William Cline and John Williamson published on Vox an interesting piece earlier this month June 18), titled “Equilibrium Exchange Rates,” in which they try to “estimate a set of medium-run fundamental equilibrium exchange rates compatible with moderating external imbalances” for the 30 largest economies. They assume that a sustainable equilibrium trade balance for the US implies a current account deficit of 3% of GDP (this is conservative – I would have thought “equilibrium” would have been lower), and try to estimate the amount of currency change needed to get there. They also assume that in general not just the US but all “countries should strive to keep imbalances (surpluses and deficits) under 3% of GDP.”
Using early June 2009 exchange rates, they find that six countries – most of whom are primarily commodity exporters, not coincidentally – have overvalued exchange rates relative to the dollar (Australia, New Zealand, South Africa, Brazil, Colombia, Mexico), and twelve, mostly in Europe, have currencies that are marginally undervalued. Of the 30 countries, eleven have currencies that are at least 15% undervalued relative to the US dollar. For convenience sake I include their 2008 GDP and rank them by size. These are:
|
Country |
Billions |
Undervaluation |
|
Japan |
$4,908 |
18.1% |
|
China |
$4,221 |
40.3% |
|
Switzerland |
$491 |
19.8% |
|
Sweden |
$479 |
15.3% |
|
Taiwan |
$392 |
29.4% |
|
Argentina |
$330 |
18.4% |
|
Thailand |
$273 |
16.7% |
|
Malaysia |
$222 |
33.2% |
|
Hong Kong |
$215 |
27.9% |
|
Singapore |
$182 |
26.3% |
|
Philippines |
$169 |
18.2% |
Economists can, and of course will, dispute the methodology and the extent of any perceived under- or over-valuation, but in my opinion the most valuable aspect of these exercises is not that they indicate the “correct” exchange rate level, whatever that means, but rather that they can indicate trends or signal interesting anomalies in the aggregate. Two things are noteworthy here, I think.
The first, and most obvious, is that eight of the eleven Asian countries within the top thirty economies (the exceptions are India, Indonesia, and Korea, whose currencies are all undervalued by 4-6%) are on the above list of significantly undervalued currencies, and the list is dominated by them (eight Asians out of eleven countries on the list). This simply suggests the not-exactly-controversial thesis that Asian countries have systematically undervalued their currencies as a strategy to generate employment growth. It also suggests that Asian central banks that worry about the impact of dollar weakness on their reserve holdings are in the funny position of having created the dollar overvaluation at the same time they were actively accumulating those overvalued dollars.
The second noteworthy consequence of their exercise, which I found much more interesting, was a finding that the authors seem to find a little surprising. They say:
The main counterpart to the overvalued dollar is the undervaluation of the Chinese renminbi, along with a few of the smaller Asian currencies. We are somewhat nervous because our estimate (based on the figure of RMB 4.88 to the dollar) of Chinese undervaluation is even larger than it was a year ago (RMB 5.81 to the dollar), despite the fact that the RMB rode the dollar up by 14% in effective terms in the intervening year. It may be that our estimate is now too large because the IMF’s projection of the Chinese surplus seems not to have declined despite the RMB’s real appreciation, although the fall in commodity prices in the past year has presumably worked in China’s favour. But all the other potential biases, notably the way of formulating the Chinese current account target as a substantial surplus rather than the deficit suggested by the FDI inflow, are in the direction of minimising estimated undervaluation. Our analysis is one more piece of evidence that the major macroeconomic imbalance in the world today stems from China’s exchange-rate policy.
Leaving aside the fact of their very high estimate of Chinese undervaluation, I think the authors are saying that although the RMB rose 14% from the last time they calculated these equilibrium exchange rates, nonetheless their measure of the adjustment needed to balance trade suggests that the RMB is actually even more undervalued than it had been a year ago.
What’s going on? How can a currency that has risen 14% against the dollar finish even more undervalued against the dollar? Part of the answer could be differential productivity growth rates, and since Chinese productivity is growing faster than US productivity it would imply that the RMB should revalue against the dollar just to maintain equilibrium. But of course there is absolutely no way Chinese productivity grew by even a fraction of the amount necessary during that time to explain this anomaly.
But remember in my June 3rd post I argued that we make a mistake when we think only currency and tariff policies can affect trade? There is a whole list of policies that, by directly subsidizing production or by implicitly or explicitly taxing consumption, will necessarily affect the trade account. Could it be that even as the RMB was nominally revaluing, other policies were implicitly “devaluing” the RMB – i.e. policies that implicitly increased subsidies to production, and/or taxed consumption – so that the net distortionary impact on trade actually increased? That could explain why a revaluing RMB is nonetheless consistent with an even more undervalued RMB in relative terms.
New lending surges
We are getting reports that June lending numbers are up on May. One of the more bizarre pieces of “good news” recently – very popular among the China bulls – were claims that new lending had moderated significantly in the past two months (so don’t worry too much about that credit bubble everyone’s talking about), but this is true only to the extent that new loans in April and May were compared to the astonishing first quarter numbers. In fact net new lending in April and May was around double the equivalent amounts last year and every year in this decade.
In June, it looks like we are retuning to an upward trajectory. According to an article in the current issue of Caijing:
Commercial bank lending in the first half is expected to hit 6.5 trillion yuan, with new loans in June coming in at about 660 billion yuan, the official Shanghai Securities News reported, citing people close to the matter.
Chinese banks lent out a record 4.6 trillion yuan in the first quarter to help start stimulus projects; while there has been a slowdown since April, the central bank says its policy remains “moderately loose.” Experts have warned against lending quality, unauthorized loan diversions, and the re-emergence of bad loans, which may cause banks to be more cautious in lending in the second quarter.
Discussing the impact of all this lending Andy Xie weighs in with another thoughtful and worried piece in the current issue of Caijing. He writes:
China‘s credit boom has increased bank lending by more than 6 trillion yuan since December. Many analysts think an economic boom will follow in the second half 2009. They will be disappointed. Much of this lending has not been used to support tangible projects but, instead, has been channeled into asset markets.
