The Singapore Economic Review, Vol 50, Special Issue(2005)463-474 o World Scientific Publishing Company World Scientifi CHINAS NEW EXCHANGE RATE POLICY WILL CHINA FOLLOW JAPAN INTO A LIQUIDITY TRAP RONALD L. MCKINNON Department of Economics, Landau Economics Building Stanford University Stanford, CA 94305-6072, USA McKinnon @stanford. edu Todays American mercantile pressure on China to appreciate the renminbi against the dollar is eerily similar to the American pressure on Japan to appreciate the yen that began over 30 years are some differences between the two cases, but downward pressure on Chinese interest exchange risk could lead China into a zero interest rate liquidity trap much like the Japan has suffered since the mid-1990s Keywords: Exchange rates; China; Japan; interest rates; liquidity trap: deflation. 1. Introduction On July 21, 2005, China gave in to concerted foreign pressure some of it no doubt well meant-to give up the fixed exchange rate it had held and grown into over the course of a decade. The US Congress had threatened, and still threatens, to pass a bill that would impose an import tariff of 27.5%o on Chinese imports unless the renminbi was appreciated and pressured the US Administration to retain China,s legal status as a "centrally planned economy(despite its wide open character) so that other trade sanctions -such as anti dumping duties- could be more easily imposed. True, the actual appreciation since July 21 of the still tightly controlled renminbi has been trivial-less than 3%. And it is much less than the 20%o to 25% appreciation called for by vociferous American critics of Chinas foreign exchange policy. But the move signaled that further appreciations had become more likely in the guise of achieving greater exchange rate Aexibilit American pressure on China today to appreciate the renminbi is erily similar to American pressure on Japan that began almost 30 years ago to appreciate the yen against the dollar There are some differences between the two cases, but downward pressure on interest rates from foreign exchange risk could lead China into a zero-interest liquidity trap much like the one Japan has suffered since the mid-1990s I Many lodged in the Institute for International Economics in Washington, DC. See the articles by Fred Bergsten, Morris Goldstein, Nicolas Lardy, and Michael Mussa in Bergsten(2005)
March 20, 2006 11:33 WSPC/172-SER 00215 The Singapore Economic Review, Vol. 50, Special Issue (2005) 463–474 © World Scientific Publishing Company CHINA’S NEW EXCHANGE RATE POLICY: WILL CHINA FOLLOW JAPAN INTO A LIQUIDITY TRAP? RONALD I. MCKINNON Department of Economics, Landau Economics Building Stanford University Stanford, CA 94305-6072, USA McKinnon@stanford.edu Todays’ American mercantile pressure on China to appreciate the renminbi against the dollar is eerily similar to the American pressure on Japan to appreciate the yen that began over 30 years ago. There are some differences between the two cases, but downward pressure on Chinese interest rates from foreign exchange risk could lead China into a zero interest rate liquidity trap much like the one that Japan has suffered since the mid-1990s. Keywords: Exchange rates; China; Japan; interest rates; liquidity trap; deflation. 1. Introduction On July 21, 2005, China gave in to concerted foreign pressure — some of it no doubt well meant — to give up the fixed exchange rate it had held and grown into over the course of a decade. The US Congress had threatened, and still threatens, to pass a bill that would impose an import tariff of 27.5% on Chinese imports unless the renminbi was appreciated, and pressured the US Administration to retain China’s legal status as a “centrally planned” economy (despite its wide open character) so that other trade sanctions — such as antidumping duties — could be more easily imposed. True, the actual appreciation since July 21 of the still tightly controlled renminbi has been trivial — less than 3%. And it is much less than the 20% to 25% appreciation called for by vociferous American critics of China’s foreign exchange policy.1 But the move signaled that further appreciations had become more likely in the guise of achieving greater exchange rate flexibility. American pressure on China today to appreciate the renminbi is erily similar to American pressure on Japan that began almost 30 years ago to appreciate the yen against the dollar. There are some differences between the two cases, but downward pressure on interest rates from foreign exchange risk could lead China into a zero-interest liquidity trap much like the one Japan has suffered since the mid-1990s. 1Many lodged in the Institute for International Economics in Washington, DC. See the articles by Fred Bergsten, Morris Goldstein, Nicolas Lardy, and Michael Mussa in Bergsten (2005). 463
464 The Singapore Economic Review 2. From Japan to China Bashing To understand the origins of the foreign exchange risk that could eventually lead to a zero- interest-rate trap, consider first the earlier mercantile interaction between Japan and the United States, and then the recent trade disputes between China and the Us Figure 1(courtesy of Kenichi Ohno) shows that Japan's bilateral trade surplus, largely in manufactures, with the United States began to grow fast in the mid-1970s, peaked out at about 1.4% of US GNP in 1986, and remained substantial subsequently. Somewhat arbitrarily, I demarcated the period of intense"Japan bashing"by many Americans and Europeans as falling between 1978 and 1995. Japan bashing"came to mean the continual threat of US trade sanctions on Japanese exports unless Japan ameliorated competitive pressure on impacted American industries. Typically, these trade disputes were resolved by Japan's agreeing to serially impose temporary export restraints on steel, autos, televisions, machine tools, semiconductors, and so on, coupled with allowing the yen to appreciate. Indeed, the yen did appreciate episodically all the way from 360 to the dollar in 1971 Just before the Nixon shock) to 80 to the dollar in April 1995 By 1995, the Japanese economy had become so depressed by the overvalued yen(endaka fukyo), that the Americans relented and Secretary of the Treasury robert rubin announced a new" strong dollar"policy. The Us Federal Reserve Bank jointly intervened with the Bank Japan an+ China 10 Gope 1. Bilateral Trade Surpluses of Japan and China with the US, 1995-2004(proportion of US Source: Kenichi Ohn The syndrome of the ever-higher yen is described in McKinnon and Ohno(1997)
