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A modest proposal
The "Hayekian" argument for international currency adjustments, as made by Alex and Brad DeLong, implies that the United States needs to shift labor into its export sector, and sooner rather than later...
Brad does offer some policy recommendations, but he leaves one out. If one sees the need for a big sectoral shift at home, yuan revaluation is hardly the most direct policy instrument. China is neither our leading trade partner nor the leading foreign investor in the United States. It would have to be the case that the dollar is significantly overvalued and that market prices, not just the pegged Asian exchange rates, are all wrong. There would be a more direct solution: boost taxes on foreign investment in the United States. The demand for dollar-denominated assets would fall, the value of the U.S. dollar would fall, and the demand for U.S. exports would rise. (If we are counting only American gdp, note that this tax brings revenue to the American government, unlike yuan revaluation, which raises borrowing costs and puts a burden on Wal-Mart and on the American consumer.) Voila!
This would put both Alex and Brad in the odd position of believing that we have not enough foreign labor, but too much foreign capital.
I find it hard to accept that conclusion. And if we had the requisite betting markets, I find it hard to believe that they would (should?) reflect U.S. economic performance as improving, contingent on such a tax hike.
Posted by Tyler Cowen on September 8, 2006 at 08:23 AM in Economics | Permalink
Comments
As I told you two or three years ago, the large accumulation of "international reserves" by the People Bank of China must be regarded as an attempt to diversify the portfolio of the state-owned banking system. Given (1) the large inflow of domestic deposits into state banks (I don't have data at hand but likely around 25% of GDP for more than ten years!!!), (2) the huge portfolio of risky domestic loans accumulated by these banks and (3) the lack of other domestic financial assets, PBC has been wise to invest part of that inflow abroad and they should continue doing it until they are able to deal with (2) and as long as (1) holds. Of course, exchange rate policy has an impact on trade flows but we know that everywhere exchange rates are determined by capital flows and exchange rate policy is largely conditioned on capital flows. In China, capital flows are controlled by government, but because of the need to diversify the banking system's portfolio this control allows PBC to invest abroad a much larger amount than the FDI flow. If China's investment in US bonds were taxed, PBC would invest in EU bonds and the tax would have minor effects on exchange rates.
Posted by: Edgardo at Sep 8, 2006 10:29:09 AM
Perhaps being in the Navy gives me a bias, but I've often thought that an important element was missing from the dollar valuation/current account debate. Countries and companies that engage in international trade pay us to secure the major trade routes so that they can safely and profitably engage in commerce. They pay us informally through cheap(er) goods and by buying our bonds rather than directly with cash (tribute). If you don't believe this, consider the issue of piracy. Piracy is very common in the littoral areas of some regions in the world, but very rare on the high seas where much of world commerce flows. Pirates don't avoid the high seas because they fear deep water, but because they fear the U.S. Navy. If exporting countries and companies had to provide their own security by enlarging national navies or creating private ones (or paying off the pirates), the cost of imported goods would increase greatly. This would drive down international trade and increase the incentive to produce domestically. The resultant decrease in overall commerce would likely impoverish many throughout the world.
Politically, it's very hard for either the U.S. or our foreign friends to admit that this system exists. We don't want to be an empire and they don't want to admit to paying tribute, but there you have it. So rather than call the matter what it is, we let market forces (cost of goods and exchange rates) determine the price of the security we provide. One must admit that in many ways this represents an advance both in subtlety and overall pleasantness upon previous imperial systems.
I think that foreign countries likely also pay a premium for using the dollar as the preferred international currency, just as I have to pay a premium if I want the convenience of using traveler’s checks. Even Hezbollah used dollars to pay off its supporters in Lebanon, who would have been much less happy if paid in Lebanese Pounds or in Rials.
The Euro and the Yuan are touted to have the potential to overtake the dollar, but are unlikely to do so until either Europe or China is willing and able to provide the security function for trade that we do. If the relationship between the security premium and the convenience premium paid on the dollar seems unclear, consider what would likely happen if the Euro or Yuan were to overtake the dollar as the preferred currency. The value of the dollar would drop, and the U.S. standard of living would decline. American taxpayers would be less willing to subsidize foreign trade by spending on a large defense budget. Other countries would have to provide for their own trade security, or Europe or China would have to step in. This would cause a large disruption in commerce as the new security measure were built and instituted. In the meantime, everyone loses money.
