China-US Currency Issues Appendices

1
China-US Currency IssuesAppendices

• Jeffrey Frankel
• Harpel Professor of Capital Formation Growth
• Chinese Leaders in Development ProgramAsh
  Center, June 8, 2012

2
Appendices

• I What is in Chinas interest?
• II Internal balance and external balance
• III What is in the global interest?
• IV Possible inadvertent effects of US pressure
• V Is the US Current account sustainable?
• VI Econometrics of the exchange rate
• VII What determines US Treasury findings
  regarding currency manipulation?

3
Appendix I From Chinas viewpoint,

• 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.
• But
• 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.
• It is time to retire the language of
  manipulation.
• Usually, it is hard to say when a currency is
  undervalued.
• Dont cheapen the language that is appropriate to
  WTO rules.
• China should do what is in its own long-term
  interest.

4
Five reasons for China to let RMB appreciate, in
its own interest, during 2004-2011

• Overheating of economy, esp. 2007-08, 2010
• Reserves are excessive.
• 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-switch
  ing policy should be the exchange rate.
• Avoiding future crashes.
• RMB undervalued, judged by Balassa-Samuelson
  relationship.

5
1. Overheating of economy

• Bottlenecks. Pace of economic growth is
  outrunning
• raw material supplies, and
• labor supply in coastal provinces
• Also
• physical infrastructure
• environmental capacity
• level of sophistication of financial system.
• Asset bubbles.
• Shanghai stock market bubble in 2007.
• Inflation 6-7 in 2007
• gt price controls gt shortages social unrest.
• All of the above was suspended in late 2008,
• due to global recession.
• But back again in 2011 skyrocketing real estate
  prices.

6
Attempts at sterilization, to insulate domestic
economy from the inflows

• Sterilization is defined as offsettingof
  international reserve inflows,so as to prevent
  them from showing updomestically as excessive
  money growth inflation.
• For awhile PBoC successfully sterilized
• until 2007-08.
• The usual limitations finally showed up
• Prolongation of capital inflows lt
  self-equilibrating mechanism shut off.
• Quasi-fiscal deficit gap between domestic
  interest rates US T bill rate
• Failure to sterilize money supply rising
  faster than income
• Rising inflation (admittedly due not only to
  rising money supply)

7
2. Foreign Exchange Reserves

• Excessive
• Though a useful shield against currency crises,
• China has enough reserves 3 by 2011
• US treasury securities do not pay high returns.
• Harder to sterilize the inflow over time.

8

The Balance of Payments
rate of change of foreign exchange reserves
(largely ),
rose rapidly in China from 2004 on, due to all 3
components trade balance, Foreign Direct
Investment, and portfolio inflows
Source HKMA, Half-Yearly Monetary and Financial
Stability Report, June 2008
8
9
FX reserves of the PBoC climbed higher than any
central bank in history
http//viableopposition.blogspot.com/2012/03/china
s-holdings-of-us-treasuries-what.html
10
Sterilization of foreign reserves Peoples Bank
of China sells sterilization bonds
Data CEIC Source
Zhang, 2011, Fig.4, p.45.
11
Sterilization of foreign reservesDecreases in
PBoCs domestic assetsthus offset increases in
foreign assets
Source Zhang, 2011, Fig.7, p.47.
12
Further, the PBoC has raised banks required
reserve ratios
Source Zhang, 2011, Fig.6, p.46.
13
Chinas tightening of banks lending rates
reserve requirements helped head off rising
inflation in 2004, 08, and again in 2011.
Fxtimes.com
14
Chinese inflation eased off in 2008-09, but rose
again through mid-2011
15
Chinese inflation, once again, began to ease off
after mid-2011
16
3. Need a flexible exchange rate to attain
internal external balance

• Internal balance demand neither too low
  (recession) nor too high (overheating).
• External balance appropriate balance of
  payments.
• General principle to attain both policy targets,
  a country needs to use 2 policy instruments.
• For a country as large as China, one of those
  policy instruments should be the exchange rate.
• To reduce BoP surplus without causing higher
  unemployment, China needs both
• currency appreciation, and
• expansion of domestic demand
• gradually replacing foreign demand,
• developing neglected sectors health,
  education, environment, housing, finance,
  services.

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4. Avoiding future crashes

• Experience of other emerging markets 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.

