Friday, July 22, 2005

WSJ : Whither the Yuan?

David Altig is vice president and associate director of research in the research department of the Federal Reserve Bank of Cleveland. His research focuses on monetary and fiscal policy issues. Before joining the bank in January 1991, Altig was an assistant professor of business economics and public policy at Indiana University. He is currently an adjunct professor of economics in the Graduate School of Business at the University of Chicago. He received a bachelor's degree in business administration from the University of Iowa and master's and doctoral degrees in economics from Brown University. His blog is Macroblog. His comments in this Econoblog represent his own opinion, not those of the Federal Reserve.

Nouriel Roubini is associate professor of economics at New York University's Stern School of Business and a senior academic researcher in the field of international macroeconomics. He was senior economist for international affairs at the White House Council of Economic Advisers from 1998 to 1999; then worked as an adviser and director of the Office of Policy Development and Review at the Treasury Department from 1999 to 2000. His latest book, "Bailouts or Bail-ins? Responding to Financial Crises in Emerging Markets," was published in 2004. He maintains the Global Macroeconomics Web site and blogs regularly at his Global Economics blog. A graduate of Bocconi University in Milan, he received his doctorate in economics from Harvard University.

July 21, 2005 6:38 p.m.

China's decision to lift the yuan's peg to the dollar marks a modest but important first step in overhauling its strict currency regime. The yuan has been strengthened1, effective immediately, to a rate of 8.11 yuan to the U.S. dollar -- compared with the 8.28 yuan it has been set at for more than a decade -- and the currency will now be allowed to trade in a tight 0.3% band against a basket of foreign currencies.
While praising the step, many economists, analysts and U.S. politicians had been hoping China's first move would have been to strengthen the yuan more sharply, making Chinese exports more expensive in the U.S. -- and perhaps helping to close the countries' wide trade gap. asked economist bloggers Nouriel Roubini and David Altig to take a closer look at the news and the numbers. What do you think? Share your comments on our discussion board.2
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10:45 a.m. EDT
Nouriel Roubini writes: Last week I predicted on my blog3 that China would soon revalue its currency. Specifically, I argued that China would revalue the peg to the U.S. dollar (by a small amount close to 3%-5% rather than a larger 10%-15% move), that it would move from the peg to the U.S. dollar to a basket peg and that it would create a fluctuation band around this basket. That is indeed what happened today even if the size of the revaluation -- 2.1% -- is somewhat smaller than what I and most would have predicted; also, the band around the basket is still very narrow (plus or minus 0.3%).
In many dimensions, the move is too small: It is too small to make a dent on the Chinese trade surplus or on the U.S.-China bilateral trade balance; also, the move won't appease those in Congress who want to pass protectionist legislation against China; finally, in the short run, the move may lead to even more speculative capital inflows into China from investors who will bet on further Chinese revaluation.
Still, this is a significant change in the Chinese currency regime, as it is the first step of a much wider currency move over time in China and in the rest of Asia that will have important repercussions over the medium term. In the short run, there will be massive speculative pressures on other Asian currencies to appreciate -- as the impact appreciation of the yen today shows -- as other Asian currencies will be proxy plays for further Chinese currency moves. Also, the Chinese move allows other Asian authorities to let their currencies appreciate somehow without being as concerned about loss of competitiveness with China. The more China will let its currency move over time, the larger will be the appreciation of other Asian currencies.
China changed its peg today given the external U.S. pressure and the domestic need to cool down the Chinese economy, as the overheating was leading to serious financial imbalances (see my China Trip Report7 for more details). But since the Chinese authorities are conservative and concerned about the economic impact of a larger move, as expected, they made a very modest and cautious move.
But this small move is a beginning of a much larger currency regime change in China and Asia. It may be the beginning of the unraveling of the so-called Bretton Woods 2 regime8, a regime that has allowed until now the cheap financing of the U.S. "twin" deficits (budget and trade). And, indeed, this morning the U.S. Treasury market reacted to this move by pushing the 10-year Treasury yield up by 0.07 percentage point. Over time, the more China and Asia move and the more they reduce their forex intervention and accumulation of U.S. dollar assets and U.S. Treasuries, the larger the impact on U.S. interest rates will become, as such intervention has been an important factor in keeping U.S. long rates low.
