Is Renminbi Appreciation Slowing?

The global slowdown and the huge uncertainty it has added to the process of evaluating the policy options available to the Chinese authorities could not have come at a worse time. Exporters are increasingly shrill about the deleterious impact of the rising RMB, although it seems to me that their real problem is partly slowing global growth and partly a domestic trend that is actually very good for China in the medium term – local wages are rising and the former exporting centers of China (i.e. Guangdong province) are shifting rapidly into higher value-added manufacturing and services aimed more at domestic consumption. Still, a lot of exporters are hurting and the appreciating RMB is an easy target, no matter how often it is pointed out that the RMB has not appreciated at all in trade-weighted terms – it has only really appreciated against the US dollar.

The combination of angry exporters and the fact that, contrary to the expectations of many, a more rapidly rising RMB has not had much impact on reducing inflation, the argument against a too-rapid appreciation of the RMB seems to be gaining ground.

“There've been many calls from the big ministries, especially the Ministry of Commerce, State Administration of Foreign Exchange (SAFE) and National Development and Reform Commission (NDRC),” said a Communist Party official familiar with the decision-making process. “They all believe that the yuan's current rise is too fast.”

This comes from an article in yesterday’s Market News International discussing the fact that in April RMB appreciation has slowed significantly, rising by a modest 0.42% over the month, including today’s 0.24% jump (it closed at 6.9898), compared to its 4.0% appreciation during the first three months of the year. The article goes on to say: “The government is preparing to step up its intervention in the foreign exchange market to maintain a sharply slower yuan rise against the U.S. dollar, abandoning the policy of recent months to use a stronger currency to fight inflation, government officials and economists told Market News International.” So what’s going on?

The same old thing. China’s monetary trap has all but eliminated its policy options. Slow appreciation didn’t seem to work, and the recent fast appreciation doesn’t seem to work either, so maybe its time to try slow appreciation again. Unfortunately both policies have resulted in the gradual or more rapid building-up of imbalances to the point where the adjustment is increasingly urgent and increasingly difficult to implement.

When the authorities began speeding up the rate of appreciation in August and September of last year, the hope was that this would result in lower inflation and a sharp reduction in overinvestment (remember that the pick-up in inflation started at the end of 2006 and the beginning of 2007, long before the pick-up in the rate of RMB appreciation), but I think this hope was based on a misunderstanding of the underlying dynamics. China’s problem is a monetary problem caused by its currency regime, and the only way to address the problem is either to alter the currency regime so that the PBoC is no longer forced to monetize massive amounts of capital inflows, or to alter the RMB trading level so that the incentive for massive capital inflows is eliminated. Neither faster appreciation nor slower appreciation will do the trick, since neither resolves the problem that needs resolving.

As early as February of 2007 (and in my June 2007 Far Eastern Economic Review articles), I pointed out that the then-glacial pace of RMB appreciation meant that China would be force to countenance the growing imbalances for much longer than was sustainable. I also pointed out that any attempt to quicken the pace of appreciation would collapse over the problem of accelerating hot money inflows. This seems to have happened, and after only six months.

That is why I argued that they had run out of options. It was clear that gradual appreciation was storing up massive imbalances that would lead to overheating and inflation, while faster appreciation could not possibly help the fight against inflation because it would actually result in even faster monetary expansion in the short term, which would increase, not decrease, monetary pressures. The Market News International article goes on to say:

Sources said that the pick-up in the pace of appreciation, which began in early December in the face of rising domestic inflation, has brought with it evidence of rising levels of speculative “hot money,” pouring into China to bet on a further rise in the currency. It has also led to increased complaints from the export sector -- which has powerful backing from the Ministry of Commerce -- that its margins are being hammered as its competitiveness is eroded by the rising currency. The opposition to the pace of the currency's rise has spilled into the public forum, where a number of influential officials and economists have called on Beijing to take action to counter market expectations about the yuan.

Xia Bin, an prominent government economist with the Development Research Center, an influential think tank under the State Council, became the latest of these when he was quoted on Monday by the official China Securities Journal as saying that the exchange rate can have only a limited impact on the fight against inflation and that expectations need to be stabilized. “There are so many people saying this -- it's clearly a government signal and there will probably be measures introduced very soon,” said Zhao Xijun, an economist at Beijing's Renmin University.

Unfortunately I am still willing to bet that a slowing pace of appreciation will not stop hot money inflows anywhere close to the extent necessary. At best, I suspect, slower appreciation will slow capital inflows marginally while lengthening the period during which the imbalance can grow, although even then inflows may actually pick up speed initially if the PBoC steps up intervention to limit the RMB’s rise. At worst it will signal to the market that with the PBoC so clearly running out of options, the probability of a maxi-revaluation will have increased so significantly that it makes more sense than ever to bet on the RMB. In fact I suspect it will be the latter. Let’s watch the hot money proxies closely over the next few months.

At any rate in neither case will inflation slow down. I expect inflation will continue to rise because of the already-huge growth in money. As it does, the lack of policy options will become clearer than ever, and those people at the PBoC and related agencies who understand how serious the monetary imbalances are will see their arguments in favor of a sharp adjustment much strengthened. I hope this happens quickly.

Unfortunately the authorities still have one or two more tricks they might try. For example, according to Market News International, “The official said that capital controls will also be introduced to stem the inflows of hot money.” Capital controls? Hmmm.