Given a 50 trillion dollar world economy more or less, and estimating the rest of the world accounts for 3/4 of it, our $800 billion dollar current account deficit represents about a 2% tax on the rest of the world's GDP in exchange for security for trade and the convenience of using our currency. That’s not bad. $800 billion dollars annually also represents a very handsome return on a $440 billion dollar defense budget, or whatever portion of that is used to protect trade. The rest of the world doesn't want to shoulder this (security) burden themselves and paying off the pirates would be more expensive. I think that the current system is likely to be more durable than some expect.
Posted by: Bill at Sep 8, 2006 10:53:06 AM
Tyler -- whoah -- "China is neither our leading trade partner nor the leading foreign investor in the US" --
really? The US may trade more with Canada/ and Mexico, but that is largely because they both import a lot more goods than China does. I'll dig up the data, but i think US imports from China are pretty close to uS imports from Canada and Mexico, tho they may be slightly lower. moreover, they are certainly growing faster.
and as for China not being the biggest foreign investor in the US, on a stock basis that is true. But what data supports the argument that they are not the biggest current lender on a flow basis. the UK may buy more US debt, but most credible folks (including Martin Feldstein) think that reflects custodial bias. From June 04 to June 05, China bought around $180b of US debt (change in the stock of Chinese holdings in the Treasury survey). The data from June 05 to June 06 isn't out, but a 70% dollar share would imply another $150b.
The oil exporters collectively may buy more, but they aren't a unified actor. And as for the dollar's overvaluation, i would note that all emerging markets, not just those in Asia, are now intervening heavily to prevent their currencies from appreciating. THe gulf countries peg to the dollar. Brazil is adding $4-5B a month to its reserves, russia more like $15b ...
As for the first comment, Chinese reserve growth is no way substitutes for domestic bank lending. China will end up with more domestic loans and more reserves. the mechanism works as follows -- when China intervenes, it buys $ for RMB. those RMB go into the banking system and are used to finance an expansion of domestic lending unless a) the PBoC with draws the RMB by issuing sterilization bills or b) the PBoC keeps the banks from lending with administration controls. John Makin of the AEI is good on this.
Tis hard to understand, I know, but an international reserve asset is useful if there is massive domestic capital flight. But it isn't a useful asset for backing a banking system that has mostly RMB deposits and RMB loans. China's banks need performing RMB assets not dollars. THat is why domestic bank recapitalization has been primarily done by issuing domestic RMB bonds -- typically bonds from the Asset Management Companies. Guonang Ma (not sure of the spelling) of the BIS is a great source on this.
brad
Posted by: brad setser at Sep 8, 2006 12:02:58 PM
This would put both Alex and Brad in the odd position of believing that we have not enough foreign labor, but too much foreign capital.
I don’t see what’s so odd about that. Labor and capital are very different. When capital immigrates, all its returns get sent home. When labor immigrates, most (much, anyhow) of its returns remain in its country where it works. Labor can be happy continuing to live indefinitely in the country where it works. Capital, on the other hand, can be expected to tire eventually of a Ponzi scheme in which it keeps purchasing new pieces of paper.
We do have too much foreign capital, relative to the amount of US capital going abroad. Among people who are concerned about the trade deficit, that point shouldn’t be controversial. Foreign capital is dangerous specifically because the returns get sent abroad and will eventually be used to claim assets in the US.
My only major objection to the modest proposal is the precedent it sets for the future. We don’t want to create the impression that the US is an inhospitable place to invest. Given the likely change in the expectations of foreign investors, a tax could prove to be a permanent solution to a temporary problem. And I think that’s precisely why it’s not an idea that can be presented seriously.
(Another objection is that it would exacerbate the imbalance between dollar-peg countries and non-dollar-peg countries. Europe, for example, would get clobbered relative to China and Saudi Arabia, and those counties would have to absorb even more reserve assets, which would tend to increase the instability.)
Posted by: knzn at Sep 8, 2006 12:30:25 PM
both the foriegn account deficit and the inequality debate are amazing -- first, a graduate level seminar in economics, with multiple professors; second, assuming everyone is operating in good faith (which i assume), even the best economists can't convince one another, let alone the world, that the data should be read one way or another. this, to me, means that there's no irrefutable basis to argue there's an impending crisis (because no one has a definitive model of what's happening and why) or that drastic action is warranted (which reminds me of the global warming debate, etc.). people who stridently assert that the problem is obvious -- along with its solution/results? -- are plainly wrong.
Posted by: dj superflat at Sep 8, 2006 12:58:38 PM
Or try a modest counterproposal: End US and EU agricultural subsidies. With access to the world market, peasant farmers in developing nations might just get high enough prices to discourage them from becoming low-wage factory laborers.
Posted by: Cyrus at Sep 8, 2006 1:27:54 PM
I agree with dj superflat! I learned a lot from reading the 19th century
writer Bastiat. I think he clears the air and makes a good case for not
worrying about trade deficits or currency exchange rates.
