China-US Currency Issues

1. China-USCurrency Issues Jeffrey Frankel Harpel Professor of Capital Formation & Growth CLD Program, Ash Center, June 8, 2012

2. An election year issue • The most recent US Treasury report, May 25, 2012, again did not find China guilty of manipulation. • But Mitt Romney, the Republican presidential candidate, disagrees with the Obama Administration’s China policy. • He says that on his first day in office he would “designate China a currency manipulator and impose countervailing duties.”

3. Historical timeline “I have listened to both sides of this debate. Here is what I think. I think those who call for a fixed exchange rate are right in the short run. And those who call for a floating exchange rate are right in the long run.How long is the short run, you ask? You must understand. China is 8000 years old. So when I say, short run, it could be 100 years.”-- Li Ruogu, Deputy Governor, People’s Bank of China, Dalian, May 2004

4. Historical timeline of currency diplomacy • 1973: End of Bretton Woods era. • Major currencies switch from fixed to floating. The rest keep their pegs. • 1977: IMF members agree that each shall “avoid manipulating exchange rates … to prevent effective balance of payments adjustment or to gain an unfair competitiveadvantage over other members.” [Principle (A) of the “1977 Decision on Surveillance over Exchange Rate Policies,” and Sect.1, Clause 3, of Article IV amended in 1978.] • In practice, the IMF almost never pressures countries to revalue their currencies upward; • It just pressures deficit countries to devalue.

5. Historical timeline of currency diplomacy 1983-84: ¥/$ Agreement. 1985: Plaza Accord. Japan, US & others cooperate to bring down overvalued $, esp. vs. ¥ . 1987-89: Louvre Agreement: $ depreciation halted. Bubbles in Japan’s equity & real estate markets, followed by crash, & severe stagnation in 1990s. 5

6. Timeline, continued • 1988:The Omnibus Trade & Competitiveness Actmandates the US Treasury report to Congress biannually on whether trading partners are manipulating currencies. • It requires the Treasury to “consider whether countries manipulate the rate of exchange between their currency and the U.S. dollar for purposes of preventing effective balance of payments adjustments or gaining unfair competitive advantage in international trade.'' • The US must hold talks with governments deemed to be breaking rules. • In the first Reports to Congress on International Economics & Exchange Rate Policy, Korea & Taiwan PoC were found to be guilty of manipulation, • while Singapore & Hong Kong SAR “got off with a warning.” • China was named in early 1990s.

7. Timeline, continued: Exchange rate • Jan. 1994: China devalues its official rate, • unifying its dual exchange rate system. • 1997-98: East Asia crisis. • China wins plaudits for keeping RMB fixed • while its neighbors are devaluing. • 1995-2005: China continues to peg • for 10 years • at 8.28 RMB/$.

8. Timeline, continued: US pressure • Oct. 2003: Treasury Secretary Snow begins to “browbeat” China to allow appreciation. • Treasury Report: RMB merits concern & talks • Speculators in financial markets start to bet on appreciation. • as reflected in either capital flows (residual; see Prasad & Wei) • or non-deliverable forwards (see appendix graph). • Feb.2005: Senators Schumer & Graham propose first of bills to impose (WTO-illegal) tariffs of 27½% against all Chinese goods if China does not substantially revalue its currency. • Subsequent versions, by Baucus-Grassley and others substitute the phrase “currency misalignment” in place of “unfair manipulation” to ease standard of proof.

9. 2005-06:Despite large balance of payments surpluses, PBoC sterilization of reserve inflows prevents excess money growth & inflation. 2007-08:Sterilization finally falters:Money becomes excessive. Inflation becomes a serious concern. Shanghai stock market experiences a bubble. Mid-2008 – early 2009:Worst of the global recession hits. China loses 26% of exports. Growth slows; danger of overheating disappears. Mid-2009 – 2011:China resumes very rapid growth in response to domestic demand stimulus + renewed exports. China is now a major engine of growth in world economy. Danger of overheating returns: esp. real estate bubble. Timeline,continued:China’smacroeconomy 9

10. Timeline,continued: Exchange rate • July 2005: China announces a new policy, • Immediate 2.1% revaluation, • followed by “managed float”: controlled appreciation, supposedly against an unspecified basket of currencies. • But, as often, de jure exchange rate regime ≠ de facto. • Statistical estimation of true regime reveals: • $ link began to loosen in 2006. • By 2007, implicit basket had shifted some weight onto other currencies, especially the €. • RMB appreciates against the $ from 2006 to 2008, • but only because € does.

11. The magnitude of daily movements vs. $ increased in the spring of 2006

12. Timeline,continued:Exchange rate • May 2008: Chinese leaders hear exporter complaints of competitiveness difficulties. • Mid-2008-April 2010: yuan repegs ≈ $ 6.84 RMB/$ • ≈ 20% stronger, vs. $, than 2005.

