The "China Bashing" Trap

Ronald McKinnon of Stanford University explains why "China bashing" is a bad idea through a comparison of the pressure being applied on China today to revalue the yuan with a period 30 years ago when similar pressure was applied to Japan to revalue the yen with less than desirable results. Some highlights:

The Problem with “China Bashing”, by Ronald McKinnon, Commentary, Project Syndicate: Pressure on China today to push up the value of the yuan against the dollar is eerily similar to the pressure on Japan 30 years ago to make the yen appreciate. Back then, “Japan bashing” came to mean the threat of US trade sanctions unless Japan softened competitive pressure on American industries. By 1995, the Japanese economy had become so depressed by the overvalued yen ( endaka fukyo ) that the Americans relented and announced a new “strong dollar” policy. Now “China bashing” has taken over, and the result could be just as bad, if not worse. ...

The financial press and many influential economists argue that a major depreciation of the dollar is needed to correct America’s external deficit. But the US current-account deficit – about 6% of GDP in 2004 and 2005 – mainly reflects a new round of deficit spending by the US federal government and surprisingly low personal savings by American households (perhaps because of the bubble in US residential real estate).

Moreover, the cure can be worse than the disease. Sustained appreciation of a creditor country’s currency against the world’s dominant money is a recipe for a slowdown in economic growth, followed by eventual deflation, as Japan found in the 1990’s – with no obvious decline in its large relative trade surplus. In a rapidly growing developing country whose financial system is still immature, introducing exchange-rate flexibility..., as the IMF advocates, is an even more questionable strategy.

If a discrete exchange-rate appreciation is to be sustained, it must reflect expected monetary policies: tight money and deflation in the appreciated country, and easy money with inflation in the depreciated country. But domestic money growth in China’s immature bank-based capital market is high and unpredictable, while many interest rates remain officially pegged. Thus, the People’s Bank of China (PBC) cannot rely on observed domestic money growth or interest rates to indicate whether monetary policy is too tight or too loose. ...

If China is to avoid falling into a Japanese-style liquidity trap, the best solution is to fix its exchange rate in a completely credible way so that there is no fear of currency appreciation. Then financial liberalization could proceed with market interest rates remaining at normal levels. But China’s abandonment of the yuan’s “traditional parity” in July 2005 rules out a new, credibly fixed exchange-rate strategy for some time.

Failing this, China must postpone full liberalization of its financial markets. This means retaining, and possibly strengthening, capital controls on inflows of highly liquid “hot” money from dollars into yuan, and continuing to peg certain interest rates, such as basic deposit and loan rates, to help preserve the profitability of banks.

Such measures are, of course, an unfortunate detour. True, China’s economy is now growing robustly and is not likely to face actual deflation anytime soon, but if China does fall into a zero-interest rate trap, the PBC, like the BOJ, would be unable to offset deflationary pressure in the event of a large exchange-rate appreciation. With short-term interest rates locked at zero, pressure for further appreciation would leave the PBC helpless to re-expand the economy.

China’s monetary and foreign exchange policies are now in a state of limbo. Instead of stable guidelines with a well-defined monetary (exchange rate) anchor and a firm mandate to complete financial liberalization, China’s macroeconomic and financial decision making will be ad hoc and anybody’s guess – as was true, and still is, for Japan.

With so many different analyses of global imbalances, with so many different policy recommendations about how to resolve them and who is at fault, and with dire warnings about every policy choice from some credible analyst, this must be pretty confusing to people with little training in the area. Quite honestly, it's pretty confusing even if you have had training and the main message seems to be that the future holds a great deal of uncertainty even for those who have studied these problems extensively.

So, since I have nothing in particular to add to the confusion on this issue that someone hasn't already said, I'll go, with appropriate apologies, to a corny, worn out analagy type ending. Should you buy an umbrella to ward off the coming economic storm? Changes in the economic weather, like changes in the weather more generally, are hard to predict until signs of change are evident. So far the clouds that are visible aren't gathering into a storm, but I wonder, is your economist uncle's arthritic knee, the one he swears predicts big storms, aching yet?

