The Global Credit Crisis and Chinas Exchange Rate Ronald McKinnon Brian Lee Yi David Wang Stanford University Singapore Economic Review Conference August.

The Global Credit Crisis and China’s Exchange Rate

Ronald McKinnonBrian Lee

Yi David Wang

Stanford University

Singapore Economic Review Conference August 6-8, 2009

Advantages of Stabilizing Yuan/Dollar RateA Potted History

• 1995 to 2004 fixed rate nominal anchor: 8.28 Y/$ [McKinnon & Schnabl, Jan 2009]

• July 2005 to July 2008, one-way bet on RMB appreciation: hot money inflows, buildup of official

exchange reserves, loss of monetary control, disrupt forward exchange market [Wang 2009]

• July 2008 to Nov. 2008, unwinding of dollar carry trade with sharp apprec.of $ effective ex rate,

(Lee 2009), Y/$ rate reset at 6.83 through to present• 2009, monetary control regained with a massive

expansion of bank credit to support fiscal stimulus for offsetting sharp fall in exports

Source: FRB

Figure 1: China’s monetary policy and the yuan/dollar rate

(1995-2009)

6.83

8.28

5.00

5.50

6.00

6.50

7.00

7.50

8.00

8.50

9.00

95/Jun 96/Jun 04/Jun 05/Jun 06/Jun 07/Jun 08/Jun 09/Jun

Fixed exchange rate anchor: monetary stability

One-way bet on yuan appreciation:loss of monetary control, inflation

"Accidental" stabilization:regain monetary control

Yuan/Dollar

Source: IMF and The People’s Bank of China

Figure 2: Foreign Reserves of China, Japan, Germany, and U.S.(2002-2009)

10

100

1,000

10,000

2002 2003 2004 2005 2006 2007 2008 2009

billi

on d

olla

rs (

log

scal

e)

ChinaJapanGermanyUnited States

1.95 Tr

/Q1

Figure 6: Bilateral Trade Balances of Japan and China versus the United States

(percent of U.S. GDP, 1955 – 2008/1)

Source: Kenichi Ohno, BEA

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

JapanChinaJapan+China

Japan Bashing

ChinaBashing

2008/Q1

U.S Mercantile Pressure, I. • Acute Japan Bashing, 1978 to 1995 - Episodic trade disputes steel, autos, color

televisions, machine tools, semi conductors - Resolution: Japan imposes “voluntary” export restraints and allows yen appreciation -Yen/dollar rate appreciates episodically from 360

in August 1971 to peak at 80 in April 1995, when U.S. announced a strong dollar policy

• Japan financial system destabilized: bubble economy 1987-90 followed by a deflationary slump and low interest liquidity trap in 1990s (McKinnon-Ohno,1997)

U.S. Mercantile Pressure, II.• China Bashing: 2000 to ?

-China surpasses Japan in 2000 as having the biggest bilateral trade surplus with the U.S

-Unlike Japan, export surge is “across the board” in low value added manufactures.

• Focus is primarily on appreciating the Renminbi: -Schumer-Graham bill of March 2005 for a 27.5% tariff on U.S. imports from China unless RMB appreciates (withdrawn October 2006, but new threat in 2007) -Section 3004 of U.S. Public Law 100-418: U.S. Secretary of Treasury must report twice a year on whether countries with trade surpluses are “manipulating” their currencies. Timothy

Geitner’s congressional testimony January 2009

• RMB rises by 2.1% on July 21 2005, and begins slow upward crawl

One way bet: RMB appreciation July 2005 to July 2008

• Hot money flows into China

• No private capital outflows to finance China’s huge trade surplus (McK & Sch 2009)• Huge buildup of official exchange reserves: government sole international intermediary• Massive sterilization: sale of central bank bonds, increases in reserve requirements of com banks• Direct restraints on domestic bank credit• Still loss of monetary control with domestic inflationary pressure added to foreign

China’s Foreign Exchange Reserves

Source: UBS

Source: EIU

Figure 3: China’s Consumer Price Indices(Growth rate: % yoy)

-4

-2

0

2

4

6

8

10

2002 2003 2004 2005 2006 2007 2008 2009

Figure 4: Renminbi and Dollar Exchange Rate Movements

(2000-2008)

Source: IFS and BIS

2000 2002 2004 2006 2008

85

90

95

100

105

110

115

120

July2008

Nominal Rate Dollar YuanEffective Rate of the RenminbiEffective Rate of the U.S. dollar

Unwinding of Carry Trades

Source: globalfinancialdata.com

Note: The commodity price index does not contain crude oil.

Figure 5: Commodity Price Indices(Jan 2002 =100)

50

100

150

200

250

300

350

400

450

500

550

600

650

700

750

2002 2003 2004 2005 2006 2007 2008 2009

The Economist Commodity-PriceIndexWest Texas Intermediate

/05

2 0 0 0 2 0 0 2 2 0 0 4 2 0 0 6 2 0 0 89 0

1 0 0

1 1 0

1 2 0

1 3 0

J u ly 2 0 0 8

U n i t e d S ta t e sJ a p a n

Figure 8: Unwinding the yen and dollar carry trades (effective exchange rates, 2006=100)

Source: BIS

Source: Brian Lee (2009)

Table 1: Returns on carry trades(2000-2007)

Note: (a) For funding in dollars, the return is the average for Brazil, Mexico, and Canada. (b) For funding in yen, the return is the average for Australia,

Korea, and New Zealand. (c) Trough to peak for the yen’s effective multilateral exchange

rate.

Caution: The unwinding of the carry trades in 2008 may not fully explain these exchange rate appreciations.