Introducing some flexibility now, even though not
ready for free floating.
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5. Longer-run perspectiveBalassa-Samuelson
relationship

• Prices of goods services in China are low
• compared at the nominal exchange rate.
• Of course they are a fraction of those in the
  U.S. lt ¼ .
• This is to be expected explained by the
  Balassa-Samuelson effect,
• which says that low-income countries have lower
  price levels.
• As countries real income grows, their currencies
  experience real appreciation approx. .3 for
  every 1 in income per capita.
• But China has been one of those countries that is
  cheap or undervalued even taking into account
  Balassa-Samuelson.

19
The Balassa-Samuelson Relationship 2005
Source Arvind Subramanian, April 2010, New
PPP-Based Estimates of Renminbi Undervaluationand
Policy Implications, PB10-08, Peterson Institute
for International Economics Undervaluation of
RMB in the regression estimated above
26. Estimated undervaluation averaging across
four such estimates 31. Compare to estimate
for 2000 (Frankel 2005) 36. As recently as
2009 (Chang 2012) 25 .
20
Appendix II Internal 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.
• gtMoved upward in the Swan Diagram
• gt appreciation called for under current
  conditions.
• Together with expansion of domestic demand
• gradually replacing foreign demand,
• developing neglected sectors health,
  education, environment, housing, finance,
  services
• General principle to attain 2 policy targets
  (internal external balance), a country needs
  to use 2 policy instruments (real exchange rate
  spending).

20
21
In 2008 2010, China was in the overheating
surplus quadrant of the Swan Diagram
21
Spending A
22
Restoring growth, andResolving current account
imbalances,
Appendix III What is in the global interest?

• in particular, the US CA deficit
• Chinas surplus,
• though Chinas surpluses have narrowed since
  2008.

22
23
Current account imbalances are smaller than in
2007, esp. Chinas
Gavyn Davies, FTblog, May 27 2012
24
Dangers of the longstanding U.S. trade deficit

• Shorter-term dangers
• Protectionist legislation
• A possible hard landing for the .
• Long-term dangers
• Dependence on foreign investors
• US net debt to RoW 3 trillion,
• and rising.
• Will lower our childrens 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.

25
Policies to reduce the US CA deficit

• Reduce the US budget deficit over time,
• thus raising national saving.
• After all, this is where the deficits
  originated.
• Depreciate the more.
• Better to do it in a controlled way
• than in a sudden free-fall.
• The already depreciated a lot against the
• other currencies
• from 2002 to 2007.
• Who is left?
• The RMB is conspicuous as the one major currency
  that is still undervalued against the dollar.

26
Appendix IV Possible inadvertent effects of US
pressure on China

• It has never worked well for the US to make a
  dozen different demands on China,
• IPR, human rights, help on N.Korea, Iran
• when we only have one carrot / stick
• keeping our markets open.
• As the worlds largest debtor, with China our
  primary creditor, the US ability to make demands
  is diminished.
• There is a particular tension between hoping
  China will continue to buy our Treasury bills,
  and asking it to stop buying our Treasury bills
• i.e., to stop selling RMB / buying ,
• which is what keeps its currency from rising.

27
Be careful what you wish for. You might get it !
2½
28
If China gave US politicians what they say they
want...

• we might regret it.
• if it included reserve shift out of T bills, to
  match switch in basket weights from .
• we could have a hard landing for the
• including a sharp fall of US securities prices.
• Skeptics argue China will not sell T bills
• because, as the largest holder, it would be the
  biggest loser when the depreciated.
• Financial market fears that China might stop
  buying US T bills could send the down in
  themselves.
• If the is falling, China will not want to be
  the only one left holding the bag.

29
If China gave US politicians what they say they
want...

• For US output employment to rise,
• we would first need other Asian currencies to
  appreciate along with RMB.
• Otherwise, fall in US bilateral trade deficit
  with China would be offset by rise in US
  bilateral deficit with other cheap-labor
  countries.
• It also depends on excess capacity in US economy
• as 2008-2012
• and no crowding out of domestic demand via higher
  interest rates.

30
Central banks reserve holdings
The share has been on a downward trend since
2000 (also during 1976-1991).
31
The global monetary systemmay 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.

SDR
32
Another possible consequence if China allows the
exchange rate to become more flexible
market-determined

• the RMB could depreciate rather than appreciate,
• in response to a slowdown in Chinese growth
• especially if
• it were the result of an increase in world oil
  prices
• or were associated with a financial crisis
• stemming from real estate or bad bank loans.

