On China: Global Impact, Domestic Costs, Hard Landing, and the RMB As an International Currency

A new book on China (and Asia) in the global economy, the costs of the Chinese currency regime, the prospects for a Chinese hard landing, and can China save the day if the US and euro area go into recession. Plus, the prospects for the RMB as a key international currency.

 

A new bookAsia and China in the World Economy, edited by Yin-Wong Cheung (UCSC and HK City U) and Guonan Ma (BIS).

The contents:

 

Introduction

Open Macroeconomics and Transmission Mechanisms:

 

  • Trilemma Configurations in Asia in an Era of Financial Globalization (Joshua Aizenman, Menzie D Chinn and Hiro Ito)
  • Some Market Measures of Capital Account Liberalization in India (Michael Hutchison, Gurnain Kaur Pasricha and Nirvikar Singh)
  • A Simple Model for “China Factor” in a Small Open Economy (Xiao Xiao, Lihua Tang, Shuzhan Zhou and Jie Li)

The Renminbi Valuation Debate:

 

Currency Internationalization and Financial Markets:

 

 

  • The Internationalization of the RMB (Yongding Yu and Haihong Gao)
  • Internationalizing the Yen, 1984–2003: Unfinished Agenda or Mission Impossible? (Shinji Takagi)
  • Bond Currency Denomination and the Yen Carry Trade (Christopher A Candelaria, Jose A Lopez and Mark M Spiegel)
  • Growing Asian Credit Card Markets Amid the Global Financial Crisis (Tae Soo Kang and Guonan Ma)

 

External Demand and Fiscal Stimulus:

 

  • Macroeconomic Effects of China’s Fiscal Stimulus (Pietro Cova, Massimiliano Pisani and Alessandro Rebucci)
  • How Much Do Exports Matter for China’s Growth? (Li Cui, Chang Shu and Xiaojing Su)
  • The Effect of Government Purchases on Economic Growth in Japan (Federico Guerrero and Elliott Parker)

 

Joe Gagnon tabulates the internal costs of the Chinese exchange rate regime:

It is currently costing the Chinese central bank about $240 billion per year to hold down the value of the Chinese currency relative to other currencies. This cost is growing rapidly. The cost would decrease significantly if China allowed its currency to float and began reducing its foreign reserves, although there would likely be a one-time capital loss at the time the currency begins to float.
To put this cost in perspective, $240 billion is considerably larger than China’s trade surplus of $183 billion last year. It is about 4 percent of China’s GDP in 2010. Moreover, this cost does not include the implicit tax on the banking system associated with China’s reserve holdings, which is passed on to Chinese households in the form of depressed rates of interest on savings deposits.
As of June 30, 2011, China’s foreign exchange reserves were $3.2 trillion, having grown rapidly from $2.9 trillion on December 31, 2010. There are two components of the cost of these reserves: First, the interest rate earned on these reserves is below the rate of interest paid to finance them. Second, the value of the reserves in terms of Chinese yuan is declining and is expected to continue to decline.

Hard landing or not? From ” China’s debt pileup raises risk of hard landing,” Reuters (10/9/2011):

China’s local governments have piled up a mountain of bad debt, some of it to finance bridges to nowhere and other white elephant projects, which now threatens to constrict growth at a time when the global economy is sputtering. It is adding to other systemic risks in China, including a sharp downturn in the property market and a rapid rise in problematic loans.
Local governments had amassed 10.7 trillion yuan in debt at the end of 2010. The government expects 2.5 to 3 trillion yuan of that will turn sour, while Standard and Chartered reckons as much as 8 to 9 trillion yuan will not be repaid — or about $1.2 trillion to $1.4 trillion.


The risks of default are rising. Nearly 85 percent of the local government finance vehicle loans in northeast Liaoning province, for instance, missed debt service payments in 2010, an audit report posted on the Liaoning Daily website said.

On the other hand, Tom Orlik writes in “Don’t Bet on Breaking China,” WSJ (10/10/2011):

It’s too soon to start betting on the collapse of China.
A shaky world economy has investors understandably nervous. For many, a hard landing for China, with GDP growth for 2012 dipping sharply below the 8% mark, has moved from outlying risk to central scenario.
One measure of bearish sentiment, the Hang Seng China Enterprises Index, has fallen 35% since the end of June.
Markets have gotten ahead of themselves. Yes, China heads into the possibility of a second global downturn with more problems than it did the first. Its main weaknesses are dependence on exports, a real-estate bubble and burgeoning public debt. All are real problems. But it has enough growth momentum and room to maneuver to make a soft landing the most likely outcome.
The importance of exports as a driver of China’s growth is overstated. …
Real-estate investment is a key driver of China’s growth, equal to around 14% of GDP in 2010. Ghost towns of empty houses raise fears that construction might be set to slow sharply. But with millions moving from the countryside to the city each year, and rising wages driving demand for higher-quality accommodations for existing city dwellers, fundamental demand is strong. ….
Rising debt is another worry. An investment-based response to the 2008 crisis saw local governments rack up enormous debts—10.7 trillion yuan ($1.68 trillion), according to the National Audit Office. Investors fear that much of that will end up as bad loans on the banks’ balance sheets.

