China still needs a one-off maxi-revaluation, but smaller than before

The Chinese stock market had a fairly volatile day, with the SSE Composite bouncing up and down by 1% or more several times during the day before it closed at 2306, down 0.8% for the day.  I think we have to go back to end of 2006 before we can find a lower close.  We have pretty much wiped out all the spectacular stock market gains of 2007.

The decline was led by financials, largely, I think, on speculation that there will not be the credit easing that many had hoped for.  This is still a market looking almost exclusively to government policy and intentions for direction.  I have no strong reason for saying this but I wonder if we aren’t at or near a bottom.  Multiples are pretty reasonable (especially if you consider B-shares, which foreigners are allowed to buy directly) and most of the comments I hear in the market suggest that many fund managers have given up on optimism.

Still, three days ago the South China Morning Post ran an article that had a different take:

Nonetheless, some managers remain unfazed, saying they are optimistic amid Beijing’s loosening of monetary policies and a slide in global crude oil prices.  Eight fund managers surveyed by Reuters recently suggested that their allocations for equities will increase.

The same article pointed out that a Galaxy Securities report showed that about one-third of mainland asset managers running the funds have less than a year’s experience, so maybe we shouldn’t take their opinions too seriously, although funnily enough the article was titled “Mutual funds double fees despite 1.1tr yuan losses.”  It discussed how in spite of losing $170-80 billion this year (of their $440-50 under management at the start of the year), they earned total fees of nearly $2.8 billion, 120% more than they did over the same period last year.  Of course this is an unfair comparison because they had a lot more under management this year than last.  Still, it’s nice work if you can get it.

One of the big questions for stock market investors is China’s currency policies, about which here has been a lot of attention again recently and a lot of back-and-forth.  In the past month there has been little appreciation in the RMB against the dollar – and even some depreciation, depending on what period you measure.  The impression most of us have is that by allowing the RMB to weaken the government hopes to introduce enough uncertainty to make the one-way bet on the RMB a lot more risky.

Maybe.  This currency strategy is part of a basket of policies aimed at reducing speculative inflows.  In an article two days ago the People’s Daily reports:

China will start regular annual checks of banks’ foreign exchange operations to make sure they observe relevant rules, the foreign exchange regulator said on Friday.  The move is a concrete step towards implementing the country’s newly approved foreign exchange rules that were set earlier this month and curbs cross-border speculative capital flows, analysts said.

These new annual checks are part of the heated debate over how the PBoC can regain badly-needed control over its explosively expansive monetary policy.  Fortunately in spite of increased attempts to control the border, much of the debate is still primarily about what to do with the exchange rate.  On Monday, joining the growing European chorus against China’s exchange rate policy, German Finance Minister Peer Steinbrueck, in a four-day meeting with his Chinese counterpart in Beijing, called for China to let its currency appreciate more quickly against the euro.

In contrast, or perhaps not, Cheng Siwei, vice-chairman of the standing committee of National People’s Congress, and an influential voice in Chinese economic policy making, told the Financial Times on Sunday that China does not need to accelerate the appreciation of the renminbi – against the US dollar, at any rate.  According to the article:

“My point is that we don’t need to accelerate the appreciation of the renminbi. The dollar will not weaken very much and may get stronger, as happened [in August],” Mr Cheng told the Financial Times in an interview.  “This makes appreciation of the Chinese currency against the dollar less necessary,” he said, because the renminbi was still likely to appreciate against other currencies.

He is certainly seems to be reflecting the public consensus among many policy-makers, but whether they really believe this or are merely trying to convince the world not to bet on an appreciating RMB I am not really sure.  At any rate I think that a lot of this talk misses the point.  It continues to posit RMB policy largely in terms of its trade impact, instead of its domestic monetary impact.

