The Treasury released its report International Economic and Exchange Rate Policies yesterday. As expected, the Treasury declined to declare China a currency manipulator. On the same day, four senators submitted legislation to tie Treasury’s hands in terms of the actions it can take against countries with “misaligned” currencies.
Figure 1: Log trade weighted real value of the Chinese Yuan. Source: IMF, International Financial Statistics.
From WSJ:
Bill Would Punish China
For Failure to Boost Yuan
By JOHN MCCARY
June 14, 2007
WASHINGTON — A bipartisan group of senators unveiled a widely anticipated bill that targets Beijing’s currency policy, but critics questioned how effective this and other such anti-China legislation would be.
The bill would require the Treasury Department to take specific action against countries that purposefully “misalign” their currencies, such as cutting off funding to the countries or filing complaints through the World Trade Organization. The bill also would give Congress more oversight of Treasury’s role in the process.
…
The measure introduced yesterday is co-sponsored by two of China’s biggest congressional critics, Mr. Schumer and Lindsey Graham (R., S.C.), and two lawmakers better known as free traders, Senate Finance Committee Chairman Max Baucus (D., Mont.) and Sen. Charles Grassley of Iowa, the panel’s top-ranking Republican.
The four senators represent a wide spectrum of political thought on trade and their cooperation underscores the depth of unease with China in Congress.
The bill has a good chance of passage given the stature of its backers, who are known in the Senate as experts on trade law, and given the eagerness of lawmakers to pass some kind of legislation addressing the China issue, said Skip Hartquist, counsel to the China Currency Coalition, which represents groups in manufacturing and agriculture. Another plus, he said, is the way in which the bill defines currency manipulation as a trade issue, rather than a monetary one.
…
The U.S. Trade Representative’s office yesterday said that it was rejecting a petition to take China’s alleged misalignment of its currency as a complaint to the WTO. Such a complaint would be similar to any that might be proposed under the legislation.
The bill also includes language that could shield other countries with arguably undervalued currencies, such as Japan, from being hit with punitive action. The bill says a country can be exempt if it takes “effective remedies” or if the president issues a waiver.
…
In previous posts, I’ve noted the difficulty in determining whether a currency is misaligned ([1], [2]) so I won’t repeat those arguments here. Despite the difficulty in establishing misalignment, I do think it’s in China’s own best interests to allow a faster currency appreciation — as opposed to the current policy trying to rein in the economy by tighter monetary and administrative policies. That’s because tighter monetary policy merely exacerbates capital inflows, reduces demand and hence imports, thus increasing the balance of payments surplus (this can be shown in a straightforward fashion in a Mundell-Fleming model, as shown here). Clearly the ongoing rapid accumulation of forex reserves is complicating the management of the Chinese macroeconomy. And, of course, more rapid appreciation will aid in the process of global rebalancing [3].
On the other hand, Americans should not delude themselves that a more rapid realignment of the yuan will drastically alter the US current account and trade deficit. This is a point all too easily forgotten in the debate. First substantial expenditure switching will occur only if the rest of the East Asian currencies follow China’s lead. For instance, Marquez and Schindler (forthcoming, Review of International Economics; working paper version here [pdf]) find that a 10% appreciation will result in only a $63 to $70 billion reduction in aggregate Chinese trade balance (and only part of this will go to reducing the United States‘ 2007Q1 $727 billion trade deficit (SAAR)). Second, a lot of our trade deficit has to do with oil; changing reliance upon oil requires much tougher choices — see here — than almost any politician has recommended.
Finally, in my view the most important effect of faster yuan appreciation (along with the other East Asian currencies) might be related to diminished purchases of dollar assets, including Treasuries. Less demand for Treasuries, holding all else constant, results in a lower prices (higher yields). Given what we’ve seen this week, I think a lot of people should re-think exactly how fast and discretely they want this adjustment process to proceed.
Figure 2: Ten year constant maturity inflation indexed yields, June 11, 2006-June 11, 2007. Source: FRED II.
[Late addition: June 14, 8pm Pacific]
The bill is online here
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currency misalignment,
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Prof Chinn, central bank Governor Zhou Xiaochuan has wanted faster and broader currency reform, but the challenge has been trying to convince the State Council (China’s cabinet) that Xiaochuan is correct.
The yuan rose for a third day because the U.S. Treasury did not label China a currency manipulator. I think the odds are increasing that there will be further yuan appreciation allowed later this year (I hope).