Assets on the other side of the balance sheet mean that in many, if not most, cases local governments are good for their debts. Even if all the borrowing by local governments goes bad, China is still not maxed out on debt. The range of analysts’ estimates for the total of national, local, and other debts that might end up on the Ministry of Finance’s balance sheet is 60% to 85% of 2010 GDP.

on a side note, Tom Orlik is the author of an excellent primer on Chinese statistics (from which I learned a lot), entitled Understanding China’s Economic Indicators (FT Press, 2012), so this assessment must be heeded.

 

But China can’t save the day if the US and Euro Area enter a downturn, perhaps in part because of self-inflicted policy mistakes (one just has to remember who said a little defaulting on US Treasurys wouldn’t be such a bad thing). From Jun Ma, “China: Downside Risks Intensifying,” Global Economic Perspectives: World Outlook 2011q4 (Deutsche Bank, October 3) [not online]:

Some investors believe that China provides a source of
independent demand to offset the possible economic
contraction in the EU and the US. We are less
optimistic. From a global perspective, China’s domestic
demand is still far too small to offset the impact of a
recession in the EU/US. First, the political feasibility for
China to offer another massive stimulus package has
declined and, therefore, the Chinese economy will most
likely decelerate on the external demand shock.
Second, consumption and investment in China
amounted to only USD5tn in 2010, one-sixth that of the
EU and the US. This implies that to offset the impact of
a 3% reduction in EU/US GDP on the global economy,
China would need to increase its GDP by 18%, which is
inconceivable.

This last point brings me back to domestic macro policy; if we are to prevent a global downturn, we need to return to a sensible macroeconomic policy framework in America which increases fiscal stimulus now, in exchange for a long term program of fiscal consolidation. Hence, a small step in the right direction would be passage of the President’s proposal. [1] And even then, much will depend on how (if?) the Europeans sort out their problems.

 

China as an international currency? [added 4pm Pacific] Jeff Frankel is skeptical, as long as China’s policy elites are unwilling to open up the financial system fully, and allow the development of deep and liquid markets — which will be hard to control:

All of a sudden, the renminbi is being touted as the next big international currency. Just in the last year or two, the Chinese currency has begun to internationalize along a number of dimensions. A RMB bond market has grown rapidly in Hong Kong, and one in RMB bank deposits. Some of China’s international trade is now invoiced in the currency. Foreign central banks have been able to hold RMB since August 2010, with Malaysia going first.

 

The current RMB phenomenon differs in an interesting way from the historical circumstances of the rise of the three earlier currencies [dollar, mark, yen]. The Chinese government is actively promoting the international use of its currency. Neither Germany nor Japan, nor even the US, did that, at least not at first. In all three cases, export interests, who stood to lose competitiveness if international demand for the currency were to rise, were much stronger than the financial sector, which might have supported internationalization. One would expect the same fears of a stronger currency and its effects on manufacturing exports to dominate the calculations in China.

 

It is not yet clear that China’s new enthusiasm for internationalizing its currency includes a willingness to end financial repression in the domestic financial system, remove cross-border capital controls, and allow the RMB to appreciate, thus helping to shift the economy away from its export-dependence. Perhaps a small elite will be able to accomplish these things, in the way that Strong did a century earlier. But so far the government is only promoting international use of the RMB offshore, walled off from the domestic financial system. That will not be enough to do it.

More detail is in this paper.

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3 thoughts on “On China: Global Impact, Domestic Costs, Hard Landing, and the RMB As an International Currency

  1. Raskolnikov

    Very good post. Thanks.
    Correct me if I’m wrong, but it looks like the bulk of China’s stimulus went into investment rather than consumption. That suggests that the central bank’s raising rates will push housing prices down and put many of the speculators out of business pronto. The problem is, is that many of these speculators are the folks who borrowed a lot of money from underground banks–which appear to be connected to state-owned operations.
    Falling housing prices will help to reduce inflation, but they are likely to produce knock-on effects that will slow the economy and increase the pressure on banks from non performing loans. The point is, the PBOC’s interest rate policy is hardly a precision tool for controling overheating. The chance that they will overshoot and trigger a recession could be quite high, don’t you think?
    Or is this overly pessimistic?

  2. don

    My neighbor does architectural advising for real estate developments in China, both residential and commercial. He says business is still booming.
    Joe Gagnon’s calculations seem a bit one-sided in a world where labor is redundant and output is demand-determined, it can pay to produce goods merely to dump them into the ocean. I recall similar arguments about the profitability of Japanese central bank operations when Japan was building reserves after the dotcom crash. The response was simply “who said our primary goal was to make a profit on our resrves?”

  3. ppcm

    It is not clear yet, whether China is on the path of changing of production curve,going from labour intensive industries to semi capital or capital intensive industry.As labour is deemed to become more “costly” manufacturers shift from textile to electronic and electronic intermediaries goods.
    Taiwan went through this mutation in the 90s,the shift was painful until mainland China became a full production backyards.
    Econ grapher charts are providing for a glimpse of diminishing returns
    (http://econgraphergraphs.blogspot.com/)
    As always the cost will not be in the production functions but in the real estates and in the financial sectors.As always look at the balance sheets,look at the non listed investments items in the balance sheets.

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