March 20, 2006 11:33 WSPC/172-SER 00215 464 The Singapore Economic Review 2. From Japan to China Bashing To understand the origins of the foreign exchange risk that could eventually lead to a zerointerest-rate trap, consider first the earlier mercantile interaction between Japan and the United States, and then the recent trade disputes between China and the US. Figure 1 (courtesy of Kenichi Ohno) shows that Japan’s bilateral trade surplus, largely in manufactures, with the United States began to grow fast in the mid-1970s, peaked out at about 1.4% of US GNP in 1986, and remained substantial subsequently. Somewhat arbitrarily, I demarcated the period of intense “Japan bashing” by many Americans and Europeans as falling between 1978 and 1995. “Japan bashing” came to mean the continual threat of US trade sanctions on Japanese exports unless Japan ameliorated competitive pressure on impacted American industries. Typically, these trade disputes were resolved by Japan’s agreeing to serially impose temporary export restraints on steel, autos, televisions, machine tools, semiconductors, and so on, coupled with allowing the yen to appreciate.2 Indeed, the yen did appreciate episodically all the way from 360 to the dollar in 1971 (just before the Nixon shock) to 80 to the dollar in April 1995. By 1995, the Japanese economy had become so depressed by the overvalued yen (endaka fukyo), that the Americans relented and Secretary of the Treasury Robert Rubin announced a new “strong dollar” policy. The US Federal Reserve Bank jointly intervened with the Bank -0.5 0.0 0.5 1.0 1.5 2.0 2.5 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 Japan China Japan + China China Bashing Japan Bashing Percent of US GDP Figure 1. Bilateral Trade Surpluses of Japan and China with the US, 1995–2004 (proportion of US GDP) Source: Kenichi Ohno. 2The syndrome of the ever-higher yen is described in McKinnon and Ohno (1997)
hina's New Exchange Rate Policy 465 of Japan several times in the spring and summer of 1995 to stop the yen,s going ever higher Since then, the yen has fluctuated widely(perhaps too much so), but has never again gone so high as 80 to the dollar- and Japan bashing more or less ceased. Nevertheless, Japan has still not fully recovered from its lost decade of the 1990 Now China bashing has superseded Japan Bashing. China's bilateral trade surplus with the United States was insignificant in 1986, but then began to grow much more rapidly than Japans after 1986. By 2000, Figure I shows that Chinas was as large as Japan's bilateral surplus, and by 2004, it was twice as large. However, Japan, with its still much bigger economy in 2004, had an overall current account surplus(measured multilaterally) of USS172 billion and China's was"only"US$70 billion. Nevertheless, a large and growin bilateral trade surplus concentrated in competitive manufactures with the United States has triggered US threats of trade sanctions and demands for currency appreciation-pressure that China had felt for a least four years before giving in last July Interestingly, in Japan's great high-growth era of the 1950s and 1960s, its manufactured exports to the United States grew even more rapidly than in subsequent decades, much like Chinas today. But back then, Japan had roughly balanced trade(no saving surplus) with the rest of the world. Because Japans imports of both primary products and manufactured goods, many from the United States, also grew rapidly, Americans broadly tolerated rapid increases in manufactured imports from Japan. Painful restructuring in American import competing industries were offset by export expansion, often in manufacturing. So pressure for net contraction in American manufacturing was minimal because there was no overall American current account deficit However, the situation changed dramatically in the late 1970s and 1980s when the US first began to run large overall current account deficits including large bilateral trade deficits with Japan(Figure 1). These overall deficits were widely attributed to an American Ro. ng shortage from large US fiscal deficits: the famous twin deficits of the era of President Ronald Reagan in the 1980s. Heavy US international borrowing, largely from Japan, could only be transferred in real terms by the United States'running a deficit in tradable goods or services-and Japan's principal export was manufactures. America ran a large trade deficit in manufactures, leading to a net contraction in the size of its manufacturing sector. Because political lobbies in American import competing sectors hurt by Japanese competition became stronger than those in the shrinking export sector, Japan bashing became more intense in the 1980s before peaking out in 1995 In the new millennium, Chinas emergence as a major trading nation has coincided with a new round of war-related deficitspending by the US federal government, and surprisingly low personal saving by American households -perhaps because of the bubble in US residential real estate. This American saving deficiency results in an enormous overall current-account deficit of about 6% of American gDP in 2004 and 2005-much bigger then the combined current account surpluses of Japan and China. Why then is China bashing in the US now so much more intense than Japan bashing or Germany bashing when the latter two countries still have larger manufactured exports and larger overall current account surpluses than Chinas? Because of the idiosyncratic
March 20, 2006 11:33 WSPC/172-SER 00215 China’s New Exchange Rate Policy 465 of Japan several times in the spring and summer of 1995 to stop the yen’s going ever higher. Since then, the yen has fluctuated widely (perhaps too much so), but has never again gone so high as 80 to the dollar — and Japan bashing more or less ceased. Nevertheless, Japan has still not fully recovered from its lost decade of the 1990s. Now China bashing has superseded Japan Bashing. China’s bilateral trade surplus with the United States was insignificant in 1986, but then began to grow much more rapidly than Japan’s after 1986. By 2000, Figure 1 shows that China’s was as large as Japan’s bilateral surplus, and by 2004, it was twice as large. However, Japan, with its still much bigger economy in 2004, had an overall current account surplus (measured multilaterally) of US$172 billion and China’s was “only” US$70 billion. Nevertheless, a large and growing bilateral trade surplus concentrated in competitive manufactures with the United States has triggered US threats of trade sanctions and demands for currency appreciation — pressure that China had felt for a least four years before giving in last July. Interestingly, in Japan’s great high-growth era of the 1950s and 1960s, its manufactured exports to the United States grew even more rapidly than in subsequent decades, much like China’s today. But back then, Japan had roughly balanced trade (no saving surplus) with the rest of the world. Because Japan’s imports of both primary products and manufactured goods, many from the United