13. The RMB rose against the $ during 2006-08, but returned to peg in mid-2008. 13

14. Timeline,continued • Oct. 2006 -- IMF Article IV consultation finds RMB “undervalued.” • 2007: US Treasury temporarily passes hot potato of exchange rate complaints to IMF, • which gets mandate for exchange rate “surveillance.” • 2008: Though financial crisis originates in US, “flight to quality” temporarily raises demand for $.

15. 2009: Chinese warnings • Premier Wen worries US T bills may lose value.Urges the US to keep its deficitat an “appropriate size” to ensure • the “basic stability” of the $ (again on 11/10/09). • PBoC Gov. Zhou, proposes replacing $ as international currency, with the SDR (March 09). • Pres. Obama & Secy. Geithner seek to reassure. SDR

16. Timeline,continued:Winter 2010 • International pressure on Beijing to appreciate; • Congressional pressure on US Treasury to find China guilty of currency manipulation in its biannual report due April 15. • But China says it will never bow to pressure.

17. April 2010: Collision is averted • April 3: Treasury announces manipulation report postponed, • Later, China announces switch to some currency flexibility: • Starting in June 2010, appreciation vs. $ resumes. • So both sides save face.

18. September 2010 – • Brazil Minister Mantega warns of ”currency wars”: • Each country intervenes to push its currency down • in effort to gain trade advantage. • November 2010, G20 Summit in Seoul – • China criticizes US Fed’s monetary easing (“QE2”) as an example of currency wars.

19. 2011: Less priority on RMB issuevs., e.g., North Korea • January: Obama-Hu Summit • Geithner notes that – including China’s higher inflation – RMB is appreciating at 10% per year in real terms. • Treasury continues not to name China as a manipulator.

20. Is the RMB undervalued?Balassa-Samuelson relationship • Prices of goods & services in China are low • compared at the nominal exchange rate. • Of course they are a fraction of those in the U.S.: < ¼ . • This is to be expected: explained by the Balassa-Samuelson effect, • which says that low-income countries have lower price levels. • As countries’ real income grows, their currencies experience real appreciation: approx. .3% for every 1 % in income per capita. • But China has been one of those countries that is cheap or undervalued even taking into account Balassa-Samuelson.

21. The Balassa-Samuelson Relationship 2005 Source: Arvind Subramanian, April 2010, “New PPP-Based Estimates of Renminbi Undervaluationand Policy Implications,” PB10-08, Peterson Institute for International Economics Undervaluation of RMB in the regression estimated above = 26%. Estimated undervaluation averaging across four such estimates = 31%. Compare to estimate for 2000 (Frankel 2005) = 36%. As recently as 2009 (Chang 2012):25% .

22. China Adjusts, 2009-12 • Various key measures suggest that China has achieved a substantial share of the needed trade adjustment since 2009: • Its trade surplus peaked at $300 billion in 2008, and has been declining since then. • Substantial real appreciation of the RMB has brought it closer to equilibrium. • Some nominal appreciation + • Some inflation and, especially, wage increases

23. China’s trade balance It even showed a monthly trade deficit in February2012 • $31 billion, China’s largest deficit since 1998. • The deficit was very temporary, however, • and probably due to seasonal factors.

24. Adjustment of relative prices • The famous “China price”: • Ever since China rejoined the world economy 3 decades ago, its trading partners have been snapping up exports of manufacturing goods, • because low Chinese wages made them super-competitive on world markets. • But in recent years, relative prices have adjusted • following the laws of market economics.

25. Adjustment of relative prices, continued • The change in relative prices is reflected as real exchange rate appreciation. • This comprises, in part, nominal appreciation • and, in part, Chinese inflation. • Government officials would have been better advised to let more of the real appreciation take the form of nominal appreciation ($ per RMB). • But since they didn’t, it showed up as inflation instead. • See charts below: • appreciation,against the $ and other currencies.

26. Appreciation versus the US $, 2005-12

27. Appreciation vs. index of currencies, 2005-12

28. The natural adjustment process was delayed. • 1st, because the authorities intervened to keep the exchange virtually fixed against the dollar, in the years 1995-2005 and 2008-2010. • 2nd, workers in China’s increasingly productive coastal factories were not paid their full value. • The economy has not completed its transition from Mao to market, after all. • As a result of these two delaying mechanisms, Chinese continued to undersell the world.

