China will do what it considers to be in its own interest. That should surely be self-evident. What is not self-evident is how it does – and should – identify that self-interest. That is almost always more difficult than naive realists tend to suppose. This is true of its policy towards North Korea. It is just as true of its policy towards the exchange rate.
The Chinese government seems to believe its interest lies in maintaining a highly competitive real exchange rate for as long as possible. The evidence also suggests it can do so for a long time. But should it do so?
Economic theory indicates that a fast-growing developing country should have an appreciating real exchange rate. This is known as the Balassa-Samuelson effect, after the late Bela Balassa of Johns Hopkins University and the Nobel laureate Paul Samuelson, who discovered it independently of each other.
The argument is straightforward. Economies contain two sorts of activity: tradeable – manufacturing and services that can be supplied readily at a distance; and non- tradeable – haircuts, childcare and so forth. With economic development, productivity in the former tends to rise faster than in the latter.
Assume, for simplicity’s sake, that we are talking about a small country with a fixed exchange rate. Then the price of tradeables will be set in the world market and the domestic price will be the world price multiplied by the exchange rate. Prices of non- tradeables will rise relative to those of tradeables, because their relative unit labour costs will be increasing. This is why haircuts are cheap in poor countries and expensive in rich ones.
What does all this have to do with China? The answer, as Andrew Smithers of London-based Smithers & Co, has pointed out, is that real exchange rate appreciation is the dog that has not barked.
Despite the modest change in exchange rate policy in July 2005, the nominal exchange rate of the renminbi has moved little since January 1994. Because China’s inflation rate has been below that of the US for most of the past nine years, the tendency of the real exchange rate has been towards depreciation. According to JPMorgan, it has depreciated by about 7 per cent since January 1998 (see chart).
Yet China seems to meet all the conditions for real exchange rate appreciation. As the International Monetary Fund notes in its September World Economic Outlook, productivity growth in industry has, on average, been about three percentage points a year faster than in services since 1979.
If a real exchange rate one would expect to appreciate depreciates, one would also expect China to become more competitive in world markets. The evidence suggests that this is the case: look at both the astonishing growth of China’s exports and the soaring current account surplus.
I would argue that there are now three fundamental indicators of a significant undervaluation. First, the scale of the required foreign currency intervention; second, the fact that the source of surplus receipts of foreign exchange is now a current account surplus rather than inflows of relatively unstable short-term capital; and, above all, that the surplus in the basic balance – the sum of the current account and long-term capital inflows – is at least 10 per cent of gross domestic product (see charts). Jonathan Anderson of UBS suggests that the undervaluation is about 20 per cent.*
As Mr Smithers argues, the progressive real depreciation of the renminbi is why China’s emergence has also been disinflationary for the world. The prices of the manufactures it exports have indeed tended to fall in dollars. But this did not have to be the case. It was the combination of a virtually fixed nominal exchange rate with a depreciating real exchange rate that made it so.
Why then has this happened? It is not an accident. On the contrary, as Mr Anderson notes, the government has worked hard to achieve this result.
In normal circumstances, powerful economic forces work against an increasingly undervalued real exchange rate. As David Hume, the great Scottish philosopher, argued, the monetary mechanism is one way of achieving this outcome. At a fixed exchange rate, a current account surplus not offset by a corresponding voluntary capital outflow will generate an increase in the monetary base. That should generate a credit expansion, excess demand, a rise in the domestic price level and an appreciation in the real exchange rate.
Overheating, in short, is not the problem, but rather the natural solution to an undervalued real exchange rate. But, as Mr Anderson points out, China’s economy is sufficiently large, sufficiently closed, sufficiently regulated and sufficiently labour-abundant to prevent this effect from working through.
The People’s Bank of China has been able to sterilise the monetary impact
of the massive purchases of foreign currency it has undertaken to keep the
exchange rate down (see charts). Moreover, because China’s overall savings
are so high and
its capital market sufficiently segmented from that of the rest of the world,
domestic interest rates are about one and a half percentage points below those
currently earned on its reserves.
Sterilisation – the sale of domestic securities to mop up the excess liquidity generated by official intervention in foreign currency markets – is not merely feasible, but even highly profitable, if one is prepared to ignore the risk of a large ultimate capital loss. In the very long run, the spending generated by low domestic interest rates is indeed likely to produce excess demand and inflation, particularly if the economy and the financial system are liberalised. But there is little sign that this is at all imminent.
The discussion in last week’s column concluded that there is a strong case for the Chinese government to absorb the surplus savings domestically, in the interests of the Chinese people. But the discussion here concludes that they can prevent such an adjustment for a very long time if they wish to do so.
So the authorities have a choice. What then should it be? If they should decide to reduce the current account surplus, should they allow faster appreciation of the nominal exchange rate or overheating and faster inflation? And how should they choose to expand demand? These will be the subjects of next week’s final column in this series.
* The Complete RMB Handbook, 18 September 2006, (restricted)