Many boom forecasters think asset market speculation will lead to spending growth through the wealth effect. But creating a bubble to support an economy brings, at best, a few short-term benefits along with a lot of long-term pain. Moreover, some of this speculation is actually hurting China’s economy by driving asset prices higher.
The current surge in commodity prices, for example, is being fueled by China’s demand for speculative inventory. Damage to the domestic economy is already significant. If lending doesn’t cool soon, this speculative force will transfer even more Chinese cash overseas and trigger long-term stagflation.
He goes on to say:
The international media has been following reports of record commodity imports by China. The surge is being portrayed as reflecting China’s recovering economy. Indeed, the international financial market is portraying China’s perceived recovery as a harbinger for global recovery. It is a major factor pushing up stock prices around the world.
But China’s imports are mostly for speculative inventories. Bank loans were so cheap and easy to get that many commodity distributors used financing for speculation. The first wave of purchases was to arbitrage the difference between spot and futures prices. That was smart. But now that price curves have flattened for most commodities, these imports are based on speculation that prices will increase. Demand from China’s army of speculators is driving up prices, making their expectations self-fulfilling in the short term.
I usually don’t quote so much from a single source, but I think Andy Xie’s piece is a very good one and well worth reading (there is a lot more). He makes many of the arguments that all of us who worry about China’s continuing failure to adapt to the huge adjustment in the global and US economies. His conclusions:
What is happening in the commodity market is glaring proof that China’s lending surge is hurting the country. Even more serious is that it is leading Chinese companies away from real business and further toward asset speculation – virtual business.
…Many analysts argue GDP growth follows loan growth, and inflation is a problem only when the economy overheats. This is naive. Borrowed money channeled into speculation leads to inflation. And China may face a lasting employment crisis if private companies don’t expand.
This lending surge proves China’s economic problems can’t be resolved with liquidity. China’s growth model is based on government-led investment and foreign enterprise-led export. As exports grew in the past, the government channeled income into investment to support more export growth. Now that the global economy and China’s exports have collapsed, there will be no income growth to support investment growth. The government’s current investment stimulus is tapping a money pool accumulated from past exports. Eventually, the pool will dry up.
If exports remain weak for several years, China’s only chance for returning to high growth will be to shift demand to the domestic household sector. This would require significant rebalancing of wealth and income. A new growth cycle could start by distributing shares of listed SOEs to Chinese households, creating a virtuous cycle that lasts a decade.
Putting money into speculative investments isn’t totally irrational. It’s better than expanding capacity which, without export customers, would surely lead to losses. Businesses currently lack incentive to invest. But many boom forecasters wrongly assume that recent asset appreciation, fueled by speculation, signaled an end to economic problems. That’s an illusion. The lending surge may have created more problems than it resolved.
My comments are never published on your site. What are you afraid of? If you are so in favor of freedom and debate why do you censor me? What are the rules on this site?
Angry, actually this is a completely private site, written and supported only by me, and by readers who want to debate or discuss the issues set out by me, and so there is no such thing as censorship here. Censorship can only occur if I were to constrain your ability to discuss these or other issues generally. A family magazine can reject pornographic articles and a legal journal can reject food recipes without having imposed censorship. You are of course free to create your own website and write anything you like as far as I am concerned, but on my site you have to follow my rules for relevance.
Although I approve almost all comments, there are exceptions. I have three separate stalkers who spend an inordinate amount of time (please get yourselves lives) writing very long, multiple, daily comments on things that are totally irrelevant to my blog (which by the way I don’t have time to read). I assume you are one of them, so let me tell you the basic (and fairly obvious) rules.
1. If you try to hijack my site to further your own agenda, whether it is to sell trading services, mortgages, or condoms, or to attack the Chinese or US governments for real or imagined slights, or even to uncover conspiracies in which I am a key participant, your comments will not be accepted. (By the way, and this is addressed to one of my stalkers, I was a teenager living in Spain when Mao Zedong died, and so no, I was never part of his inner circle and was never involved in the conspiracies that you have so cleverly uncovered).
2. If you use language that is unnecessarily crude or offensive and/or otherwise aimed at getting me blocked in China, your comments will not be accepted.
3. If you insult participants in your responses or make personal attacks, your comments will not be accepted.
Quote Michael: “How can a currency that has risen 14% against the dollar finish even more undervalued against the dollar?”
Part of the answer seems to lie in the assumptions used:
The authors use the IMF’s currenct account forecasts, and they say that the IMF has not revised China’s current account forecast downwards compared to last years estimate, in spite of the appreciation of the CNY.
But if you assume that the current account surplus is still the same, then of course the currency is still as undervalued as in the previous analysis, because in the analysis “undervaluation” is measured by “extent of surplus”.
Quote Michael: “Part of the answer could be differential productivity growth rates, and since Chinese productivity is growing faster than US productivity it would imply that the RMB should revalue against the dollar just to maintain equilibrium.”
This is only true if wages do not rise in line with productivity growth.
I have no idea how average Chinese wages developed over the last twelve months, but in the longer run, they appear to have risen substantially.
Good point, Thomas, which begs the question, with the RMB up and with the US trade deficit down so sharply, how can an equilibrium measure of currency undervaluation suggest that the RMB is even more undervalued than it was? That brings us right around to Michael’s idea that other policies may have had the effect of “devaluing” the RMB. I notice that trade conflicts are more than ever in the headlines, which is probably an partial consequence.
I am a little confused about your second point. If wages had indeed risen considerably this would have reduced the undervaluation, not increased it, although it seems this might not have happened anyway. I think Nick Lardy has argued that over the past five years the RMB’s undervaluation has actually increased because the differential productivity growth was less than the differential wage growth. Although there has been greater productivity growth in China than in the US in the past five years, albeit slowing, it has been less than the difference in wage growth. This might explain part of the reason for increased undervaluation of the RMB but I agree with Michael that it is too small to explain much.
I wonder if differential productivity growth already captures many of the “undervaluation” processes Michael mentions. After all if you artificially lower the corporate borrowing cost, to take one example, doesn’t this show up as increased productivity?
