The Global Credit Crisis and China

1
The Global Credit Crisis and Chinas Exchange
Rate

• Ronald McKinnon
• Brian Lee
• Yi David Wang
• Stanford University
• Singapore Economic Review Conference
• August 6-8, 2009

2
Advantages of Stabilizing Yuan/Dollar RateA
Potted History

• 1995 to 2004 fixed rate nominal anchor 8.28 Y/
• McKinnon Schnabl, Jan 2009
• July 2005 to July 2008, one-way bet on RMB
  appreciation hot money inflows, buildup of
  official exchange reserves, loss of monetary
  control, disrupt forward exchange market Wang
  2009
• July 2008 to Nov. 2008, unwinding of dollar carry
  trade with sharp apprec.of effective ex rate,
  (Lee 2009), Y/ rate reset at 6.83 through to
  present
• 2009, monetary control regained with a massive
  expansion of bank credit to support fiscal
  stimulus for offsetting sharp fall in exports

3
Figure 1 Chinas monetary policy and the
yuan/dollar rate (1995-2009)
Source FRB
4
Figure 2 Foreign Reserves of China, Japan,
Germany, and U.S.(2002-2009)
Source IMF and The Peoples Bank of China
5
Figure 6 Bilateral Trade Balances of Japan and
China versus the United States(percent of U.S.
GDP, 1955 2008/1)
Source Kenichi Ohno, BEA
6
U.S Mercantile Pressure, I.

• Acute Japan Bashing, 1978 to 1995
• - Episodic trade disputes steel, autos,
  color televisions, machine tools, semi
  conductors
• - Resolution Japan imposes voluntary export
  restraints and allows yen appreciation
• -Yen/dollar rate appreciates episodically from
  360
• in August 1971 to peak at 80 in April
  1995, when U.S. announced a strong
  dollar policy
• Japan financial system destabilized bubble
  economy 1987-90 followed by a deflationary
  slump and low interest liquidity trap in 1990s
  (McKinnon-Ohno,1997)

7
U.S. Mercantile Pressure, II.

• China Bashing 2000 to ?
• -China surpasses Japan in 2000 as having the
  biggest
• bilateral trade surplus with the U.S
• -Unlike Japan, export surge is across the
  board in low
• value added manufactures.
• Focus is primarily on appreciating the Renminbi
• -Schumer-Graham bill of March 2005 for a 27.5
  tariff on U.S. imports from China unless RMB
  appreciates (withdrawn October 2006, but new
  threat in 2007)
• -Section 3004 of U.S. Public Law 100-418 U.S.
  Secretary of Treasury must report twice a year
  on whether countries with trade surpluses are
  manipulating their currencies. Timothy
• Geitners congressional testimony
  January 2009
• RMB rises by 2.1 on July 21 2005, and begins
  slow upward crawl

8
One way bet RMB appreciation July 2005 to July
2008

• Hot money flows into China
• No private capital outflows to finance
• Chinas huge trade surplus (McK Sch 2009)
• Huge buildup of official exchange reserves
• government sole international intermediary
• Massive sterilization sale of central bank
  bonds,
• increases in reserve requirements of com
  banks
• Direct restraints on domestic bank credit
• Still loss of monetary control with domestic
  inflationary pressure added to foreign

9
Chinas Foreign Exchange Reserves
Source UBS
10
Figure 3 Chinas Consumer Price Indices (Growth
rate yoy)
Source EIU
11
Figure 4 Renminbi and Dollar Exchange Rate
Movements (2000-2008)
Source IFS and BIS
12
Figure 5 Commodity Price Indices (Jan 2002 100)
Source globalfinancialdata.com Note The
commodity price index does not contain crude oil.
13
Figure 8 Unwinding the yen and dollar carry
trades (effective exchange rates, 2006100)
Source BIS
14
Table 1 Returns on carry trades (2000-2007)
Source Brian Lee (2009)
Note (a) For funding in dollars, the return is
the average for Brazil, Mexico, and Canada.
(b) For funding in yen, the return is the
average for Australia, Korea, and New
Zealand. (c) Trough to peak for the
yens effective multilateral exchange rate.
Caution The unwinding of the carry trades in
2008 may not fully explain these exchange rate
appreciations.
15
Dollar carry trade unwinds and accidental
stabilization of the RMB since July 2008