Posted by: RogerM at Sep 8, 2006 2:56:58 PM
Tyler's proposal is much less realistic than he would have us believe: the tax on foreign investment causes foreign capital inflows to fall and raises domestic interest rates. This impact on consumption and investment will hit domestic production much harder than the rise in exports from the weaker dollar.
Posted by: Andrew S at Sep 8, 2006 3:20:55 PM
To Brad Setser: Sorry but you're wrong about how the accumulation of "international reserves" is financed. PBC takes funds from state-owned banks through reserve requirements on all deposits and uses these funds to purchase US bonds. It's as simple as that. The consolidated balance sheet of state-owned banks + PBC shows "international reserves" and domestic loans in the asset side and deposits and currency in the liability side. Contrary to other experiences where the accumulation of "international reserves" is (or used to be) financed with the inflationary tax or direct domestic borrowing by the central bank, in China the financing comes directly from state banks and does not create any inflationary pressure because of the high flow of domestic deposits. This policy started around 1995 and although today I do not follow closely what is going on in China it is my understanding that it has not changed (fyi: as an economist with the World Bank Mission in Beijing I was an adviser to PBC for financial reform between 1994 and 1996 and I used to prepare flow-of-funds accounts so the Chinese could understand how they were financing the spending of government and state enterprises as well as the accumulation of reserves).
Posted by: Edgardo at Sep 8, 2006 3:55:00 PM
Anything slowing down the inflow of foreign capital
will push up long term interest rates in the US.
Maybe that should happen, but given the fragility
of the housing sector alone, it will almost certainly
trigger a recession. Of course that will help with
the adjustment as then we'll buy fewer imports from
China and everywhere else. If we tank hard enough,
we might even take the whole world economy with us!
Posted by: Barkley Rosser at Sep 8, 2006 4:08:38 PM
Edgardo --
China's reserve accumulation far exceeds the funds that flow to the PBoC from mandatory reserve requirements on the (growing) deposit base of the banking system. the PRC has raised reserve requirements as well to help with sterilization, but that isn't enough -- the PBoC still has to sell massive amounts of sterilization bills. and as Jon Anderson (UBS) and Stephen Green (standard Charted) note, the banks all have excess liquidity (i.e. more reserves than required) so the higher reserve requirements aren't really biting. what is biting is administration caps on new loans.
So yes, the consolidated state bank + PBoC balance sheet will show liabilities in RMB (from the PBoC to the banks, both sterilization bills and reserves) against the the PBoC's fx reserves. The PBoC has an intrinsic currency mismatch right now.
But I don't think that implies that the banks are holding fx assets as a hedge against their domestic bad loan portfolio. Nor should they -- i can think of a set of correlated shocks that would hurt both their RMB portfolio and any unhedged fx position (a large revaluation for one). They are actually holding RMB assets, not fx assets, with the PBoC issuing the RMB assets and taking on the currency risk with its fx portfolio.
and given the scale of inflows into the PBoC, i think it is relatively clear that the causality works more the other way -- the surge in fx at the PBoC leads to a surge in RMB issuance, and that RMB issuance has been a key reason for the overall strong growth in domestic liquidity -- i.e. it is one reason why m2 growth has been quite high, now close to 20%. The PBoC constantly complains about the difficulties sterilizing inflows on this scale -- see Yu Yongding's various speeches.
Tyler -- I responded to some of your points -- perhaps not the actual points themselves so much as the the thrust - on my blog.
I also agree with Andrew S's point in the inflow tax ... it would force adjustment, but most of the adjustment would come via a slowdown in domestic activity. true, a slowdown in domestic demand growth/ import growth has to be part of the adjustment picture. but i would like to see the US sustain its current pace of export growth as well ... and that likely implies further $ depreciation, particularly if global growth slows -- as is likely -- with less impetus from US demand growth.
Posted by: brad setser at Sep 8, 2006 4:23:59 PM
It is correct that taxing inflows would raise domestic interest rates, but so would slowing down Chinese accumulation of Treasury securities...Here is a good rule of thumb. If you believe any proposition about international trade, formulate its converse as applied to international investment. Ask if you still believe it.