In the past I warned against biting the hand that feeds you9 as the U.S. was aggressively pushing for a large Chinese revaluation while, at the same time, needing such Chinese and Asian cheap financing of its twin deficits. If a modest 2.1% currency move increases U.S. long rates by 0.07 percentage points, consider the implication of a 15%-20% move in currency values in China and Asia over time. It could get ugly for the U.S. unless the U.S. seriously tackles its fiscal deficit (by reversing some of its unsustainable tax cuts) and its large and growing current-account deficit.
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11:38 a.m. EDT
David Altig writes: Nouriel, not surprisingly, puts his finger on one of the key issues: How close is the new yuan-dollar exchange rate to the value it would take if allowed to float freely? In other words, how many shoes are yet to drop?
My colleagues Owen Humpage10 and Pat Higgins have done some interesting calculations that are slated to appear in a forthcoming Cleveland Fed publication. They find that, although the Chinese central bank has increased the pace of foreign exchange reserves over the past year, much of this activity has been "sterilized." Roughly speaking, while the Chinese central bank has been increasing the supply of money to accumulate dollar assets on the one hand, they have at the same time been engaging in domestic operations to reabsorb that liquidity with the other hand. The end result has been that the pace of money creation in China -- monetary base growth, specifically -- has not been accelerating, even as the central bank has appeared to intervene more and more to sustain the peg.
Why is this interesting? Because, again roughly speaking, sterilized exchange rate operations have no effect on the value of the currency, outside of a short window of time. That the Chinese central bank has been fairly successful at maintaining its target while sterilizing a good portion (about half) of its interventions may mean either of two things. One possibility is that the value of the Chinese currency hasn't been, and so isn't now, as far away from its "fundamental" value as many people think. The second possibility is that the Chinese fixed exchange rate regime has been held together by the chewing-gum-and-chicken-wire device of capital controls.
The latter possibility means that the announcement that China plans to loosen capital controls -- presciently blogged by William Polley11 a few days ago -- is at least as big a story as today's announcement. On that proposition, I bet Nouriel and I agree.
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12:20 p.m. EDT
Nouriel writes: David, correctly, points out the role of sterilized intervention in China. One of the reasons China decided to change its currency regime is that this intervention was leading to two serious financial costs and vulnerabilities for China:
1. Piling up more and more U.S. dollar foreign exchange reserves would lead to severe capital losses for China -- i.e., the change in the value of its dollar reserves when converted into local currency -- once the Chinese currency was allowed to appreciate. With more than $700 billion of foreign exchange reserves today (out of which most likely more than $500 billion are in U.S. dollars), a 10% move of the Chinese currency implies capital losses of $50 billion, a massive loss for a country like China. Not moving the peg would have implied intervening and accumulating even more forex reserves over time -- to the tune of over $200 billion a year lately -- and thus even larger capital losses for China down the line. Essentially, China and the rest of the Asian economies were getting tired of accumulating U.S. dollar reserves on which they knew that they would eventually suffer larger massive currency valuation capital losses.
2. The forex intervention has been -- as suggested by David -- only partially sterilized (only 50% of it lately) as it has become increasingly difficult for China to issue local currency bonds to mop up the monetary liquidity created by such intervention. This increase in the Chinese monetary base has led to excessive liquidity creation in China, feeding the credit boom and the investment boom and the real-estate bubble that have all exacerbated the financial vulnerabilities of the Chinese economy and increased the risk of a hard landing for China12. Thus, the currency move today is the beginning of a process that, over time, will allow China to reduce its forex intervention and, thus, reduce an accumulation of reserves that has been feeding the severe financial bubbles of its economy. But, paradoxically, in the short run a small move of 2.1% will only lead to even more speculative capital inflows into China and will thus trigger the need to accumulate even more reserves to prevent the currency value from breaching the new band.
As for the loosening of the capital controls, such liberalization will not -- in the short run -- lead to significant capital outflow out of China and prevent appreciation pressures. The reason is as follows: With the currency move today there is now a greater likelihood that the Chinese currency will further appreciate over time. Thus, international traders and investors, Chinese expat communities in Asia and foreign firms doing investments and FDI in China will have an even greater incentive to bring capital into China to obtain large capital gains once the Chinese currency moves even further. So, liberalization of capital outflows won't help in the short run, as capital is going only one way today, into China rather than out of China!
And this could really be the beginning of the end13 of the Bretton Woods 2 regime of fixed pegs to the U.S. dollar in Asia. Malaysia already decided today14 to drop its peg relative to the U.S. dollar. This China move may also force Hong Kong to phase out its long term currency board and U.S. dollar peg. And other Asian currencies will soon sharply appreciate15, following the yen's lead today. Even currencies at the periphery of this Bretton Woods regime (such as those in Latin America) may sharply appreciate16. The systemic consequences of this currency realignment throughout Asia and the world could be radical and have significant impacts on U.S. long-term interest rates, on U.S. financial markets and on the U.S housing bubble17.