States, also grew rapidly, Americans broadly tolerated rapid increases in manufactured imports from Japan. Painful restructuring in American importcompeting industries were offset by export expansion, often in manufacturing. So pressure for net contraction in American manufacturing was minimal because there was no overall American current account deficit. However, the situation changed dramatically in the late 1970s and 1980s when the US first began to run large overall current account deficits — including large bilateral trade deficits with Japan (Figure 1). These overall deficits were widely attributed to an American saving shortage from large US fiscal deficits: the famous twin deficits of the era of President Ronald Reagan in the 1980s. Heavy US international borrowing, largely from Japan, could only be transferred in real terms by the United States’ running a deficit in tradable goods or services — and Japan’s principal export was manufactures. America ran a large trade deficit in manufactures, leading to a net contraction in the size of its manufacturing sector. Because political lobbies in American import competing sectors hurt by Japanese competition became stronger than those in the shrinking export sector, Japan bashing became more intense in the 1980s before peaking out in 1995. In the new millennium, China’s emergence as a major trading nation has coincided with a new round of war-related deficit spending by the US federal government, and surprisingly low personal saving by American households — perhaps because of the bubble in US residential real estate. This American saving deficiency results in an enormous overall current-account deficit of about 6% of American GDP in 2004 and 2005 — much bigger then the combined current account surpluses of Japan and China. Why then is China bashing in the US now so much more intense than Japan bashing or Germany bashing when the latter two countries still have larger manufactured exports and larger overall current account surpluses than China’s? Because of the idiosyncratic
466 The Singapore Economic Review way in which world trade, and Asian trade in particular, is organized, China's bilateral trade surplus with the United States is bigger and more noticeable to American politicians. Virtually all East Asian countries today have overall current account surpluses, and several ave bilateral trade surpluses with China. China buys high-tech capital goods and industrial intermediate inputs from Japan, Korea, Taiwan, Singapore, and European countries such as Germany -and also buys raw materials from many sources in Asia, Latin America, Africa, and elsewhere. China then transforms these inputs into a wide variety of middle-tech manufactured consumer goods for the Us market. Many of China's exports are from final processing industries, where valued added per good produced in China itself is not high because many of the components come from Asian neighbors and elsewhere However, Americans see the proliferation of"Made in China"labels in the huge influx of imported of consumer manufactures, and American politicians myopically blame China for being an unfair competitor. But China is merely the leading edge of a more general, albeit somewhat hidden, East Asian export expansion into the United States- which in turn reflects very high savings rates by Asians and abnormally low saving by Americans 3. Selective Restraints on Exports China bashing today primarily takes the form of pressuring China to appreciate its currency, or to let the yuan/dollar rate be more"flexible". China's ongoing accumulation of dollar claims from its trade surplus and inflows of foreign direct investment(FDI would lead to an indefinite upward spiral in the renminbi if it was floated. 3 By contrast, in the earlier 1978-1995 period of Japan bashing, American demands for a general appreciation of the yen were often coupled with the demand that Japan impose"vol untary"restraints on exports of particular products. Because past waves of Japanese exports into the world and American markets were successively concentrated in heavy industries such as steel, autos, televisions, semi-conductors, and so on -it made sense to soften the impact on different American import-competing industries by temporarily restricting Japans export growth in particular products. American industrial lobbies in heavy industries were concentrated and politically potent In contrast, recent Chinese exports into the American market have been low to middle ch products of light industry. Rather than being concentrated in particular heavy industries, ey are spread across the board, and protectionist lobbies for specific industries in the United States are not so ardent as in the earlier Japan-bashing campaigns. The one big exception is textiles and apparel, where Chinas position has been complicated by the expiration on January 1, 2005, of the international multi-fiber agreement(MFA)that had limited Chinese textile exports into world markets. However, as a matter of practical politics for relieving foreign distress, China could voluntarily, but temporarily, re-impose constraints on its own textile exports through tariffs or quotas -as per Japans earlier restraints on its exports- although neither were(are)legally obligated to do so 3See McKinnon(2005, Chapter 5)
March 20, 2006 11:33 WSPC/172-SER 00215 466 The Singapore Economic Review way in which world trade, and Asian trade in particular, is organized, China’s bilateral trade surplus with the United States is bigger and more noticeable to American politicians. Virtually all East Asian countries today have overall current account surpluses, and several have bilateral trade surpluses with China. China buys high-tech capital goods and industrial intermediate inputs from Japan, Korea, Taiwan, Singapore, and European countries such as Germany — and also buys raw materials from many sources in Asia, Latin America, Africa, and elsewhere. China then transforms these inputs into a wide variety of middle-tech manufactured consumer goods for the US market. Many of China’s exports are from final processing industries, where valued added per good produced in China itself is not high because many of the components come from Asian neighbors and elsewhere. However, Americans see the proliferation of “Made in China” labels in the huge influx of imported of consumer manufactures, and American politicians myopically blame China for being an unfair competitor. But China is merely the leading edge of a more general, albeit somewhat hidden, East Asian export expansion into the United States — which in turn reflects very high savings rates by Asians and abnormally low saving by Americans. 