Posted by: Tyler Cowen at Sep 8, 2006 4:34:38 PM
To Brad Setser: You apply the standard approach to Western banking systems to a system that is totally controlled by government (through PBC). In China, effective reserve requirements are determined ex-post by whatever amount of funds PBC is able to mobilize from state banks (the reforms of 1993-94 succeeded in improving substantially PBC's ability to mobilize these funds); it doesn't matter how you call the specific regulation or mechanism used by PBC to do it. You should look at state banks + PBC as just one bank to realize that if you are forced both to lend huge amounts to state enterprises and to pay back depositors 100% of their claims in case of distress (this policy has been applied many times when bank branches run into liquidity and solvency problems), you should invest part of your funds into low risk assets and US bonds are such assets (exchange rate risk is a minor problem compared with the high risks of all other domestic assets).
Unfortunately the rethoric of Western monetary policy has been learnt by some Chinese officials and they repeat arguments about sterilization that make no sense when you have such a huge inflow of savings into state banks and you control these banks. From my early experience in Argentina and Chile (between 1965 and 1984) I learnt that what matters is how government spending is financed and how this spending is allocated to the accumulation of international reserves and all other uses. In my approach the relevant issue is how large a reserve of foreign assets the government wants to accumulate (indeed my definition of "international reserves" is often broader than the standard IMF definition) and how is going to finance the accumulation. You may remember the many studies on the demand for international reserves based on trade flows that turned out to be useless; they ignore that governments demand reserves to deal with a lot of risks many of which have nothing to do with trade flows. I hope this explanation may help you to understand better what is going on in China.
Posted by: Edgardo at Sep 8, 2006 5:13:54 PM
this is awesome. professor, meet the real world (to the extent international monetary bureaucrats represent the real world, which they don't for most purposes, but might here). the brilliant thing is that, objectively, i'm about as educated and smart a non-economist (meaning, it's not my field) you're likely to find (as are many if not most of the other commenters), yet i can't tell whether brad or edgardo is right, if that term's even applicable. nor would i necessarily trust any consensus on the issue (because there are all sorts of things that might affect whether (e.g.) a climate scientist or economist would model things in one way or another, accept certain premises, etc.). so that leaves me where?
Posted by: dj superflat at Sep 8, 2006 6:28:36 PM
Edgardo -- The state banks still finance SOEs, but I don't think that is all they do. They also have a fairly active business financing property developers (often with ties to the party, bien sur) and make consumer loans (auto loans, mortgages) and the like. to me, China's financial system increasingly looks like that of many of the Asian tigers before their crises. Directed lending to the SOEs is still a problem, but I increasingly worry about connected lending ...
Two key difference tho. Chinese banks don't have lots of exchange rate risk. They take in RMB deposits and make RMB loans. And China has growing reserves and a current account surplus, so there isn't much risk of a devaluation. I agree that demand for international reserves has little to do with trade flows, in the classic sense. months of imports is worthless. But China doesn't build up its reserves now because it needs protection v. international capital movements either. It has far more than it needs for that purpose. Rather it is building up reserves to support its export sector ...
Call it directed lending -- but of a different kind.
I disagree strongly though with the argument that
"you should invest part of your funds into low risk assets and US bonds are such assets"
US bonds are not such an asset for banks in emerging economies that have RMB (local currency generally) deposits. $ bonds and RMB liabilities = an intrinsic mismatch, and a big one.
A 40% reval would wipe out any bank with that kind of mismatch. I suspect the PBOC's capital losses on China's dollar reserves will likely be quite significant -- maybe not quite as large as the losses the state banks incurredlending to SOEs in the 90s, but large. and I wouldn't want that risk in the banking system.
Fortunately, the banks don't have that kind of mismatch -- their assets constitute a mix of RMB sterilization bills, RMB loans to SOEs (some performing/ some not), AMC bonds (which largely have replaced dud SOE loans from the 90s) and a mix of new kinds of lending -- to property firms (often with local gov connections), to consumers and the like.
In some broad sense tho it is true that the banks are vehicle mobilize Chinese savings to buy US debt. Through a combination of required reserves and sterilization bill purchases, the banks hold lots of central bank liabilities -- and the growth in those liabilities (along with base money) offsets the increase in the foreign assets of the central bank (tho the fx risk lies with the government). Or, put a bit differently, I do think it is fair to argue that the part of China's reserve growth that corresponds with China's domestic savings surplus is ulimately financed out of domestic bank deposits.
But the causality isn't one way in my view -- the PBoC's reserves are growing by more than China's current account surplus. And the pace of deposit growth is in my view a function in part of base money growth from reserve growth ...
Posted by: brad setser at Sep 8, 2006 6:31:17 PM
Tyler --not to nitpick, but in the first instance, in your analysis, wouldn't a RMB revaluation lead to an increase in Chinese reserve accumulation (assuming it has no impact on capital flows, a big assumption). The US would pay more dollars for Chinese imports, increasing China's dollar exports (tho not the amount of RMB its firms get). But China's import bill wouldn't necessarily rise commensurately ... the $ price of oil, for example would be unchanged. Basically, the terms of trade shift in China's favor. the J curve and all. And more reserve accumulation = more Chinese financing ...
