February 12, 2007
The 2007 Economic Report of the President on Exchange Rate Determination (and the Renminbi)
The 2007 Economic Report of the President was released Monday afternoon. Chapter 7, entitled "Currency Markets and Exchange Rates," is a laudable exegesis on the determination of exchange rates.
For a long time, China had a fixed exchange rate with the United States. To maintain its fixed exchange rate, the Chinese government had to stand ready to buy or sell yuan, China's domestic currency, for U.S. dollars at a fixed price. From 2000 to July 2005, this price was set at approximately 8.28 yuan per dollar. Over this time period, Chinese productivity growth was much higher than U.S. productivity growth and Chinese prices on average grew much more slowly than U.S. prices. High productivity growth implies a high return to investment in China relative to the United States. The slow growth of Chinese prices implies that, holding the exchange rate constant, Chinese goods were becoming cheaper relative to goods in the United States. Therefore, both in terms of maintaining interest rate parity and in terms of maintaining PPP, there was pressure for the yuan to appreciate relative to the U.S. dollar. How did the Chinese authorities prevent the appreciation?
The Chinese authorities prevented the appreciation by buying U.S. dollarsand exchanging these dollars for yuan. The pressures for appreciation of the yuan implied that the yuan was facing higher demand -- that more goods could be purchased for dollars converted to yuan, and investments in China delivered, on average, a higher return. To offset the increase in demand, the Chinese government effectively increased the supply of Chinese assets and decreased the supply of U.S. assets. Chinese foreign-exchange reserves increased from around $150 billion in early 2000 to almost $1 trillion by September 2006, a truly remarkable increase. In other words, the Chinese prevented an appreciation of the exchange rate by effectively printing yuan and using those yuan to accumulate U.S. dollar assets.
By fixing the exchange rate, the Chinese monetary authority is unable to use monetary policy for any other goal. By printing yuan, the Chinese raise the amount of currency in the country, which in turn, holding all else equal, raises the domestic price level, thus raising the economy's inflation rate.
But if they are just printing enough to buy and hold U.S. assets, from where does the domestic price pressure arise? The price pressure arises as the yuan, which are used to purchase the dollar assets, flow back into the Chinese economy. In other words, the prices increase because of foreign demand for Chinese goods. On the surface, this foreign demand appears to arise as a result of the Chinese exchange-rate regime; however, this demand is the same demand which was originally putting pressure on the Chinese exchange rate. At the old prices, there was not enough supply of Chinese goods to meet all of the demand. Because the exchange rate was unable to adjust, the price of Chinese goods had to adjust.
Could the Chinese conduct a monetary operation to lower inflation? To lower inflation, the Chinese would need to remove yuan from circulation, perhaps by selling domestic bonds. This transaction is sometimes referred to as sterilization. The action, however, will tend to raise the value of the currency: the currency would become scarcer as a result of the reduction in supply. As the currency becomes more valuable the foreign-exchange value of the currency would tend to appreciate. Any monetary action the Chinese undertake to reduce domestic inflation tends to undo their exchange-rate intervention (see Box 7-4).
This example also illustrates why the Chinese intervention does not systematically change the relative real prices between the United States and China. Had the Chinese government not intervened, Chinese domestic prices would have remained the same in terms of yuan and become more expensive in terms of dollars through a change in the exchange rate. With the intervention, Chinese domestic prices rose in terms of yuan and became more expensive in terms of dollars even though the value of the nominal exchange rate was unchanged. This outcome occurs any time a country takes actions to fix its exchange rate: fixing the nominal exchange rate does not necessarily have any impact on the relative prices between two countries. In other words, fixing the nominal exchange rate does not tend to move countries away from purchasing power parity. The only effect is that domestic goods prices have to do all of the adjustment since the exchange rate is fixed. (pp. 163-64).
I think of this exposition as basically the Monetary Approach to the Balance of Payments [ppt] (see a longer exposition here [pdf]). In this view an excess of money supply can only induce a short term trade surplus, if the exchange rate is held fixed. That is because over time, the price level will rise to reassert equilibrium.
In Richard N. Cooper's famous discussion of three views of the effects of devaluation ("An Assessment of Currency Devaluation in Developing Countries" (1971)), he pointed out that the elasticities, absorption and monetary approaches to the balance of payments roughly corresponded to the short, medium, and long run horizons. How is that point relevant to the question of China's case?
Well, this means that while the ERP's reasoning is not incorrect, I wonder whether their conclusion that the peg is irrelevant to relative prices applies in a meaningful way to the time horizons we're interested in -- namely over several quarters to several years.
Really, the equivalence result holds immediately if prices are as flexible as exchange rates. If you are a believer in sticky prices as an empirical phenomenon, then you might question the equivalence result posited in the ERP. Furthermore, while it may be the case that sterilization (which China has been pursuing vigorously) does raise interest rates and hence the attractiveness of a currency, extant capital controls and financial repression might allow for effective sterilization.
