Ss china the us & currencies harvard kennedy school presentationPresentation Transcript
China, the US, and Currency Issues Jeffrey Frankel Harpel Professor, Harvard University Chinese Future Leaders, January 29, 2010
Topics to be addressed
The US twin deficits
The call on China to appreciate the RMB.
What is in China’s interest?
What is China’s actual exchange rate policy?
Shifting power relationships
API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University US external deficits have shown a negative trend in the long run (1960-2007) temporarily interrupted in recessions of 1980, 1990, 2001, & 2008. Previously CA>TB, due to intl. investment earnings. Now reversed.
The US deficits improved in 2008-09, but this will again be a temporary reversal, attributable to the US recession (=> import quantities ↓ & oil prices ↓) Trade & current accounts, in $ billions per quarter
Dangers of the U.S. trade deficit
including scapegoating China
Rising dependence on foreign investors
Hard landing for the $.
US net debt to RoW now ≈ $3 trillion,
Will lower our children’s standard of living.
When the US cuts its deficit, that will mean the rest of the world losing its surplus
The longer adjustment is postponed, the harder it will be.
Policies to reduce the US deficit
Reduce the US budget deficit over time,
thus raising national saving.
After all, the current account deficit originated in the budget deficit (“twin deficits”).
Depreciate the $ more.
Better to do it in a controlled way
than in a sudden free-fall.
The $ has already depreciated a lot against the €
& other currencies.
Who is left?
The RMB is conspicuous as the major currency that is still undervalued against the dollar.
Critics of the twin deficits view say that the US current account deficit is sustainable.
Global savings glut (Bernanke)
It’s a big world (R. Cooper; Al Greenspan..)
Valuation effects will pay for it (Gourinchas)
US as the World’s Banker (Kindleberger…)
The US offers superior-quality assets (Caballero, Forbes, Quadrini & Rios-Rull, Wei & Wu …)
“ Dark Matter” (Hausmann & Sturzenegger)
Bretton Woods II (Dooley, Folkerts-Landau & Garber)
Exorbitant Privilege of $
Among those who argue that the US current account deficit is sustainable are some who believe that the US will continue to enjoy the unique privilege of being able to borrow virtually unlimited amounts in its own currency.
When does the “privilege” become “exorbitant?”
if it accrues solely because of size & history, without the US having done anything to earn the benefit by virtuous policies such as budget discipline, price stability & a stable exchange rate.
Since 1973, the US has racked up $10 trillion in debt and the $ has experienced a 30% loss in value compared to other major currencies.
It seems unlikely that macroeconomic policy discipline is what has earned the US its privilege !
The “Bretton Woods II” hypothesis
Dooley, Folkerts-Landau, & Garber (2003) :
today’s system is a new Bretton Woods,
with Asia playing the role that Europe played in the 1960s—buying up $ to prevent their own currencies from appreciating.
More provocatively: China is piling up dollars not because of myopic mercantilism, but as part of an export-led development strategy that is rational given China’s need to import workable systems of finance & corporate governance.
My own view on “Bretton Woods II”:
The 1960s analogy is indeed apt,
but we are closer to 1971 than to 1944 or 1958.
Why did the BW system collapse in 1971?
The Triffin dilemma could have taken decades to work itself out.
But the Johnson & Nixon administrations accelerated the process by fiscal & monetary expansion (driven by the Vietnam War & Arthur Burns, respectively).
These policies produced: declining external balances, $ devaluation, & the end of Bretton Woods.
There is no reason to expect better today:
Capital mobility is much higher now than in the 1960s.
The US can no longer necessarily rely on support of foreign central banks:
neither on economic grounds (they are not now, as they were then, organized into a cooperative framework where each agrees explicitly to hold $ if the others do),
nor on political grounds (China & OPEC are not the staunch allies the US had in the 1960s).
3) A possible rival currency to the $ exists.
Central banks’ reserve holdings Frankel & Chinn (2007) estimated effects of country size, market depth, ability to hold value, and network effects
Simulation suggests € could overtake $ by 2022 .
When will the day of reckoning come?
Not in 2008: In the short run, the financial crisis caused a flight to quality which evidently still meant a flight to US $.
Chinese warnings in 2009 may have marked a turning point:
Premier Wen worried US T bills will lose value. On Nov. 10 he urged the US to keep its deficit at an “appropriate size” to ensure the “basic stability” of the $.
PBoC Gov. Zhou in March proposed replacing $ as international currency, with the SDR.
