China’s competitive devaluation
China took the world by surprise on Tuesday by raising bank lending and deposit rates for the first time since 2007. The story is, that restrictive monetary policy (i.e., raising rates) is needed to curb excessive lending, with an eye on mitigating inflation pressures. See this Bloomberg article to the point.
While restrictive monetary policy is needed, raising rates is not the only tool available to policy makers: China could allow their currency (CNY) to appreciate. With support from the fiscal sector, a broad CNY appreciation would improve prospects for global growth ex China via import demand. Instead, the higher domestic rates may crimp domestic demand, perhaps reducing inflation, but contemporaneously lowering import demand.
In my view, China’s move yesterday should be viewed as competitive devaluation: reducing domestic prices in order to capture a competive edge. The currency war, as so-called by Brazil’s finance minister, Guido Mantega, is afoot; and China just confirmed its participation.
Textbook economics says that a central bank cannot have it all: independent monetary policy, a fixed exchange rate, and open financial markets (the impossible trinity). China has a fixed exchange rate (currently, it’s effectively pegged to the USD, see chart below) with tightly monitored capital markets. This means that the Chinese economy effectively matches the “easy monetary conditions” of its counterpart, the US. Monetary policy in China is too loose.
Going forward, further accommodative monetary policy in the US will likewise loosen policy further in China; inflation pressures will be even more robust. But, large-scale asset purchases on the part of the Fed will likewise weaken the USD, which is positive for US exports and negative for US import demand.
All in all, policy makers in China are looking at the USD move with tunnel vision. If the CNY maintians its current trajectory (effectively flat), then any shift in relative prices based on the recent (or future) rate hikes will reduce the CNY real exchange rate (all else equal, of course) – that’s competitive domestic devaluation.
The table has already been set.
Chinese policy makers have slowed the nominal appreciation. Think about what could be if the CNY had maintained its 2005-2008 trajectory, where the CNY appreciated against the USD nearly 20%. Using the compounded annual growth rate (CAGR) over the same period, where the CNY gained 0.5% on a monthly basis against the USD, the month-end September CNY would be valued 11% higher against the USD than it is now.
They slowed real appreciation, too. The real appreciation of the CNY against its trading partners – the real exchange rate accounts for both nominal appreciation and price differentials across countries – slowed from an average 0.4% monthly gain spanning the period 2005-2008, as measured by the CAGR, to just 0.05% since then. (I use the JPMorgan real exchange rate index, but the BIS makes similar data available free of charge.)
The Chinese authorities are fully aware of the economic value of external demand (exports). The media will say that China’s trying to “cool” domestic inflation by raising domestic bank rates; but that’s not the full story. In my view, what they’re really trying to do is to “cool” domestic inflation in order to shift relative prices and depreciate the real exchange rate, all to gain a competitive advantage in global goods markets.
I guess, I no longer understand. I thought that raising interest rates would strengthen a country’s currency because it would make owning the currency more desireable because of the higher rate of return and in fact that is the reason for the decline in the dollar–along with chronic trade deficits. If the game is more subtle by dampening domestic demand and thereby increasing the trade surplus it gives me an opportunity to trot out my modest proposal for starting a trade war. It is apparent to anyone that pays attention that “free trade has been a disaster for most Americans–exporters have liked it and the corporations which have outsourced jobs have liked it but for most Americans who have faced stagnant wages or suffered long term unemployment it has been a disaster and certainly is one of the reasons why the government is running such large deficits. I understand the notion of comparative advantage and the idea that other countries can produce goods and services mmore cheaply than the U.S. because of lower labor rates, less regulation–particularly environmental, and better education, but something which has been niggling at me is corporate tax rates. You see this a lot in the U.S. where companies threaten to relocate from unionozed high tax states to non unionized low tax states and it is basically a race to the bottom. Not much we can do about that absent a new constitution, but we could at least deal with the tax issue on an international basis. Lots of the right wing folks want to make the U.S. more competitive by lowering corporate tax rates. How about imposing tariffs on imported goods and services to match the U.S. corporate tax rates? If the top rate in the U.S. is 24% and in Ireland it is 8% then when I import some Irish Lace–mpore likely Irish whiskey– how about slapping a 16% tariff on it? It is not really protectionism, Ireland can always simply raise the rate and its goods would escape the tariff and it might be able to supply more services to its populace with larger corporate rates, but it would level the playing field for a lacemaker trying to decide where to build its factory. Just a thought.