Good arguments, Menzie, but you’re missing the what’s really important about what’s going on here.
First a point of ec. philosophy:
You can’t both argue that free markets are desirable inherently and then argue (as here) that free markets are in this particular case undesirable because moving to them would be painful.
I don’t understand why the many esteemed folks who make your argument believe for some reason the US should be immune to the pain of free market adjustments, especially since the pain is largely a result of our own voluntary behavior, with excess consumption, low savings, and asset bubble-chasing driving valuations to unhealthy levels.
Indeed, I’d argue that over the medium and longer term, some pain is exactly what the markets should extract to bring people back to more healthy economic behavior.
Yes, a sudden float would bring credit market seismicity and broad-based asset revaluation. We’ve seen a small example of that over the last week or so.
But in the bigger picture, the US is in a better position to handle abrupt shifts than China because China’s banking and social welfare systems are so fragile and untested, and the US is a free-market democracy, where as we know markets allow for healthy adjustment and the individual has experience and the ability through any number of financial and other instruments to adjust for changing times, whereas China is a more controlled environment unprepared and unfamiliar at the micro level with the wrath of markets.
It’s time for China to join the free market. If they refuse and just feed us more “we’re adjusting” hooey as their reserves grow at simply uncomprehensible rates, it’s time to force them.
Let’s insist those reserve dollars be put to work in a healthy way allowing the Chinese laborer’s standard of living to compete at a level commensurate with China’s standing as an economic power, rather than the unhealthy way those reserve dollars are allocated now, into unhealthy and unsustainable credit market fake “stability”, hedge fund managers’ billions, and the US consumer’s addiction to debt.
The bigger picture is not about increases of the price of goods at Wal-Mart, it’s about the US consumer learning which goods should be purchased in the first place, and which money should be put away for a rainy day. The US consumer won’t learn this lesson until she has to.
Which of these people would you want to take out your appendix: Charles Schumer, Lindsey Graham, Max Baucus, or Sen. Charles Grassley? Okay, don’t all raise your hands at once. I can’t believe we give these people such power over the lives of others when they are so uneducated. Government should not, I repeat, government should not be making monetary policy for the US or for China.
We have allowed legislators to control aspects of our lives when they know nothing about it. Legislators are necessary to pass laws to prevent a conflict of rights, but legislators do not bestow those rights. Markets should be allowed to clear.
All I can say to these men is to be careful what you ask for, because you may get it, and if it demonstrates greater stability than the dollar, the yuan may become the world’s reserve currency.
US GDP grew by 3.1%. Not bad right? Well the world average grew at 5.4%? Does that make you stop and think at any level? Then there is China growing at better than 10%.
When is congress going to stop playing games with the US economy and begin to release our productive economy? The barriers to entering markets and competing in markets are huge as reflected in the US growth rate. The strength of America has been its free market economy. The only way we can compete with China is to continue to honor freedom above all.
(1) Dr. Chinn–it’s more the symbolic gesture of yuan revaluation that matters IMHO. Like most economists say, revaluation without a concomitant adjustment on the part of the US (i.e., more saving) is not likely to result in an improved US current account balance.
China’s interest in revaluing is to get America off China’s case in the sense of “see, we revalued, but your current account deficit is still there. Go find another scapegoat.” America has no one to blame but itself in this respect.
Also, watch out–the Europeans are also on China’s case over much the same things: yuan undervaluation, IP violations, market access, etc.
Move now, China, and be done with it.
(2) All I can say to these men is to be careful what you ask for, because you may get it, and if it demonstrates greater stability than the dollar, the yuan may become the world’s reserve currency.
LOL, Dick F. When that happens, I’m moving to one of those islands in the middle of nowhere they keep flogging at the back of lifestyle magazines.
Dick said, “We have allowed legislators to control aspects of our lives when they know nothing about it. Legislators are necessary to pass laws to prevent a conflict of rights, but legislators do not bestow those rights. Markets should be allowed to clear.”
Do you actually think that markets are currently “clearing” vis-a-vis the dollar/yuan exchange rate? The Chinese clearly manipulate the yuan. So, it’s all right for Chinese legislators (or whatever they have) to “set monetary policy” but US legislators should “let markets clear?” That makes zero sense.