Funding Returns from Returns of Unwinding in 2008:

Currency Funding Investment Appreciation Carry trades Trough to Peak Appreciationsc

US Dollar 3.4 10.2 a 1.1 a 7.9 a 19%

Japanese Yen 0.1 5.3 b 5.2 b 10.7 b 44%

Interest rates

Dollar carry trade unwinds and “accidental” stabilization of the RMB since July 2008

• Credit crunch summer and fall of 2008 dries up short-term finance for dollar, yen, and commodity carry trades• Surprise dollar appreciation, July to Nov 2008, of approx 20% against all currencies except the Japanese yen

with a general fall in commodity prices.• PBC stops gradual (and predictable) appreciation of RMB,

and stabilizes at 6.83 yuan/dollar.• Hot money inflows stop, some private outflows, minimal

increases in official exchange reserves. PBC regains monetary control

• Massive domestic credit expansion: cuts in reserves required of commercial banks while lifting credit ceilings,

reductions in deposit and loan interest rates • Domestic spending largely offsets collapse in exports

Source: China Customs Statistics Information

Figure 9: China’s Nominal Trade(in billions of U.S. dollar, monthly)

-

20

40

60

80

100

120

140

160

2005 2006 2007 2008 2009

Exports Imports

/04

Source: UBS

Figure 10: China’s interest rates(%)

Source: UBS

Figure 11: China’s New loans to non-financial institutions

(RMB bn)

Source: UBS

Figure 12: China’s M2 and Bank Lending(Growth rate: % yoy)

Loans for 15 large U.S. banks

Source: Wall Street Journal

2Q 2009 in billions Change from 1QComerica 46.60 -4.1%Marshall & Ilsley 48.60 -1.8%Wells Fargo 821.60 -2.6%Fifth Third 81.40 -1.5%SunTrust 122.80 -0.9%Regions 96.20 0.5%Citigroup 641.70 -2.4%Bank of America 942.20 -3.6%US Bancorp 182.30 -1.1%PNC 165.00 -3.7%BB&T 100.30 0.1%KeyCorp 70.80 -3.9%J.P. Morgan Chase 680.60 -3.9%Amercian Express 62.90 -3.2%Capital One 146.30 -2.7%

Total for 15 banks 4,209.30 -2.80%

Source: SCB

M2 growth around the world

Violation of interest parity conditions and breakdown of China’s forward market

mid 2007 to mid 2008

• Open Interest Parity (OIP): E(∆S) = it(yuan) – it(dollars) , where S = yuan/dollar

• Covered Interest Parity (CIP): ft = it(yuan) – it(dollars)

where f = (F – S)/S is forward premium on dollars

OIP breaks down when the interest differential is less than expected appreciation because of fall in US rates

CIP breaks down when SAFE had to impose controls on financial capital inflows, i.e., borrowing in dollars

• Result: China’s exporters can’t cover dollar earnings forward, thus tightening credit constraint

Source: Datastream.Note: OIP is Open Interest Parity.

Figure 13: Interest Differentials versus Percentage Changes in the Yuan/Dollar Exchange Rate

(2002-2009)

-12

-10

-8

-6

-4

-2

0

2

4

6

2002 2003 2004 2005 2006 2007 2008 2009

Yuan/Dollar Change (yoy)

Interest Differential

Fed Funds Rate

China overnight

09/5July

OIP holds OIP failsOIP

Restored

Exchange rate stabilization 8.28 yuan/dollar

Accidental stabilization6.83 yuan/$

Source: Wang (2009)

Figure 14: Forward Rate vs. Forward Rate from Covered Interest Parity

(yuan/dollar,6 month)

6.0

6.2

6.4

6.6

6.8

7.0

7.2

7.4

7.6

7.8

8.0

Oct-08 Dec-29 Apr-04 Jul-05 Sep-27 Dec-27 Mar-31 Jun-27 Sep-22 Dec-22 Mar-26

Outright Forward

Implied Forward

06 07 08 09 Jun

Source: Wang (2009)

Figure 15: Percentage Deviation From Covered Interest Parity

(yuan/dollar, by maturity)

-10%

-8%

-6%

-4%

-2%

0%

2%

Oct-08 Dec-29 Apr-04 Jul-05 Sep-27 Dec-27 Mar-31 Jun-27 Sep-22 Dec-22 Mar-26

6 Month3 Month9 Month

06 07 08 09 Jun

Reducing China’s Saving-Investment Surplus

Increase share of household disposable income in GDP in order to increase private consumption

• reduce personal income and sales taxes• increase government transfer payments• increase dividend payouts from enterprises• Increase government social expenditures.

Stimulate household spending• increase consumer credit • abolish one-child policy?

Objectives

(1) Reduce China’s trade surplus (2) Counter cyclical downturn in China and rest of the

world

• Caveat: Stabilize exchange rate (Mundell-Fleming)

Figure 16: Investment, Savings and Current Account of China

(as a percent of GDP)

Source: EIU

0

10

20

30

40

50

60

2000 2001 2002 2003 2004 2005 2006 2007 2008

Investment

Savings

Current Account Surplus

Source: UBS

Figure 17: China’s Labor Income and Operating Surplus

(Share in GDP(%))

Source: UBS

Table 2: China’s Economic Positions in 1997 and 2007

Note: The NPL ratio is 2.8% for four largest commercial banks, Dec 2008.

Conclusion:Countering the Global Cyclical Downturn in 2008-09

• New U.S. fiscal stimulus is problematic: weak domestic financial institutions, and trade deficit would increase

• China now a big actor on the world stage with stronger public finances and much stronger banking system

• To stimulate the U.S. and world economies, the primary fiscal stimulus should be in China and other surplus Asian economies—and possibly Germany.

• Nov 2008, China announces a half trillion dollar fiscal stimulus—now supported by rapid bank credit expansion

• U.S. quid pro quo: No more China bashing on exchange rate, or through antidumping duties, and other policies