The Fixation on Nominal Exchange Rates and What I Really Fear for China

While most of the developed world is pondering a possible double dip, China is in the seemingly enviable position of fighting excessive growth.  Although some commentators are concerned about the quality of China’s growth, the overwhelming majority is charmed by its formidable growth.  Then why should I fear for China? 

To explain, let’s start with an introduction of real exchange rate (RER).  RER is nominal exchange rate (NER) adjusted for inflation rate and is more important in determining a country’s current account balance with another country.  However, the current debate on rebalancing global trade, especially Sino-U.S. trade, has focused on appreciating the Yuan, the Chinese currency, against USD in terms of NER. 

In China’s situation with the U.S., its NER with the U.S. has been largely fixed in the last few years.  Rebalancing global trade can only be achieved through internal inflation relative to the U.S.  Since it is difficult to control internal money flows, internal inflation frequently leads to asset bubbles, which is the reason for the bubbly real estate prices in many Chinese cities and the excessive growth in China today.  However, in China’s situation, the internal inflation process may also lead to some peculiar dynamics that effectively depreciate Yuan in terms of RER, thus offsetting the impact of internal inflation on rebalancing global trade.  These dynamics are little noticed and are what I really fear for China.  Here are three of the prime examples.  

The first dynamic is related to real interest rates.  The real interest rates in the U.S. today have dropped significantly [i.e., 5-year Treasury bond rate was 1% at the end of 2007 and is 0.17% at the end of July 2010].  In comparison, the real interest rates in China are likely to have dropped much more and are often negative, due to the inflation reacceleration from the massive stimulus in 2009-2010 and largely fixed nominal interest rates.  Despite higher inflation rates in China, this dynamic effectively depreciates Chinese Yuan in terms of RER.  Because investments are above 50% of Chinese economy, much higher than their 35% share of the U.S. GDP, this dynamic means that the relatively more reduced investment costs in China would give a very strong monetary stimulus particularly to China’s investment growth.  This impact on investment also means even faster productivity growth in China, which effectively depreciates the RER of Yuan against the USD, given the largely fixed NER.  As a result, this dynamic would push China backwards on the track to rebalance its economy and trade. 

The second dynamic is related to the first.  Wage growth relative to productivity growth would also affect RER.  Even if productivity in the U.S. has been growing at a faster pace than wage growth in the post-crisis period, productivity growth is likely to be so fast in China that it is growing even faster relative to wage growth during the same period when compared to the U.S.  Despite media attention on workers successfully gaining significant concessions from some foreign owned factories, that is still the exception instead of the norm.  Most organized labor movements are likely to be prime targets to be crushed. 

The third dynamic is also related to the first one, with the additional element of financial repression.  Even if real deposit interest rates are often in negative territory, with few investment options, Chinese households can only put most of their savings in the bank.  Since this dynamic constitutes substantial real losses of personal wealth of Chinese households, it keeps consumption in check very effectively. 

These three are just some of the prime dynamics.  The overall impact of these dynamics means that even though China seems to be doing something to rebalance global trade, they are always behind the curve, and the Yuan consistently depreciates against the USD in terms of RER.  To be ahead of the curve, China needs to raise real interest rates drastically, provide many more investment options to its households, substantially appreciate the Yuan against the USD in terms of NER, award its workers much higher wages, and spend heavily to help its people consume. 

These dynamics are among the fundamental issues facing China today.  In comparison, the things on which most people focus their attention, such as bubbly housing prices in many Chinese cities, are just symptoms of these dynamics and are not themselves fundamental causes.  For example, the bubbly housing prices are due to a combination of negative real interest rates, few investment options, and extremely low carry costs in terms of maintenance fees and zero property taxes.  Put another way, these prices are a result of internal inflation process and financial repression. 

Without taking the suggested prescriptions, the continued unfolding of these dynamics would yield a few predictions, with some actually being pretty counter-intuitive to what most commentators think.  First, the Chinese current account surplus and the U.S. current account deficit are likely to explode instead of shrink, as some in the U.S. have wished, even with some mild appreciation of Yuan in terms of NER.  These explosions will happen even if the U.S. consumers retrench significantly by consuming less and saving more.  Because of the open border to capital and trade flows in the U.S., as long as things are getting cheaper in relative terms in China, procurers in the U.S. will purchase from the China, instead of the U.S.  As a result, China will be able to force China-made goods down the throat of the broken American consumers. 

Second, China will invest more money into USD assets, instead of less, because this is the only way for them to avoid significant upward pressure on the Yuan.  This will likely keep downward pressure on the U.S. Treasury bond yields as long as China runs a huge trade surplus against the U.S.  This prediction follows from the accounting identity stating that the sum of current account balance and capital account balance should be zero to keep the exchange rates intact.  This identity is taught in any MBA international course but many commentators seem to miss it and still worry about China stopping the purchase of U.S. Treasury bonds.  Further, these worriers seem not to understand that China has few options to park its vast and ever increasing foreign exchange reserves other than U.S. Treasury bonds.  China’s attempt to invest in the bonds of other governments is likely to be met with vocal protest, because that would appreciate the currencies of those countries and reduce their trade surplus or increase their trade deficit.[1]  China’s stockpiling of commodities could quickly inflate bubbles in commodity prices due to the narrowness of this asset class. 

The third prediction, which is my fear, is that China is increasingly cornering itself by reducing the RER of Yuan while they should have been doing exactly the opposite.  Given the fixation of the current debate on adjusting the NER between Yuan and USD, one day, the continuously exploding trade deficit, coupled with the likely persistent high unemployment rate in the U.S. means that the only outcome will be the threat of trade war, or trade war itself. 

China’s action against appreciating the RER of Yuan relative to the USD is out of necessity.  Its employment problem has always been the most important political problem.  However, solving the employment problem by growing the economy through a persistent current account surplus is at the expense of its trading partners.  In good years, no trading partners get really bothered by it.  However, since the start of the financial crisis, the U.S. has suffered from sustained and elevated unemployment levels (8 millions jobs lost) with no end in sight, which is likely to evolve gradually from an economic problem to a political problem.  By then, I am afraid that China may have hit the wall in terms of depreciating the RER of Yuan through the above dynamics, while the fixation of almost everyone on NER means that the Yuan has to appreciate significantly in terms of NER, with the alternative being a trade war.  This will not be pretty for the world, but it will probably be even worse for China. 

By then, China will be in a very precarious position, especially because the above dynamics means that China probably has become more dependent on investments and a current account surplus to grow its economy instead of less.  I suspect that China may yet become another Japanese growth story with a collapse of its economy or its economic growth rates.  If China has trouble, the most commodity driven economies, which are often emerging markets, will likely experience subdued growth rates as well.  Further, the above issues apply not only to China but also countries that have run consistent current account surpluses.  In comparison, the U.S., which controls final demand and may finally realize that this control gives it much stronger bargaining power, may end up as the relative winner.   So from China’s point of view, aggressively adopting the above suggested policy remedies and sincerely reducing global imbalance would be the most urgent task of all for its own economic security and future. 

[1] For example, even though Japanese government bonds have much lower yield than U.S. Treasury bonds, China has started to increase buying those bonds.  Despite many of the same worriers also worrying about Japanese government finances, Japan vocally protested, instead of welcoming, China’s attempt to invest in its government bonds.   

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