Finally, in my view the most important effect of faster yuan appreciation (along with the other East Asian currencies) might be related to diminished purchases of dollar assets, including Treasuries. Less demand for Treasuries, holding all else constant, results in a lower prices (higher yields). Given what we’ve seen this week, I think a lot of people should re-think exactly how fast and discretely they want this adjustment process to proceed.
Very good point. In my opinion, it couldn’t come at a worse time too. It reminds me a bit of the solution to the housing problems. Crack down on subprime loans AFTER the market starts to fall? Ouch.
Yields are under pressure from various sources. I agree that this is clearly one of them.
This also has modest implications for the inflation outlook, since a weaker dollar sees the price of imports rise.
Another pressure is that headline inflation has been running high for the past 6 months. We’ll find out tomorrow if that trend continues. The consensus, according to briefing.com is for a whopping 0.6% increase in May. Ouch.
Yet another pressure point is that for a decade the spread between headline inflation and core inflation has been widening. I understand that removing food and energy from the inflation outlook makes some sense, but at some point you have to wonder if there is a secular change going on. Even the Fed itself is starting to wonder.
All these things taken together are why I like TIPS right now (not that it has worked out for me all that well over the past month).
gab wrote:
Do you actually think that markets are currently “clearing” vis-a-vis the dollar/yuan exchange rate? The Chinese clearly manipulate the yuan.
gab,
You write as if you believe that the US monetary authorities do not manipulate the dollar. Never forget that the world trusted the US and gave the US unprecedented monetary control under Bretton Woods and it the trust was violated. The US in essence inflated currencies around the world for its own selfish reasons.
The fact that China is sterilizing the yuan is nothing compared to what we did after Bretton Woods, and understand that China is simply doing what the US did for years.
Now do I believe that China should stop sterilizing the yuan of course, but not because of the trade balance with the US. As noted in the treasury report China has “weak consumption” and also noted was that “Chinese officials emphasized the priority they place on continued implementation of reforms to address economic imbalances and to shift growth toward consumption and away from investment and exports. They also acknowledged the role of exchange rate reform in that process.”
If China continues on their current path the yuan will continue to strengthen against the dollar, and there will be an increase in consummer consumption by the Chinese people, but that path requires them to carefully allow the yuan to strengthen as they break with the weakening dollar. Mundell warned them years ago when they linked to the dollar to keep the link weak so that China did not import US inflation.
The Chinese do understand that they need to give the yuan a foundation. Because the US was their primary trading partner it made sense to link to the dollar. Now as China is moving toward more international trade their monetary system can take on more of its own character. It is highly probable that they will begin to move toward a gold foundation to their currency as Mundell has also suggested.
And no I do not believe that markets are currently clearing for a number of reasons, but specifically to the US because the FED manipulates the dollar in ways that prevent clearing. Both inflation and deflation can take up to 20 years to clear because of long term contracts, but the FED has been whipping us into inflation and deflation about every 3 to 5 years in an attempt to regulate the economy.
Finally do I believe free markets work when they are allowed to work? You bet I do.
RN,
First a point of ec. philosophy:
1. Some prefer to remove a Band-Aid quickly. It is a brief moment of pain followed by instant relief.
2. Some prefer to remove a Band-Aid slowly. There will be less pain but it will be over a longer period of time.
It is hard to say that one way is superior to the other. It is all in the eye of the beholder.
However, the “game” changes dramatically if the Band-Aid is allowed to grow over time. It turns especially bad for those using Option #2 if the Band-Aid is growing faster than you are removing it.
RN: I think you’ve got me confused with somebody else. I don’t believe that free markets are inherently desirable. Competitive markets (in the textbook sense) might be, but those are rare, and need not coincide with free markets. I do believe that markets are typically the best way to allocate resources, but oftentimes there are distortions (sometimes associated with government intervention, sometimes associated with market power), so that blanket generalizations are something I don’t engage upon.
Moving to more concrete issues, I agree that it is in both China’s and the world’s interest that there be more rapid adjustment. That adjustment needs to take place in real effective terms, and not merely against the dollar. But, I also think that a really sharp shock to the financial system is not in anybody’s interest (notwithstanding the intuitive appeal of Stagflationary Mark‘s band-aid metaphor). We are remarkably ignorant about who holds what assets and liabilities, and positions on derivatives (where the notional value of derivatives far exceed the value of the underlying assets in many asset classes). While slower shifts provide no guarantee that a financial crisis will be avoided, my intuition is that sudden sharp moves could lead to systemic problems.