I am pretty pessimistic about the usefulness of capital controls in such a large country with such active and porous borders. Increased capital controls are likely mainly to distort economic activity (how do you distinguish between legitimate trade and FDI transactions and hot-money-related transactions without significantly increasing the cost of monitoring?) while increasing the opportunities for corruption, without seriously reducing hot money inflows for more than a few months – which is all it will take for people to figure out how to get around the new rules. After all China has had capital controls basically since 1949, and the empirical evidence suggests that capital controls become eroded over time as alternative channels develop. Can anyone doubt whether Chinese businesses, with extended family networks abroad, have figured out how to evade capital controls?

By the way and on a very related topic, some of my blog readers might remember in March when I quoted one of my former Tsinghua students, now a VP at a large investment bank, who told me about a sign he had seen at his golf club in Shenzhen saying that, according to SAFE, as of April 1 Shenzhen golf clubs would no longer be able to accept Hong Kong dollars as payment for their services. A few days ago he sent me another message: “Remember I told you about the banning of the use of HKDs in Shenzhen golf clubs? Ha ha I again used HKD today to pay. No problem.”

Meanwhile, and making it all the less likely that more moderate appreciation will eliminate hot money incentives, the drumbeat for a maxi-revaluation is steadily rising. According to yesterday’s Bloomberg:

China may revalue the yuan by 10 to 15 percent in the coming months as policy makers seek to temper inflation close to an 11-year high, according to Frank Gong, head of China research at JPMorgan Chase & Co. The currency's 16 percent gain since the last revaluation of 2.1 percent on July 21, 2005 has failed to curb import prices, and attracted funds seeking to take advantage of continued yuan gains which have flooded the economy with excess cash… The chances of a one-off adjustment are higher than the 10 to 20 percent odds previously forecast, wrote Gong in the note published yesterday. He was unavailable for comment today.

The authorities are really in a tough position, and I am certainly glad I am not the one forced to make the decision about what to do. The wrong decision, or even the right decision at the wrong time, could be a real career buster. I think for political reason the authorities need to try every alternative policy option before they can develop a very wide consensus that none of them work. Unfortunately the longer they wait the more difficult the adjustment will be.

I am curious to see the trade data for the next few months. If export growth slows, as I expect, and if inflation picks up, as I also expect, what is there left for them to try? By the way I heard one recent projection of 8.4% CPI inflation for April. If true, it implies an annualized rate of inflation for the first four months of 2008 of 9.5%. I suspect that April CPI inflation may actually be higher, but if it is 8.4% this will certainly provide some relief, since it implies no real month-on-month inflation for April.

Comments

[Bo Peng:]

Mr. Pettis, I raised the issue of carry cost for hot money in your previous article here and would appreciate to hear your thoughts on this side of the coin. My guess is that lots of hot money going into China last year didn't do very well unless they went into stock market and real estate AND pulled out in time. With the new situation this year, I think the government has less incentive to go one-off revaluation.

Unless oil, grain, and other commodities prices start to come down soon, inflation will be a global problem, not just a Chinese problem. The Fed has so far succeeded in transferring asset bubbles (from housing and credit to commodities and oil) and exporting inflation. But the dog will come back and bite us in the ass when the other cenbanks wake up and start to refuse taking delivery of our latest export.

2008 Apr 29 10:07 PM

[Mississippian:]

If the RMB has to rise by 15-20% in the next 12 months, there has to be a great paired trade by going long CNY (I understand this is not a perfect investment) and by shorting some american company whose cost of goods would be negatively affected by the rise in the RMB. Best case, this company would not be able to easily put this cost on the backs of its customers. Any ideas on what to short? WMT maybe?

2008 Apr 29 11:50 PM

[M. Pettis:]

Continuum, I think inflation is already a global problem. Countries like China who have intervened to manage their currency against the dollar (China, Vietnam, several Latin American countries) are seeing it much more because they imported and jacked up loose global money. I am not sure it is relevant whether or not hot money last year may or may not have been profitable. What matters is whether there are massive hot money inflows, and if so how they affect PBoC policy. For several months those of us who have been trying to measure hot money have argued that the flows have accelerated sharply and that the PBoC must adjust its policies accordingly. In the past month or two government officals have acknowledged that hot money is at dangerous levels. The interesting question is: what next?

Mississipian, Sorry but I am really only trying to understand China. I don't have stock picks one way or the other. I am long Chinese B-shares because I think in the medium term they are good value but since I no longer am on a trading desk I don't really spend much time thinking about trading plays. By the way it is tough to go long CNY except on the NDF market, and this has already priced in a signficiant reval.

2008 Apr 30 04:14 AM

[roamantik:]

Michael:
Investopedia defines hot money as: 'Money that flows regularly between financial markets in search for the highest short term interest rates possible. CDs are an example of hot money.'
Do you refer to hot money as per the Investopedia definition or, as I suspect, define it on a wider, more encompassing basis?

2008 Apr 30 10:52 AM

[M. Pettis:]

Roamantic, I am not sure there is an widely-accepted accepted definition of hot money, and certainly the Investopia definition is a purely domestic one -- international finance types would never define it that way.

Sometimes hot money is considered a synonym for portfolio flows, but even this is a little narrow. For example, many people in China who work for foreign companies or who otherwise are paid salaries indexed to foreign currency, or who have foreign currency savings, are converting foreign currency into RMB as quickly as possible so as not to lose purchasing power. This does not fit any of the regular defiinitions of hot money, but from the PBoC's point of view it is exactly the same thing and is usually included in hot money estimates.

2008 May 04 08:43 AM