Monday, April 25, 2005
Leaving aside that Martin Wolf and others happen to strongly agree with my views on not biting the hand that kindly feeds you, what is more important here is that, reading carefully the Chairman's remarks, one notices that the Fed has finally realized - and is repeating quite closely - what Brad Setser and I have been saying for a while (see for example here and here and here), i.e. that the Chinese exchange rate and forex intervention policy is leading to major financial imbalances in the Chinese economy, i.e. difficulties in fully sterilizing the forex intervention leading to excessive monetary and liquidity creation that is potentially inflationary, and that is thus exacerbating the financial and investment bubbles and misallocation of economic resources that risk causing a Chinese hard landing; and that is thus in China's interest to move its peg sooner rather than later for internal balance reasons.Inhale!
One of my undergraduates was equally confused by this article in this morning's WSJ in which Mary Kessel quotes Stanford economist Ronald McKinnon:
Mr. McKinnon argues that if China lets go of its fixed exchange rate of 8.28 yuan to the dollar "that won't reduce its trade surplus," with the U.S. and other countries. "It's an illusion that it would," he says.My student asks how this is possible? "Does this mean that the Japanese still bought domestic goods even though they had become relatively more expensive, and, or did foreign countries continue to buy japanese imported goods even though they had become more relatively more expensive?" The answer is of course that a large trade wall, in the form of interlocking merchant associations and retailing laws that favor small vendors and domestic supply chains, have hindered the ability of American firms to compete there ... but the same could happen in China. I recall living in Ukraine and at first jumping for joy if we found Polish products on the shelves, for we knew they were better than the domestic stuff. By the time I left, barely a year later, Italian and Greek products dominated the more upscale grocery shops. In that case it was simply building the supply chains up. In the case of Japan and China, there may be more legal barriers in place.
Mr. McKinnon reached that conclusion after tracking the experience of Japan's currency in the years following World War II as the yen moved from a fixed-rate to a floating-rate currency. Like China, Japan set its currency-exchange rate to the dollar during its early period of rapid expansion. Like China, Japan was heavily export-oriented. Like China, Japan's economy expanded an average of about 9% a year while it kept its currency's peg in place.
Mr. McKinnon attributes much of Japan's success during the first two postwar decades to its exchange-rate peg, which kept prices for tradable goods from fluctuating wildly, allowing Japanese companies and consumers to plan spending and take manageable risks.
In 1971, however, U.S. inflation spiraled out of control and Japan was forced to move to a floating-exchange rate. The yen strengthened to 80 to the dollar from 360 to the dollar during the next 25 years. The yen's appreciation was at least supposed to fix Japan's trade imbalance, by making imports less expensive. But the imbalance stubbornly remained -- partly because of Japanese savings habits and partly because as Japan's trading partners put political pressure on Japan to push the yen higher, asset bubbles formed, then burst, and the economy slumped. In other words, a stronger currency may give Asians more buying power, Mr. McKinnon says, but it doesn't mean they will spend more.
This conclusion, that a change in currency-exchange policy may not predictably influence spending habits, challenges core modern economic models. "It's a widely held theory by respectable economists, but it's a widely held false theory," Mr. McKinnon says. "And that can lead to very poor policy making."
Kash is concerned that revaluation will have major repercussions on the U.S. -- "I have in mind actions similar to those taken in 1998 as the LTCM affair was unfolding" -- but I think this is overblown. According to the Treasury, Chinese holdings of US Treasuries is under $200 billion. (Japan has 3.5 times as much.) They may hold some U.S. currency, but that is largely for liquidity purposes and not to be sold off on forex markets. Unless you think the selloff would be more than half this number, it's hard to believe the volumes overwhelm those experienced during the LTCM wind-down. In other words, there will be an effect to floating if the Chinese decide to do so, but it's manageable.