@JackFoster
I suppose we have no way of reliably quantifying productivity growth in China’s manufacturing sector (or more specifically: the export-oriented portion manufacturing sector). There are simply too many variables we don’t know about. So while it is surely safe to say that China’s labor productivity is increasing much faster than America’s and Europe’s, the exact extent of the difference is an open question.
Regarding my point on wages: What I meant to say is: Michael is right if wages did in fact not increase significantly faster than in the US. If however they did increase much faster, then they counterbalanced the productivity differential, and they can no longer explain an increasing undervaluation of the RMB.
Personally, I think that any attempt to quantify the “undervaluation” of a currency smacks a bit of voodoo science: We already have so much trouble trying to figure out why Chinese exports and imports go up and down. How can we possibly hope to figure out the effect of a 10 % fx rate change on the trade surplus with any degree of accuracy? It depends on so many things, and few of those things stay constant over time.
This would require significant rebalancing of wealth and income.
Key quote from Mr. Xie’s article.
Russian analysts, noting a recent anomalous surge in bank lending there, have argued that this is a signature of schemes to rollover unpayable loans. So for instance, two banks might swap deadbeat debtors each making a loan to the other’s debtor, which then pays off its prior loan. The old loans are shown as paid off, new lending is report, but actually each debtor owes as much as it did before and payoff prospects are no better. Alternatively, a single bank can lend money to an affiliate of its debtor, which directs the funds to retiring its old debt. Again, it looks like new lending but the stock of loans outstanding doesn’t change. Any chance this is going on in the Chinese case?
Professor Pettis: Thank you for your latest post.
Thomas is right to underscore that the Cline Williamson results reflect their use of the IMF “benign baseline scenario”.
According to the IMF April 09 WEO, the US current account deficit had been running around 6-7% of GDP in 2008 and will be halved to just under 3% in 2009. They simulate a similar figure until 2014 under their “benign scenario” — assuming a stable foreign debt/GDP ratio — with trend GDP just under 3%.
For China the CA surplus was 10% of GDP in 2008; rising slightly in 2009 and dropping to 9.4% by 2014. Their GDP growth rates are 6.5% in 2009, 7.5% in 2010 and 10% in 2014.
These outcomes are debatable as they are based on UNCHANGED exchange rates, declared macro policies and neutral “real” commodity and oil prices. More puzzling, why the 3% US and 9.4% China current account numbers are sustainable is not clearly spelled out.
Using this scenario to calculate equilibrium exchange rates appears circular, as China’s current account surplus remains unchanged despite an “appreciating effective exchange rate of 14% in the intervening year”.
Such an exercise needs a counter factual i.e. what would the CA surplus have been without the recent 14% appreciation of the RMB? But for that we would also need to know trend productivity and the “output gap” in the US and China — plus some ball park numbers for all the non-trade measures that Prof. Pettis underscores.
In sum, the Cline-Williamson piece is interesting but the results look strange. To add to the debate, the RIETI #E3B.doc (Japan 2005) has estimates that range from a modest to zero undervaluation of the RMB. Similarly, Keidel (2005) of Carnegie has argued that the RMB rate is not the problem — they are basically structural. In contrast, Lardy and Goldstein argue that the RMB is undervalued by at least 30-40%. Do readers have more recent estimates to shed light on my ignorance? best regards James
regards James
Prof Pettis,
Andy Xie is very smart.But he proposed that China should distribute shares in SOE to all Chinese ppl and claimed that this will solve our net consumption problem.Isn’t this naive?
PS: The OECD has just submitted new forecasts.
For China, the OECD now forecast GDP growth of 7.7% and 9.3% for this year and 2010; whereas the CA surplus declines from 9.9% to 9.6% of GDP from 2008 to 09 and falls further to 7.8% in 2010. As the projected growth rates are not hugely higher than the IMF’s I wonder if the drop in the CA surplus reflects exchange rate movements? regards James
Good post. Balanced opinion that both current debtors and creditors should be able accept.
I especially liked the following argumentation:
“We are not among those who argue that the primary cause of the financial crisis was a savings glut in Asia – China’s surpluses did not force the quants to invent asset-backed securities, the rating agencies to overrate mortgage-backed securities, AIG to take a position on only one side of collateralised debt swaps, nor Lehman and others to leverage at 30 to 1″
Fair enough!
“A meaningful pursuit of reduction in international imbalances and corrective movement in exchange rates has been on the international agenda for some time now, including in the IMF’s mandate to provide multilateral surveillance. It is in this context, then, that we prepared this second set of “fundamental equilibrium exchange rates” estimates, and we hope that they will provide a useful input into international policy efforts toward reducing imbalances.”
A refreshing old-style kind of economics à la Rueff that everyone should appreciate. I doubt that these changes that would imply efforts are on anyone’s agenda. Since, at this stage of the monetary crisis, it would imply:
1- a significant reevaluation of the yuan and assorted Asian currencies,
2- strict deflationary policies in the US and elsewhere including a host of OECD countries.
We are still on the path that leads to the destruction of the monetary system. But at least a few of us do shout.
Regards to Michael for the debate.
I recall reading somewhere that the credit boom might prove to be an unmitigated disaster due to the recipients being state controlled companies. The article goes on to detail how China’s growth has been fueled by private companies not the state controlled ones. In a sense the stimulus might prove to be white elephant food.
Regarding the chart, it would be interesting to see the effects on USD reserves held by each nation. I am beginning to think that China and Japan might be better off writing some off. It would be a more direct way to stimulate the USD and would avoid the direct appreciation of the RMB.
On the topic of the commodity speculation, there is a piece up at ChinaStakes on copper that talks about how a lot of the copper imports aren’t even leaving the warehouses at ports’ free trade zones, to avoid taxes. And concludes a lot of this stock will end up being re-exported.
http://www.chinastakes.com/2009/6/chinas-destocking-will-put-pressure-on-copper-futures-markets.html
China’s recovery plan seems to be very similar to that of the American workers who saw their 401k’s drop 30% and are now betting big on a recovery in junk bonds, commodities and emerging markets.