3. Selective Restraints on Exports China bashing today primarily takes the form of pressuring China to appreciate its currency, or to let the yuan/dollar rate be more “flexible”. China’s ongoing accumulation of dollar claims from its trade surplus and inflows of foreign direct investment (FDI) would lead to an indefinite upward spiral in the renminbi if it was floated.3 By contrast, in the earlier 1978–1995 period of Japan bashing, American demands for a general appreciation of the yen were often coupled with the demand that Japan impose “voluntary” restraints on exports of particular products. Because past waves of Japanese exports into the world and American markets were successively concentrated in heavy industries — such as steel, autos, televisions, semi-conductors, and so on — it made sense to soften the impact on different American import-competing industries by temporarily restricting Japan’s export growth in particular products. American industrial lobbies in heavy industries were concentrated and politically potent. In contrast, recent Chinese exports into the American market have been low to middle tech products of light industry. Rather than being concentrated in particular heavy industries, they are spread across the board, and protectionist lobbies for specific industries in the United States are not so ardent as in the earlier Japan-bashing campaigns. The one big exception is textiles and apparel, where China’s position has been complicated by the expiration on January 1, 2005, of the international multi-fiber agreement (MFA) that had limited Chinese textile exports into world markets. However, as a matter of practical politics for relieving foreign distress, China could voluntarily, but temporarily, re-impose constraints on its own textile exports through tariffs or quotas — as per Japan’s earlier restraints on its exports — although neither were (are) legally obligated to do so. 3See McKinnon (2005, Chapter 5)
hina's New Exchange Rate Policy 467 4. The Exchange Rate and the Trade balance Although temporary restraints on particular export products, whose rapid growth disrupts markets in importing countries, are all well and good, America's demand that China appre- ciate its currency against the dollar is as unwarranted now as the earlier pressure on Japan to appreciate the yen. A sustained appreciation of a creditor countrys currency against the world's dominant money is a recipe for a slowdown in economic growth, followed by even tual deflation, as Japan found to its sorrow in the 1990s. But the net effect on its trade surplus is indeterminate. Nevertheless, a reading of the recent financial press and writings of many infuential economists on both sides of the Pacific Ocean suggests that a major depreciation of the dollar is needed to correct the current account and trade deficits of the united states For this purpose, they argue, East Asian countries should stop pegging their currencies to the dollar. Especially China should substantially appreciate the renminbi and then move to unrestricted floating This mainstream view rests on two crucial presumptions. The first is that an apprecia- on of any Asian countrys currency against the dollar would significantly reduce its trade surplus with the United States. The second is that a more flexible exchange rate is needed to fairly balance international competitiveness. But under the regime of the international dollar standard, neither presumption holds empirically. Consider the effect of the exchange rate on the trade balance first If a discrete exchange rate appreciation is to be sustained, it must reflect relative monetary policies expected in the future: relatively tight money and deflation in the appreciated country and relatively easy money with inflation in the country whose currency depreciates. There are three channels through which this necessarily tighter monetary policy imposes deflationary pressure in a creditor economy that appreciates First, there is the effect of international commodity arbitrage. An appreciation works directly to reduce the domestic currency prices of imported goods whose world market prices are more or less fixed in dollars. (The pass-through effects of an exchange rate change for countries on the periphery of the dollar standard are much stronger than in the United States itself. And because domestic exports are seen to be more expensive in foreign exchange the fall in foreign demand for them directly bids down their prices measured in the domestic currency. This fall also indirectly reduces domestic demand elsewhere as the export and mport-competing sectors contract. Second, there is a negative investment effect. A substantial appreciation makes the coun- try look like a more expensive place to invest, particularly in export or import competing activities. This applies most strongly to foreign direct investment(FDI) as well to purely national firms looking to compete in foreign markets. Even foreign investment in domestic nontradables, service activities of many kinds, will be somewhat inhibited because most potential foreign investors are capital constrained. That is, they are limited by their equity positions or net worth and an exchange rate appreciation will require more equity in mCkInnon and Ohno(1997)
March 20, 2006 11:33 WSPC/172-SER 00215 China’s New Exchange Rate Policy 467 4. The Exchange Rate and the Trade Balance Although temporary restraints on particular export products, whose rapid growth disrupts markets in importing countries, are all well and good, America’s demand that China appreciate its currency against the dollar is as unwarranted now as the earlier pressure on Japan to appreciate the yen. A 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 to its sorrow in the 1990s.4 But the net effect on its trade surplus is indeterminate. Nevertheless, a reading of the recent financial press and writings of many influential economists on both sides of the Pacific Ocean suggests that a major depreciation of the dollar is needed to correct the current account and trade deficits of the United States. For this purpose, they argue, East Asian countries should stop pegging their currencies to the dollar. Especially China should substantially appreciate the renminbi and then move to unrestricted floating. This mainstream view rests on two crucial presumptions. The first is that an appreciation of any Asian country’s currency against the dollar would significantly reduce its trade surplus with the United States. The second is that a more flexible exchange rate is needed to fairly balance international competitiveness. But under the regime of the international dollar standard, neither presumption holds empirically. Consider the effect of the exchange rate on the trade balance first. If a discrete exchange rate appreciation is to be sustained, it must reflect relative monetary policies expected in