[p2p-research] Everyone wants to talk about currencies

[Ryan]

  Sent to you by Ryan via Google Reader: Everyone wants to talk about
currencies via China Financial Markets by Michael Pettis on 1/9/10

I will be in NY and Boston during the first week of February and plan
to meet a number of investors there to discuss China. I believe it
becomes official on February 1, but I recently joined the Hong Kong
subsidiary of one of China’s top broker/dealers, Shenyin Wanguo, as
their Chief Strategist, where my responsibility will be to provide
research and advice to large institutional clients of the company. I
will continue teaching at Peking University and doing research for the
Carnegie Endowment – this new responsibility simply takes off from my
existing work.

Unfortunately it will mean that my blog postings (in the future, and
clearly not this one) will become shorter and perhaps more reacting to
market events, but of course it also means that it will be much easier
for me to travel to meet clients and friends in Asia, Europe, North
America and elsewhere for more focused (and perhaps more open)
discussions of China and the international economy.

For now I suspect everyone will want to discuss currencies. One of the
more interesting pieces of news for me was yesterday’s Financial Times
story on President Sarkozy’s finding “unacceptable” the disordered
currency markets (“disorder” means a rising euro). According to the
article:

Nicolas Sarkozy on Thursday stepped up his attack on global exchange
rate imbalances saying “monetary disorder” had become “unacceptable”.
The French president said he would make exchange rate policy an
important theme of France’s presidency of the G8 and G20 forums of
advanced and developing economies in 2011.

“There cannot be financial, economic and social order until we put an
end to currency disorder,” he said at a conference in Paris. Mr Sarkozy
has long railed against Chinese “monetary dumping” and the dominance of
the dollar, but has sharpened his criticism in recent days reflecting
concern in Paris that a balanced economic recovery in the eurozone
could be choked off by an overvalued currency.

With a large trade deficit and with exports that are more
price-sensitive than Germany’s, France feels more susceptible to
exchange-rate movements than its neighbour across the Rhine. “We can’t
increase the competitiveness of our businesses in Europe and have the
dollar lose 50 per cent of its value against the euro,” Mr Sarkozy
said. “When we produce in the eurozone and sell in the dollar zone, are
we supposed to just give up selling?”

So we are sort of stuck, aren’t we? The dollar is overvalued, and it
must rebalance downwards in order to force up US savings rates relative
to US GDP, but since it cannot decline against Asian currencies, whose
central banks intervene heavily, it must decline against the floating
currencies like the euro.

But the euro is probably already overvalued against the dollar, so
European manufacturers will be forced to accept the brunt of the
adjustment. This will be painful for everyone in Europe, but I suspect
it will be most painful for Germany, a country that is more dependent
on manufacturing than the rest of the region and so who will suffer
more if there is a sharp drop in demand for European manufactured
goods. The fact that President Sarkozy is nonetheless making the most
noise about the euro indicates that this is going to become a very
popular political topic and has great demagogic appeal.

Later in the article Sarkozy was quoted as saying “You know how close I
feel to the US. But this is not possible. The world has become
multipolar. We must have a multi-monetary system.” As a half-French
half-American I have to say I suspect that it is not likely to be easy
to convince too many Americans of the truth of the first part of his
statement. I think however, that although the US and the world (except
perhaps export-dependent Asian countries) would be better off with a
multi-monetary system, Sarkozy may be confusing issues.

The dominance of the dollar in reserve accumulation has little to do
with a lack of an alternative currency and a lot to do with the
inability of any country but the US to absorb the trade deficits
created by export-dependent development strategies. Trade-surplus
countries buy dollars because when they buy euros, they cause angry
reactions from European businessmen and politicians who are
uncomfortable with the impact of a rising euro on domestic
manufacturing and employment. In fact, the rise of the euro against the
dollar is precisely what Sarkozy claims to oppose in the first part of
his statement and to support in the second part. If Asian central banks
rely less on the dollar and more on the euro for their reserve
accumulation, guess what will happen. Yes, the euro will rise against
the dollar.