The global monetary system may move from dollar-based to multiple international reserve currencies
The € could challenge the $.
The SDR is again part of the system.
Gold in 2009 made a comeback as an international reserve too.
Someday the RMB will join the roster with ¥ & ₤.
= a multiple international reserve asset system.
Countries should have the right to fix their exchange rate if they want to.
True, the IMF Articles of Agreement and the US Omnibus Trade Act of 1988 call for action in the event that a country is “unfairly manipulating its currency”.
Almost no countries have been forced to appreciate.
Pressure on surplus countries to appreciate will inevitably
be less than pressure on deficit countries to depreciate.
In my view, it is time to retire the language of “manipulation.”
Usually, it is hard to say when a currency is undervalued.
Don’t cheapen the language that is appropriate to WTO rules.
China should do what is in its own long-term interest.
From China’s viewpoint,
This does not preclude mutually-beneficial bargains, between equals
E.g., China agrees that:
its exchange rate is part of the problem,
it will cooperate to lower the RMB/$ rate in a gradual matter,
and it won’t dump US treasury bills.
In exchange, US agrees that:
its low national saving deficit is part of the problem,
it will cooperate to reduce the budget deficit,
and it won’t close off the US market to Chinese goods.
But a bargain isn’t even necessary;
It is in China’s own interest to begin appreciating the RMB.
What is in China’s interest?
Five reasons China should let RMB appreciate, in its own interest
Overheating of economy
It gets harder to sterilize the inflow over time.
Attaining internal and external balance.
To attain both, need 2 policy instruments.
In a large country like China, expenditure-switching policy should be the exchange rate.
Avoiding future crashes.
RMB undervalued, judged by Balassa-Samuelson relationship.
1. Overheating of economy:
Bottlenecks. Pace of economic growth is outrunning:
raw material supplies
level of sophistication of financial system.
Stock market bubble.
Inflation 6-7% in 2007
=> price controls
shortages and social unrest.
All of the above was suspended in late 2008,
due to sharp loss of exports in global recession.
But it is back again now.
Attempts at “sterilization,” to insulate domestic economy from the inflows
Sterilization is defined as offsetting of international reserve inflows so as to prevent them from showing up domestically as excessive money growth & inflation.
For awhile PBoC successfully … until 2007-08 .
The usual limitations are finally showed up:
Prolongation of capital inflows
Quasi- fiscal deficit
Failure to sterilize
2. Foreign Exchange Reserves
Though a useful shield against currency crises,
China has enough reserves: $2 ½ trillion by Jan.2010;
& US treasury securities do not pay high returns.
Harder to sterilize the inflow over time.
Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008 Components of China’s rising balance of payments and the evolution of foreign exchange reserves
Attempts to sterilize reserve inflow: While reserves (NFA) rose rapidly, the growth of the monetary base was kept to the growth of the real economy – even reduced in 2005-06. Successful sterilization in China: 2005-06 In 2005-06 China was remarkably successful.
In 2007-08 China had more trouble sterilizing the reserve inflow
PBoC began to pay higher interest rate domestically, & receive lower interest rate on US T bills => quasi-fiscal deficit.
Inflation became a serious problem.
True, global increases in food & energy prices were much of the explanation.
China’s overly rapid growth itself contributes.
Appreciation is a good way to put immediate downward pressure on local prices of farm & energy commodities.
Price controls are inefficient and ultimately ineffective.
Sterilization faltered in 2007 & 2008 Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008 Growth of China’s monetary base, & its components
China’s CPI accelerates in 2007-08 Inflation 2002 to 2008 Q1 Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008
3. Need a flexible exchange rate to attain internal and external balance
Between 2002 and 2007, China crossed from the deflationary side of internal balance (ES: excess supply, recession, unemployment), to the inflationary side (ED: excess demand side, overheating). And again in 2009.
=>Moved upward in the “Swan Diagram” ( E≡ RMB/$)
=> appreciation called for under current conditions.
General principle: to attain 2 policy targets (internal & external balance), a country needs to use 2 policy instruments (real exchange rate & spending).
China is now in the overheating + surplus quadrant of the Swan Diagram Spending A Exchange rate E in RMB/$ YY: Internal balance Y = Potential ED & TD ES & TD ES & TB>0 China 2010 BB: External balance CA =0 China 2002 ED & TB>0
4. Avoiding future crashes
Experience of other emerging markets (1994-2002) suggests it is better to exit from a peg in good times, when the BoP is strong, than to wait until the currency is under attack.