the future: relatively tight money and deflation in the appreciated country and relatively easy money with inflation in the country whose currency depreciates. There are three channels through which this necessarily tighter monetary policy imposes deflationary pressure in a creditor economy that appreciates. First, there is the effect of international commodity arbitrage. An appreciation works directly to reduce the domestic currency prices of imported goods whose world market prices are more or less fixed in dollars. (The pass-through effects of an exchange rate change for countries on the periphery of the dollar standard are much stronger than in the United States itself.) And because domestic exports are seen to be more expensive in foreign exchange, the fall in foreign demand for them directly bids down their prices measured in the domestic currency. This fall also indirectly reduces domestic demand elsewhere as the export and import-competing sectors contract. Second, there is a negative investment effect. A substantial appreciation makes the country look like a more expensive place to invest, particularly in export or import competing activities. This applies most strongly to foreign direct investment (FDI) as well to purely national firms looking to compete in foreign markets. Even foreign investment in domestic nontradables, service activities of many kinds, will be somewhat inhibited because most potential foreign investors are capital constrained. That is, they are limited by their equity positions or net worth — and an exchange rate appreciation will require more equity in 4McKinnon and Ohno (1997)
468 The Singapore Economic Review dollars to buy any given amount of domestic physical capital. The upshot is that, in the country with the newly appreciated currency, investment slumps Third, there is a negative wealth effect from being an international creditor with net ollar assets. Because these dollar assets lose value in terms of the domestic currency, the deflationary impact of an exchange appreciation is accentuated. This negative wealth effect further reduces domestic consumption as well as investment and aggravates the slump (growth slowdown) in the domestic economy So we have three avenues through which the impact of an appreciation reduces domestic spending and sets (incipient) deflation in train within a creditor country holding dollar assets. The fall in aggregate domestic demand also reduces the demand for imports and could well offset the fact that imports have become cheaper. True, the relative price effect of an appreciation also makes domestic exports more expensive to foreigners, so exports decline. But the fall in imports could be sufficiently strong so as to leave the net trade balance indeterminate theoretically. For example, when Japan was cajoled(forced)into appreciating the yen several times from the mid-1980s into the mid-1990s, it was thrown into a decade-long deflationary slump with no obvious decline in its large trade surplus measured as a share of its gnp 5. The Exchange Rate as Monetary Anchor Beyond wanting to"adjust "the trade balance, many economists and commentators in the financial press- including such heavyweights as the International Monetary Fund-also argue for exchange rate flexibility in order to insulate domestic macroeconomic policy from the ebb and fow of international payments. The IMF advises China to make its exchange rate more flexible in order increase its "monetary independence, particularly from the United States. But is this good advice for a rapidly growing developing country whose financial system is still immature? Outside of Europe, the dollar is the prime invoice currency(unit of account) in inter national trade in goods and services. All primary products -industrial materials, oil, food grains,and so forth- are invoiced in dollars. A few mature industrial countries invoice some of their exports of manufactured goods and services in their own currencies. But even here, the international reference price of similar manufactures is seen in dollar terms. So manufacturers throughout the world"price-to-market "in dollars if they can. Beca ause most East Asian countries invoice their trade in dollars, these countries collectively are a natural dollar area. Japan is the only Asian country that uses its own currency to invoice some of its own trade. Even here, almost half of Japan's exports and three-quarters of its imports are in dollars. But when China trades with Korea, or Thailand with Malaysia, all the transactions re in dollars For three closely related reasons, each East Asian country has a strong incentive to peg to the dollar, either formally or informally, thus hitching its monetary policy to that of the center country
March 20, 2006 11:33 WSPC/172-SER 00215 468 The Singapore Economic Review dollars to buy any given amount of domestic physical capital. The upshot is that, in the country with the newly appreciated currency, investment slumps. Third, there is a negative wealth effect from being an international creditor with net dollar assets. Because these dollar assets lose value in terms of the domestic currency, the deflationary impact of an exchange appreciation is accentuated. This negative wealth effect further reduces domestic consumption as well as investment and aggravates the slump (growth slowdown) in the domestic economy. So we have three avenues through which the impact of an appreciation reduces domestic spending and sets (incipient) deflation in train within a creditor country holding dollar assets. The fall in aggregate domestic demand also reduces the demand for imports and could well offset the fact that imports have become cheaper. True, the relative price effect of an appreciation also makes domestic exports more expensive to foreigners, so exports decline. But the fall in imports could be sufficiently strong so as to leave the net trade balance indeterminate theoretically.5 For example, when Japan was cajoled (forced) into appreciating the yen several times from the mid-1980s into the mid-1990s, it was thrown into a decade-long deflationary slump with no obvious decline in its large trade surplus measured as a share of its GNP. 5. The Exchange Rate as Monetary Anchor Beyond wanting to “adjust” the trade balance, many economists and commentators in the financial press — including such heavyweights as the International Monetary Fund — also argue for exchange rate flexibility in order to insulate domestic macroeconomic policy from the ebb and flow of international payments. The IMF advises China to make its exchange rate more flexible in order increase its “monetary independence,” particularly from the United States. But is this good advice for a rapidly growing developing country whose financial system is still