Thursday, June 24, 2010

China's Exchange Rate Policy and Economy

There is a great piece in Vox this week from Barry Eichengreen and Andrew Rose about the effect of an appreciating Renminbi on China's growth.  In case you haven't been paying attention, China has for years kept is currency artificially low.  This is great for China's exports as it makes them cheaper around the world.  But it also leads to massive imbalances as, in order to keep the currency low, they have to sell lots of yuan by turning around and buying lots of dollar and euro denominated assets.  Right now this is great for us as it keeps our cost of borrowing low, but in general it is bad as it sustains a massive trade imbalance.  Letting the value of their currency rise to market levels would make chinese goods more expensive but also make US goods cheaper to the Chinese.

After almost two decades of astounding growth, the pent-up demand for consumer goods is probably very high and the US and other nations could benefit greatly from the opportunity to sell to Chinese consumers at fair market prices.  And so there has been increasing pressure on China to let its currency appreciate.  Recently the Chinese have finally succumbed to the pressure and announced that they would allow for some appreciation and it looks like they have begun to act on this.

Eichengreen and Rose ask the question, what would letting the renminbi rise do to China's economy?

Here is their answer:

In a new paper, we ask what can be learned from other times and places about the likely effects of China now exiting its de facto pegged exchange rate regime in favour of renewed currency appreciation. It turns out that it is possible to construct a sample of other “exits up,” although the resulting data set is relatively small.

We have identified 27 instances where a fixed peg was abandoned and the currency appreciated over the subsequent year either against the dollar or Special Drawing Rights. Many of these are clustered around the end of the Bretton Woods System in the early 1970s, although there are also a number of other episodes ranging from Equatorial Guinea in 1979 to Mozambique in 2004 and Malaysia in 2005. The average rate of appreciation in the first year is not too different from China’s 2005-8 average of 7% (Eichengreen and Rose 2010).
What do we find?

The average annual rate of GDP growth slows by 1 percentage point between the five years preceding the exit and the five years following. But there is no growth collapse. Exiting up does not doom the economy to a Japanese-style lost decade.
More generally, we find little evidence of economic and financial damage as a result of exits up.

  • There is no increase in the incidence of banking and financial crises.
  • There is no evidence of significant stock market declines.
  • There is no evidence of a significant deterioration in the current account.
  • There is no evidence of a significant fall in the investment rate.

A variety of other economic and financial variables are similarly unaffected.
While the rate of export growth slows from 9.5% to 5.5% per annum, the rate of import growth slows by nearly the same amount.

Because countries that exit up were growing faster than other countries in the five years preceding the policy change – by 1.5 percentage points per annum on average – it is hard to say whether the slowdown is a healthy correction that avoids overheating or something more. One bit of evidence is that countries that exit up were also running higher inflation than other countries in that preceding period, consistent with the overheating view. Their inflation rate is about 5 percentage points higher, too big a difference to be explained away on Balassa-Samuelson grounds.
So what accounts for the growth slowdown in a proximate sense? Since the rates of growth of exports and imports slow by the same amount, the answer is not the contribution of net exports. Nor are there significant changes in the rate of growth of investment and government spending. Rather, there is a significant slowdown in the growth of household consumption. With the country now exporting less, there is a decline in consumption of both imports and domestically-produced goods (all relative to their prior rates of growth). Again, this could be a healthy adjustment to more sustainable growth rates that avoids overheating. Or it could be that the slowdown could have been avoided entirely had the government boosted public consumption and taken measures, such as liberalising financial markets and developing the social safety net, to encourage household consumption.
The experience of other countries gives little reason to think that an exit up will have seriously adverse consequences for the economy. But it points to the possibility of economic growth slowing. If the authorities wish to limit the risk of an excessive slowdown, they can maintain the level of public spending and redouble their efforts to foster the growth of private consumption. If more domestic spending means more spending on, among other things, imported goods, this will represent a Chinese contribution to global rebalancing.

And herein lies the future for China in my opinion: the pent up demand for education, healthcare, rural infrastructure and household consumption, as well as existing and looming environmental problems will soon start to create enormous pressure on the economy. By inflating their currency and starting to spend their reserves internally rather than on dollar- and euro-demoniated debt will be good for themselves and for everyone else. But it does mean that there will be a structural adjustment internally - their comparative advantage in many export industries will go away. But these will end up being replaced by new industries that serve the domestic demand.

This would be excellent news for Oregon, as China is our biggest export market.  However a lot of what we ship over there are intermediate goods: things like microchips that get turned into iPhones and shipped right back to the US.  This type of manufacturing might end up migrating somewhere else, like Vietnam, which would not really matter to Oregon.  But 1.2 billion new iPhone customers in China would benefit us a lot.