As a domestic monetary problem, I think, the argument for appreciation is much stronger.  In that context there is an excellent new piece out by Ronald McKinnon and Gunther Schnabl (MS), with the title “China’s Financial Conundrum and Global Imbalances”.  Although I think I disagree with its main recommendation, it is a typical McKinnon piece – elegant and informative – whose abstract includes the following:

China’s financial conundrum arises from two sources: its large saving (trade) surplus results in a currency mismatch because it is an immature creditor that cannot lend in its own currency. Instead foreign currency claims (largely dollars) build up within domestic financial institutions. And economists—both American and Chinese— mistakenly attribute the surpluses to an undervalued renminbi.  To placate the United States, the result is a gradual appreciation of the renminbi against the dollar of 6 percent or more per year.

This predictable appreciation since 2004, and the fall in U.S. interest rates since mid 2007, not only attracts hot money inflows but inhibits private capital outflows from financing China’s huge trade surplus. This one-way bet in the foreign exchange markets can no longer be offset by relatively low interest rates in China compared to the United States, as had been the case in 2005-06. Thus, the People’s Bank of China (PBC) now must intervene heavily to prevent the renminbi from ratcheting upwards—and so becomes the country’s sole international financial intermediary.

Despite massive efforts by the PBC to sterilize the monetary consequences of the reserve buildup, inflation in China is increasing, with excess liquidity that spills over into the world economy. China has been transformed from a deflationary force on American and European price levels into an inflationary one. Because of the currency mismatch, floating the RMB is neither feasible nor desirable—and a higher RMB would not reduce China’s trade surplus. Instead, monetary control and normal private-sector finance for the trade surplus require a return to a credibly fixed nominal yuan/dollar rate similar to that which existed between 1995 and 2004.

MS argue that “Currency stabilization would allow the PBC to regain monetary control and quash inflation,” and point out that China’s immature financial system and rapidly transforming economy make monetary aggregates pretty useless in discussing domestic monetary conditions – something I have argued many times.  They conclude: “For a developing country like China on the periphery of the dollar standard, the exchange rate is best considered just an extension of domestic monetary policy – and not an instrument of trade policy.”

I agree wholeheartedly.  The issue for the PBoC is not what they should do to the RMB directly to rebalance international trade.  As I have argued many times, China’s trade surplus is more a function of the way the currency regime converts capital inflows via the banking system into increasing industrial production.  Of course part of the reason China runs a trade surplus is that the RMB is undervalued – and I am sympathetic to Nicholas Lardy’s and Morris Goldstein’s argument that thanks to China’s rapid productivity growth relative to that of its trade partners the RMB may be even more undervalued today than it was earlier in the decade.

But it has always seemed to me that the soaring trade surplus was largely a monetary phenomenon – locked into place by the self-reinforcing cycle of rising trade surplus leading to expanding money leading to surging fixed asset investment leading to a rising trade surplus.  That is why in 2003 and 2004, when most analysts were arguing that China’s then-seemingly-large trade surplus was a temporary phenomenon that would soon subside, I instead argued that it would continue to rise inexorably.

What is worse, as MS recognize, is that more recently China’s trade surplus has been augmented by rising speculative inflows based on the expectation that the RMB must rise in order to rebalance the trade surplus.  Rather than make things better (rebalance trade, reduce inflation), however, a rising RMB has actually made things worse.  It has caused an already excessively loose monetary policy to careen out of control.

MS blame this mostly on “China bashing” – the criticism of China’s currency regime as the root cause of the trade imbalances has created appreciation pressure – because it has created widespread expectations of currency appreciation.  If the market hadn’t been convinced of the need for the RMB to appreciate in order to rebalance trade, it wouldn’t have bet so heavily on appreciation and in so doing worsened China’s domestic monetary problem.

So what should China do?  MS argue that in order to regain control of the money supply China needs to eliminate expectations of a rising RMB.  One possibility is to let the RMB float, but MS quickly reject this option.

I agree with their rejection of the option to float, although for different reasons (I think).  MS say that China’s financial immaturity forces a significant currency mismatch onto domestic balance sheets, which makes currency volatility very risky and perhaps self-reinforcing.  This volatility would have an adverse impact on domestic production and consumptions.

I would argue that if the RMB were to float, rather than quickly reach some sort of stable equilibrium it would suffer from massive and persistent volatility as small changes in the perception of relative Chinese risk or growth prospects caused large, self-reinforcing flows into or out of the country.  Perhaps we are arguing the same thing, but I am not sure.