This is the kind of thinking that seemed to work before, say in 2002 when a prominent economist actually called on Greenspan to create a housing bubble:
http://www.nytimes.com/2002/08/02/opinion/dubya-s-double-dip.html
Thomas, at least in the U.S., productivity is calculated by subtracting changes in wages and hours-worked from changes in output.
Interesting that in the Caijing news piece that we have this conflicting information…..
» The volume of crude oil processed in May rose 10.7 percent year-on-year to a record 31.2 million tons, with gasoline, diesel and kerosene output totaling 19.3 million tons, up 16.7 percent year-on-year, the China Petroleum and Chemical Industry Association said on June 22.
» China’s crude output and sales are expected to keep rising to reflect increased industrial demand, said Jiang Xinmin, an expert with the National Development and Reform Commission, as quoted by the official Xinhua news agency.
» Oil product sales in May reached 18.3 million tons, down 0.2 percent from a year earlier.
From wires
————-
So we have increase refining that reflects ‘increased industrial demand’ and sales down .2 percent from a year earlier. I guess if demand is up and sales are down they are giving it away.
Glen,
maybe it’s as simple as “what you refine in May you sell in June” Refiners must make some anticipatory demand decisions?
Prof Pettis, sorry to go a bit off point (i mean not on the Currency valuation topic), but what are you feelings for yearly RMB Total loan growth? I am beginning to feel that 8 Trillion may be a little low. Looking at the PBOC statistics and rounding to the nearest Billion RMB (whilst incorporating the rumour for June 2009 quoted in your post):
2008
JAN 804Billion RMB
FEB 243Billion RMB
MAR 286Billion RMB
APR 464Billion RMB
MAY 319Billion RMB
JUN 332Billion RMB
JUL 382Billion RMB
AUG 272Billion RMB
SEP 378Billion RMB
OCT 182Billion RMB
NOV 478Billion RMB
DEC 772Billion RMB
= 2.448 Trillion RMB in the First Half
= 4.912 Trillion RMB for the entire year.
———————————————–
2009
JAN 1600Billion RMB
FEB 1100Billion RMB
MAR 1900Billion RMB
APR 591Billion RMB
MAY 665Billion RMB
(JUNE 660Billion RMB) (rumour so far)
= 6.516 Trillion for the first half.
If 8 Trillion (and i am not sure where i got this 8 trillion figure from – was it a prediction from an official?) were the total 2009 amount, then the monthly average for the remaining 6 months would be 247billion / month. This seems a bit too low for an economy that is not out of the woods and apparently relying on loans for stimulus… Do you think the economy can handle such a dip in the second half?
Finally someone is addressing the main issue, the unsustainable investment boom.
I would criticize Andy Xie on three points:
1. investment boom was not government led, it was private and export led. It had become government led only in the past half year. Sustaining an investment boom at the magnitude of 57% of GDP from government sources can not be maitained for very long.
2. Distribution of wealth and income is not easy. Because this would draw the corporate cash flow from investments, so investment would decline, and the broader economy would crash. Wages and taxes could only be increased by borrowing more from inside China and then from the rest of the world making the balance of payment of China negative
3. Distribution of SOEs among the population is naive. They tried it in the Czech Republic in the early 90s. It doesnot solve the ownership problem, there would not be strong owners to enforce productivity improvements. But more importantly there would be no extra demand either.
Extra demand could be only created via raising wages and taxes _and_ upholding the corporate lending boom to prevent a largescale collapse in investments at the same time of stimulating consumption.
This would anyway crash a lot of industries in China, but new industries would start to develop (health care, entertainment, services in general).
Again and again. China must become a net borrower from a net saver. Which would just crash the rest of the world.
Although this is not a serious economic comment, it’s ironic to me that the so-called “correct” exchange rate turns out to be between 4 and 5 RMB to the dollar. When I used to live in China we would joke about the “Coca-Cola” exchange ratio where one dollar in the U.S. buys a Coke and 4 or 5 RMB in China buys a Coke thus implying what the exchange rate would be absent of the central banks efforts to keep the yuan undervalued. I used to keep this hypothetical exchange rate in mind as well as the actual exchange rate (at the time 8.28) in mind when I bargained for stuff at markets to give myself a mental goal post as to what portion of the discount (relative to buying the same product in the U.S.) was due to RMB undervaluation vs. simply being cheaper for other reasons.
The Chinese yüan overvalued:the best prove for it the high export surpluss.
And by the level of the export surpluss overvalued by a hugh level.40% I think is an optimistic assesment for the level.
However,the most interesting point for me is the growth in productivity,but from an other standpoint.
If the productivity growth in China higher ,than in the US,then the wage growth have to be higher than in the US.
But ultimatedly it mean a higher potential debt growth for the Chinese customers,and it mean faster consumption growth than in the US with a faster loan volume growth.
But we experiencing the oposite of it.
The US debt growing,the Chinese stagnating.(external)
There have to be a reason,why we can not see the “proper” pattern.I mean,if China could utilise the internal market,then they doesn’t need the investment and the export.
I think China is in the catch 22.
‘What’s going on? How can a currency that has risen 14% against the dollar finish even more undervalued against the dollar’?
Consider the transshipment of goods through Hong Kong.
‘From 1997 to 2005, Hong Kong’s re-exports of Chinese goods to overseas destinations amounted to 1/3 of China’s total exports. In 2005, the value of U.S. goods re-exported to China through Hong Kong was 14% of total reported U.S. exports to China’.
http://www.treas.gov/offices/international-affairs/economic-exchange-rates/pdf/2007_Appendix-2.pdf
I read the Xie piece a couple days ago and commented elsewhere that investing in commodities and building inventories at beaten down prices is a very good idea for China as a whole. Prices are up from the bottom, but well below averages over the past 5 years and far below the recent peak:
http://finance.yahoo.com/q/ta?s=%5EDJC&t=5y
It seems as though Xie builds his whole piece around the assertion that this is a risky endeavor. Not putting the recent price moves in proper context is a big mistake on his part.
I personally think that these commodity purcahses are another example of Chinese businesses pursuing an excellent opportunity that will benefit the Chinese economy over time.
