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 balances with another country. However, the current debate on rebalancing global trade, especially Sino-U.S. trade, has focused on appreciating Yuan, the Chinese currency, against USD in terms of NER.
In China’s situation with the U.S., its NER with the U.S. is 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, internal inflation process may also lead to some peculiar dynamics that effectively depreciate Yuan in terms of RER. These dynamics are little noticed by now and are what I really fear for China. I discuss 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 65% 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 one. Wage growth relative to productivity growth would also affect RER. Even if the productivity in the U.S. have been growing at a faster pace than wage growth in the post-crisis period, the 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 concession from some foreign owned factories, that is still the exceptions instead of the norms. Most organized labor movements are likely to be prime targets of being crushed.
The third dynamic is also related to the first one, with the twist of financial repression. Even if real interest rate are often in the negative territory, with few investment options, Chinese households can only put most of their savings in the bank. Since this dynamic constitutes substantial erosions in the 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 the global trade, they are always behind the curve, and 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 Yuan against the USD in terms of NER, and award its workers much higher wages.
These dynamics are among the fundamental problems facing China today. In comparison, things like bubbly housing prices in many Chinese cities are just symptoms of these dynamics. 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 property taxes and maintenance fees. 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 counterintuitive to what most commentators think. First, 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 the open border of the capital and trade flows in the U.S., as long as things are getting cheaper and cheaper in relative terms in China, China will be able to force China-made goods down the throat of the broken American consumers.
Second, China will invest more money into the USD assets, instead of less, because this is only way for them to avoid significant upward pressure on Yuan. This will likely keep the yields on U.S. Treasury bond low as long as China runs 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 identify 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.
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 preoccupation of the current debate on the NER between Yuan and USD, one day, the continuously exploding trade deficit, coupled with 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 problems. However, solving employment problem by growing the economy through persistent current account surplus is at the expenses of its trading partners. In good years, no trading partners get really bothered by it. However, since the start of financial crisis, the U.S. suffers from sustained and elevated unemployment levels (8 millions of 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 pre-occupation of almost every one on NER means that Yuan has to appreciate significantly in terms of NER, with the alternative being a trade war. This will not be pretty for the whole 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 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. In comparison, the U.S., which control the final demand and may finally realize that this control gives it much stronger bargaining power, may end up as the relative winner.
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 balances with another country. However, the current debate on rebalancing global trade, especially Sino-U.S. trade, has focused on appreciating Yuan, the Chinese currency, against USD in terms of NER.
In China’s situation with the U.S., its NER with the U.S. is 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, internal inflation process may also lead to some peculiar dynamics that effectively depreciate Yuan in terms of RER. These dynamics are little noticed by now and are what I really fear for China. I discuss 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 65% 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 one. Wage growth relative to productivity growth would also affect RER. Even if the productivity in the U.S. have been growing at a faster pace than wage growth in the post-crisis period, the 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 concession from some foreign owned factories, that is still the exceptions instead of the norms. Most organized labor movements are likely to be prime targets of being crushed.
The third dynamic is also related to the first one, with the twist of financial repression. Even if real interest rate are often in the negative territory, with few investment options, Chinese households can only put most of their savings in the bank. Since this dynamic constitutes substantial erosions in the 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 the global trade, they are always behind the curve, and 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 Yuan against the USD in terms of NER, and award its workers much higher wages.
These dynamics are among the fundamental problems facing China today. In comparison, things like bubbly housing prices in many Chinese cities are just symptoms of these dynamics. 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 property taxes and maintenance fees. 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 counterintuitive to what most commentators think. First, 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 the open border of the capital and trade flows in the U.S., as long as things are getting cheaper and cheaper in relative terms in China, China will be able to force China-made goods down the throat of the broken American consumers.
Second, China will invest more money into the USD assets, instead of less, because this is only way for them to avoid significant upward pressure on Yuan. This will likely keep the yields on U.S. Treasury bond low as long as China runs 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 identify 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.
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 preoccupation of the current debate on the NER between Yuan and USD, one day, the continuously exploding trade deficit, coupled with 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 problems. However, solving employment problem by growing the economy through persistent current account surplus is at the expenses of its trading partners. In good years, no trading partners get really bothered by it. However, since the start of financial crisis, the U.S. suffers from sustained and elevated unemployment levels (8 millions of 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 pre-occupation of almost every one on NER means that Yuan has to appreciate significantly in terms of NER, with the alternative being a trade war. This will not be pretty for the whole 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 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. In comparison, the U.S., which control the final demand and may finally realize that this control gives it much stronger bargaining power, may end up as the relative winner.
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