33
Especially now that the quarterly overall
balance of payments (fx reserve changes) is no
longer gtgt 0
Gavyn Davies, FTblog, May 27 2012
34
Another possible consequence, continued

• Indeed, the RMB depreciated in May 2012

35
Increased flexibility, continued

• On 14 April, 2012, the Chinese central bank
  announced that the band of RMBs trading prices
  against the US dollar in the inter-bank spot
  foreign exchange market is enlarged from 0.5 per
  cent to 1 per cent on each business day. The
  main purpose was probably to increase the
  perceived risk of the speculators and thereby
  decrease hot money movements. This enlarged
  range has, however, not been utilised so far. The
  largest changes have been of the order of 0.2 per
  cent.
• Re-pegging the renminbi to a basket issues and
  implications in Asian-Pacific Economic
  Literature (APEL), May 2012. Heikki Oksanen,
  University of Helsinki. http//onlinelibrary.wiley
  .com/doi/10.1111/apel.2012.26.issue-1/issuetoc .

35
36
Prices on Non-Deliverable Forwardsshowing
post-2003 speculation on RMB appreciation
36
37

• Appendix VIs the US Current Account
  sustainable?

38
Economists were (are) split between
those who saw the US deficit as unsustainable,
requiring a fall,
and those who saw (see) no problem.

• Ken Rogoff
• Maury Obstfeld
• Larry Summers
• Martin Feldstein
• Nouriel Roubini
• Menzie Chinn
• Me
• Lots more

• Ben Bernanke
• Ricardo Caballero
• Richard Cooper
• Michael Dooley
• Pierre-Olivier Gourinchas
• Alan Greenspan
• Ricardo Hausmann
• Lots more

38
Some claim that the financial crisis of 2007-09
fits their theories.
39
The events of 2007-09 struck major blows against
both interpretations of CA.

• Most of us in the unsustainability camp would
  have predicted that something like the US
  sub-prime mortgage crisis would cause a big fall
  in the .
• Instead , the strengthened.
• Most of those in the sustainability camp had been
  arguing that the US has uniquely superior assets
  (corporate governance, securities markets, bank
  regulation)
• Instead, the crisis showed the US system to
  suffer serious flaws
• of crony capitalism like other countries (Simon
  Johnson, Ragu Rajan)
• or worse excessive deregulation (Joe
  Stiglitz)
• The answer, for the moment The US Treasury
  bills still play unique roles in the world
  monetary system.

40
Critics of the twin deficits view say that the US
current account deficit is sustainable.

• Global savings glut (Bernanke)
• Its a big world (R. Cooper Al Greenspan..)
• Valuation effects will pay for it (Gourinchas)
• US as the Worlds 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)

41
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.

42
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 !

43
The Bretton Woods II hypothesis

• Dooley, Folkerts-Landau, Garber (2003)
• todays system is a new Bretton Woods,
• with Asia playing the role that Europe played in
  the 1960sbuying 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 Chinas need to import workable
  systems of finance corporate governance.

44
There is no reason to expect better today

• Capital mobilityis 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.

45
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.

46
Appendix VI Exchange Rate EconometricsEstimatin
g the weights

• A problem made-to-order for OLS regression.
• Regress changes in value of RMB against
  changes in values of candidate currencies.
• ? log RMBt
• c a ?log t ß1?log t ß2 ?log
  t
• The coefficients are the basket weights.
• Can impose a S ß j 1.

F Wei (2007), Frankel (2009)
47
Does the Balassa-Samuelson relationship have
predictive power?

• Typically across countries, gaps are corrected
  halfway, on average, over subsequent decade.
• gt 3-4 real appreciation on average per year,
  including effect of further growth differential.
• Correction could take the form of either
  inflation or nominal appreciation, but
  appreciation is preferable.