Thomas, JackFoster and Chan-Lee, thanks for your comments and elucidations. There certainly is some circularity in the Cline-Williamson piece but it does nonetheless capture what would normally seem a real paradox and must be explained, even if, as Thomas points out, there can never be real precision in determining the extent of under- and over-valuation – a point I tried to make several times when I argue that anything that affects the gap between consumption and production is, in a sense, a currency policy. On the other hand, Thomas, I don’t want, like too many academic economists do, to commit the mistake of the drunk man who one night loses his car keys in the middle of the road but searches for them on the sidewalk under the streetlamp because the light is better there. Just because it is difficult and probably even theoretically impossible to quantify the extent of misevaluation does not mean that we should assume the issue doesn’t exist and cannot be discussed.
David Woodruff, these are old tricks, and there have been rumors, and more, about this happening quite a lot here. I have even heard bankers laugh at how easy it is to do. Of course they themselves have never done it.
Daniel from Paris, thanks, but my standard, and perhaps a little too glib, joke is that to avoid a sharp contraction in trade and an increase in trade tensions, we need statesmanship in the US, China, Europe and Japan, so of course I am pessimistic. This old-fashioned stuff – the balance of payments and basic economic history – has been scandalously neglected in economics courses for decades.
Houhui, I am hearing 800 billion to 1 trillion in June. There is almost no way in hell that they are going to keep to the 8 trillion figure. That would require a too sharp slowdown in the second half. My guess is that they blow out 10 trillion.
Lemmiwinks, I accept many of your points. It all demonstrates, I think, just how difficult it is going to be to get out of this mess. A government-led investment surge can only be a short term solution and probably makes things worse in the medium term, but in fairness it is not clear that policymakers have too many options.
Matt, I help a lot of my students get summer internships in New York and there was sort of running joke among them in the 2002-5 period that everything that cost RMB 1 in Beijing cost $1 in New York. Comparing exchange rates is always a very touchy-feely process.
RodgerRafter, I am not sure I agree. First, commodity prices may be low compared to the last three years, but they are still high compared to historical levels. My personal opinion is that commodity prices will decline further, but a much more important argument against buying now is that China already has a built-in hedge which, by buying up commodities now, it is undermining. The reason I say this is because Chinese and US demand are probably the greatest factors affecting global commodity prices. If the Chinese economy booms in the next few years, commodity prices will almost certainly rise, whereas if it stagnates, commodity prices will almost certainly decline. This means China is partially hedged – they pay high prices when they are doing well and low prices when they are doing badly. Buying now, reduces the hedge and implicitly “doubles the bet” on their recovery. Of course if the Chinese economy takes off, and causes commodity prices to surge, China will have looked very clever by buying now, but this doesn’t disguise the fact that they merely doubled up on their bet – only a good strategy if winning is the only possible outcome.
Quote Michael: “everything that cost RMB 1 in Beijing cost $1 in New York”
Several Chinese people here in Germany have independently told me they feel that German salaries are “way too low” compared to Chinese salaries, because everything that costs 1 RMB in China costs 1 Euro in Germany.
Though whenever we get down to discussing it in detail, they are forced to acknowledge that for most things, the price differential is far less extreme, probably more like 1 RMB = 0.2 Euros for most comparable services (which is still twice the prevailing exchange-rate, but of course services are always much cheaper in developing countries).
[...] called Equilibrium exchange rates which was highlighted by Professor Michael Pettis on his article Can the RMB be more undervalued today than it was last year?, I saw a very interesting entry, Malaysia.It states that the Malaysia Ringgit is undervalued by [...]
On the topic of economic history, Michael I believe a while back you mentioned you were thinking of putting a list of recommended economic history books. I, for one, would be very interested to see it.
I’d put a plug in for “Power and Plenty,” a very good historic survey of world trade history by Ronald Findlay and Kevin O’Rourke.
John Lee raises some valid concerns that the loan growth is going to cause trouble…
“Even though state-controlled enterprises produce between one-quarter and one-third of all output in the country, they receive more than 75 per cent of the country’s capital, and the figure is rising.
China’s state sector owns almost two-thirds of all fixed assets in the country. This is the reverse of what occurred in South Korea (as well as Japan and Taiwan), where the private sector received more than three-quarters of all capital during the 1960s and 1970s.”
“The massive bias towards the state sector would be acceptable if the 120,000 state-controlled enterprises could learn to innovate and adapt. Unfortunately, except for a handful of centrally managed state-controlled enterprises, this is not the case.
To put the situation in perspective: China’s overall use of capital is half as efficient as India’s. World Bank findings indicate that about one-third of recent investments made by the state-controlled sector generated zero or negative returns. This might increase the chances of the Chinese Communist Party remaining in power, but at enormous cost to the country.”
http://www.nst.com.my/Current_News/NST/Tuesday/Columns/2589079/Article/index_html
Prof. Pettis, your postings seem to imply that the Chinese policy makers are intentionally or unintentionally proceeding on a course that will inflate an asset bubble via lending to help the Chinese economy through the current global downturn, but that this can only be sustained for a short term basis. Is it your impression that this is being done to buy time to shift the economy over to rely more on domestic Chinese demand (or to develop demand from other foreign markets). Or, alternatively, does it seem to be more that policy makers are simply hoping that this will allow the Chinese economy to “hold it’s breath” until this downturn has passed and everyone can return to the previous export led status quo. In other words, are you seeing government statements being backed up by commitment and actions in developing domestic demand?
Michael,
I don’t agree with your view that China buying up commodities now is like doubling their bet. It may be true that China success will cause commodity prices to rise but buying commodities is a hedge. I don’t think an airline company would decline to buy jet fuel forward under the basis that if jet fuel goes up it will be because we are demanding more fuel due to higher travel volume? Of course, it might be a contributing factor to higher fuel prices but one has no way of knowing if it is the only factor or even the dominant one. It is a required input and thus buying it now hedges the cost of that input. China will need vast commodity inputs for its future economic growth, 3% or 10%, doesn’t matter. And what of the hedge achieved re: their USD reserves? A devaluing USD will push USD denominated commodity prices higher independent of China growth, no? I think China is wisely selling very expensive UST assets and buying relativley inexpensive commodities that they know they will use no matter what.
