetheless to list Anderson’s arguments because I think his are often the strongest arguments against a revaluation. I hope I am not violating copyright laws (although if I am, my excuse is, why not? around here everyone else does…), but here are excerpts from Anderson’s piece on why a one-off revaluation does not make sense:

1. It would hurt the wrong people…As we've also discussed numerous times, the problem behind the trade surplus is not overly competitive exports per se ... but rather imports, or more specifically the sharp drop in import demand over the last few years as rising domestic heavy industrial capacity has taken over market share at home and in some cases (e.g., steel) pushed surplus production abroad. In this environment, the optimal solution for the Chinese authorities is to (i) raise costs for overinvested heavy industrial sectors in order to force out marginal players and rekindle import spending, without (ii) overly penalizing traditional labor-intensive export manufacturers, who are the single largest employer of poor rural migrants. What's the best way to achieve these aims? The short answer is to let the renminbi strengthen steadily, but not in big discrete jumps.

2. The timing is getting worse. Even if the authorities had been thinking about a one-off move before, it's unlikely they would still be considering it now on the heels of the painful weather-related disruptions in transport and power supply in January and February. Not only will Q1 2008 data point to a visible slowdown at home; most available data have also come off sharply over the past month or two, and the Chinese senior leadership has expressed public concern about the potential impact on mainland exporters. In short, this is not an environment where it would make sense to try an abrupt change of tack on currency policy.

3. …The central bank still has a long way to go before it runs out of options for managing a more gradual scenario…Equally important, FX reserve pressures have been fading over the past six months following the "scare" in the first half of 2007, when inflows jumped sharply (see Chart 2 above). The trade surplus was essentially flat through all of last year on a seasonally adjusted basis and could actually begin to decline in 2008, and as we show below, the strong portfolio capital inflows of a few quarters ago seem to be drying up as domestic equity and property markets fall.

4. No need for emergency inflation fighting. One of the most common arguments in favor of a large up-front revaluation is that the PBoC now needs emergency measures to fight inflation. But this argument makes no sense to us, for the following two reasons. First, as we've stressed continually over the past months, there's no indication whatsoever from the data that current headline inflationary pressures are structural in nature. …As of end-December "core" non-food CPI is perfectly stable; all of the increase in headline CPI in 2007 has come from food, and nearly all of the pressures within food have come from meat and eggs prices alone. This is hardly a picture of widespread, spiralling inflation (the picture may change temporarily in January and February as weather-related shortages lead to price spikes, but this effect should soon fade as well).

And second, there's no rationale behind expectations that renminbi strengthening would help moderate domestic food price increases – for the simple reason that is not a significant importer of food.

5. Fading speculation worries. Another very common argument is that can't successfully pursue a gradual renminbi strategy, since letting the currency appreciate by 8% to 10% per year would bring in a flood of speculative capital and overwhelm the PBC's ability to control the money supply. And in the first half of 2007, it seemed that this was precisely the case: "hot" money was visibly returning to the mainland once again in large amounts, and the central bank was forced to slow down the pace of exchange rate appreciation so as not to encourage further speculation.

However, over the past six months those pressures have faded. As it turns out, the main driver of capital inflows was not exchange rate expectations but rather the booming equity and property markets.

I have a lot of respect for Anderson, and like reading his stuff, although I have to say that I often disagree with his predictions and this is one case where I disagree, largely because I think he misses the main point except at the very end, where he partly addresses it. Whenever people point out to me all the reasons why a one-off revaluation is a bad idea, I have no disagreement. It is a bad idea. If China is forced into a one-off revaluation, it will not be because this is a “good” policy choice that will leave the economy in better shape than it was before the policy was implemented. It is almost certainly a bad policy choice, but unfortunately the alternatives may all be worse. By waiting so long on adjusting the currency China has found itself in a trap where it must choose between the least bad options. I have discussed this often in my blog and don’t want to beat this thing to death, but I do think it is worth making a few points.

Clearly China cannot go back to the old days of a pegged exchange rate or the painfully slow appreciation it experienced until last summer. That leaves only two more options – the current strategy of much more rapid appreciation, or a one-off revaluation. There are such serious problems with the rapid appreciation option that in my opinion by a process of elimination we are left with the last one. What are the problems? At least three, I think:

1. The current appreciation strategy postpones the resolution of the monetary problem for perhaps another two years, during which time the imbalances caused by explosive money growth can only get much worse. Another two years of this kind of reserve growth is almost certainly a terrible idea. As it is, China’s monetary regime should have been altered in 2003 or 2004, and because it wasn’t, we have spent the last three years with explosive monetary growth. By October of last year all the gradualist ideology and wishful thinking in the world (and there has been a lot of both) could not prevent the economic authorities from recognizing that China had built serious imbalances thanks to its out-of-control monetary policy, and if these weren’t addressed there was a risk of a very sharp adjustment. That is why the October Economic Conference resulted in the abrupt policy shift. It is hard to imagine that another two years of this can be anything but disastrous fro China.

2. Anderson disagrees, but there is some evidences that hot money inflows are indeed high and likely to rise, although masked partly by complexities in the way the PBoC accounts for reserve accumulation and by over- and under-invoicing in the trade accounts. The trader in me finds it hard to believe, in any case, that a low-risk 10-14% return in dollars for bringing money into China will not cause large speculative inflows, even if there are capital controls. If it takes another two years to get to where we want to go, the impact could be hundreds of billions of dollars of additional monetary expansion because of speculative inflows. This is the opposite of what we need.

3. Finally, and this is a problem that almost no one to my knowledge has discussed, but there is serious a problem with the end game that needs to be addressed before we get there. A gradual appreciation, unlike a one-off revaluation, creates no credible signal that we have reached the upper limit of the appreciation path. If the RMB appreciates for two years at 8-10%, how do investors and speculators know when we have reached the "correct" level and stop speculating on additional appreciation? In past cases, sustained currency appreciation develops its own momentum, and often a currency will switch from heavily undervalued to heavily overvalued (Japan in the 1980s?). This could well happen in China, and it would cause a whole new set of problems that would be very difficult to control.

Notice that none of my reasons for a one-off revaluation are positive reasons. I came to the conclusion that China would be forced into this policy only because I was forced to conclude that every other policy would fail. In other words it is only by a process of elimination that I arrived at this conclusion. That doesn’t mean, of course, that the financial authorities will necessarily come to the same conclusion I did, but it does suggest, at least to me, that if they don’t, China’s financial system and near-term economic prospects face some very ugly adjustments. A one-off revaluation is a bad idea, but everything else is worse.

Comments

[M. Pettis:]

There is a long history of countries locking themselves into an unbalanced system from which the only escape is a very unattractive option (and we Mexicans don't need to be convinced of this). I guess this is what China is facing. Do you think they should have began aoppreciating the currency long ago?

2008 Feb 21 03:39 AM