29. But then two things happened. • 1st, the yuan was finally allowed to appreciate against the $ during 2005-08 & 2010-11, by 25% cumulatively • =17% + 8%. • 2nd, and more importantly, labor shortages began to appear => China’s workers at last began to win rapid wage hikes. • Major cities raised their minimum wages sharply over each of the last 3 years: • 22% on average in 2010 & 2011; • somewhat less in 2012, in response to slowing demand: • 8.6 % in Beijing, 13% in Shenzhen & Shanghai. • Meanwhile another cost of business, land prices, rose even more rapidly.

30. Overheating also shows up in rapid rise of land prices Real Beijing land prices 30

31. Renminbi versus various currenciesJune 2010 to May 2012 (daily observations; 18/6/2010 values = 100) Nominal appreciation continued into 2012 ”Re-pegging the renminbi to a basket: issues and implications” Asian-Pacific Economic Literature (APEL), May 2012,.Heikki Oksanen, U. of Helsinki 31 Sources: Chinese State Administration of Foreign Exchange; RMB/eff(ective) is the value of the RMB against its trade-weighted basket, calculated by JP Morgan, extracted from Bloomberg. Legend: line down (up) indicates depreciation (appreciation) of the currency or a basket against the RMB.

32. Real appreciation • The RMB’s real appreciation against the $from 2009 to 2012 has amounted to 12%, • reducing the degree of undervaluation by roughly half, • depending on whether one measures it against the $ or against all currencies. • More is expected, as China’s relative wages continue to rise. • In any case, China’s real exchange rate is already closer to this measure of equilibrium than are most countries’ exchange rates (Cheung, Chinn & Fuji, 2010).

33. 5 types of adjustment are gradually taking place in response to the new high level of costs in the factories of China’s coastal provinces: • 1st, some manufacturing is migrating inland, • where wages & land prices are still relatively low. • 2nd, export operations are shifting to Vietnam or Bangla Desh • where wages are lower still. • 3rd, Chinese companies are beginning to automate, • substituting capital for labor. • 4th, they are moving into more sophisticated products, • following the path blazed earlier by Japan, Korea, & other Asian tigers • in the “flying geese” formation. • 5th, multinational companies that had in the past moved some stages of their production process to China, out of the US, or out of other high-wage countries, arenow moving back.

34. All five of these ways of reallocating resources represent the economic process operating as it should. • None of this comes as news to most observers of China.

35. But many Western politicians are unable to let go of the syllogism that seemed so unassailable just a decade ago: • (1) The Chinese have joined the world economy; • (2) their wages are $0.50 an hour; • (3) there are a billion of them, and so • (4) their exports will rise without limit: “Chinese wages will never be bid up in line with the usual textbook laws of economics because the supply labor is infinitely elastic.” • But it turns out that the laws of economics do eventually apply after all -- even in China.

36. Expansion of the services sector.This 6th dimension of adjustment still lags behind, • despite the consensus in favor of it. • China has had great success in manufacturing • especially via exports. • Now it needs to help the other side of the economy catch up: services, via domestic demand • Housing, retail, education, environmental quality, • health care, pensions, social safety net. • Some of this could be done via government spending • especially with the economy in slowdown in 2012, • as China did in 2009; but that was mostly heavy investment.

37. References by the speaker • “Historical precedents for the internationalization of the RMB;”  Written for a workshop in Beijing of the CFR & the China Development Research Foundation, Nov. 2011.   Summary at RIETI & Vox, Oct. 2011.  • "The Renminbi Since 2005,"  in The US-Sino Currency Dispute: New Insights from Economics, Politics and Law, edited by S.Evenett (CEPR: London) 2010. • “New Estimation of China’s Exchange Rate Regime,”  in Pacific Economic Review 14, no.3, August 2009. NBER WP no. 14700.   • “Comment on ‘China’s Current Account and Exchange Rate,’ by Yin-Wong Cheung, Menzie Chinn & Eiji Fuji,” in China’s Growing Role in World Trade,   NBER, edited by Feenstra & Wei (University of Chicago Press, 2010). • “Comments on Cline and Williamson’s ‘Estimates of the Equilibrium Exchange Rate of the Renminbi?’,”in Debating China's Exchange Rate Policy, M.Goldstein & N.Lardy, eds. (Peterson Institute for International Economics), 2008.   • "Assessing China's Exchange Rate Regime," with Shang-Jin Wei,  Economic Policy 51, July 2007.  Video interview.  Vox summary.   NBERWP 13100.     • "On the Yuan: The Choice Between Adjustment Under a Fixed Exchange Rate and Adjustment under a Flexible Rate,"  in Understanding the Chinese Economy, edited by G. Illing (Oxford U. Press), 2006. NBERWP 11274. • “On the Renminbi,”CESifoForum, 6, no.3, Autumn 2005 (Ifo Institute for Economic Research, Munich). http://ksghome.harvard.edu/~jfrankel/