Japan is worried too

It always surprises me how readily people believe that the status of
the dollar as a reserve currency has to do with same nefarious
conspiracy. As long as the US is willing and able to run large trade
deficits, the dollar will be the overwhelming currency of choice for
reserve accumulation. Once the US ability or willingness stops, which I
suspect is likely to be the case over the next few years, central banks
will stop accumulating dollars. Like it did during the period of large
US deficits in the 1960s and the 1980s, the talk about dollar hegemony
will once again fade away as US trade deficits decline.

Sarkozy’s comments were reinforced, in a way, by comments the same day
from Naoto Kan, Japan’s finance minister. Here is what the South China
Morning Post said in an article today.

Japan’s new finance minister backed off his call for a weaker yen
following an apparent rebuke from the prime minister yesterday, saying
currency levels should be determined by markets.

Still, Naoto Kan said the government should pay heed to the views of
the country’s business community, signalling that he was sticking to
the view of favouring a weaker yen to boost the competitiveness of
Japanese exports. ”Currencies undoubtedly should be determined by
markets,” Kan said. “But I also believe that generally speaking, it’s
the finance minister’s job to act against currency moves when needed.”

…He jolted markets in his first press briefing as finance minister on
Thursday, saying he hoped the yen would weaken further and that he
would work with the Bank of Japan to achieve an appropriate exchange
rate level.

For those who remember the 1980s, when many policymakers in Japan
insisted that Japan’s trade surplus had nothing to do with the value of
the currency, and everything to do with domestic competitive advantages
in manufacturing, it is a little weird seeing them now worry so much
about the impact of a rising yen on their manufacturing sector and on
the process of economic recovery. Currencies do matter, I guess.

Currency talk is likely to be the flavor of this year. The currency
issue simply will not go away, and the fighting over it is likely to
get worse, not better. On that topic, a research fellow at the
Institute of World Economics and Politics at CASS had an interesting
proposal earlier this week. According to an article in Bloomberg:

China should consider a one-time appreciation in the yuan of 10 percent
against the dollar to reduce inflows of speculative capital into China,
a researcher at the Chinese Academy of Social Sciences said. The
revaluation could be followed by a cap of 3 percent in annual moves up
or down for the currency against the greenback, Zhang Bin, a research
fellow at the Institute of World Economics and Politics at CASS, which
advises the cabinet, said in an interview from Beijing today. He said
he couldn’t predict whether his proposal, outlined in an essay, would
be adopted by the government.

China may see “huge” inflows of so-called hot money as foreign
investors step up bets on yuan gains, Zhang Xiaoqiang, deputy head of
the National Development and Reform Commission, said in a statement
yesterday. The government has rebuffed calls from U.S. and European
officials to allow the market to set the exchange rate and has pegged
the yuan at about 6.83 per dollar since July 2008 to help exporters
weather a global recession.

“It’s a good strategy to protect China from the impact of short-term
capital inflows,” said Zhang. “Now is a very good time. Foreign
pressure will intensify this year and China should take an active
strategy.”

…A 10 percent revaluation would have limited impact on exports and slow
growth in overseas sales by 3.3 percent, said Zhang. Exports dropped
1.2 percent in November from a year earlier, following a 13.8 percent
decline the previous month. China’s customs bureau is scheduled to
report trade figures for December sometime between Jan. 12 and 14.

Zhang, who has been interviewed by Xinhua news agency on global
economics previously, said the revaluation should be adopted soon. “The
earlier, the better,” said Zhang. “We shouldn’t wait until after
foreign capital flows into China and expectations on yuan gains
increase.”

Does the value of the RMB matter for trade?

What would the impact on trade be? Strangely enough many of the
opponents of RMB revaluation insist that it would have no impact on
trade balances. A new “International Finance Discussion Paper” (Board
of Governors of the Federal Reserve System) by Shaghil Ahmed sees it
differently (“Are Chinese Exports Sensitive to Changes in the Exchange
Rate?”)