Houhui,
where do you think the savings that stand behind the expected 8+ trn loan growth are coming from?
Last year gross savings growth was 5 trn household+ 2 trn corporate which stood against 5 trn corporate borrowing.
The difference, 2 trn savings growth was lent out to the world as balance of payments suffict.
However if Chinese corporation this year borrow more than the corporation and households save (assume they save about the same as last year), then China must have already become a net borrower by now?
The US is borrowing big time, and simultanously China becoming a net borrower, should have we have had to see evidence of this on financial markets?
Can it be happenning that all this increased borrowing is not actually net borrowing, because the corporates simply deposit what they lend?
Can someone please explain these numbers?
I just got it from PBOC website, I want to compare how borrowings and savings grow.
Borowings: May 2009
RMB loans increased by RMB 664.5 billion in the month.
loans to households rose by RMB 187.6 billion.
Loans to non-financial companies and other sectors grew by RMB 476.9.
Savings: May 2009
RMB deposits grew by RMB 1.33 trillion in the month. !!!!!!!!!!!
household deposits grew by RMB 188.6 billion,
fiscal deposits increased by RMB 447.4 billion,
deposits of non-financial companies rose by RMB 669.8 billion
I guess those numbers are characteristic of the whole year?
What does this mean?
Corporates dont seem to be borrowing at all. They are net savers!
Households dont seem to be saving at all. They are starting to become net borrowers!
What are fiscal deposits? Money printing put another way?
Professor Pettis: I have problems with the Cline-Williamson methodology in estimating Full Equilibrium Exchange rates (FEER).
This approach is relevant when the law of one price holds, but may give strange results in dual economies where 2/3rds of the population lives in rural areas, with vast supplies of excess labour.
Estimates of a big undervaluation of the RMB (30-40%) might be legitimate for the Coastal enclaves — but hardly for the hinterland. If the FEER is a weighted average — rapidly evolving dual economies can lead to funny results.
Hence, despite an increase in the nominal effective ex rate, the real rate might actually decline.
Why: because huge infra structure investments (road, rail, electricity) that link the hinterland to the coast, damp overall wages, but boosts productivity à la Schumpeter.
This might explain why the wage share has been falling thereby damping consumption. This is perpetuated by the exchange rate policy that locks in low wages to facilite job creation and social peace. regards James
I have compared savings and loan growth data from PBOC.
It seems like starting from 2009 both corporates and household savings and borrowings have started growing very rapidly.
However if I look at the net borrowing and saving, the picture is more muted.
The net borrowings of the corporate sectore rose to average 149 bn yuan a month in 2009 from a monthly avg of 112 bn yuan in 2008.
Household net savings rose from avg 327 to avg 420 bn a month.
Total net savings (including “fiscal” savings) rose from 232 bn a month to 429 bn a month.
So the net effect of the loan boom are more modest (around 30% growth) than the gross numbers (suggesting a higher than 200% growth).
Michael, are there any official/unofficial figures about employment? I have yet to hear even of anecdotal evidence of unrest or other tell-tale signs of increasing distress amongst the working classes.
My take is that the the key goal for the central bank is to keep employment levels high. If these loans are going into speculative assets rather than productive assets, there should be evidence of increasing unemployment. It also does not reconcile with China’s surplus growing (esp. in light of the fact that commodity prices are supported by imports into China).
On the other hand, if China is subsidizing production, my naiive expectation is that inputs (the speculative assets) should be dropping in price.
Lemmiwinks, those numbers are not Characteristic for the whole year, there was much more lending in Quarter 1.
If a company borrows 100 RMB, then deposits it in a bank, then the bank can lend out a portion of it again – depending on reserve requirements. 8 Trillion RMB of lending doesn’t need a full 8 Trillion RMB of new money. These Net numbers can confuse things a bit.
They key is the debt burden created by perhaps 10Trillion RMB of new loans, which need to be serviced / paid back. Also where the lending is going, if it is being re-deposited, then it is not really adding to economic activity, it is just swelling banks balance sheets allowing them to lend more.
OGT, I will do so at some point, but there are so many great books that it becomes a little tough to put together a list. Certainly one book that will be on my list is Barry Eichengreen’s Golden Fetters.
Glen, two days ago in my comments I told Houhui that I was hearing that June loans would be Rmb 800 billion to Rmb 1 trillion. Today the rumors are Rmb 1.2 trillion. There is almost no question that much of the lending is wasteful, something facilitated by the fact that loans are implicitly guaranteed and are at very low interest rates.
Andrew, yes, I think policymakers are hoping to buy time for a transition, but I am worried that they need far more time than they realize and that the current stimulus will actually make the transition more difficult. It is a very tough position in which to be.
Max, no airline is big enough to drive oil prices by its purchases – in fact I suspect the entire industry in the aggregate cannot have a significant impact on oil prices – so there is no correlation between its profitability and the price of oil. In that case buying oil forward is indeed a useful form of hedging because it reduces overall volatility, which is the point of hedging. In China’s case, the high positive correlation between its growth rate and oil prices – one much noted among oil producers and users – changes the whole picture. If China can move oil prices, than Chinese “hedging” actually increases its volatility.
As for “a devaluing USD will push USD denominated commodity prices higher independent of China growth,” there are two problems with that. First devaluing against what? The only currency against which the dollar is very likely to depreciate is the Rmb, so no, a devaluing dollar will actually cause the price of oil to decline for China. Second, if we are so certain of a devaluing dollar against all currencies generally (although I have never understood why high levels of USD debt are so widely expected to cause the dollar to devalue against the euro, when in Europe debt levels are higher and growth slower), we are also probably certain of slowing US growth, in which case it is hard to imagine how contractions in both the US and Chinese economies are likely to result in higher oil prices. By the way if China’s commodity purchases were truly driven by hedging needs, the same strategy would be even more useful for smaller economies with smaller impacts on global commodity prices, and yet as far as I know no one does it to anywhere near the same extent.
Lemmiwinks, you need to be careful of definitions here. China is not a net borrower. It is a net creditor. We know this because it runs a current account surplus. If within China people borrow and lend to each other, it will have no impact on the net position.