48
Referencesfor statistical estimates of RMB
undervaluation

• Chang, Gene Hsin, 2008, Estimation of the
  Undervaluation of the Chinese Currency by a
  Non-linear Model, Asia-Pacific Journal of
  Accounting Economics Vol.15, No. 1, April,
  29-40.
• Chang, Gene H. , 2012, Theory and Refinement of
  the Enhanced-PPP Model for Estimation Equilibrium
  Exchange Rates --- with Estimates for Valuations
  of Dollar, Yuan and Others, SSRN
  abstract1998477, Feb. 2.
• Cheung, Yin-wong, Menzie Chinn and Eiji Fuji,
  2010, Chinas Current Account and Exchange
  Rate, in Chinas Growing Role in World
  Trade, Rob Feenstra Shang-Jin Wei,
  eds. (U.Chicago Press, 2010).
• Cline, William, and John Williamson, 2008,
  Estimates of the Equilibrium Exchange Rate of
  the Renminbi, in Debating China's Exchange Rate
  Policy, edited by M.Goldstein and N.Lardy
  (Peterson Institute for International Economics),
  155-165.  
• Frankel, Jeffrey, 2005, On the Renminbi,
   CESifo Forum, vol.6, no.3, Autumn (Ifo Institute
  for Economic Research, Munich) 16-21.
• Subramanian, Arvind, April 2010, New PPP-Based
  Estimates of Renminbi Undervaluation and Policy
  Implications, PB10-08, Peterson Institute for
  International Economics.

49

• Appendix VII Analysis of the U.S. Treasurys
  biannualReport to Congress on International
  Economics and Exchange Rate Policy
• -- Frankel Wei (2007)

50
Two hypotheses regarding determinants of US
Treasury decisions whether partnersare
manipulating currencies

• (1) Legitimate economic variables
• the partners overall current account/GDP,
• Additions to its foreign exchange reserves,
• the real overvaluation of its currency vs.
• (2) Variables suggestive of domestic American
  political expediency
• the bilateral trade balance,
• US unemployment,
• an election year dummy .

51
Two hypotheses regarding determinants of US
Treasury decisions whether partnersare
manipulating currencies

• (1) Legitimate economic variables
• the partners overall current account/GDP,
• its reserve changes,
• the real overvaluation of its currency vs.
• (2) Variables suggestive of domestic American
  political expediency
• the bilateral trade balance,
• US unemployment,
• an election year dummy .

52

• Those countries named as manipulators, or given
  warnings, have always been Asian.
• What political economy determines Treasury
  findings?
• Econometric analysis
• Domestic political variables are as important as
  global manipulation criteria.

53
Explaining findings of Treasury Department
biannualReport to Congress on Int. Ec.
Exchange Rate Policy

•   All countries
  15 Asian economies
  Excluding oil exporters
• US bilateral TB -0.92
  -0.99
• 0.07
  0.15
• Partners 0.014
  0.028
• CA/GDP 0.002
  0.007
• Partners Real -0.18 -0.23
  Exchange Rate 0.03 0.11
• Change in 0.003 -0.012
• reserves/GDP 0.003 0.009
• US unem- 0.022 0.08
  ployment 0.010 0.037

statistically significant at 99 level
54
Findings suggest the domestic US variablesaffect
the Treasury decision as much as the legitimate
global manipulation criteria

• weak role for partner reserve accumulation,
• very high significance of bilateral balance,
• significance of US unemployment, and
• significant (borderline) extra effect of
  unemployment in election years.

55
Implication

• If the IMF were interpreting Article IV,
  rather than the Treasury interpreting the 1988 US
  law,
• the criterion of consistent uni-directional forex
  intervention would receive more emphasis,
• and US-specific variables such as the bilateral
  trade balance would not appear at all.

56
Some sympathy for the Treasury

• It walks a fine line.
• An additional finding
• Treasury is eager not to single out one country
  for unique opprobrium.
• No single country is left exposed on its own.
• the top-ranked country is less likely to be named
  than if it had some other country to hide behind,
  while
• the 2nd- 3rd-ranked countries are more likely
  to be moved up, to give the leader company.

57
Has US pressure pushed the pace of increased
flexibility?

• We (Frankel Wei, 2007) searched an electronic
  database of news reports(FACTIVA/NewsPlus),
  recording the number of US news reports of US
  officials asking China to speed up RMB
  flexibility/revaluation.
• Two separate time series on the cumulative
  numbers of complaints
• from US Treasury and
• from officials of other government agencies
• Esp. the White House, Congress Fed.

57
58
Complaints Treasury other US
58
59
We added complaints as a regressor (Table 19)

• No evidence that U.S. official complaints are
  associated with RMB appreciation relative to the
  currency basket.
• There was evidence that cumulative complaints
  were associated with a reduction in the RMBs
  weight on the US .

59