The main results of the paper can be summarized as follows: First,
including the latest period of greater real exchange rate variability
reinforces the conclusions of some earlier studies, such as Marquez and
Schindler (2007), which found that Chinese exports respond quite
strongly to movements in the real exchange rate, and go against studies
which fond little effect of exchange rate changes or effects that go in
the opposite direction to conventional wisdom.

Second, considering the components of the real exchange rate,
consistent with the theoretical model, when the source of Chinese real
exchange rate appreciation is movements of the RMB against other
emerging Asian countries, this does not have a significant effect on
Chinese processing exports, but it does have a significant negative
effect on Chinese non-processing exports. On the other hand, when the
source of the renminbi appreciation is movements against the currencies
of non-emerging Asian Chinese trading partners, generally both types of
exports go down. Moreover, even though processed exports remain very
important for China, increases in non-processed exports have recently
accounted for more of the overall increase in exports. Finally, model
simulations indicate that the path of total Chinese real exports would
have been quite a bit lower if the renminbi had appreciated more in
recent years.

Overall, the results suggest that greater exchange rate flexibility
could have significant impact on China’s trade balance by restraining
growth of exports, particularly non-processed exports.

…The implications of the results for global imbalances depend on what
is exactly meant by global imbalances, which is not always clear-cut.
If China’s large current account surplus or its bilateral current
account surplus with the United States by itself contributes to global
imbalances, along with the U.S. bilateral current account deficit with
China, then our results suggest that greater degree of appreciation of
the Chinese currency would substantially help mitigate global
imbalances. If, however, the big part of global imbalances is the U.S.
overall current account deficit and the current account surplus of the
emerging market world taken together, then it is less clear that
greater appreciation of the Chinese currency would make a significant
dent to global imbalances. For example, following an adjustment of the
Chinese real exchange rate one scenario could well be that the fall in
exports by China is largely matched by a rise in exports by other
emerging market economies, including in emerging Asia, leaving
aggregate current account balances of the United States and of emerging
market economies more broadly unchanged.

But the results do seem to imply that greater flexibility of the
exchange rate would help China toward its stated desired goal of
shifting the sources of growth more toward domestic demand with less
dependence on external demand.

Regular readers of my blog might remember that from late 2006 until the
beginning of 2008 I had argued that the best way for China to address
the domestic (and of course external) problems caused by the
undervalued exchange rate would be for a 15-20% one-off revaluation.
This would both force through a rebalancing and help revive consumption
growth, all the while protecting the country from the problem of hot
money inflows, which had become terrible by that time.

After the onset of the crisis I backed away from such a large
revaluation (not because it wouldn’t be a good idea in the long run,
but rather because it would be too painful in short run) while still
arguing that a one-off 10% revaluation still made sense. Needless to
say I enthusiastically agree with Zhang Bin although, like him, I am
doubtful that policymakers will be willing to absorb the short term
cost in exchange for domestic economic benefits that probably won’t
accrue until well after 2012, when the current leadership will have
retired.

Hot money

My guess is that we will see a much smaller appreciation, perhaps 2-3%
during the first quarter. Apparently I am not the only one who believes
that appreciation pressures are mounting. That terrible bugbear, which
made China’s too-little-too-late appreciation strategy from 2005 to
2008 so difficult for the PBoC, hot money inflows, seems to be rapidly
becoming a problem again. Earlier this week a senior policy advisor
sounded, and not for the first time, the warning. According to an
article in Bloomberg:

China may see “huge” speculative inflows as overseas investors step up
bets on yuan gains, making it difficult to manage liquidity, said Zhang
Xiaoqiang, deputy head of the nation’s top planning agency. Loose
monetary polices in developed countries, a weakening U.S. dollar and
China’s economic recovery will put renewed pressure on the yuan to
appreciate, Zhang, from the National Development and Reform Commission,
said in a statement on its Web site today. The country is becoming more
reliant on foreign economies, he said.