I wouldn't bet on the "capital flows unchanged part" though -- a small revaluation might lead to more capital inflows. A big one might prompt outflows/ much smaller inflows. That is what makes this complicated.
And if i am write, the J curve would really be a J curve -- the one off increase in China's export revenues (same volumes, higher prices) woudl lead over time to slower volume growth ...
Just noting that the equilibrium here strikes me as very complex.
Obviously,
Posted by: brad setser at Sep 8, 2006 6:38:07 PM
oops -- meant to hit preview not post -- drop the obviously at the end and "if I am write" is "if I am right"
Posted by: brad setser at Sep 8, 2006 6:39:26 PM
Brad, can you give a historical example of a 40% revaluation? The only examples I know are related to black market rates (for example, Chile after 9/11/73). Also, can you detail a scenario in which a 40% revaluation may occur in China? or even a 20% revaluation? I think you're wrong about the exchange rate risk PBC is taking and given the alternatives, US bonds are by far the best investment to self-insurance China's banking system.
Posted by: Edgardo at Sep 8, 2006 7:19:41 PM
Edgardo,
They have not been sudden, but the rise of the dollar in the early
80s exceeded 40% I believe, and we have seen similarly large swings
among the major currencies over the last couple of decades. However,
I would agree that we are not likely to see a huge and sudden
appreciation of the RMB/yuan. The Chinese will not let that happen,
even if there are some in the US who would like to see it happen.
Posted by: Barkley Rosser at Sep 8, 2006 8:50:31 PM
Bill(first post)says $800 billion(current account deficit) is a good return on $440 billion(defense budget), but neglects that it will someday have to be repaid.
Posted by: lee at Sep 8, 2006 9:34:56 PM
"The demand for dollar-denominated assets would fall, the value of the U.S. dollar would fall, and the demand for U.S. exports would rise."
If the Chinese have pegged their currency to the dollar...how exactly would the value of the dollar fall?
No matter what we do...the value of the dollar is exactly what China decides it is.
Posted by: monkyboy at Sep 9, 2006 5:15:03 AM
Edgardo -- through to peak, the euro went from say .85 in 01/early 02 to 1.35 at the end of 04, and was above 1.3 for a period -- it is now more like 1.25-1.28. But the cumulative move is still quite large. The real appreciation of the yen over time has also been quite significant. I did not mean to imply that there would be a one-off 40% move. There clearly will not be. Only that the cumulative move -- and unless China dumps its dollars/ treasuries, it will have the same asset/ liability structure -- will be quite large, creating large capital losses for China's central bank.
It should be noted that China's central bank is quite profitable now on a cash flow basis. The stock of base money is large (good for central bank profits) and PBoC sterilization bills now pay less than Treasuries. That is offset by the PBoC's growing currency mismatch, but the "capital loss" from the exchange rate move may be partially offset by central bank profits, and the central bank's balance sheet may be patched up by an extended period when the PBoC doesn't turn over profits to the rest of the government. Real problems would arise tho should the diministed stock of PBoC assets (post revaluation) fail to provide the interest needed to cover the PBoC's undiminished stock of interest paying liabilities (some PBoC liabilities -- cash -- do not pay interest, but a growing fraction do).
Posted by: brad setser at Sep 9, 2006 11:11:11 AM
dj:
No one pretends there is a consensus about the likely consequences of present trade/investment imbalances or the best policy course. Climate change is much less controversial. In that debate essentially all of the opposition is paid advocacy.
Is the planet warming? Consensus: yes. Is human activity a major driver? Consensus: yes. Should we act to reduce C02 emissions? Consensus: yes. How do we accomplish that? All hell breaks loose -- it's a political and economic question then.
Posted by: STS at Sep 9, 2006 2:24:45 PM
Bill: Thanks for the Navy perspective. I think the economics profession has actually touched very tangentially on your point in the "dark matter" debate. Not that "piracy suppression" per se entered the conversation, but that there are international benefits to dollar hegemony which aren't explicitly accounted for and "security" broadly defined would fall into that category.
Posted by: STS at Sep 9, 2006 2:28:07 PM
brad,
There is more to China than its central bank.
The high valuation of the dollar helps Chinese businesses compete against American companies for customers and investors.
Let's be honest, America and China are in direct economic competition...making America carry the "weight" of a high valuation of the dollar is an advantage China isn't going to give up without a reason.
Posted by: monkyboy at Sep 9, 2006 3:42:53 PM
