All roads lead to the renminbi

I am amazed with the number of “experts” I’ve heard arguing that the West’s fixation with the renminbi is misplaced: China is doing the West a much bigger favor, the argument goes, by embarking on structural measures to rebalance its growth model and, in the process, increase imports.

I’m not going to finger point here but the fact that some of them work for brand-name investment banks makes me wonder whether it’s vested interests speaking in lieu of economic acumen… which would be ironic for anyone competing to become the Chinese government’s most trusted advisor... That’s because telling China that its renminbi policy is secondary is like telling your best friend that the wedding dress she is about to get looks terrific when it really looks dreadful!

Another way to put this is that a (two-way) flexible renminbi is a critical piece of the “puzzle” called “Addressing China’s structural problems”. The argument works on a number of different levels:

First, the obvious: A flexible renminbi would help reduce Chian's reliance on net exports by shifting capital away from export and/or import-substituting sectors and towards domestic-oriented industries. It would also encourage firms operating in export industries to becoming more competitive.

Second, a flexible renminbi gives policymakers some room to maneuver in their efforts to control investment growth. It's no news that investment in China has grown by 8 percentage points of GDP (to 45%) in the space of 8 years. This has prompted many an analyst(including in China) to warn against potential excesses in capacity leading to price declines, lower profits, loan defaults, financial sector instability and a collapse in investor confidence.

What’s the role of the renminbi here? The answer is “control of monetary policy”. Basically, one reason why investment has been growing rapidly is very low lending rates, which, in turn, have been low due to government ceilings on deposit rates.

Liberalizing interest rates is critical for improving allocative efficiency and contain investment growth (you can only go so far with the “Thou shalt not lend” approach!) But interest rate liberalization will be harder to manage while the renminbi is fixed: Even with capital controls in place, raising rates would drive speculative capital into China, forcing further rate hikes to withdraw excess liquidity.

Of course, flexible exchange rates are no panacea either. Even countries with floating currencies are invariably flooded with speculative capital, which can complicate the conduct of monetary policy. Yet, one lesson from the 2008 panic was that those emerging markets with policies in place to increase their economies’ resilience to exchange rate swings came out of the crisis in pretty good shape (contrast, say, Brazil with the Baltics or with Hungary).

In this sense, a stable renminbi can even be counterproductive: As Chinese companies get comfortably accustomed to a stable exchange rate, the incentive to develop and trade financial instruments to manage exchange rate risk is minimal. This postpones the date when they are ready to face not just a stronger, but also a more volatile home currency.

Third, a stronger renminbi would help “transfer” wealth away from corporates and towards households, facilitating the rebalancing of growth towards domestic consumption. When people refer to China’s large pool of savings, they often cite a misleading fact: That private consumption to GDP is at (a shocking) 35%. The number is misleading in that it is partly a symptom of a low labor share of income rather than abnormally high household savings.

The low labor share of income, together with low prices for fuel and utilities and an artificially competitive exchange rate, have allowed corporate profits to soar. This has brought corporate savings (including state-owned enterprises (SOEs)) to more than 20% of GDP.

Clearly, raising utility and fuel prices and/or structural reforms to provide education and healthcare and thus reduce households' precautionary savings would be desirable and in the right direction. But at the core of the matter is the low level of household income. A stronger renminbi would raise households’ real incomes, even if at the expense of (export-oriented) companies. No, I’m not talking “socialism” here.. The point is about boosting private consumption; and creative incentives for better corporate governance by making companies less reliant on cheap inputs and a cheap exchange rate to maintain a competitive edge.

Finally, we do also have the global imbalances. Here, some note that the renminbi may have too little a role to play in narrowing the global imbalances. One argument rests on a counter-example: Accordingly, the US trade deficit remained large between July ‘05 - July ‘08, even as the renminbi appreciated some 20% during that period. A second argument questions the very presumption that the renminbi is undervalued.

I find the first argument misleading. First, we don’t have the counterfactual—as in, what the US trade deficit would have been, had the CNY not appreciated. Second, relative price levels do matter. Depending on how low the starting point is, a 20% appreciation may not be enough to restore competitive equilibrium. Third, people forget that China runs a trade surplus not just with the US but also with the eurozone and (yes!) with Japan—ie. regions with overall current accounts in balance or surplus! In other words, the plummeting US savings ratio is only part of the story behind the US external imbalance with China.

When it comes to how much undervalued the renminbi is, here we are entering abstract expressionist territory. That’s why my preferred approach to assessing an “equilibrium” exchange rate rests on the concept of external sustainability (instead of reduced form equations with ad hoc explanatory variables, or estimations based on current account “norms” and the like). The question boils down to the following: Having amassed a sizable amount of claims on US residents, and with trade surpluses continuing to add to those claims, how does China plan to get paid back?

Counting on the rest of the world to absorb an increasing amount of US exports (via the dollar’s depreciation vs. the euro, the yen etc) won’t work anymore, when countries compete for the “most undesirable currency of the season” award. Resting on the astuteness of US investors to generate a positive income balance despite an overall net foreign liability position of the US as a whole also has its limits—including from China’s perspective: The People’s Republic of China will not exactly be serving its people, if it continues to channel an excessive amount of national savings into low-yielding US Treasuries when there are higher returns to be made either at home or elsewhere.

Importantly, we should not forget that the US income balance has been positive partly “thanks” to the dollar’s weakness. In the same vein, America’s net foreign asset position remained fairly stable (pre-2008) despite large US current account deficits, thanks to capital gains on US foreign assets resulting from the dollar’s depreciation. So, barring a surge in the US net exports to China, China will have to allow exchange rate adjustment if it wants to get “paid back” (in part with capital losses).

All in all, there is no way around the fact that China needs to allow two-way flexibility of the renminbi urgently and for its own sake. Downplaying the importance of this step is naïve, if not disingenuous, for anyone with the word “economist” in their job description… If anything, China’s own fixation with the renminbi does enough to prove them wrong!