immature? Outside of Europe, the dollar is the prime invoice currency (unit of account) in international trade in goods and services. All primary products — industrial materials, oil, food grains, and so forth — are invoiced in dollars. A few mature industrial countries invoice some of their exports of manufactured goods and services in their own currencies. But even here, the international reference price of similar manufactures is seen in dollar terms. So manufacturers throughout the world “price-to-market” in dollars if they can. Because most East Asian countries invoice their trade in dollars, these countries collectively are a natural dollar area. Japan is the only Asian country that uses its own currency to invoice some of its own trade. Even here, almost half of Japan’s exports and three-quarters of its imports are in dollars. But when China trades with Korea, or Thailand with Malaysia, all the transactions are in dollars. For three closely related reasons, each East Asian country has a strong incentive to peg to the dollar, either formally or informally, thus hitching its monetary policy to that of the center country. 5Qiao (2005)
hina' s New Exchange Rate Policy 469 First, as long as the purchasing power of the dollar over a broad basket of tradable goods and services remains stable, as it has from the mid-1990s to the present, then peggin to the dollar anchors the domestic price level. The extent of dollar-invoiced trade among neighbors in East Asia is now much greater than trade with the United States itself. Thus e anchoring effect for any one country pegging to the dollar is stronger because East Asian trading partners are also pegging to the dollar Second, East Asian countries are strong competitors, particularly in manufactures, in each others markets as well as in the Americas and Europe. No one East Asian country wants its currency to appreciate suddenly against the world's dominant money. This would lead to a sharp loss in mercantile competitiveness in export markets, followed by a general slowdown in its economic growth, followed by outright deflation if appreciation continued. Third, domestic financial markets in a high-growth developing country such as China now, or Japan in the 1950s and 1960s, exhibit both rapid transformation and incomplete liberalization. In Chinas immature bank-based capital market, domestic money growth 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 as leading indicators of whether monetary policy is being too tight or too easy. Hence the importance of relying on an external monetary anchor- 360 yen/dollar in the 1950s and 1960s for Japan, and 8.28 yuan/dollar from 1995 to July 21, 2005 for China -as a benchmark for the national monetary (and fiscal) authorities. To secure their well-defined exchange rate target, the authorities can then use a range of ad hoc administrative controls over bank credit, reserve requirements, limited interest rate adjustments, and sterilization of the monetary impact of accumulating official exchange reserves. The incidental or indirect effect is then to stabilize the domestic price level However, this external monetary benchmark was not useful in the earliest stages of Chinas transition to a market economy. After 1978, China began gradually dismantling internal price controls but left restrictions on foreign trade largely intact except for a few special economic zones. For almost a decade and a half afterward, the economy was not generally open to free international commodity or financial arbitrage. Foreign trade was organized by state trading companies that(tried to) insulate domestic from foreign relative prices independently of the exchange rate -the so called air lock system. Indeed, beginning at the overvalued but meaningless level of about 1. 7 yuan per dollar in 1978, the renminbi was devalued several times in the 1980s to reach 5.5 yuan per dollar in 1992 without much impact on domestic prices. Into the early 1990s, China was following a national monetary policy that was effectively independent of the foreign exchanges, and price inflation followed the roller coaster ride shown in Figure 2. This early Chinese experience with highly variable rates of inflation illustrates how difficult it is for a very high growth economy to stabilize its national price level independently McKinnon and Schnabl(2004), McKinnon(2005) Figure 2 and the expression "roller coaster ride"are courtesy of Funke(2005
March 20, 2006 11:33 WSPC/172-SER 00215 China’s New Exchange Rate Policy 469 First, as long as the purchasing power of the dollar over a broad basket of tradable goods and services remains stable, as it has from the mid-1990s to the present, then pegging to the dollar anchors the domestic price level. The extent of dollar-invoiced trade among neighbors in East Asia is now much greater than trade with the United States itself.6 Thus the anchoring effect for any one country pegging to the dollar is stronger because East Asian trading partners are also pegging to the dollar. Second, East Asian countries are strong competitors, particularly in manufactures, in each other’s markets as well as in the Americas and Europe. No one East Asian country wants its currency to appreciate suddenly against the world’s dominant money. This would lead to a sharp loss in mercantile competitiveness in export markets, followed by a general slowdown in its economic growth, followed by outright deflation if appreciation continued. Third, domestic financial markets in a high-growth developing country such as China now, or Japan in the 1950s and 1960s, exhibit both rapid transformation and incomplete liberalization. In China’s immature bank-based capital market, domestic money growth 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 as leading indicators of whether monetary policy is being too tight or too easy. Hence the importance of relying on an external monetary anchor — 360 yen/dollar in the 1950s and 1960s for Japan, and 8.28 yuan/dollar from 1995 to July 21, 2005 for China — as a benchmark for the national monetary (and fiscal) authorities. To secure their well-defined exchange rate target, the authorities can then use a range of ad hoc administrative controls over bank credit, reserve requirements, limited interest rate adjustments, and sterilization of the monetary impact of accumulating official exchange reserves. The incidental or indirect effect is then to stabilize the domestic price level. However, this external monetary benchmark was not useful in the earliest stages of China’s transition to a market economy. After 1978, China began gradually dismantling internal price controls but left restrictions on foreign trade largely intact except for a few special economic zones. For almost a decade and a half afterward, the economy was not generally open to free international commodity or financial arbitrage. Foreign trade was organized by state trading companies that (tried to) insulate domestic from foreign relative prices independently of the exchange rate — the so called air lock system. Indeed, beginning at the overvalued but meaningless level of about 1.7 yuan per dollar in 1978, the renminbi was devalued several times in the 1980s to reach 5.5 yuan per dollar in 1992 without much impact on domestic prices. Into the early 1990s, China was following a national monetary policy that was effectively independent of the foreign exchanges, and price inflation followed the roller coaster ride shown in Figure 2.7 This early Chinese experience with highly variable rates of inflation illustrates how difficult it is for a very high growth economy to stabilize its national price level independently. 6McKinnon and Schnabl (2004), McKinnon (2005). 7Figure 2 and the expression “roller coaster ride” are courtesy of Funke (2005)