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2:10 p.m. EDT
David writes: I remain less convinced than Nouriel that we have a firm notion of how much further the Chinese currency will appreciate or how much effect liberalization of capital controls will have on exchange-rate dynamics. We simply don't know how private decision-makers in China will respond when offered the opportunity to freely move their own financial capital about the world. I don't find it at all implausible that private accumulation of dollar assets could put a pretty good dent in whatever reduction we see from the central bank.
I am going to stick with Ben Bernanke's position18 (or my version of it): The really important question is whether, when the dust settles, the Asian taste for saving outside of Asia will persist. If it does, it is hard to conjure up a scenario in which a good fraction of that saving won't continue to flow in the direction of the U.S. If it doesn't, there probably isn't enough that can be done via fiscal deficit reduction to stave off the effects on the U.S. economy that Nouriel fears. (I guess that Nouriel is not much convinced by the recent good news19 on that front!)
I have long agreed with Nouriel that the probable impact of a change like today's will be some upward pressure on U.S. interest rates. And yes, that will likely rebound to the detriment of the interest-sensitive sectors that have benefited from the long (and unexpected) spell of low interest rates that has been around for several years now. But the market, today at any rate, has responded in a fairly orderly manner, and I simply don't see the argument yet that clearly suggests the adjustment-road ahead will be all that much rougher.
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3:20 p.m. EDT
Nouriel writes: I beg to disagree. If China were to liberalize its capital account regime -- on capital inflows as much as on capital outflows -- and stop intervening, the Chinese currency could appreciate by more than 20%, minimum. Think of it: China has a current-account surplus that is now growing to more than 4-5% of its GDP; it also has long-term capital inflows in the form of FDI that are another 2-3% of GDP; and on top this, last year it had hot money capital inflows that were another 5% of its GDP. Each one of these three forces leads to a currency appreciation; and this is why China was forced last year to intervene to the tune of $200 billion in forex-reserve accumulation to prevent the yuan from appreciating. Given today's move, liberalizing the capital account would increase the capital inflows as investors are now expecting further appreciation of the Chinese currency (see the wise blog comments by Brad Setser on this today20); thus, it would not lead to any meaningful capital outflows.
And, indeed, in preparation for the move today, China tightened -- rather than loosened -- its controls on capital inflows to try to stem the onslaught of speculative capital that is now going to rush into China to profit from further expected appreciation. So, there is only one direction that the yuan can go if intervention is reduced and capital controls are eased: up!
The hard part for China and the rest of Asia will be now to manage the massive speculative inflows of capital that are betting on further appreciations of the yuan and other Asian currencies. As the extensive coverage today of the news and blogosphere comments on the China move on my RGE Monitor21 suggest, markets are now expecting that China will now allow further upward movements of the yuan and of other Asian currencies: Malaysia already dropped the towel and abandoned its peg today; soon, Hong Kong's currency board will undergo serious pressure, and a range of currencies in Asia and around the world are strengthening. It should also be noted that, while China moved its peg by only 2.1%, the official announcement22 left significant ambiguity on whether it will allow its central parity relative to its undisclosed basket to move further on a daily basis. So, it is reasonable to expect that, over the next few months, China will allow a 10% appreciation or more of its currency relative to such a basket.
As for the impact on the U.S., this depends on the factors that have caused the bond conundrum. Unless one believes -- a la Bernanke -- that such a conundrum is explained only by a persistent global savings glut, the impact of this change in currency regime in China and Asia on the U.S. financial markets could be serious. The effect of Chinese and Asian intervention on U.S. long rates is hard to measure but estimates range between 0.5 and 1.5 percentage points.
But the general equilibrium effects of such forex intervention -- or its reduction after a significant 10-15% currency move in China and Asia -- could be much larger than the direct effects as:
1. Chinese/Asian savings rates are high and consumption rates are low because undervalued currencies make imports expensive and thus dampen domestic consumption;
2. If China/Asia moves, Asian private investors who were willing to hold and accumulate large stocks of U.S. dollar assets under the assumption that their currencies would remain stable relative to the U.S. dollar will now face large capital losses on their holdings of U.S. dollar assets and will thus be less willing to hold them;
3. A sharp movement downward of the U.S. dollar relative to Asian currencies would -- over time -- increase U.S. inflation and induce the Fed to tighten more than it would have otherwise; such further increase in U.S. short rates would contribute to increase U.S. long rates.