Already some of my students whose parents own their own businesses have
been telling me that Chinese speculative money held abroad is flowing
back into the country. One of my students from rich coastal city
Wenzhou, the most free-wheeling and business-savvy city in China, and
perhaps the world, just rolled his eyes when I asked him if his family
and friends were tying to bring money into the country. “Of course,” he
said. I didn’t get the impression that he thought mine was an
especially astute question.

Meanwhile all the big guns in the “monetary alarmist” camp in China
have been pounding the table (in the discreet way preferred of
policymakers here) about the risks of monetary expansion. As everyone
now knows, the PBoC yesterday sold three-month bills at a higher
interest rate for the first time in 19 weeks. Long Chen, one of the
students in my PBoC Shadow Committee seminar, reported to the class via
email as soon as it happened: “Hey guys, the primary yield of 3M PBOC
bill increased this week. Significant sign.”

Yes, although the increase was tiny, it may indeed be a significant
sign that the PBoC no longer wants to wait and is starting to tighten
conditions, although I can only add that conditions are so alarmingly
loose that it would take an awful lot of tightening to get back just to
“loose”, and it would be hard to do this without seriously undermining
current growth and employment in the short term. My guess is that this
may be a beginning, but it will be a very slow and tentative beginning.
The PBoC has already been lambasted (unfairly, in my opinion) for
jumping the gun in 2007 and 2008 and they have little political capital
against which they can afford another “mistake”.

In fact much of their action tends to be signaling – what in the US we
would call “jawboning”. Four days ago, for example, Governor Zhou made
another attempt to warn about risks to the banking system in an
interview with China Finance very similar to a speech he gave late
December. According to an article in Bloomberg:

Chinese central bank Governor Zhou Xiaochuan reiterated government
warnings that investment in industries with excess capacity and in
redundant infrastructure projects could threaten banks’ loan quality.

The People’s Bank of China will guide credit, seeking to avoid
volatility in lending, Zhou said in an interview dated yesterday on the
Web site of China Finance, a central bank publication. Investment in
duplicated projects or industries with overcapacity could “pose a risk
to the quality of banks’ loans,” Zhou said.

China’s policy makers are seeking to contain risks from an
unprecedented credit boom, in which banks extended 9.21 trillion yuan
($1.3 trillion) of new loans in the first 11 months of 2009. Liu
Mingkang, chairman of the China Banking Regulatory Commission, said
yesterday that lenders have “more than” enough capital, while also
cautioning that asset bubbles may emerge in the world’s third-biggest
economy.

It is hard to be both soothing and at the same time to raise the alarm.

To move away from currencies and monetary policy, I saw an interesting
article about the US in Xinhua.

A recent New York Times/CBS News poll has found that more than half of
Americans said they are spending less money in stores and online. A New
York Times report available on its website Saturday quotes the poll as
saying that nearly half of Americans said they were spending less time
buying nonessentials.

“Some are working longer hours, but a larger proportion are spending
additional time with family and friends, gardening, cooking, reading,
watching television and engaging in other hobbies,” says the report.
The report also quotes the U.S. Department of Labor’s time-use survey
as showing that compared with 2005, Americans spent less time in 2008
buying goods and services and more time cooking or taking part in
“organizational, civic and religious activities.”

Net demand from abroad

This is almost certainly good news for the US in the medium term, but
if true, needless to say, it seriously undermines hopes that US net
demand will revive enough to justify the overcapacity issues
exacerbated by China’s fiscal and credit expansion. There has been some
hope that boosting trade with developing countries, and especially with
developing Asia, will result in a new source of net demand. James Kynge
said something like this in the Financial Times earlier this week:

Popular narratives sometimes overshoot. One of the latest to outlast
its veracity is the conventional wisdom that China’s export engines
have been spiked by subsiding consumer demand in the US. This, so the
argument goes, leaves Beijing with no option but to spur domestic
demand to compensate for lost export revenues.