470 The Singapore Economic Review 25% Retail Price Index → Producer Price Index 600006050500900000. 8 Figure 2. China: Alternative Annual Inflation Rates, 1978-2003 Source: Funke(2005) In 1994, however, China unified its exchange rate regime and moved to effective current account convertibility in international payments so as to permit direct price arbitrage in markets for internationally tradable goods and services. All well and good. But in unifying its official exchange rate with so-called swap-market rates, the PbC devalued the official rate too much-from 5.6 to 8.7 yuan/dollar(Figure 3)-where 8.7 was the previous swap market rate. This large, if somewhat accidental, depreciation then aggravated the burst of inflation over 1993-1996. Figures 2 and 3 show that CPIinflation reached more than 20%o in 1995-a penalty for depreciating the exchange rate too much in the new regime of greater economIc openness However, from 1995 to July 21, 2005, the Chinese authorities held the now-unified exchange rate constant at 8.28 yuan/dollar(plus or minus 0.3%). For these 10 years, they subordinated domestic monetary and fiscal policies to maintaining the fixed exchange rate including not devaluing in the Asian crisis of 1997-1998 when they came under great pressure to do so. They also further dismantled tariffs and quotas on imports in line with their WTO obligations. Consequently, Figure 2 shows the end of the roller coaster ride in China's CPI after 1996, and Figure 3 shows the convergence to the American rate of price infation Chinas CPI increased just 1. 8% from July 2004 to July 2005. (In 2004, a substantial blip in primary commodity prices including oil was not fully passed through to the retail level) But, in the new millennium, using an international monetary anchor has greatly helped China stabilize its domestic price level compared to its earlier "roller coaster ride
March 20, 2006 11:33 WSPC/172-SER 00215 470 The Singapore Economic Review -5% 0% 5% 10% 15% 20% 25% 30% 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 GDP Deflator Retail Price Index Consumer Price Index Producer Price Index Figure 2. China: Alternative Annual Inflation Rates, 1978–2003 Source: Funke (2005). In 1994, however, China unified its exchange rate regime and moved to effective current account convertibility in international payments so as to permit direct price arbitrage in markets for internationally tradable goods and services. All well and good. But in unifying its official exchange rate with so-called swap-market rates, the PBC devalued the official rate too much — from 5.6 to 8.7 yuan/dollar (Figure 3) — where 8.7 was the previous swap market rate . This large, if somewhat accidental, depreciation then aggravated the burst of inflation over 1993–1996. Figures 2 and 3 show that CPI inflation reached more than 20% in 1995 — a penalty for depreciating the exchange rate too much in the new regime of greater economic openness. However, from 1995 to July 21, 2005, the Chinese authorities held the now-unified exchange rate constant at 8.28 yuan/dollar (plus or minus 0.3%). For these 10 years, they subordinated domestic monetary and fiscal policies to maintaining the fixed exchange rate — including not devaluing in the Asian crisis of 1997–1998 when they came under great pressure to do so. They also further dismantled tariffs and quotas on imports in line with their WTO obligations. Consequently, Figure 2 shows the end of the roller coaster ride in China’s CPI after 1996, and Figure 3 shows the convergence to the American rate of price inflation. China’s CPI increased just 1.8% from July 2004 to July 2005. (In 2004, a substantial blip in primary commodity prices including oil was not fully passed through to the retail level.) But, in the new millennium, using an international monetary anchor has greatly helped China stabilize its domestic price level compared to its earlier “roller coaster ride
hina's New Exchange Rate Policy 471 Yuan/USD Policy Change Juy21.2005 Exchange Rate(RHS) 8:08+8 CPI Inflation Differential: Chi 0 Figure 3. China-US Inflation Differential and Exchange Rate. 1993-2005 Source: me Behind the scenes in this remarkable convergence of Chinese to American rates of inflation is the high rate of growth in money wages in China. In Chinas"catch up phase, where the level of output per person is much less than in mature industrial economies, growth in productivity per worker is naturally very high. However, as long as money wages grow rery fast to reflect this productivity growth, currently 10% to 12% per year, then international competitiveness remains balanced. And this is what happened in China in the past 10 years and in Japan in its fixed exchange rate period from 1950 to 1970. As long as the nominal exchange rate remains securely fixed, then wage growth in the peripheral country naturally tends to track productivity growth in the most open tradable sector, i.e., manufacturing for China now and for Japan back in its 1950s and 1960s. 8 This high growth in money wages, reflecting high productivity growth, then secures the convergence of the rate of inflation in the peripheral country to that in the center country (Figure 3)and secures the sustainability of the fixed exchange rate. But if the exchange rate appreciates and future appreciation seems more likely, then employers in the tradables sector will bid more cautiously for workers so money wage growth slows below the rate of productivity growth. This slowdown in wage growth then becomes integral to the general deflationary pressure arising from anticipated exchange appreciation-as in Japan from the mid-1980s into the 1990s 8See my previous article for The Weekly Economist in September 2004 The Weekly Economist(2004)