“I thought that raising interest rates would strengthen a country’s currency because it would make owning the currency more desireable because of the higher rate of return…
That’s where the closed capital account comes in. It is far easier to control an exchange rate if the effects of interest rate differentials are limited through capital controls. That is to say, if I don’t allow my most people to benefit from the interest rate differential, then it doesn’t have much impact.
The obvious thing for China to do here is the natural thing – trade with the strong currency area. Right now, that means Europe and Japan.
“I thought that raising interest rates would strengthen a country’s currency because it would make owning the currency more desireable because of the higher rate of return and in fact that is the reason for the decline in the dollar–along with chronic trade deficits”
In a fully floating currency regime with open markets, the increasing interest differential would normally appreciate the currency, all else equal, relative to other markets (that don’t hike). But China is neither fully floating nor open, so anything goes. They keep the exchange rate at whatever level they choose (of course this will eventually lead to inflation).
Furthermore, the domestic demand story could curb capital inflows to equity markets, which would offset the effects of the interest differential.
What is clear, is that the currency impact is not clear. But it would be clear if Chinese policymakers raised the value of the CNY (which they set directly).
Protectionism is a dangerous game, and China’s the biggest trade bully out there. “Free trade” is neither here nor there when you’ve got such stark current account imbalances. Will the US slap a 10% tariff on Chinese imports (as Nixon did)? Who knows, but we’re walking that path now.
terry: “How about imposing tariffs on imported goods and services to match the U.S. corporate tax rates?”
Interesting idea. 🙂
Terry: “I understand the notion of comparative advantage”
Doesn’t the comparative advantage argument assume full employment?
Thanks to you and K Harris for the explanation. I sort of thought the reference to the impossible trinity contained the explanation, but I am simply not that conversant in how those controls work and how that impacts the economic theory when it comes to currency valuations.
I am not sure, but if we were working in a purely theoretical world it would because at anything less than full employment wages would be bid down until full employment was reached and only then could we compare wages in for example China and the U.S. Of course, comparative advantage involves a lot of things other than wages. Presumably we have a compartive advantage over China in raising grains because we have more arable land which is highly fertile and the investment in large capital goods which makes planting and harvesting highly efficient. Other products dependent on natural resources not so much. For example both China and the U.S. have vast coal reserves. Apart from wage rates China probably has a comparative advantage because it has even less mine safety regulation than we do at least based on the practically monthly reports of mine catastrophes in China compared to a couple a year here in the states. I am not suggesting either a tariff based on lack of safety or environmental regulation and I am certainly not suggesting te U.S. race to the bottom in these areas, but focusing soley on the issue of business taxes.
“Only 23 per cent of investors surveyed blame the Chinese policy of pegging its currency, the yuan, to the US dollar and for ignoring a request from the US to allow the yuan to appreciate quickly on the basis that it is artificially keeping its currency devalued to make its exports cheaper.”
Okay, Japan’s to blame, too. Germany, too. Perhaps the question was too specific to one nation. The US is certainly not without blame, with its policies to encourage spending and dissaving (at least in the real estate market).
The Australians are very proud of the strength in their currency – as long as China doesn’t blow up, that economy’s set…despite the AUD hitting parity in interim trading.
Agreed on the IMF meetings – but what did they really expect? These things take time and political pressure. I honestly don’t understand the international politics. Why don’t the US and Japan (and other countries, too, of course) multilaterally oppose China’s manipulation, especially since China is aggressively buying up JGBs , too (see Marshall Auerback’s article to the point).
Global liquidity is going to rise markedly as the Fed engages in a new asset-purchase program – this is essentially it’s goal. I may be naive here – but the Fed very likely sees the decline in the dollar as a byproduct of the easy policy, not the policy itself.
Yes, the emerging markets are left wide open to a slew of capital inflows – it’s already underway. But specific to Asia, each central bank that maages their currency will choose their policy tool to manage the new liquidity and combat inflation: the currency or not. For example, South Korea’s inflation rate jumped 1 ppt in September to 3.6% Y/Y and the central bank left their policy rate unchanged (that was a surprise). They did this because of the managed currency – had they hiked, capital inflows would increase and the currency would appreciate. Singapore allowed their managed rate to appreciate further – to combat the easy policy coming from the West that will eventually translate into inflation in Asia.
Speculation abounds – heck the Fed hasn’t even printed one extra dollar and the trade-weighted dollar is down over 5% (including yesterday’s hiccup). But Asia’s got liquidity with which to contend in the pipeline – and simple one-off taxes are not going to stop it. The BRL’s barely moved since the tax increase.
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I don’t know of any other topic that involves so many well-informed people who are so misinformed and under-informed. The P.R. crew seems to be putting in some overtime on this one.