So, in my view, the Mundell-Fleming model (IS-LM-TB) with low capital mobility is a more appropriate way to analyze the implications of the Chinese peg and managed float (see here [pdf]). In the short term, the real exchange rate can be affected by the exchange rate regime.
Figure 1: Log real trade weighted value of the Chinese yuan. Source: IMF, International Financial Statistics.
That being said, neither approach says anything about what constitutes currency manipulation (although the Mundell-Fleming model would suggest that the current value of the renminbi is not attaining internal or external equilibrium).
Posted by Menzie Chinn at February 12, 2007 08:30 PMdigg this | reddit
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Tracked on February 15, 2007 12:51 PM
What you say makes sense and we all just need to chill out a bit.
Posted by: China Law Blog at February 12, 2007 09:45 PM
Menzie -- I think you are way too diplomatic here. As you say, in the short-run, the real exchange rate can be affected by the nominal exchange rate. and in this case, the relevant time horizon is what in the economics textbooks must be considered the short to medium rum -- i.e. a 1-5 year horizon. if the long-run is the next twenty years, well, then the impact of the nominal XR on the real exchange rate may be minimal.
The problem I have with this part of the ERP is that it in no way fits the facts on China. China's real exchange rate has depreciated by all measures i know since 2002 (largely v. the euro). The fall in the RMB / euro has not been offset by rising Chinese domestic inflation. Indeed, i think cumulative inflation differentials between the US and china are such that the recent nominal appreciation hasn't generated much of a real appreciation if you start the clock ticking at say the end of 2001. Only in 2004 did Chinese inflation exceed US inflation; in other years, US inflation has topped Chinese inflation.
The ERP asserts that changes in the nominal XR do not have an impact on the real exchange rate, when in this case, changes in the nominal exchange rate have had an impact on the RER. So in a sense they define the interesting puzzle -- namely the absence of greater pressure for real appreciation from higher levels of inflation in China -- away. There are two theories here. One is that the absence of inflation is evidence that the real exchange rate isn't undervalued (I find that hard to believe -- look at the increase in China's current account surplus, which follows the change in the XR with a lag); the other, per Martin Wolf, is that maintaining an undervalued RER has required that China adopt policies to restrain domestic demand growth and push up savings (think fiscal policy/ no distribution of SOE profits/ administrative curbs on credit growth). But if you assert that the nominal XR has no impact on the RER, well, you just sort of cut the discussion short.
Incidentally, the oil exporting countries (almost all of which peg to the $ or a euro/ $ basket) are a far better example. All have high and or accelerating rates of inflation that are leading to a real appreciation.
the only potential exception is Saudi Arabia, where inflation (measured inflation) remains implausibly low. but in the oil exporters, the theory fits -- rising inflation is eroding the nominal depreciation that came from the dollar peg and the dollar's fall, and in some cases (Russia, Iran) there has been a strong real appreciation.
p.s. I haven't looked at the box, but in China, sterilization hasn't raised the value of the currency or pushed up domestic interest rates, presumably b/c the government has a lot of non-market controls on bank lending that effectively force the banks to buy the sterilizatin bills at a low rate. Even so, China has allowed a lot of base money growth; it just hasn't trickled into strong price pressures.
Posted by: brad setser at February 13, 2007 12:53 PM
I would agree with brad s.
The real kicker in all this is the apparently wilfull ignoring of the fact that Chinese inflation simply has not been taking off like it is supposed to. Indeed, in some years in the not-too distant past, China actually had deflation. There does seem to be a tendency for ERPs to often have these odd empirical lacunae that appear to be there for ideological reasons. I guess this is one of those, or maybe they do not really have anybody on the CEA right now who is all that competent in regard to international finance.
Posted by: Barkley Rosser at February 13, 2007 01:33 PM
If China and the oil producing countries are essentially pegging to the dollar but their inflation rates are markedly different doesn't that kind of shoot the IS/LM model in the foot and even the Mundell-Fleming refinement?
Generally, I agree with Brad and Barkley, but we need to dig deeper. Why is there no inflation in China, but there is inflation in the oil producing countries? This is an especially important question if the IS/LM components are all essentially the same.
Posted by: DickF at February 13, 2007 01:53 PM
brad setser and Barkley Rosser: I agree that the ERP analysis is not relevant, given observed data on Chinese inflation, as well as the presence of (apparently somewhat effective) capital controls.
DickF: I hope I didn't convey the idea that I believe IS-LM-BP is always the appropriate model. When inflation is rapid (and/or when countries cannot effectively sterilize, then inflows may manifest themselves in increases in money base), so that the real exchange rate is weakly affected. In sum, much depends upon the central bank's reaction function or monetary target (as alluded to in the ERP), as well as the degree of structural openness. On characterizing the Gulf countries, I defer to Brad S.
Posted by: menzie chinn at February 13, 2007 05:03 PM
Sorry Menzie. My comments were meant to be a general assessment of the IS/LM model not a criticism of you.