Comments

[save_the_rustbelt]

Business risk management models always emphasize anticipation, prevention, and transfer of risk.

Risk management requires a certain well-honed paranoia.

Remember what grandma said "better be safe than sorry."

We have helped create dynamic economic growth in China, on t hebacks of many Americans. That is the problem.

[Winslow R.]

"Quite honestly, it's pretty confusing even if you have had training and the main message seems to be that the future holds a great deal of uncertainty even for those who have studied these problems extensively."

My uncertainty comes mostly from trying to 'read' the people in power.

My wife is certain we are headed for depression/war as the steps to get there are in the interest of those in power. It is only the last step into war that causes 'the problem' for the well to do.

I would like to believe those that understand where the steps lead will abort and take a new path.

[a]

As cynical as it may sound, I'm waiting for the Chinese to starve themselves.

If you think shifts in farmers from rural areas to city is sustainable I'd think again. It happened before to industrial wannabe nations, who were later forced to return to agriculture. Reinstating the agriculture is currently going on in some of the former Soviet block countries who developed very inefficient industries during communist years and now realized that the only way out is to become agrarian again. This does not mean they are not going to be modernized and enter the EU. It just means someone has to do the farming and provide the food for the EU. And since the land is non-polluted and very good, I think is going to be a good deal for both EU and the countries in question.

I am not saying China cannot be an industrial nation, but shifting too much from agriculture to industry can be detrimental. The global trend seems to be towards developing industry, and agriculture definitely benefits with improved tools and methods, but the land is not going to farm by itself.

Chinese did stupid things before (like the cultural revolution) and they may as well head again for a disaster.

And yes, there is a link between the valuation of yuan and the migration of farmers from rural areas to city. As long as the yuan stays low, that migration will continue as the chinese will want to make cheap stuff to sell to US and around the world.

[Winslow R.]

a wrote:

"As cynical as it may sound, I'm waiting for the Chinese to starve themselves."

This has happened before, but it doesn't have to happen again.

McKinnon wrote:

"But the US current-account deficit – about 6% of GDP in 2004 and 2005 – mainly reflects a new round of deficit spending by the US federal government and surprisingly low personal savings by American households (perhaps because of the bubble in US residential real estate). "

This paragraph is a bit unclear and would have been clearer if the author had included the the numbers for the gov deficit 4% and personal savings deficit 2% in terms of GDP.

There would then be a collective gasp from the crowd as people realized:

Gov deficit = foreign savings + private domestic savings

4% = 6% + (- 2%) (triple deficit theory)

and the solution to the private domestic savings 'problem' becomes obvious - increase gov deficit spending.

I'll pull a Killus, repetition until silenced.

[hj]

China is not Japan. Japan was a recently conquered nation, dependent on us strategically and militarily. When we applied pressure it found it difficult to resist. China is nothing like Japan and much better situated to defend its own interests. And it shows no signs of capitulation.

[dryfly]

Copy hj and add that when Japan readjusted its currency (mid-80s) typical wage rates had reached parity with much of Japan's western trading partners. Its Achilles Heel was that it tried to continue to compete like it was still an up and coming Asian Tiger (with low labor cost).

In short it had become more like 'us' then like 'them'. Once the currency readjusted its high labor cost position became VERY exposed.

China today still has VERY low labor costs. Even in Shanghai or Guangdong I'm told by colleagues who operate there that factory labor has gone up 400% in the last decade... but still only costs about $1000-$2000 per person per year (depending on skill)... and that is for 10-12hrs/day 6 days a week. If you go inland to places like Wuxi & Wuhu the rates quickly fall back to the pre-boom rates of about 25 cents an hour.

If the RMB-dollar shifts 30-40%, like many predict, it will not make a huge dent in their competitiveness from a labor rate perspective. You'd have to be Scrooge not to see this.

So why is it important if it won't have an effect?

First of all it will have some effect at the margins - highly efficient work in the US will find they are under far less extreme price pressure almost immediately. High labor content inefficient work in the US won't see any relief. Really efficient work stays inefficient works still leaves. If I understand comparative advantage correctly - that's how its supposed to work, right?