So, while I agree with David that a sharp reduction in the Asian and world appetite for the U.S. assets would be painful for the U.S. even if the U.S were to make a significant fiscal adjustment, the lack of such fiscal adjustment would inflict greater pain than otherwise. And I indeed do believe that the recent improvement of the U.S. fiscal balance will be totally temporary. In fact, official CBO forecasts23 suggest that, if all the tax cuts are made permanent (income tax cuts, dividend tax cuts, capital gains tax cuts, repeal of estate taxes, full fixing of the alternative minimum tax), the U.S. fiscal deficit could surge to be as high as $500-600 billion by 2009 (see my recent blog on the reemergence of Voodoo Economics24).
We live in a fragile world with geostrategic risks on the rise (terrorism, North Korea, Iran, political and potential supply shocks in oil exporting countries), large and growing global current-account imbalances, asset bubbles in bond and housing markets, and froth in financial markets where leverage, carry trades and excessive risk taking are on the rise. This is a fragile disequilibrium for the global economy. The Chinese move today signals that China -- and soon Asia -- may be willing to start doing its share of an orderly global rebalancing (as the small move today is a signal of much larger currency moves in the future). We will see if the U.S. is also willing to step up to the plate and do its share by reducing its structural fiscal deficit with structural measures (reversing some of the unsustainable tax cuts) and dealing with its financial froth before it is too late. If that doesn't happen, the risk of a hard landing of the U.S. and global economy significantly increases.
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4:30 p.m. EDT
David writes: Wow! Nouriel always has a good story to tell, and tells it well. But there are a lot of "all else equals" in the tale. In essence, I'm not so much disagreeing with him as much as cautioning that the web of effects that may arise from broad financial reforms are so complex that I wouldn't place very big bets on any particular outcome.
Well, OK, when it gets right down to it, I am disagreeing. In the overall scheme of things, if you put any faith at all in markets' ability to provide best guesses of such things, the expected magnitude of RMB-appreciation looks pretty moderate. By the last update I received, non-deliverable forward foreign exchange contracts were suggesting a total appreciation of about 8% over the next twelve months. That includes the 2% today. This is up a bit from yesterday, when 6% was the bet, but it still doesn't add up to great drama.
This may not, of course, reflect where the Chinese currency will end up over the longer horizon, or where events would force the central bank in the event of any particular configuration of reforms. But it does indicate where those with their money on the line see the process heading, given what is actually likely to occur. Which is really to emphasize another point I have often made: It is in the interest of the Chinese central bank and the Chinese government to maintain a pace of reform that is consistent with an orderly transition to wherever we are headed. Thus far, this has certainly been the model (although I know Nouriel has the opinion that the road we are on will leave them, and us, with few options).
It is worthwhile to note that we have very little knowledge at this point about what this new regime actually amounts to, other than a small appreciation in the current exchange rate. The range of the "float" is essentially the same range that was, at least hypothetically, in operation prior to today's announcement. It may well be the case that the peg will be managed less severely now, but plus or minus 0.3 percentage points is still a pretty narrow corridor.
Furthermore, to the best of my knowledge we have no idea what this basket of currencies might be that will inform future decisions about the level of the dollar versus the RMB, or what will trigger reactions to changes in that value of that basket. In other words, it remains to be seem how much change this regime change actually amounts to.
One final point for this round. A nominal currency peg doesn't mean a real exchange rate peg, and it is the real exchange rate that drives the flow of real goods and services that we really care about. My emphasis on capital controls is in part driven by the fact that, over the longer haul, those sorts of controls can screw up the real exchange rate in ways that a purely nominal exchange peg won't. If the only change we see is another six percentage points on the nominal exchange rate, I just don't believe that the underlying real exchange rate implications will have any substantial near-term impact on our current-account deficit.
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5:05 p.m. EDT
Nouriel writes: In my view the Chinese move today is the beginning of a much larger currency move in China and Asia. The Chinese are smart enough to know that a 2.1% move will have little effect on their trade balance,on their internal financial vulnerabilities, on the protectionist pressures in the U.S. Congress, and that such a small move will only increase speculative inflows into China. So, for them, this is the beginning of a much larger currency move that, over time, will lead to a managed float a la Singapore and to significant capital account liberalization.