The other option is for China to peg the RMB credibly against the US dollar until its financial system was sufficiently robust and flexible to permit it a floating exchange rate.  Of course I agree with this option, and have been arguing this for a long time.

Where MS and I disagree is on the definition of “credible”.  I think MS argue that except for the effect of the “blame China” crowd, as they put it, a reasonable level at which to peg would be the current RMB exchange rate.  Because it would require a reduction in trade-related criticism to eliminate the expectations of appreciation (and thus to achieve credibility), this would have to be done as part of an internationally coordinated effort.  I think many analysts have interpreted MS as saying that the RMB is not undervalued, and perhaps this is indeed what they are implying.

In my opinion, however, that the RMB is definitely undervalued, and if it is, a peg at current levels runs the risk of locking current imbalances into place for much longer.  I am not so worried about the adverse impact of China’s trade surplus on the rest of the world, although I do agree that long-running imbalances can create balance sheet vulnerabilities that can later prove destabilizing.  Still, this is probably the biggest disagreement I have with my friend Brad Setser, who is much more worried about the economic consequences of China’s trade surpluses on the US, Europe and the rest of the world.

For me the issue is, as MS point out, largely a domestic monetary issue.  If this can be fixed (i.e. if net inflows can be sharply reduced) and China can regain control of its domestic monetary policy, then the trade surplus will quickly adjust, via a better balance between the growth in consumption and growth in industrial production.

But what is a “credible” rate at which to peg?  Since the beginning of 2007 I have been arguing that China needed to engineer a one-off 15-20% revaluation and peg.  There was nothing “fundamental” about that 15-20% number.  It was merely the smallest amount by which I thought a revaluation would be credible.  For my way of thinking, any other option would either lock in the monetary imbalances for too long (e.g. a peg at current levels, or a slow appreciation) or cause an explosion in speculative inflows that would undermine the very goal an appreciation was trying to achieve (e.g. a rapid appreciation).  A “non-credible” revaluation and peg would, of course, fall into the latter camp.

I continue to believe that China needs to engineer maxi-revaluation before it pegs, but now I think the needed revaluation is less than what I used to argue for.  At this point I think an 8-10% revaluation followed by a peg would do the trick, especially if the PBoC announced explicit market-oriented measures to make the peg credible – for example by providing tools for speculators that allowed them to bet on continued appreciation without increasing speculative inflows (I have written about these elsewhere).

I am convinced that financial risks have risen enough in China that a smaller revaluation should be enough to stop or even reverse speculative inflows, which should bring monetary growth much more into line with PBoC wishes.  The fact that a smaller revaluation is enough to halt or reverse inflows is not a good thing, by the way.  The last two years of monetary growth have almost certainly resulted in a much more vulnerable banking system, and I think investors are nervous enough that their exit level is lower than it had been before.  The longer the PBoC wait to regain control of monetary policy, by the way, the less it will take to cause speculative investors to flee the country.

The biggest risk continues to be the effect of a revaluation on bank balance sheets, which are, I think, vulnerable and getting more so all the time. On that note Caijing has an article claiming that government auditors have accused nine banks and four fund managers of lending billions of RMB for illegal stock market and real estate speculation.  I am sure the real number is much higher than whatever the auditors found.  Bank instability is a real risk for an abrupt change in the exchange rate policy, but it is pretty clear to me that the longer breakneck monetary expansion continues, the more vulnerable the banking system will be to a shock.

One Response to "China still needs a one-off maxi-revaluation, but smaller than before"

  1. Qingdao   September 2, 2008 at 6:47 pm

    Excellent post, as usual. As you note MS argue that the chinese appreciate the rmb “to placate the United States.”HKMAWP08_05 Do External Political Pressures Affect the Renminbi Exchange Rate?Li-gang Liu, Laurent Pauwels, and Jun-yu Chan find;”we find that neither the overall foreign pressure indicator nor the US-specific pressure indicator has any significant influence on RMB’s daily returns.”