By Michael Pettis
On Friday the US Treasury released its presumably semi-annual (it was due last October) report to Congress on currency issues, and in it refrained from calling any of the countries under review “currency manipulators.” Today’s People’s Daily had this to say :
Major trading partners of the United States, including China, did not manipulate their currencies to gain an unfair advantage in international trade in 2010, according to a report released by the U.S Treasury Department on Friday. ”Based on the resumption of exchange rate flexibility last June and the acceleration of the pace of real bilateral appreciation over the past few months,” China’s behavior did not qualify under the official definition of manipulation, the Treasury said in its long-delayed semiannual report to the Congress on International Economic and Exchange Rate Policies.
With respect to exchange rate policies, ten economies were reviewed in this report, accounting for nearly three-fourths of U. S. trade. Many of the economies have fully flexible exchange rates. A few have more tightly managed exchanges rates, with varying degrees of management. ”No major trading partners of the United States” met the standards identified by the Congress as currency manipulator, concluded the report.
Perhaps not surprisingly the Bloomberg version of the story was a little more nuanced:
The U.S. declined to brand China a currency manipulator while saying its No. 2 trading partner has made “insufficient” progress on allowing the yuan to rise. China should follow through on President Hu Jintao’s commitments to allow more exchange-rate flexibility and boost domestic demand, the Treasury Department said in a report to Congress yesterday on foreign-exchange markets.
The yuan “remains substantially undervalued,” according to the report, which was originally due in October and says no major trading partner meets the legal standard of improperly manipulating its currency. “It is in China’s interest to allow the nominal exchange rate to appreciate more rapidly.”
The Obama administration and U.S. lawmakers say China’s currency policy gives the nation’s exporters an unfair competitive advantage. U.S. concerns have grown as China’s rising economic power put the economic relationship off balance. China had a $252 billion trade surplus with the U.S. in the first 11 months of 2010, according to Commerce Department data. “The Treasury will continue to closely monitor” the pace of appreciation, the department said in a statement.
I know a lot of people in the US and around the world — including some in the Treasury Department itself — were very unhappy (although not surprised) by the report’s failure formally to name China a currency manipulator, even while insisting that the RMB is kept artificially low and that this is hurting US manufacturers. It seems hard to see how you can believe one thing without believing the other.
So should Secretary Geithner have called China a currency manipulator? I am ambivalent. It is pretty clear to me that domestic policies within China are at the source of the huge imbalance between production and consumption. High savings rates rarely have to do with culture or personal preferences, as is widely assumed, and a lot to do with policies that affect the balance between production and consumption. After all a nation’s savings is simply its total production minus its total consumption, and to the extent that there are explicit policies aimed at constraining consumption and boosting production, they inevitably affect the savings rate. These policies also inevitably force a rising trade surplus onto the rest of the world.
The RMB has appreciated a scant 3.7% in the past two years. I know many people are arguing that Chinese CPI inflation of 5% should be considered as part of the RMB’s real appreciation, but as I argued in my newsletter last week, that would only be true if Chinese inflation affected all input prices equally. If the price of inputs in the tradable good sector rose by less (and most inflation has been in food prices), it is not at all clear that there has been real appreciation anywhere near the CPI inflation numbers.
On that topic I had an interesting email conversation with one of my favorite China analysts, Mark Williams of London-based Capital Economics, who pointed out the following:
This talk of real exchange rate appreciation does seems to have become a big talking point recently and is being repeated by people that should know better. One way to cut through confusion about what is the appropriate price measure is to look at export prices. The US produces a quality-adjusted measure of the unit price of goods shipped from China. According to the latest figures (December), China’s export prices were up 0.8% y/y in dollar terms. In other words, once currency appreciation is factored in, factory gate export prices in renminbi continue to fall.
So clearly there is a problem with relative prices and just as clearly it is not being resolved. This suggests that the world may be justified in being angry with China’s currency policies. But against that I would make two points.
First, we are in the final period before the change of leadership in 2012. It is widely understood that during a presidential election year in the US we come close to policy paralysis, with no important initiatives. It is less widely understood that in China, similarly, at least one or two years before the succession very little gets done. I think it is unlikely that we will get major moves on the currency, or on anything else for that matter. Once the new leadership is in place they will have to decide on the timing and extent of the adjustment, and I think everyone understands that it is going to be a difficult process. The current leadership won’t do it.
Second, I worry that we are focusing too much on the currency while ignoring all the other variables that cause the domestic imbalances in China. If China is forced into a major revaluation, this may simply result in a worsening of the other domestic variables.
It’s not just the currency
To explain why, let me turn to an article published in the New York Times two weeks ago by Harvard Law professor Mark Wu, about the revaluation of the renminbi. Probably because it was the eve of President Hu’s visit to the US it got a certain amount of comment. Although I think I am in broad sympathy with his sentiments, I have to say nonetheless that he repeated two very common fallacies that have been repeated so many times and in so many different places that I think they should be (again) addressed and explained.
In his article Wu said that many American believe a stronger renminbi would create jobs in the US. But, he argues, these claims “are more wishful thinking than actual truths.” He goes on:
Consider the first idea, that a strengthened Chinese currency would increase the growth rate of American exports to China. From 2005 to 2008, the renminbi appreciated nearly 20 percent against the dollar. Yet, American exports to China over those three years grew at a slightly slower pace than in the previous three-year period when the renminbi did not appreciate at all (71 percent versus 89 percent).
This is because many of America’s top exports to China are for capital-intensive goods like aerospace and power-generation equipment. Price is but one of several factors for these purchases, along with technology, quality and service. In addition, American companies in those industries are usually competing against European and Japanese firms rather than Chinese manufacturers.
…Second, I recently did an analysis of the top American exports to our 20 leading foreign markets, and found little evidence that an undervalued Chinese currency hurts American exports to third countries. This is mostly because there is little head-to-head competition between America and China. …By and large, we are going after entirely different product markets.
…Finally, it is unlikely that a stronger renminbi would bring many jobs back home. Instead, companies would most likely shift labor-intensive production to Vietnam, Indonesia and other low-wage countries.
His first argument, that if the currency mattered to the trade balance, a rising RMB after 2005 should have caused an increase in the growth rate of US exports to China, is broadly correct only if the wage-productivity growth differential, real interest rates, and credit growth were constant. But they weren’t. This is the problem with looking at individual factors within an economy without an overall model that shows the relationship between different factors.
Remember that an undervalued currency creates upward pressure on the trade surplus because it reduces the real value of household income while subsidizing production in the tradable goods sector. This causes production to grow faster than consumption (which is normally constrained by the level of household income), forcing the balance to be exported.
But the wage/productivity growth differential and very low interest rates do the same thing. By constraining the growth of real household income and subsidizing production, they too increase the gap between what is produced and what is consumed.
So raising the value of the currency would only have resulted in a positive impact on trade rebalancing – by reversing the flow of wealth from households to producers of tradable goods – if real interest rates and credit growth had stayed constant and workers wages had kept pace with productivity growth. In fact they moved in the wrong direction after 2005 – making Chinese products more, not less, competitive. As with Japan after the Plaza Accord, policies aimed at unwinding the employment effect of currency appreciation more than compensated for the appreciation.
In other words, the exchange rate appreciation after 2005 may very well have caused a relative improvement in the trade balance between the two countries, but the widening differential between wages and productivity and, more importantly, the reduction in real interest rates and the forced expansion of credit would have had the opposite effect.
So while it is true that China’s trade surplus increased after the RMB started revaluing in 2005, that doesn’t mean the currency appreciation had no impact. There is a big difference between saying that the RMB exchange rate is not the only thing that matters to the US trade account and saying that the RMB exchange rate doesn’t matter at all. The former statement is almost certainly true, while the latter statement violates common sense and nearly all historic precedent.
The rest of Wu’s arguments are implicitly based on the second fallacy, that international trade can only settle on a bilateral basis. He says that because there is little overlap between what China produces and exports and what the US produces and exports (a claim about which I have already expressed my skepticism), changes in China’s balance of trade will have no effect on the US balance of trade. It can only matter if when China sells one fewer widget to the US or Mexico, American widget makers immediately take up the slack.
This is only partly true. In fact trade almost never settles bilaterally. It settles multilaterally. It doesn’t matter whether or not China and the US produce the same thing for currency appreciation to have an affect on the two countries’ trade balances.
So even if Wu is right in saying that a revaluation of the renminbi would directly reduce Chinese exports to the US without directly stimulating production in the US, so what? If Americans weren’t producing what China used to sell, that just means that the US purchased those products from another country, let’s say Mexico.
But aside form the fact that this is not such a terrible outcome for Mexico, it will still affect US production. After all if Mexico suddenly increases its exports to the US by a very large amount, wouldn’t that cause Mexican wages, interest rates and the peso to rise. And wouldn’t Mexicans begin to import more, from the US for example?
Remember that Mexico’s current account (which is mostly the trade account) is exactly equal to the excess of domestic savings over domestic investment. It is hard to imagine that a massive surge in Mexican exports would be perfectly matched, dollar for dollar, by a surge in Mexican savings, and no increase in Mexican investment. Wouldn’t Mexican workers consume at least part of their higher income? Wouldn’t Mexican exporters increase capacity at least a little? Both of these would cause imports to rise.
How to make Chinese capital goods more competitive
As I have written in the past, in fact Mexico’s trade surplus wouldn’t change much, and it certainly wouldn’t change by the full value of the increase in exports. This means that Mexican imports would rise, perhaps by the same amount as Mexican exports. Those imports have to come from somewhere, and if they didn’t come at least in part from the US, the other country that saw its exports to Mexico increase would undergo the same process as Mexico, and its imports in turn would rise, mutatis mutandi, until someone somewhere purchased something from the US.
I would argue that in fact there is a very different reason why the US should not push China so hard on revaluing the currency, and this reason is implicit in my response to Wu’s New York Times article. What would happen if the US were indeed able to force China to raise the value of its currency faster than China could tolerate?
The good news for China is that raising the RMB shifts income from the tradable goods sector to households, and so lowers the trade surplus. The bad news is that if this happens too quickly, and results in an increase in domestic unemployment, as export companies experience financial distress or move abroad, gross household income might actually decline. The rebalancing would still take place, but it would take place very painfully.
So how would China respond? Almost certainly by stepping up investment and lowering real rates. This effectively shifts wealth from households to borrowers, and allows the capital-intensive sector to take up the slack created by the contracting tradable goods sector (and of course there is a lot of overlap between the two).
So would the world be better off? No, China would be worse off because not only has there been no meaningful rebalancing, but of China’s two vulnerabilities, it has exchanged some reliance on the lesser of the two evils (export growth) for greater reliance on the greater of the two (overinvestment).
The US also would be worse off. Not only will there have been no Chinese trade rebalancing, but there would have been a shift in the composition of Chinese trade that would more directly harm the US.
This is because all Chinese exporters would suffer, but at the same time all Chinese capital-intensive industries would benefit. The net result would be a shift in Chinese exports away from labor-intensive exports (shoes, lighters, toys, etc.) and towards capital-intensive exports (steel, ships, chemicals, cars, etc). In other words Chinese exports will become more directly competitive with US-produced goods.
So of course the level of the RMB matters, and of course the US is right to be very impatient with the glacial pace of China’s rebalancing attempts, but by focusing only on the currency the US may actually make things worse for both countries.
Back to trade tension
On a related topic Monday’s People’s Daily has this article:
China has no need to revalue the yuan for trade reasons, as export growth will slow to a 10 percent this year and its surplus is set to contract by 2015, its trade chief said. Imports from the world’s second largest economy will probably grow faster than exports this year, Commerce Minister Chen Deming said at the Davos forum.
Chen dismissed calls for China to strengthen the yuan to tackle the trade surplus, and called instead on countries with reserve currencies – a reference to the United States – to prevent their currencies from weakening. “It is not a sound argument to ask China to appreciate the yuan for trade reasons,” Chen told Reuters on Friday in an interview during the World Economic Forum in Davos.
Chen Deming, as Minister of Commerce, has always opposed RMB revaluation, so there is no need to read too much into these statements. But if Chinese imports do rise faster than exports, it doesn’t follow that the RMB is not undervalued and that the world is correctly rebalancing.
It may have far more to do with very anemic demand growth in the rich countries. According to the article Minister Chen also said that he “saw little prospect of a currency or trade war, but it was necessary to remain alert over exchange rate tensions.”
I am not sure I agree with the first part of his statement. Monday’s Financial Times had two very interesting, related articles about just that topic. In the first one, it says:
Trade tensions between Brazil and China are expected to increase after the Asian country emerged last year as the biggest foreign direct investor in Latin America’s largest economy. Analysis of data from Brazil’s central bank shows that China accounted for about $17bn of Brazil’s total FDI inflows in 2010 of $48.46bn, up from less than $300m in 2009, according to Sobeet, a Brazilian think-tank on transnational companies.
“This is the first time we have had so much investment from China,” Luis Afonso Lima, president of Sobeet, told the Financial Times. Exports of commodities, such as iron ore and the “soya complex” of beans, oil and meal, to China helped to keep Brazil’s economy afloat during the financial crisis. However, tensions have surfaced after China last year also emerged as one of the biggest sources of cheap imports into Brazil, helped by a surge in the value of the real, which is undermining the competitiveness of domestic industry.
My friends in Brazil tell me that the anger arises from the perception that with all the difficulty Brazil has had in preventing its currency from revaluing excessively, the surge in Chinese investment has made the process all the more difficult. More Chinese investment requires more central bank intervention, and so more monetary expansion.
This hurts partly because of inflationary pressure and partly because a rising real reduces the value to Brazil of its commodity exports and makes it more difficult for Brazilian manufacturers to survive. And that difficulty is the topic of the second Financial Times article:
Brazil’s new government has warned [of] a looming “trade war” between Latin America’s biggest economy and its main trading partners, including China. Brazil has until recently viewed China as a crucial market for its exports and a close ally in the “Brics” club of fast-growing, large developing countries, which also includes India and Russia. But a growing flood of cheap Chinese manufactured goods into Brazil is testing the relationship.
“The relationship with China is important but, from an industrial perspective, it is extremely negative,” said a statement from the São Paulo Industrial Federation, known as Fiesp. While Brazil reported a trade surplus with China of $5.2bn last year, this was due to commodity exports, Fiesp said. On the industrial front, imports of manufactured goods from China rose a “devastating” 60 per cent last year. The deficit in manufactured goods was a record $23.5bn, up from only $600m seven years ago.
I am often asked about the shifting balance of global power relations, away from the traditional West and towards the BRICs. I am skeptical. BRICs are a great marketing concept with which to sell emerging market paper, but the idea that they have the same global interests requires that you squint ferociously when you look at them. Four countries with more diverse and even opposed global interests, economic as well as political and geopolitical, it would be hard to find than Brazil, Russia, India and China.
This is an abbreviated version of the newsletter that went out Monday. Academics, journalists, and government and NGO officials who want to subscribe to the newsletter should write to me at [email protected], stating your affiliation, please. Investors who are clients of Shenyin Wanguo Securities will already receive the newsletter. Investors who are not clients but who want to buy a subscription should write to me at that address.
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