March 20, 2006 11:33 WSPC/172-SER 00215 China’s New Exchange Rate Policy 471 8.2765 8.108 -10 -5 0 5 10 15 20 25 30 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Percentage 4 5 6 7 8 9 10 Yuan/dollar CPI Inflation Differential: China - US (LHS) Yuan/USD Exchange Rate (RHS) Policy Change July 21, 2005 Figure 3. China-US Inflation Differential and Exchange Rate, 1993–2005 Source: MF. Behind the scenes in this remarkable convergence of Chinese to American rates of price inflation is the high rate of growth in money wages in China. In China’s “catch up” phase, where the level of output per person is much less than in mature industrial economies, growth in productivity per worker is naturally very high. However, as long as money wages grow very fast to reflect this productivity growth, currently 10% to 12% per year, then international competitiveness remains balanced. And this is what happened in China in the past 10 years, and in Japan in its fixed exchange rate period from 1950 to 1970. As long as the nominal exchange rate remains securely fixed, then wage growth in the peripheral country naturally tends to track productivity growth in the most open tradable sector, i.e., manufacturing for China now and for Japan back in its 1950s and 1960s.8 This high growth in money wages, reflecting high productivity growth, then secures the convergence of the rate of inflation in the peripheral country to that in the center country (Figure 3) and secures the sustainability of the fixed exchange rate. But if the exchange rate appreciates and future appreciation seems more likely, then employers in the tradables sector will bid more cautiously for workers so money wage growth slows below the rate of productivity growth. This slowdown in wage growth then becomes integral to the general deflationary pressure arising from anticipated exchange appreciation — as in Japan from the mid-1980s into the 1990s.9 8See my previous article for The Weekly Economist in September 2004. 9The Weekly Economist (2004)
472 The Singapore Economic Review 6. A Liquidity Trap for China? Partly arising out of codicils to the accord that secured Chinas entry into the wto, financial liberalization remains an important objective of China's government. Liberalizationhas both an internal and external dimension. The government wants to move toward the decontrol of domestic interest rates, particularly on bank deposits and loans. Then, with freer interest rates, a more robust domestic bond market at different terms to maturity can be established Eventually, the liberalization of capital controls in the balance of payments will permit more active forward market for hedging foreign exchange risk to develop These are important and laudable objectives for improving the efficiency of Chin apital markets in the long run. Now, however, with China's economy threatened by ongoing appreciation of the renminbi, liberalizing the financial system could have perverse short-run consequences. In the face of undiminished foreign exchange risk, i.e., the probability that the renminbi could appreciate, a near zero interest rate liquidity trap is possible-even likely. Figure 4 shows China's interbank interest rate in mid-2005 falling toward 1% even as the US federal funds rate(coming off all time lows)rose to 3. 5%. In early 2006, the US rate rose to 4.5% while Chinas remained at 1.4%. Although the PBC still pegs bank deposit and some loan rates, Chinas interbank interest rate is fairly freely determined(Figure 4 also shows Japan's short-term interest rate being stuck close zero since 1996: the dreaded The basic problem is one of achieving portfolio balance between the holding of dollar and renminbi interest-bearing assets. In a liberalized capital market, investors must be com pensated by a higher interest rate on dollar assets because of the risk that the renminbi might appreciate. But interest rates on dollar assets are given in world markets independently of what China does. Thus, the only way in which the market can establish the necessary inter est differential is for interest rates on renminbi assets to fall below their dollar equivalents 12 10 Japan(call money rate) US(federal funds rate) -China(interbank rate) Jan-92 96 Jan-98 Jan-00 Jan-0 Figure 4. Short-Term Interest Rates: China, Japan and the United States Source: IMF. Gunter Schnabl
March 20, 2006 11:33 WSPC/172-SER 00215 472 The Singapore Economic Review 6. A Liquidity Trap for China? Partly arising out of codicils to the accord that secured China’s entry into the WTO, financial liberalization remains an important objective of China’s government. “Liberalization” has both an internal and external dimension. The government wants to move toward the decontrol of domestic interest rates, particularly on bank deposits and loans. Then, with freer interest rates, a more robust domestic bond market at different terms to maturity can be established. Eventually, the liberalization of capital controls in the balance of payments will permit a more active forward market for hedging foreign exchange risk to develop. These are important and laudable objectives for improving the efficiency of China’s capital markets in the long run. Now, however, with China’s economy threatened by ongoing appreciation of the renminbi, liberalizing the financial system could have perverse short-run consequences. In the face of undiminished foreign exchange risk, i.e., the probability that the renminbi could appreciate, a near zero interest rate liquidity trap is possible — even likely. Figure 4 shows China’s interbank interest rate in mid-2005 falling toward 1% even as the US federal funds rate (coming off all time lows) rose to 3.5%. In early 2006, the US rate rose to 4.5% while China’s remained at 1.4%. Although the PBC still pegs bank deposit and some loan rates, China’s interbank interest rate is fairly freely determined. (Figure 4 also shows Japan’s short-term interest rate being stuck close zero since 1996: the dreaded liquidity trap.) The basic problem is one of achieving portfolio balance between the holding of dollar and renminbi interest-bearing assets. In a liberalized capital market, investors must be compensated by a higher interest rate on dollar assets because of the risk that the renminbi might appreciate. But interest rates on dollar assets are given in world markets independently of what China does. Thus, the only way in which the market can establish the necessary interest differential is for interest rates on renminbi assets to fall below their dollar equivalents. 0 1 2 3 4 5 6 7 8 9 10 11 12 13 Jan-90 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 percent per annum China (bank rate) Japan (call money rate) US (federal funds rate) China (interbank rate) Figure 4. Short-Term Interest Rates: China, Japan and the United States Source: IMF, Gunter Schnabl
