E xample of China’s RMB, continued (2005-2014)

ITF-220 - Prof.J.Frankell

Example of China’s RMB, continued (2005-2014)

ITF220 - Professor J.Frankel

China has mostly taken the BoP surplus as fx reserves.

But it also allowed RMB appreciation (2005-08 & 2011-12).

ITF-220 - Prof.J.Frankell

Appendix: Five reasons China warranted a more flexible exchange rate regime, in its own interest

• Overheating of economy in 2007-08 & 2010-12: => real appreciation.

• Excessive reserves ($3.7 trillion as of 2014)– Harder to sterilize the inflow over time.

• Attaining internal and external balance.– To attain both, need 2 policy instruments. – In a large country like China, the expenditure-switching policy

should be the exchange rate.– Along with expenditure-increasing policies (2009).

• Avoiding crash: – Experience suggests it is better to exit from a peg in good times,

when the BoP is strong, than to wait until the currency is under attack.

• RMB undervalued, judged by Balassa-Samuelson relationship.

ITF-220 - Prof.J.Frankell

Longer-run perspective:Balassa-Samuelson relationship

• Prices of goods & services in China are low– not just low judged by Absolute PPP (.23 relative to the US),– but also low by standards of Balassa-Samuelson relationship

estimated across countries (which predicts .36).

• The RMB is undervalued in this specific sense.– 2000 estimate was 35%

• before 2007 statistical revisions by IPC project.– Now undervaluation estimate more like 15%.

ITF-220 - Prof.J.Frankell

Estimation of B-S relationship for 2000

• For every 1% increase in real income/capita (relative to US), prices increase .4% (relative).

• China’s estimated residual is .15– Using revised ICP stats.– Subramanian (2008).

loginc00

Fitted values logRER00 CHN

6.17768 10.6917

-2.15096

.370385

CHN

Frankel (2006)118 countries, PWT

Real appreciation

• The RMB’s real appreciation against the $from 2009 to 2012 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).

China Adjusts, 2009-12

• Various measures suggest that China has achieved a major share of the needed trade adjustment since 2009:

• Its trade surplus peaked at $300 billion in 2008, and declined thereafter.

• Substantial real appreciation of the RMB has brought it closer to equilibrium. – Some nominal appreciation +– Some price inflation and, especially, wage increases.

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.

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.

Appreciation versus the US $, 2005-12

0.9

1.0

1.1

1.2

1.3

1.4

1.5

2005 2006 2007 2008 2009 2010 2011

CNY/USD,2005M06=1

nominal

real

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

Appreciation vs. index of currencies, 2005-12

0.95

1.00

1.05

1.10

1.15

1.20

1.25

1.30

1.35

2005 2006 2007 2008 2009 2010 2011

CNY Index,2005M06=1

Real valueof CNY

Valueof CNY

China’s trade balance

The surplus peaked in 2007, and then fell.

Source: Reserve Bank of Australia (June 2013)

China runs a deficit in primary products, offset by a surplus in manufactures.

13

China’s trade balance

The bilateral surplus with the United Statesis as big as ever – which has no economic importance,

but is politically sensitive.

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.

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%. • Though less against other currencies.

• 2nd, labor shortages began to appear => China’s workers at last won rapid wage hikes. – Major cities raised their minimum wages

sharply over each of the last 3 years: • 22% on average in 2010 & 2011;

• Meanwhile another cost of business, land prices, have risen even more rapidly.

Chinese wages have been rising

16Source: “China’s wage inflation,” Aug. 28, 2013

Real appreciation

• The RMB’s real appreciation against the $from 2009 to 2012 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).

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, are now moving back.

• 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.

• 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.

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– 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 2014,– as China did in 2009; but that was mostly heavy investment.