China: Caught in a Monetary Trap

Scattered throughout my writing are references to the way I view China’s currency regime, why I believe monetary policy is out of control, why I have insisted since 2003 that China’s trade surplus and foreign exchange reserves could only grow, and why I claim that the authorities are increasingly going to have to consider a maxi-revaluation as the only solution to a worsening problem.

I have been asked several times to summarize this argument. Here is a very brief summary:

1. Since at least 2002-2003, China has been caught in a monetary trap. By tying the value of the RMB to the dollar, and especially by setting it too low, the Chinese authorities ran the risk that in a time of excess global liquidity they would find themselves in the position of excess money inflows leading to excess domestic money expansion.
   This would be reinforced as domestic money expansion funded rising industrial production, which would cause an increase in the trade surplus and so increase money flows further. Since global conditions at the time already suggested excess global liquidity, this risk was pretty high.
   
   This is why I argued as far back as 2003-2004 that China’s then-high trade surplus could only rise, and as it rose it would necessarily feed domestic money expansion (the PBoC must create the local money with which to buy all those dollars), which would fund more investment, greater industrial production, and a rising trade surplus. The key figure to watch is growth in foreign currency reserves.

2. Because of the self-reinforcing nature of this system, this process must necessarily go on until a very sharp adjustment stops it. The adjustment could come in the form, as it has in the past to China and other countries, of sharply rising domestic investment (“good” version: massive infrastructure spending; “bad” version: forced corporate investment via rising inventories).
   Or, it could come as rapid debt deflation, a collapse of the banking system into bad debts, a breakdown of sovereign external or domestic credit (from excess fiscal expansion), or out-of-control inflation (which is, of course, one way that the currency can adjust), or it could come as a combination of these factors.
   
   It is possible but unlikely that the adjustment will be benign, and the longer we wait the less likely it is. This last statement is hard to prove but seems reasonable largely because of historical precedents.

3. The key to stopping or slowing the process is to stop money inflows into China. Capital controls erode over time, and after so many decades of capital controls their use is pretty limited in China, especially given the existence of China- or offshore-based transnational family business networks and China’s size and long borders. This means the only useful way to address capital inflows is to adjust the currency.

4. Unfortunately, even adjustment is problematic. A slow adjustment, which we saw from July 2005 to roughly July 2007, means many more years of domestic monetary imbalances. This runs the risk of causing the adjustment, when it finally comes, to be all the more chaotic.

5. A rapid adjustment, which we have seen since last summer, will only encourage hot money inflows, which will cause the domestic monetary problem to accelerate before it is fixed. In addition, it is highly likely that a rapid appreciation of the RMB will overshoot whatever the “correct” exchange rate might be.

6. That leaves only one option: a one-off maxi-revaluation that causes hot money inflows to subside or even reverse. This may have an adverse impact on China’s trade account, but for reasons I have discussed often I think this impact is less than what many think it will be, and anyway it will happen one way or the other.
   Nonetheless, with Chinese exports having risen and still rising so strongly even with the RMB appreciation of the past three years, it seems to me that we would need to see a huge, adverse impact on exports before it slowed export growth to zero, and much of this slowing growth would be absorbed by rising domestic consumption.

7. The main argument in favor of a maxi-revaluation, however, is not that it will be painless. The main argument is that the alternatives are much more painful.

8. How much revaluation? I leave it to smarter economists to argue about what a “reasonable” or “appropriate” exchange rate is. My approach is much simpler. As a former emerging-market bond trader and someone who has spent much of his career watching hot money, investment flows, and investor sentiment, I have tried to estimate what I believe to be the smallest possible revaluation that is nonetheless credible and likely to cause investors, especially speculative investors, to reconsider the direction of the RMB trade. This wholly unscientific approach suggests to me that we will need a 15-20% revaluation of the RMB.
   
   Notice that this means that even though, between inflation and nominal appreciation, the RMB has already risen substantially since I first proposed this over one year ago, I still haven’t changed my estimate. It also means that a smaller revaluation will be a very poor policy choice.

This whole argument in favor of a maxi-revaluation depends crucially on the assumption that foreign exchange inflows will continue to accumulate at extraordinary levels until the adjustment is made. This is the bet I made four years ago – I argued that reserves would surge. Of course like everyone else I seriously underestimated just how much it would surge. The key argument against continued rapid appreciation is of course the incentive this creates for speculative inflows.

I have already argued many times that I believe speculative inflows are a serious problem. Logan Wright, of Stone & McCarthy, has probably done the best work in trying to understand what is happening with foreign currency flows in China. He has a new two-part paper that examines this. I strongly urge anyone interested in this to read his papers (and get on his mailing list), but to summarize his newest paper, I will quote the opening paragraph:

Our analysis indicates that hot money inflows, which we estimate at $81-147 billion in 2007, were less volatile than the data initially indicated throughout last year and have likely increased in recent months, driven by faster appreciation of the yuan against the dollar. The implications of these findings are that current trends in foreign exchange reserve growth and foreign currency lending growth are likely to continue, even if the central bank enacts new restrictions on short-term foreign debt. In addition, some evidence points to the central bank continuing to use the daily central parity as a policy tool, rather than a channel permitting greater market influence over the yuan's value.

Comments

[flow5]

Is this about the Phillips Curve?

[Carl Zha]

Michael Pettis,

People's Bank of China had been using "sterilized intervention" to prevent excess liquidity and offset the rise in money supply resulting from intervention. Why do you think this policy hadn't worked?

[roamantik]

Michael:
I am surprised that you have not discussed other alternatives to massive revaluation of the RMB in order to curb hot money inflows.
Didn't Chile impose a minimum one-year term on new investments specifically to discurage hot money? Given your experience in Mexico I would assume you are familiar with this stratagem. Didn't it work like a hot damn?
ALso, the relative lack of interest of large money blocks (pension funds, mutual funds) in China plays (to date, anyway) and the mitigating effect that the large Chinese SWF would have if it were to channel its funds domestically (highways, airports, ...) instead of buying US Treasury bills, would seem to me to largely offset the need for PBoC to revalue the RMB.

[M. Pettis]

Carl, there is a lot of controversy about whether or not this kind of sterilized intervention can work to reduce monetary excess, but in China the controversy seems besides the point. Given low real rates, clearly excessive levels of investment, excessive loan growth in the banking system (and the need for loan growth caps), speculative frenzies in the stock, real estate and art markets, the rapid growth of of informal banks, and rapidly rising inflation, it seems pretty clear that China is suffering from excess money.

Roamantic, Chilean-style restrictions cannot work in China since the official restrictions on capital inflows are already stricter. You cannot bring one-year money into China, so imposing the Chilean tax burden on one-year flows would be pointless. Hot money inflows into China are either illegal, or hidden in legitimate flows (under- and over-invoicing exports and imports, for example).

Also Chinese SWFs cannot divert their investment into China without making the monetary problem much worse, not better. This is a very commonly held but mistaken view of the uses to which reserves can be put. The whole point of the SWF's is to enable the country to get better returns from forced reserve accumulation. If they tried to spend it domestically they would simply force the central bank to accumulate even more reserves.

[sharpe_mind]

Mr. Pettis, this is a rather small point, but it seems to me that you could have the SWF invest in China- it would have to be for a project that uses primarily imported parts or labor though- such as buying oil (of which there is already speculation), stocking up Boeing airplanes or outsourcing the construction of a nuclear power plant to GE, etc.

In effect this would be like increasing China's consumption metrics, by the state instead of the private sector.