• Credit crunch summer and fall of 2008 dries up
  short-term finance for dollar, yen, and
  commodity carry trades
• Surprise dollar appreciation, July to Nov
  2008, of approx
• 20 against all currencies except
  the Japanese yen with a general fall in
  commodity prices.
• PBC stops gradual (and predictable)
  appreciation of RMB, and stabilizes at 6.83
  yuan/dollar.
• Hot money inflows stop, some private outflows,
  minimal increases in official exchange
  reserves. PBC regains monetary control
• Massive domestic credit expansion cuts in
  reserves required of commercial banks while
  lifting credit ceilings, reductions in deposit
  and loan interest rates
• Domestic spending largely offsets collapse in
  exports

16
Figure 9 Chinas Nominal Trade (in billions of
U.S. dollar, monthly)
Source China Customs Statistics Information
17
Figure 10 Chinas interest rates ()
Source UBS
18
Figure 11 Chinas New loans to non-financial
institutions (RMB bn)
Source UBS
19
Figure 12 Chinas M2 and Bank Lending (Growth
rate yoy)
Source UBS
20
Loans for 15 large U.S. banks
Source Wall Street Journal
21
M2 growth around the world
Source SCB
22
Violation of interest parity conditions and
breakdown of Chinas forward market mid 2007 to
mid 2008

• Open Interest Parity (OIP) E(?S) it(yuan)
  it(dollars) , where S yuan/dollar
• Covered Interest Parity (CIP) ft it(yuan)
  it(dollars)
• where f (F S)/S is forward premium
  on dollars
• OIP breaks down when the interest differential is
  less than expected appreciation because of fall
  in US rates
• CIP breaks down when SAFE had to impose controls
  on financial capital inflows, i.e., borrowing in
  dollars
• Result Chinas exporters cant cover dollar
  earnings forward, thus tightening credit
  constraint

23
Figure 13 Interest Differentials versus
Percentage Changes in the Yuan/Dollar Exchange
Rate (2002-2009)
Source Datastream. Note OIP is Open Interest
Parity.
24
Figure 14 Forward Rate vs. Forward Rate from
Covered Interest Parity (yuan/dollar,6 month)
Source Wang (2009)
25
Figure 15 Percentage Deviation From Covered
Interest Parity (yuan/dollar, by maturity)
Source Wang (2009)
26
Reducing Chinas Saving-Investment Surplus

• Increase share of household disposable income
• in GDP in order to increase private consumption
• reduce personal income and sales taxes
• increase government transfer payments
• increase dividend payouts from enterprises
• Increase government social expenditures.
• Stimulate household spending
• increase consumer credit
• abolish one-child policy?
• Objectives
• (1) Reduce Chinas trade surplus
• (2) Counter cyclical downturn in China and rest
  of the world
• Caveat Stabilize exchange rate (Mundell-Fleming)
  

27
Figure 16 Investment, Savings and Current
Account of China (as a percent of GDP)
Source EIU
28
Figure 17 Chinas Labor Income and Operating
Surplus (Share in GDP())
Source UBS
29
Table 2 Chinas Economic Positions in 1997 and
2007
Source UBS
Note The NPL ratio is 2.8 for four largest
commercial banks, Dec 2008.
30
ConclusionCountering the Global Cyclical
Downturn in 2008-09

• New U.S. fiscal stimulus is problematic weak
  domestic financial institutions, and trade
  deficit would increase
• China now a big actor on the world stage with
  stronger public finances and much stronger
  banking system
• To stimulate the U.S. and world economies, the
  primary fiscal stimulus should be in China and
  other surplus Asian economiesand possibly
  Germany.
• Nov 2008, China announces a half trillion dollar
  fiscal stimulusnow supported by rapid bank
  credit expansion
• U.S. quid pro quo No more China bashing on
  exchange rate, or through antidumping duties, and
  other policies