In reading Scott Sumner’s take on the China currency peg dilemma, I see that both he and Paul Krugman hit on the fundamental problem in the debate: reserves. Everyone is talking about the peg as if relaxing the peg will be the magic bullet to America’s current account problem. But this is clearly not the case.
If China were to unilaterally revalue it’s currency, the Chinese would start buying fewer dollars incrementally. Part of the benefits of revaluation would accrue to Chinese export competitors in Europe (principally Germany) and in Asia (depending on their currency policy response). As US economic policy would be unchanged, US imports would switch from China to its competitors without any benefit accruing to the US.
If the Chinese revalued, but then also bought euros, selling dollar assets, a Yuan revaluation would effectively be a US dollar depreciation against both the Yuan and the euro (not to mention against other Asian countries again depending on whether they move in concert with the Chinese). In this case, the US would be able to reduce its current account deficit. (**Note: I changed this section to more accurately reflect the mechanics.)
Either way, the policy aim appears to be to force the Chinese to effect a US dollar depreciation – and this is what has the Chinese so outraged.
The Wall Street Journal quotes China’s Premier Wen as saying:
“I can understand that some countries want to increase their share of exports,” Mr. Wen said, in an apparent reference to the Obama administration’s goal. “What I don’t understand is the practice of depreciating one’s own currency and attempting to press other countries to appreciate their own currencies solely for the purpose of increasing one’s own exports,” he added. “This kind of practice I think is a kind of trade protectionism.”
It is not the peg that matters. This is the symptom. It is China’s accumulation of reserves – it’s capital account surplus – which are at issue. Krugman has it right when he says:
…the right way to think about China’s exchange rate is, initially, not to think about the exchange rate. Instead, you should focus on China’s currency intervention, in which the government buys foreign assets and sells domestic assets, on a massive scale.
Ostensibly, this is the same issue the US should have with Japan since they also have been accumulating an enormous amount of US dollar reserves. But, no one is talking about this because the Japanese have a floating currency. In reality, what is at work here is a high savings rate – a high private sector balance – which is not met by an equivalent government sector deficit. The differential therefore shows up as a capital account deficit aka trade surplus.
Let me illustrate how this works across a number of countries using a chart I showed you when discussing the financial sector balances in Europe last week.
As you can see in the diagram, the Netherlands, Germany, Austria and Finland are the only countries depicted with capital account deficits. In each case, the countries have very large private balance surpluses (Finland to a lesser degree). Also, in each case, the government deficits are smaller than their private surplus. Hence, the capital account deficit.
However, if you look at Ireland, now in a depression, their huge private savings rate is more than offset by the budget deficit. Hence, the capital account surplus (trade deficit).
How do we resolve this problem? On some level, this is a political problem more than anything else. Take Ireland, for example. Why shouldn’t they have high private sector savings? After all, they accumulated lots of private sector debts during the housing bubble. In their case, they cannot devalue because they are locked into the eurozone. The only way the Irish can run a trade surplus is through an internal devaluation aka an across the board wage and salary cut. This would make Irish exports more attractive, improving their trade balance and cutting their budget deficit.
But, that’s never going to happen in isolation. What will happen is the Irish will cut their budget deficit by cutting expenditure. This will precipitate a decrease in private savings and greater levels of debt distress along with the lower GDP the cuts entail. (**Note: I added ‘in isolation’ to the end of the first sentence to reflect its meaning more clearly.)
So, what about the Chinese (or the Japanese) then? How do we get them to stop accumulating reserves? One way is to revalue their currency. But for fear of the repercussions in the domestic export economy, this is likely to happen slowly. Another way, would be to decrease stimulus, putting the government into a surplus position. In China’s case, this is promising. Signs of overheating are everywhere. The Chinese needs to reduce excess fixed capital investment. I am assuming this policy would reduce government support of export industries giving it a double effect on savings. Since exports are the issue abroad, that would make sense. (**Note: the last paragraph originally erroneously spoke of increasing the Chinese government deficit when it should be decreasing. Apologies.)
The last possibility then is to encourage less saving and more spending. However, this could prove a tough nut to crack as well. For one, Shang-Jin Wei, a Professor of Finance and Economics at Columbia University’s Business School, thinks the high savings rate has much to do with the one-child policy.
He writes:
There are approximately 122 boys born for every 100 girls today, a ratio that translates into cutting about one in five Chinese men out of the marriage market when this generation of children grows up…
“The increased pressure on the marriage market in China might induce men and parents with sons to do things to make themselves more competitive,” Wei says. “Increasing savings is one logical way to do that, to the extent that wealth helps to increase a man’s competitive edge. Parents increase household savings mostly by cutting down their own consumption.”
Wei worked with Xiaobo Zhang of the International Food Policy Research Institute in Washington, D.C., to see if his hypothesis held up, comparing savings data across regions and in households with sons versus those with daughters. “We find not only that households with sons save more than households with daughters in all regions,” Wei says, “but that households with sons tend to raise their savings rate if they also happen to live in a region with a more skewed sex ratio.”
The effect is significant. The household savings rate in China rose from about 16 percent of disposable income in 1990 to over 30 percent today, which is much higher than most countries. About half of the increase in the savings rate of the last 25 years can be attributed to the rise in the sex ratio imbalance. “It’s a very high ratio of savings to income,” Wei says. “The comparable savings rate in the United States would be 2 or 3 percent before the crisis, and about 6 percent since the crisis.”
Even those not competing in the marriage market must compete to buy housing and make other significant purchases, pushing up the savings rate for all households.
“While the conventional explanations for the high savings rate all play a role, they are not as important as people previously thought,” Wei says.
I am not sure what kinds of (gender-based) consumption incentives one could offer to induce more spending. But, the gender skew will be with us for some time. Chinese policy makers need to do anything they can to encourage greater spending. In particular, Chinese policy makers could think about incentives that increase the marginal propensity to spend in families with male children. In concert with a slow revaluation, this will certainly alleviate much of the trade imbalance now causing so much discussion.