I venture to guess that over the next 12 months, the Chinese currency will be allowed to appreciate by more than 10% and that other Asian currencies as well as other effective members of the "Bretton Woods 2" club around the world (including countries as far as India, Russia, Chile, Brazil, etc.) will also follow and allow their currencies to appreciate relative to the U.S. dollar. If this is the case, the system of "vendor financing"25 that has led to the large accumulation of U.S. dollar reserves by foreign central banks to the tune of over $500 billion a year may unravel: While central banks won't stop intervening, they may reduce their rate of forex intervention by significant amounts. Even a reduction of 50% in the rate of intervention would imply a foreign financing of the U.S. twin deficits of only $250 billion a year rather than $500 billion plus a year of recent times.
This would imply an unraveling of the Bretton Woods 2 regime and will force the U.S. to make significant and painful adjustments to its private and public savings droughts, droughts that much more than a global savings glut explain why the U.S. external balance has been worsening over time. Then, U.S. private spending, both consumption and investment, may have to fall sharply -- driven by higher U.S. interest rates and a bursting of the housing bubble -- relative to U.S. output to make room for an improvement of U.S. net exports.
And how much U.S. private spending may be squeezed will depend on whether there is a meaningful structural reduction in the U.S. fiscal imbalance. Less foreign financing of the U.S. external deficits would, for unchanged fiscal balance, tend to crowd out private consumption and private investment via higher interest rates. This U.S. adjustment could be painful26.
Finally, I am concerned about the financial consequences of an uncoordinated global rebalancing, where the lack of policy coordination between the U.S., China/Asia and Europe may lead to significant financial markets' volatility. There is now a huge incentive for hedge funds, prop desks and other highly leveraged institutions to try the Asian Currency Revaluation bet and go for a currency kill in Asia. You can expect massive capital inflows into all of the currencies of the effective Bretton Woods 2 regime as investors test the central banks' willingness to prevent sharp -- rather than small -- movements of their currencies. This may imply major short positions on the U.S. dollar and massive long positions on a wide range of currently semi-fixed or heavily managed currencies.
The stakes are so high that traders/investors may want to test how far they can collectively push such currencies and make significant capital gains on this speculative attack. Herding behavior and momentum trading are typical of financial markets, and the Chinese move today is a signal that it's open season on trying to push up a wide range of Asian and other currencies. This is why policy makers and regulators may want to be wary of systemic risks associated with such large capital flow movements. In 1998, Russia's currency crisis triggered the LTCM crisis and a 10% plus move of the Yen relative to the U.S dollar in a matter of three days. The financial debris from these sharp currency and financial assets swings was significant. This China currency move could similarly be a turning point for the currently stable -- but structurally highly unstable - disequilibrium in the U.S. and global economy. A disorderly global rebalancing can't be ruled out.
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6:35 p.m. EDT
David writes: Nouriel says "policy makers and regulators may want to be wary of systemic risks associated with such large capital flow movements." There are certainly no truer words than those, and over time I have become convinced that the truly important work of central bankers is to handle those episodes when the feared meltdowns come a'calling. It is interesting, then, that Nouriel references the 1998 Russian/LTCM crisis, which was the back-breaking straw piled on the 1997 Asian currency crisis. If I had to choose one example of a case where severe stress in global financial markets was weathered just fine, that would be a good candidate.
Now, Nouriel might argue that things were not so hot for those countries whose currencies were under attack, and this time around that country is us (as in U.S.). Here we reach an impasse, because I just don't buy it. The fundamentals of the U.S. economy just look too strong and, as I just happened to be blogging about yesterday27, I continue to read our large current-account "imbalance" as being substantially driven by external factors, rather than homegrown malfeasance.
For sure, it is not an easy task to defend our fiscal deficits without reservation. But a few points are in order. First, relative to GDP, they really aren't that large. Second, though you might argue that the real problems have to do with the long-term status of Social Security, Medicare, and the like, those problems were with us before the Bush tax cuts and certainly during the allegedly-halcyon surplus days of the late '90s (as documented here28, for example). And they are not going to be fixed by simply repealing those tax cuts that Nouriel doesn't like.
None of this is to claim that it's time to fall asleep at the wheel. Nor is it to claim that there aren't some tough adjustments ahead. We may well be at the beginning of an upward climb in long-term interest rates that many of us have long expected, and the reversal of the current-account deficits that all of us knew would come sooner or later. And though I am not much convinced by Nouriel's worst-case scenarios, I'm glad he's out there reminding us to not forget about them.


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