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
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.
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.
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