This became an über-narrative last year. Its snowballing popular appeal
was powered by two unassailable charms: it made sense and seemed
largely true – but not any longer. Its potency appears set to wane in
coming months not so much because of a challenge to its central plot,
but by other things happening off stage.

The telling off-stage action is the recent upsurge in trade with
south-east Asia and the “newly-rising economies” of Brazil, Africa and
India. Although Chinese trade with these places has historically been
limited, it has grown so fast in the past five years that a robust
performance in 2010 may be enough to offset any moderate weakness in
China’s trade with the US.

A friend wrote to me to ask what I thought of this possibility, citing
Kynge’s article, and my response (with some editing) was:

The idea that net demand from developing countries can replace net
demand form the US is alarmingly widespread, both in China and abroad,
and mainly indicates to me a lack of familiarity with the history of
developing countries. The developing world excluding China is roughly
the same size as the US, so if you want them to replace the US you need
the developing world to run trade deficits of roughly equal to 7% of
their GDPs.

Leave aside the huge problem that most developing countries also want
trade surpluses and have a stubbornly tough time understanding why they
should run deficits in order to help Chinese employment, the historical
evidence suggests that just a few years of trade deficits of 2% of GDP
will lead to external debt crisis. For example it took the Asian Tigers
just a few years of deficits after 1993-94 to run into the Asian
crisis. Do Malaysia, Indonesia, Vietnam and so on really want to go
through that again? Developing country demand cannot replace the US.
Even Europe cannot replace the US. This is an unrealistic hope.

No, I think the rapid growth of US consumption relative to (very
healthy) US GDP over the past 30 years or longer may have been a
special historical circumstance whose life, if not over, is coming to a
close. Except for small countries whose trade surplus can easily be
accommodated, I think the days of rapid growth driven by trade-surplus
policies may be over.

This is getting to be another of my very long pieces (as my friend
Kaiser Kuo reminded me last night at my club), so I will stop, but not
before referring to one last interesting article about another
controversy in Chinese academic circles. China is trying very hard to
boost the quality of its scientific and technological research, which
is, with a few exceptions, of very low quality. I am skeptical about
how successful they will be, in part because the educational system
here, as a history teacher in the top high school in Shanxi province
once told me, is a machine for stamping out critical and creative
thinking, and in part because the process is not being driven by
scientists but by bureaucrats. Here is what the South China Morning
Post says:

The exposure of two researchers who published fake data in an
international journal is the subject of heated debate in mainland
scientific circles, with opinion divided on whether the blame should
rest on unscrupulous individual behaviour or deep flaws in the academic
system.

Zhong Hua and Liu Tao from Jinggangshan University in Jiangxi published
faked datasets in specialist journal Acta Crystallographica Section E
in 2007. The fraud would have gone undetected without new computer
analysis, the journal said on its website.

Leading British medical journal The Lancet urged China to tighten
measures against scientific fraud, otherwise it would not become the
research superpower President Hu Jintao has pledged by 2020.

These kinds of problems are so commonplace that normally I wouldn’t
bring it up except for two reasons. The first is that it is a measure
of how complex the problem is that there is even a debate about this
episode. Normally, faking research brings universal condemnation, but
the researchers have earned some sympathy because they are desperately
responding to a very difficult system. The second reason I cite this
article, which follows the first, is because of a very perceptive quote
from Professor Jiang Gaoming of the Institute of Botany under the
Chinese Academy of Sciences:

“All living creatures have an instinct to survive. When a bad system
determines the survival of researchers, they have to do all kinds of
corrupt and unethical things to live. The outcome is inevitable,” Jiang
wrote.

This is something I often tell my students, especially about the
banking system. It is not because they are especially stupid or
dishonest that bankers have made bad loans, but rather because they are
responding intelligently to bad incentives. Any system with distorted
incentives creates distorted results.

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