Secondly it would make the US far more competitive in China vs Eurozone & Japan... we'd see exports climb even if the imports from China slowed only a little.

The result of the two could be a significant rebalancing.

However if the Chinese stall and their standard of living & wages increase based primarily on currency imbalance... then they are far more likely to follow Japan's path when the inevitable rebalancing eventually occurs. Then they will be facing a disadvantage in BOTH wage rates & currency shift. Not fun.

M2C.

[Robert]

Moreover, the cure can be worse than the disease. Sustained appreciation of a creditor country’s currency against the world’s dominant money is a recipe for a slowdown in economic growth, followed by eventual deflation, as Japan found in the 1990’s – with no obvious decline in its large relative trade surplus

Surely Japan is an exceptional case - a mercantilist rogue in what was designed as an ostensibly cooperative post WWII monetary system. Japan was doing anything but trying to curb its trade surplus. They have whole ministries devoted to the objective of coordinated victory in trade. They did everything they could in the 90s NOT to adjust, restructure, hollow, and fought tooth and nail, and dragged their feet on every NTB or liberalization proposal put forth, all the while looking serious, nodding heads "Yes Hills-san, yes Kantor-san, yes Barshefsky-san, we understand", delay delay delay....anything but adjusting, anything that might disturb their harmony, or be at their expense except buy some overpriced airlpanes and military gear. And still, today, just look at Tanigaki, running 6++% of GDP fiscal gaps and still whining & squawking about how Japan shouldn't end ZIRP because of economic uncertainty despite what is robust growth, record profitability, rising asset prices & prob the lowest OECD unemployment ouside Switz. I don't begrudge them for that, but it seems wrong for Prof M. to hold them out as the poster-child for what could go wrong if one sincerely "tried" in earnest.

But seemingly, the Prof has no answers, no solutions, other than more of the same. If one is ill, one must take medicine now or take it later, but one'll have to take it sooner or later. Where will "more of the same" take us? At least he could have suggested "a pact" that would remove the inflation threat of the accumulating/accumulated reserves, an entente whereby we'll let them continue to accumulate to them at stable rates of exchange, but they can't dispose of more than say 8% of their reserves in a given year which gives us in simple terms a 12-year work-out and then they can wrestle with our kids about getting paid or the terms of rollover.

But this may be yesterdays' problem, for both Japan and China are in rough balance at $70 oil. When it's just the big two, Japan & China, we "own" them as much as they "own" us for the USA is as Winslow's pointed out, too big for them to cause it to fail. But what happens when our 6% GDP current acct gaps must rely on oil-surplus nations? ANd/or at $100bbl they must sell bonds to pay for oil imports. Are we [our current a/c] prepared to face real "the market"?

[camille roy]

As a non-economist, I find these issues perplexing, but take scant comfort from the fact that economists seem also to find them perplexing, given their diversity of views.

I have observed, however, that the (American) economists I've read largely take one of two positions:
1. China should float or loosen the peg because it is good for the U.S. and good for China.
or
2. China should NOT float/loosen because the current regieme is good for China.

In other words, there seems to be agreement that the current situation is bad for the U.S. The disagreement seems to be on what is the best course, in terms of China's interests. That seems to be an acknowledgement of a sort that the hollowing out of so much of the American economy may not serve us well in the long term.

Of course in the long term we are all dead. I was here in San Francisco during the dot com boom and I remember the incredible tide of money that washed in. This town was stuffed to the gills with people and money. And then the money left. Whoosh. I do think the current real estate bubble is another huge tide of funny money, and that tide does now seem to be beginning to roll out.

[Winslow R.]

"1. China should float or loosen the peg because it is good for the U.S. and good for China.
or
2. China should NOT float/loosen because the current regieme is good for China."

Number 2 is also short-term 'good' for the U.S. as we are trading real wealth for the ability to 'save' paper dollars. This could continue 'forever' (until U.S. loses superpower status) dispite the claims to the contrary. It would be doubly good for the U.S. if we weren't squandering our good fortune with wasteful government spending in Iraq. Will we come to our senses before the opportunity to 'inject' noninflationary money into the economy in a productive manner is lost to an invasion of Iran?

Hopefully not.