Chan-lee, I agree there are always problems with currency valuation methodologies. That is why I am more interested in changes and trends than in the results.
Odin, official unemployment numbers show a rise in unemployment, but they are not terribly reliable and probably understate unemployment by a factor of 2 to 3. Other definitions of unemployment, however, also indicate rising levels, but of course, like in the currency valuation discussed above, there is no unambiguous measure of employment and unemployment. Most of us just look at trends. As for unrest, actually there have been quite a few riots and demonstrations – this is almost a daily occurrence. Whether the number of incidents is rising or not is a little tough to say because around two years ago the government stopped providing the numbers. Most people I know who try to follow these things think it is rising.
Lemmiwinks
The difference is roughtly 28 billion $(deposit vs loan),in that month the trade surpluss was 13.4 billion $.
But it roughtly match the deficit of the US (I think it is just an accident)
Michael,
My apologies if you interpreted my words to mean that I thought an airline could drive up the cost of oil by itself. I actually said jet fuel. And of course, I meant the airline industry. In any event, I was merely trying to give and example of entity “A” doing well appearing to be correlated to the price of “B” going up not being a good reason for entity “A” to avoid buying “B” to hedge. Chinese growth does drive up the cost of oil obviously, but it by no means is the only reason oil has risen to higher levels these past 6 years. Buying oil now before other factors drive up the cost of oil would be a wise hedge. Do you really think the Chinese moves to secure oil resoruces with the Russian and Brazilian deals was so dumb?
As for your argument on the USD and oil, I am not sure I follow your line of thought. I said that a weakening USD will cause the price of Oil to rise. Its priced in USD isn’t it? Your response was ………
“The only currency against which the dollar is very likely to depreciate is the Rmb, so no, a devaluing dollar will actually cause the price of oil to decline for China.!
I feel this is sort of condescending. When I said a devaluing USD isn’t it clear that I mean against everything but the remimbi? You may not think the USD will weaken against any other major currency but that does not refute the argument that if it does, China will pay more for oil. So buying oil now would be a hedge for its FX reserves in the sense it reduces their exposure to a weakening USD against OTHER currencies. In fact, this has little to do with the renmimbi. China imports oil, it must come up with FX to buy it. Right now their FX reserves can purchase X amount of oil at today’s prices. If the USD weakens 10% and this causes Oil per USD to rise 10% then IF their FX reserves were all USD (of course they are not) they could buy 10% less oil with those same reserves. I suppose the proof is in the pudding so to speak. Ever since the FED announce the UST QE program in mid march spot oil has risen about 50% and the DXY index has weakened about 8%. Of course, Chinese buying had something to do with the rise in the price of oil, but surely it is not the only factor. Any oil that China bought with its USD reserves this past two months is a good hedge. In your view, they should not have bought oil right? If they had not, it is highly likely that their FX reserves would now be able to purchase < X barrels of oil they could have bought prior to the FEDs announcment.
Lastly, you claim that Europe has higher levels of debt than the USA? I assume that since we were discussing exchange rates, your “europe” was the Eurozone right? I believe you are mistaken then. Eurozone as a whole has lower levels of debt than the USA. On top of that current fiscal deficits in Eurozone are running about half of the USA. 6% vs. 12%…
Yes, I know that China is a net creditor thats why I was wondering how loan growth could exceed savings growth without the BoP turning negative.
Then I looked into PBOC data and I found that in 2009 savings have been growing faster than loans, so China is actually lending to the rest of the world almost twice as much a month than a year ago.
Hi Houhui,
I have actually checked deposit growth data back to January and I found that deposits have been growing very fast indeed. Faster than loans, actually.
So much of the money is redeposited (if it is deposited by the sellers of investment goods, at least there is some stimulus), but not much net consumer demand is being created.
Another interesting trace I found was that household net saving growth was decelerating from January through May, in April going into negative saving growth. I dont know if it is a trend or a transient characteristic of this time of the year, I was lazy to check last years figures.
Prof Pettis,
Many thanks for the articles and your comments on the board. I am definitely no expert on economics and definitely not one on currency valuations so find this very interesting.
I read elsewhere a few months ago that the Chinese had indeed been buying vast amounts of commodities at prices seemingly very low. You argue that in general, commodity prices are still high historically. I take your argument that if demand doesn’t recover that this will affect the price negatively but, can this be taken against a much larger potential growth globally? We have some very large countries (physically and by population) that are in the process of modernisation. I can’t quote figures, but the likes of Brasil, China and India account for more than 1/3 of the worlds population and to me, for these countries to modernise and industrialise more, the demand will be higher than that of the Western countries during their growth heights?
I agree with you on the ‘double bet’ of commodity accumulation. I think what some readers don’t appreciate in this is that whatever the input price fluctuation, most of this is passed on to the consumer.
An interesting side note to this commodity accumulation is one theory being touted that the moves towards a global currency could be based on a basket of commodities, rather than a basket of currencies. I think there are some merits towards this (as well as many cons) and like this in theory. If this could be implemented, the current commodity accumulation doesn’t seem to be too bad an idea. Do you have time to add some thoughts towards this?
Thanks for the response Professor P.
I look forward to your posts every week, even if my own outlook on the Chinese economy is more optimistic than most people around here.
I would agree that incidents of unrest are rising. They have always been very very frequent (especially in the countryside and small township level). There are often local issue based, and aimed at local governments, often about corruption or economic issues. Stratfor publish a weekly China Security Memo which summarises the most significant events of the previous week.
Prof Pettis.
Thank you for you continuing updates. I have a question regarding the “implicit” government backing for this stimulus lending. I think as I have mentioned before, the “commercial” state owned banks are being very outspoken about how their lending doesn’t need guarantees – implicit or otherwise – and follows their own “strict” guidelines.
In what way would you say that the lending has an implicit guarantee? IS it that the government wouldn’t allow a bank to fail…hence the lending is guaranteed? (on this point i think this is not necessarily true for local city banks) OR is it contained in a logical argument – the government demanded stimulus lending, the (supposedly non-policy) banks responded, hence the government was always expecting to back up at least some of the lending?