If I were you, assuming that you are open-mindedly eager to fully get this, I would google MICHEAL HUDSON, then go to his website and read “What Went Wrong at the IMF Meeting” (? title?). You need not agree with what he has to say but give him a chance. He has been more often correct than anyone else over these past few years… and, he is right again, trust me, I am only trying to help you. This all has little to do with ideology and much to do with morality. The US caused the collapse and depreciating/inflating our way out of the mess should not come at the expense of human progress.
Paul Krugman summed it up yesterday.
October 19, 2010, 9:48 am
China Raises Rates
“As if to illustrate my point about the non-equivalence of the United States and China: China raises interest rates.
So, the United States is pursuing an expansionary domestic monetary policy, which increases overall world demand; however, a side consequence of this policy is a weaker dollar. China is pursuing a weak-yuan policy; to counter the inflationary domestic effects of that policy, it’s pursuing a contractionary domestic monetary policy, reducing overall world demand.
We’re doing the right thing; they’re making the world as a whole worse off.”
Rebecca – “I honestly don’t understand the international politics. Why don’t the US and Japan (and other countries, too, of course) multilaterally oppose China’s manipulation, especially since China is aggressively buying up JGBs , too (see Marshall Auerback’s article to the point).”
The advanced economic nations lack the courage to take on China. Too many western corporate interests are bowing at the feet of the communist government in China, seeking market share, cheap production sourcing, and other crumbs. It’s the very reason that western R&D facilities are popping up across China.
Marshall is on target, though he is too polite in his assessment. Good article.
China is a rogue economic power. The advanced nations were foolish to think that China would play by the international rules once allowed on the global economic stage. China is more than willing to engage in open economic warfare on a multitude of fronts. There will be more incidents in the future. The advanced nations made a bad decision in providing China a chair at the table. China lacks the maturity to be a key participant.
Paul Krugman reached the same conclusion on October 17:
“Major economic powers, realizing that they have an important stake in the international system, are normally very hesitant about resorting to economic warfare, even in the face of severe provocation — witness the way U.S. policy makers have agonized and temporized over what to do about China’s grossly protectionist exchange-rate policy. China, however, showed no hesitation at all about using its trade muscle to get its way in a political dispute, in clear — if denied — violation of international trade law.
Couple the rare earth story with China’s behavior on other fronts — the state subsidies that help firms gain key contracts, the pressure on foreign companies to move production to China and, above all, that exchange-rate policy — and what you have is a portrait of a rogue economic superpower, unwilling to play by the rules. And the question is what the rest of us are going to do about it.”
As usual, Krugman is half right. From the linked Bloomberg article:
“There is a risk the hike does exacerbate capital inflows and will complicate inflation matters,” said Ben Simpfendorfer, an economist at Royal Bank of Scotland Group Plc. in Hong Kong. “But the property sector was the greater risk and demanded strong action.”
And as usual, Geithner (or predecessor, or successor-see treasury secretary operation manual) is wrong every October, delaying a decision on whether China is a currency manipulator until after November elections, and then the issue is forgotten till next October.
Some say the US is the currency manipulator, but if China pegs to us, that would mean we both are currency manipulators. We do have the power to enact tariffs and not just give lip service about what China should do. If we would decouple then the US would no longer need to be a currency manipulator. The yen is 81 and the euro is 1.38. What’s the problem here?
Then China can go tame it’s growing real estate bubble as it sees fit.
The “gains from trade” argument does assume full employment. When it was first laid out, we were in the dawning days of classical economics, so this is not a surprise. The “gains from trade” argument becomes ambiguous below full employment, and less likely to be true, the less fully employed we are.
I would also ask whether the “gains from trade” argument is true at full employment, if there is a large current account imbalance. Particularly if the current account imbalance is the result of policy, we are already in a “second best” environment, in which additional interference in markets may lead to a superior outcome.
There is a second issue that we always need to keep in mind when discussing changes in trade patterns. That’s the domestic cost of adjustment. “Falling off the production possibility frontier” is the classroom description. (Again, there is a classical assumption at work – we start at full employment, so are on the “frontier”.) The issue is that resources have to move from one activity to another, and in the process, are unemployed for a time. In good times, a period of unemployment may not be a high cost for increased efficiency. In bad times, dislocations due to shifts in trade could push the economy into a downward spiral. That’s sort of the point that is made when folks argue that a stronger yuan or bilateral tariffs wouldn’t help the US, because there is no domestic capacity to make import substitutes.
An interesting discussion on Mr. Soros’s article related to this matter: