What happens if the RMB is forced to revalue?

Because of US and European pressure Beijing may allow much faster appreciation of the renminbi than it likes over the next year, but this will almost certainly be accompanied with policies that reduce the adverse employment impact. In my opinion the most likely such policy involves credit. If Beijing expands cheap credit, however, it may exacerbate dangerous imbalances within the economy.

Before explaining, let me suggest why I think we are going to see much faster renminbi appreciation. Part of the reason has to do with what looks like good economic numbers. The real estate market seems to be recovering, manufacturing is doing well, and Chinese growth is strong. Here is what Saturday’s Xinhua had to say about the most recent PMI index:

The Purchasing Managers Index (PMI) of China’s manufacturing sector rose to 53.8 percent in September, up 2.1 percentage points from August, the China Federation of Logistics and Purchasing (CFLP) said Friday. The reading of the September index was the highest since May and marked the 19th consecutive month that the index was above the boom-bust line of 50 percent

Meanwhile on Sunday data released for non-manufacturing industries showed the same trend, especially (shudder) in the property sector. Here is Credit Suisse on the subject:

The non-manufacturing PMI was up 0.2pps (sa) in September, with the business expectation index rising 1.5pps to 67.3 (sa). The improvement was triggered by the rebound in property sales transactions in September, in our view, which raised the business activity and expectation indices for the real estate and construction sectors this month. Meanwhile, the retail trade indices fell, but remained elevated, in our view.

So far no big surprise. As I have said many times in the past two years, most recently in my May 12 entry, Beijing’s response to the global crisis seems to be a panicky process of stomping on the accelerator when things began to slow down, and then as the economy overheats, real estate development surges, and doubtful investment projects explode, stomping on the brakes.

There is little fine-tuning that they can do – we’re stuck with the choice between bad growth and no growth. I am pretty sure that one way or another we are going to clock in investment-driven GDP growth numbers of 8-10% well into 2012 – although, as Mahatma Gandhi famously complained, speed might be irrelevant if you are going in the wrong direction.

The South China Morning Post version of the story identifies one of the risks associated with the economic rebound.

Mainland manufacturing surged ahead faster than expected last month as domestic demand underpinned growth in the world’s second-biggest economy. The official Purchasing Managers’ Index rose to a four-month high of 53.8 last month, beating a Bloomberg forecast by economists of 52.5 and confirming the country’s economic resilience. Analysts warned, however, of rising inflation risks and a protectionist backlash from the mainland’s trading partners.

…Goldman Sachs said Beijing’s policy since July had been akin to having “one foot on the brake and the other foot on the accelerator”. The bank said the September PMI “suggests the foot on the accelerator has been heavier than expected, and the foot on the brake lighter than expected. Growth in the coming months will continue to be the result of the tug of war between the tightening and loosening measures in different areas of the economy, but the latter appears to be gaining the upper hand.”

Along with Goldman’s slightly different use of the brake/accelerator simile I favor, the article points out that rapid manufacturing growth will put upward pressure on the country’s trade surplus. Add to this what looks like buoyant economic conditions, at least on the surface, and I can only assume that it will increase foreign impatience with the impact of China’s deficient demand on foreign growth.

Currency wars

So the trade environment will continue to deteriorate and continue to take center stage. By now everyone is probably aware of the remarkable statement last week from Brazil’s finance minister. Here is the Financial Times version:

An “international currency war” has broken out, according to Guido Mantega, Brazil’s finance minister, as governments around the globe compete to lower their exchange rates to boost competitiveness.

Mr Mantega’s comments in São Paulo on Monday follow a series of recent interventions by central banks, in Japan, South Korea and Taiwan in an effort to make their currencies cheaper. China, an export powerhouse, has continued to suppress the value of the renminbi, in spite of pressure from the US to allow it to rise, while officials from countries ranging from Singapore to Colombia have issued warnings over the strength of their currencies.

“We’re in the midst of an international currency war, a general weakening of currency. This threatens us because it takes away our competitiveness,” Mr Mantega said. By publicly asserting the existence of a “currency war”, Mr Mantega has admitted what many policymakers have been saying in private: a rising number of countries see a weaker exchange rate as a way to lift their economies.

What is remarkable is not that Mr. Mantega has said something that we didn’t know, but rather that someone so senior has said what everyone has avoided saying for so long. The Europeans, too, have entered the fray more aggressively and are complaining about a rising euro. We are certainly in a global beggar-thy-neighbor process, in which the first round, just like in the 1930s, takes place as currency intervention, and the second round will take place as tariffs.

I have always argued that the only way to avoid a real deterioration in trade relations is for the major economies to come to a grand bargain and agree to adjust over an eight to ten year period, although I have also always been very pessimistic that this would happen, but it seems perhaps President Sarkozy is making a valiant attempt to do just that. From an article in Saturday’s Financial Times:

France and China have been in talks for the past year as part of an effort by Paris to heighten co-ordination of exchange rates to promote stability of the international monetary system in the wake of the financial crisis.

The talks and their content have been kept secret, in an attempt to draw China into a discussion on global currency co-ordination, a subject that Beijing has been reluctant to countenance in the past.

In an ambitious move reminiscent of the currency accords of the 1980s, President Nicolas Sarkozy hopes to open a debate on the subject when France takes over the presidency of the G20 group of leading nations in November, according to people familiar with the matter.

I wish him good luck but I very much doubt that anything useful will come of it. There are rumors going around about who will replace Larry Summers in the White House and even rumors about Tim Geithner being replaced at Treasury (you can read a little more about these rumors here). Both of them have been, I think, very reluctant to allow an escalation of the trade conflict, but in a world in which everyone is behaving childishly, this attempt at grown-up behavior looks increasingly out of step.

And as everyone by now knows, the US House of Representatives on Wednesday passed a bill to press China to let its currency rise faster. Although this bill does not bind President Obama in any way, and might not even survive a WTO challenge, it is nonetheless pretty clear that the world is tilting inexorably towards more trade conflict.

So the renminbi must rise

After all everyone is already doing it – cheating on trade, that is. The big surplus countries are dragging their feet on enacting the kinds of policies that will increase domestic demand and so reduce the drag on global growth caused by their deficient demand. The big deficit countries are either in collapse (Europe) or are warily eyeing the amount of their domestic demand that leaks abroad to create foreign jobs (the US). In a world of beggar-thy-neighbor policies and anemic global demand growth, countries that do not retaliate will almost certainly see rising unemployment.

So that is why I think pressure on the renminbi is inexorable. The way the numbers work, I see only three options. First, the US can allow its trade deficit to explode. Second, the world can organize a concerted attempt to deal with imbalances. Or third, each country can continue implementing policies aimed at acquiring a larger share of dwindling global demand.

The first two, I think, are unlikely, and so I suspect the renminbi issue will not go away. But excessive focus on currencies and tariffs is likely to make a bad situation worse, and this is what I really want to discuss today. Currencies matter to trade, and it is strange to see the gyrations among many economists who try to deny it.

Most notable, I think, is the complete reversal of official opinion in Japan. Twenty years ago when it was the undervalued yen that was at the center of trade disputes, Japanese officials were adamant that currency intervention has nothing to do with trade imbalances (the problem is “structural” everyone insisted). But after the PBoC started intervening against the yen a few months ago, suddenly Japanese officials have decided that in fact currency intervention matters a great deal to trade.

Perhaps to someone more cynical that I am the reversal in Japanese opinion is not so surprising. As Tokyo seems to have discovered, currencies do indeed matter. The level of the currency has a big impact on the relationship between domestic production and consumption, and of course the difference between the two is the savings rate, which determines the trade surplus (i.e. the excess of savings over investment).

For that reason I am always puzzled by people who say that devaluing the dollar will have no impact on the US trade deficit because the problem is low savings relative to investment. No, that is not the problem. That is simply one of the definitions of a current account deficit. But if the dollar devalues, and consumer prices rise, US consumption is likely to decline. In addition, to the extent that any of the stuff Americans used to import before the devaluation is now produced domestically (not all, but any), then US production must rise. Since savings is equal to production minus consumption, the US savings rate must automatically rise.

But just because the currency matters to trade, it does not mean that it is the only thing that matters, or even the most important thing that matters. Anything that affects the level of production, the level of consumption, or the level of investment, will automatically affect the trade balance.

This is why I worry that we are putting too much pressure on the renminbi. There are many ways for China to rebalance, and they all involve the same process of transferring income from producers to households. Raising the value of the renminbi, for example, increases the real value of household income in China by reducing the cost of imports.

It balances this by lowering the profitability of exporters. The net result is that if it is done carefully, the household income share of China’s GDP rises when the renminbi is revalued, and with it consumption rises too. Since China must export the difference between what it produces and what it consumes or invests, raising the value of the currency also reduces China’s trade surplus.

But what would happen if China were to raise the currency too quickly? In that case the profitability of the export sector would decline so quickly that exporters would be forced either into bankruptcy or into moving their facilities abroad to lower-wage countries. Either way, they would have to fire local workers

But firing workers reduces household income and household consumption. If it reduces household income faster than the revaluation increases real household income (by lowering import prices), the net result is a reduction in total household income and a reduction in household consumption.

Balancing and unbalancing

This is the problem China faces. It must raise the value of the renminbi as part of its rebalancing towards greater domestic consumption, but if it does so too quickly, the rebalancing will occur not as an increase in consumption relative to rising production, but rather as a drop in production relative to declining consumption.

This may seem like a confusing point, but it is worth understanding. China can rebalance with high unemployment as well as with low unemployment, and the difference has to do with the speed of the rebalancing. If China adjusts too quickly, consumption will actually decline, and production will decline even faster. In that case China rebalances (consumption rises as a share of GDP), but under conditions of rising unemployment.

That is why too much focus on the currency is dangerous. It is clear that the US and Europe have become very impatient with the slow adjustment process in China, made all the worse by a European crisis which is almost certain to cause the European trade surplus to surge. Every major economy in the world, including China, is implicitly expecting US consumption to drive employment growth, as Premier Wen more or less told President Obama last week, but with soaring unemployment the US is in no mood to divert its own demand abroad.

And so there is a good chance that the US will overreact, and will use the threat of tariffs to force the renminbi to appreciate much faster than China can absorb. Even Tim Geithner seems to think that we will see much faster appreciation. Here is what an article in Friday’s Financial Times said:

Tim Geithner, US Treasury secretary, said the renminbi was on track for significant appreciation against the dollar and there would be no “trade war” or “currency war” between the US and China.

So after years of dragging its feet, postponing a rebalancing, and forcing rising trade surpluses onto the rest of the world, China may have to adjust its currency policies so quickly that it risks a sharp contraction at home. So what will China do?

This, for me, is the most interesting and perhaps important question. Most probably Beijing will do the same thing Tokyo did after the Plaza Accords and Beijing did after the renminbi began appreciating in 2005. It will lower real interest rates and force credit expansion.

This of course will have the effect of unwinding the impact of the renminbi appreciation. As some Chinese manufacturers (in the tradable goods sector) lose competitiveness because of the rising renminbi, others (in the capital intensive sector) will regain it because of even lower financing costs. Jobs lost in one sector will be balanced with jobs gained in the other.

But there will be a hidden cost to this strategy – perhaps a huge one. The revaluing renminbi will shift income from exporters to households, as it should, but cheaper financing costs will shift income from households (who provide most of the country’s net savings) to the large companies that have access to bank credit. So China won’t really rebalance, because this requires a real and permanent increase in the household share of GDP. Instead what will happen is that it will reduce Chinese overdependence on exports and increase China’s even greater overdependence on investment.

This will not benefit China. It will fuel even more real estate, manufacturing and infrastructure overcapacity without having rebalanced consumption. Expect, for example, even more ships, steel, and chemicals in a world that really does not want any more.

So we are still pretty much stuck. China and other surplus countries like Germany and Japan need to understand that their policies are causing real damage in the US, and the US needs to understand that the surplus countries simply cannot adjust fast enough to suit the US, but neither side is very interested in understanding the other.

An optimal solution will require real grown-up behavior on the part of the major economies, who must agree to resolve the trade imbalances carefully and with determination. Of course grown-up behavior is probably too much to ask from countries that have displayed so little of it to date. Instead trade relationships will simply continue to deteriorate.

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For those who are as fascinated by these things as I am, I see that on October 3 German made the very last payment on its WWI reparations debt. German reparation payments were at the heart of the financial imbalances of the 1920s, and of course those imbalances led to the buoyant asset markets and trade imbalances of the 1920s, the collapse of European banks in 1930-31, and eventually the Great Depression.

Its one of history’s nasty little jokes that it waited for the advent of this crisis before it finally put that one permanently behind us.

On a related note I want to quote an interesting piece from Douglas Irwin’s “Did France Cause the Great depression?” The non-gated copy is here

A large body of economic research has linked the gold standard to the length and severity of the Great Depression of the 1930s. The gold standard’s fixed-exchange rate regime transmitted financial disturbances across countries and prevented the use of monetary policy to address the economic crisis. This conclusion is supported by two compelling observations: countries not on the gold standard managed to avoid the Great Depression almost entirely, while countries on the gold standard did not begin to recover until after they left it.