Menzie Chinn,
I should have offered my own opinion of how the Band-Aid should be removed.
I completely agree with…
Moving to more concrete issues, I agree that it is in both China’s and the world’s interest that there be more rapid adjustment. That adjustment needs to take place in real effective terms, and not merely against the dollar. But, I also think that a really sharp shock to the financial system is not in anybody’s interest…
That last post was mine.
Menzie — i had the opposite reaction to you to the finding that a 10% RMB appreciation would reduce China’s trade surplus by $60-70b (over 2% of China’s GDP). the overall magnitude of the reduction struck me as quite large. the standard rule of thumb in the US used to be a 10% move in the $ would reduce the US trade deficit by about 1% (there are some issues here), so China’s trade balance seems more responsive to changes in the RER than the US …
then there is the big question for me — which is that it seems that the current trajectory of modest RMB appreciation v the $/ no real RMB appreciation if the $ is falling seems likely to result in ever larger Chinese trade surpluses. you can make an argument that current trends cannot continue, but all signs suggest china’s export growth accelerated in late 06 and now is running above its early 06 pace. there isn’t much sign that China’s export boom is going to slow absent some policy evolution, much as one can argue that it should, jsut because 30% export growth off a $1,000b base is different than 30% export growth off a $500b base, or off a $200b base. my question is — what, in the absence of faster rmb appreciation than the Chinese have signaled that they are wiling to allow — would help bring down the chinese trade surplus (with the world, not jsut with the US), which my all indications is set to increase dramatically this year?
brad setser: I think we’re in agreement on several key points. The $60-70 bn decrease in China’s multilateral trade deficit is not inconsequential. However, it’s not clear how much of that reduction will show up in the bilateral US-China deficit. In addition, while this effect seems larger than the comparable rule-of-thumb used for the US, the US is a more closed economy (in the sense of exports plus imports divided by GDP) than China, so one could imagine a bigger response.
What will stop the rapidly growing trade surplus? Aside from protectionism, slower rest-of-world growth; indeed, it would have to be consumer retrenchment in the US that would induce a slowdown in Chinese exports.
By the way, don’t get me wrong — I’m all for somewhat more rapid (albeit measured) Chinese yuan appreciation in real effective terms. Just don’t expect it to help the US much directly through expenditure switching. If the rest-of-East Asia follows, and real US Treasury rates continue their upward climb, then I can see the US-China bilateral deficit shrinking.
I am amused that the balance of trade between the US and China always seems to come back to the relative currencies, but in truth the balance of trade is normal for the economies of the two countries and monetary manipulations will only destroy wealth either on the backs of the Chinese people (a situation the Chinese seem will to reject) or on the backs of the American people (a situation that American economists seem to embrace).
The only way for the balance of trade to be actually changed is for the Chinese economy to generate consumption from the Chinese consumer. Imports will only increase when they can be used and that means consumers either business or personal. This is not dependent on monetary conditions other than the creation of a stable monetary relationship that will allow businesses of both countries to make valid and accurate economic calculations.
Mundell is correct in encouraging the Chinese government to free the internal economy in China and allow the prosperity that the Chinese are experiencing to be realized by the people.
American economists would be wise to understand that monetary manipulations destroy wealth and have caused the US economy to grow at less than the world average. By world standards US growth is very weak. The US will never maintain its economic position in the world until it begans to stop the monetary games and also follows Mundell’s suggestion freeing the internal economy of the US.
This result for both countries will be an massive increase in world wealth.
I think we should strike the balance between economics and Political economy.
1. It’s hard to define the “fair value” of a currency
2. Even if we were able to do so there’s a gap between this fair value and the actual value. Economic and Political forces can allow the actual rate to converge to this value
3. There is an arbitrage between economics and politics: with the reform of its exchange rate regimes, the chinese authorities have shown their goodwill but have also shown that they are not going to obey the US concerning trade disputes
4. If a conflict between the US and China is to happen on a currency there’ll be an important issue concerning justice: the WTO focuses on Trade and goods, exchange rate are monitored by the IMF, yet the Article IV is quite loose on this aspect. So for instance if the US were to raise tariffs on chinese products because of an alleged manipulation of the currency, the Chinese could plead for a resolution by the WTO on trade issue but not on exchange rates…