Posted by: DickF at February 14, 2007 06:12 AM
It has become very fashionable in the political community to blame currency manipulation for trade problems and many economists jump on the bandwagon by doing extensive analysis to demonstrate how currency manipulation can "create" trade. But if we look with an unbiased eye we see such things as the US auto makers losing market share to the growth of the Japanese auto makers. Men like Rep. Sander Levin (D-MI http://freep.com/apps/pbcs.dll/article?AID=/20070213/BUSINESS01/702130401 )crying that Japan is manipulating the currency to steal market share as Toyota moves toward being the largest auto maker in the world. But Levin conveniently misses the 13 Toyota factories in the US who do not have any FOREX gains. But Toyota is underfire for using foreign parts. All this whining makes me ill.
A currency is a medium of exchange. Any manipulation of the currency will always degrade its usefulness in its primary purpose. If there is a demon ruining US trade it occupies the largest building on capitol hill and it wears both Democrat and Republican costumes.
Congress is driving manufacturing out of the US through its tax policy and government regulations. It will take brave men to turn the trend around.
Posted by: DickF at February 15, 2007 05:38 AM
Good Early Morning, from California.......to everyone, in this discussion.
When Mao was still alive his financial adviser was a Kohanite, from San Francisco. This gentlemen now deceased, approximately fifteen years created the financial system used today within PRC.
Micro facts & events, often dictate world events and still do to this day.
Plus 95% of PRC population live a life-style comparable to the majority of persons of Central America or Mexico..
A viable middle class is emerging, within PRC, but ability of this societal segment is not sufficiently large enough to support the durable goods capacity of a nation exporting huge quantities of consumer goods namely United States and ECC.
The value of a nations currency is predicated today by trust and faith and the capacity of a nation to create GNP. The Renbeni is over-valued or under-valued depending upon your viewpoint.
It has been overlooked that under current US Tax Law Treaties: no citizenry of Hong Kong, Macau, Singapore, Taiwan, S Korea, Japan or PRC pays US Federal Income Tax on Imports or profits made on ventures, within the US only unless a formal corporate structure is established and that is questionable, how much tax if any is paid.
Citizens of the aforementioned nations likewise pay no taxes on offshore profits to their nation.
This 10 to the 8th currency floats in limbo and goes directly to jail in Switzerland.........
What about this money? What part of the US National debt could it pay? and in return how would that payment affect value of US dollar? against the Renminbi?
PRC has over-produced durable goods and quality is so mediocre that middle class Americans unlike well to do within society can least afford to replace them.
Yet corporate America (i.e. Wal-Mart, Target-Sears and "All the Rest") are strangulated by their impotence to source within the United States, Canada or Mexico...
China (PRC) through financial system created, under Mao perpetuated to this date; must commencing now or within months allow its currency to float freely against all other currencies...
It must also commence taxing, its citizenry or it will never develop a Representative Democracy!
China currency to self-sustain must create society whereby thirty percent (minimum) are middle-class to our standards, within one decade...
Until one "US Dollar" can be obtained by common citizenry throughout PRC no middle-class can or will emerge, for the long haul.
It is a false society until that time. Society reminiscent of centuries gone by where only a few who advised the dynastic leaders held wealth and power. Today's manpower requirements are greater since the society at large is not only large, but more technologically advanced. Make no mistake however the Cities of Beijing and Shang Hai are population controlled and require special papers, for access and to obtain living quarters.
Through lack of control foreign investment within United States has, within five decades destroyed our capacity to build consumer goods.
Only so many humans can work within fields of Computer Science and Economic Modeling.
This date 2007, thousands of factories, within PRC have millions of units of goods. Goods, from cancelled orders, in the United States. Goods manufactured to North American specification that can not be used, within PRC by their citizens.
We have seen goods offered to us C.I.F $1.50... Goods that retail at Macy's, Bloomingdale's or Neiman Marcus at $150.00... No clothing representative; however, will ever offer those goods. He or she could not survive financially...
That is what we are discussing, financial survivorship? is it not?
We believe it is great the PRC owns plus US $7 Trillion in Treasury Notes.... Just great that one nation is relied upon to determine value of our currency let alone their currency value...
Yes, Capitol Hill must awaken. So must PRC awaken, in matters that pertain to banking and currency values.
An acquaintance born on the Hill in Hong Kong educated with a Masters from Berkley former Sr Vice President of major US Investment Bank who traded US $Billion's daily told me: No one, nor any team within United States and only a few Chinese at the very top of PRC banking system know true value of any PRC registered banking institution.
What appears on the surface is only bright metal and paint. Paint to hide decadent sins and huge losses.
Oh yes, China Automobiles are arriving, with components of cast iron you would not want on your ironing board cover!
Since you are competent and observant please read Volker Report on Iraq Oil for Food Program. Enter the Swiss database at Ministry of Justice search away.
Yes we now are discussing oil and who created the US $60 plus per barrel and yes click on membership listing at London Metals Exchange. You want to discuss economics, it must be lived.
Posted by: MrAllen2008 at February 17, 2007 04:49 AM