Sorry to be a bit fuzzy in my question
China is sitting on a large amount of dollars, so what should they do?
Options:
1) Purchase natural resources in other countries, thereby guaranteeing the country as a whole long-term benefits.
2) Stimulate private demand, i.e stimulate private imports. This would mean more welfare-optimized demand for individuals, however maybe suboptimised on a national level.
3) Continue speculating on the value of the dollar.
Increasing domestic lending leads to 1) or 2) depending on who gets the loans. The currency-peg leads to 3).
For the outside world it is irrelevant whether China purchases copper due to real demand or due to speculation. It is just important that China purchases something, thereby avoiding a huge debt imbalance (be it nominal/perceived or real, the effect is negative).
Dr Jim Walker has also argued that “other policies were implicitly ‘devaluing’ the RMB”, namely “flooding the system with money” at the same time the govt widened the USDRMB band in Summer 2005, thereby mispricing capital in order to subsidize FAI directed mainly at export-dependent (in one way or another) firms. Dr Jim has called it “the worst policy mistake made in China in a decade.”
Stefan
There are other options beyond those you list. They could use their excess production capacity to accumulate/build real assets within the country. Examples: 1) Infrastructure and public owned assets such as roads, bridges, power plants, pollution control improvements, electric distribution systems, hospitals, restoration and permanent improvements to government owned land, development of underdeveloped portions of the country. 2) Business assets. 3) Personal assets such as housing, improvements to privately owned land, automobiles, and other durable goods.
All of these examples (and more) represent accumulation of real wealth within the country. Unfortunately China has chosen to accumulate primary fiat currency or equivalents (US Treasury bonds) rather than use their excess production capacity to increase domestic consumption and accumulation of real wealth within China. This may or may not be a conscious decision but it is the outcome of their overall policies. The evidence I have seen on this blog and elsewhere suggests they are unwilling to change those policies on their own. It will likely take substantial external pressure to make it happen, such as imposition (or at least threat) of substantial protectionist measures by countries being damaged by their policies.
Mercantilists should always be given the same answer:
Buy our products or accept our currency.
So, China should either buy products from the west, or accept whatever happens with the currencies in the west.
China has no justification for talking about new reserve currencies. If China wishes, they may buy gold for their entire currency reserve. But the west must never accept to have its debt to China denominated in gold or anything else than its own currency.
Buy our products, or accept our currency.
1.16tr yuan worth of loans spent on stocks
Bloomberg in Shanghai
Jun 30, 2009
New bank loans worth about 1.16 trillion yuan (HK$1.32 trillion) on the mainland were invested in the stock market in the first five months of this year, China Business News reported, citing a government economist.
That was 20 per cent of the 5.8 trillion yuan in loans that banks extended in the period, Wei Jianing, a deputy director in the macroeconomics department of the Development and Research Centre under the State Council, was reported by the newspaper as saying.
The Shanghai Composite Index has rallied 63.41 per cent this year and is the world’s third-best performer. The market plunged a record 65.39 per cent last year.
Property sales in the country jumped 45.3 per cent to 1 trillion yuan in the first five months of the year, compared with a 19.5 per cent decline for all of last year, the statistics bureau said.
Record lending after the central bank scrapped loan quotas in November last year is helping the economy revive after its weakest growth in almost a decade.
Some new loans must have entered the nation’s stock and property markets in the first quarter, said Cheng Siwei, a former vice-chairman of the Standing Committee of the National People’s Congress.
About 2.4 trillion yuan worth of bank loans in that quarter were invested in projects, leaving a further 2.18 trillion yuan in new loans to be accounted for, Mr Cheng said.
“Where did it go? It is undeniable that a portion of the lending may have flowed into stock and real estate markets and triggered the rebound in these two markets,” he said.
A further 30 per cent of the loans in the first five months might have been used for discounted bill financing, or short-term credits used to fund working capital needs, China Business News said.
Peng Wensheng, an economist at Barclays Capital, said the rally in stocks and property was to be expected, given the size of the stimulus spending and the resultant bank loans.
Mike, I join this party after the bar is closed I fear, but for anyone still finishing their drinks…
I talked to Bill and John about your thoughtful post on their FEERs work, and the discussion that ensued. There are 2 points that are worth sharing.
First, they would probably argue that at the most basic level, the problem is misdiagnosed, in that it is less about RMB-USD than USD:
a) The needed effective exchange rate appreciation of the RMB remains unchanged;
b) The needed effective depreciation of the dollar has become larger.
c) It follows directly that the needed bilateral change against the dollar is larger than before.
China’s greater need to appreciate against the dollar than before can be seen in this light as merely the mirror image of the US greater need to depreciate on an overall basis than before.
This is the meta-perspective that differs from your analysis.
Second, there may be one error in the numbers you lay out when you ask “How can a currency that has risen 14% against the dollar finish even more undervalued against the dollar?” The 14% increase was not against the dollar, it was the trade-weighted rise, most of which was from the rise of the dollar against other currencies; the rise against the dollar (from Feb 08 to Mar 09) was only 4.8 percent.
Finally, keep in mind John and Bill’s work is meant as a regular second-guessing of the Fund’s tracking of rates, not a China-assessment per se (though you can and do argue that they are close to the same!).
All best,
Dan Rosen
[...] Can the RMB be more undervalued today than it was last year? [...]
[...] Can the RMB be more undervalued today than it was last year? mpettis.com/2009/06/can-the-rmb-be-more-undervalued-today-than-it-was-last-year – view page – cached William Cline and John Williamson published on Vox an interesting piece earlier this month June 18), titled “Equilibrium Exchange Rates,” in which they try to “estimate a set of medium-run fundamental equilibrium exchange rates compatible with moderating external imbalances” for the 30 largest economies. They assume that a sustainable equilibrium trade balance for the US implies a current account deficit of 3% of GDP (this is conservative – I would have thought “equilibrium” would have been lower), and try to estimate the amount of currency change needed to get there. They also assume that in general not just the US but all “countries should strive to keep imbalances (surpluses and deficits) under 3% of GDP.” — From the page [...]