The Dismal Economist

The FT’s money supply blog reports on the ECB’s first “environmental statement”:

The European Central Bank has a new target! Not only does it want to control inflation, it wants to save the environment, too. It has just published its first “environmental statement”, signed off by Vítor Constâncio, vice-president, which reveals a goal of reducing its total carbon footprint by 15 per cent in 2011 compared with 2009.

The ECB is hardly a smoke-belching industrial company (please, no jokes about hot air production). But it does operate three high-rise buildings in Frankfurt and has more than 1,500 staff, quite a few of whom travel around the world regularly. The euro’s monetary guardian also produces a lot of weighty, paper-consuming publications.

[…] Alas, those gains were offset by a 13 per cent increase in energy consumed for heating and cooling purposes. The ECB says that was partly the result of providing additional air conditioning at weekends – those out-of-hours meetings to combat the economic crisis clearly took their toll on the environment.

There’s a funny video on YouTube explaining QE: Quantitative Easing Explained

I am presently attending the Beijing Forum at Peking University to present in a session on Global Imbalances and their Solutions. While the Great Firewall is preventing me from accessing youtube, facebook and the like, I have the privillege of getting a complementary copy of China Daily every morning in my hotel. Yesterday’s headline demanded that another firewall is created ( ‘Firewall needed’ to prevent cash surge), warning over capital influx as US starts “unbridled money printing” (=QE2):

China should “set up a firewall” as uncontrolled dollar printing in the United States will drive more liquidity into emerging markets, a central bank adviser said on Thursday.

“The most urgent need for the emerging market economies is to curb capital inflows,” Xia Bin, an academic member of the central bank’s monetary policy committee, told a financial forum in Beijing.

Xia’s comments came as the US Federal Reserve announced a new round of quantitative easing – pledging to buy $600 billion of government bonds – to prop up the ailing economy.

Claiming the US quantitative easing was “unbridled money printing”, Xia said China should push for plans to stabilize the world’s major currencies at the upcoming G20 summit.

In an essay published on Thursday elaborating his thoughts on reforming the international framework for prudent macroeconomic management, Xia warned that “another crisis would be inevitable” if the world failed to restrain the issuance of major reserve currencies, such as the US dollar.

Policymakers in emerging market economies criticized the Fed’s decision of pumping money into the economy, as they fear the flood of cash will intensify asset-bubble risks and push up their currencies. Analysts said such countries might roll out more measures to curb capital flows.

[…]

High real estate prices in China’s major cities and the country’s well-performing stock market, which has rebounded about 30 percent from the July low, could receive a boost from capital inflows, analysts said.

Xia said he is concerned about asset-bubble risk in China as a spillover from US policy.

Pressure for yuan appreciation could also increase, analysts said.

“The quantitative easing policy might not fulfill the target of revitalizing the US economy as the country’s financial system is still saddled by heavy debts, but the move will add pressure for yuan appreciation,” said Li Daokui, central bank adviser and professor at Tsinghua University.

The central bank set the reference rate of the yuan at 6.6708 against the greenback on Thursday while the dollar continued to weaken. But Li said there is no need to “overly panic”, and China’s exchange rate should move at its own pace.

Li said there will be a substantial amount of speculative capital flow into China, but given the country’s $5.5 trillion economy, the shockwave of “hot money” would be limited compared to its impact on Brazil and India.

“China is less sensitive or vulnerable to capital inflows given the comprehensive capital controls,” said Louis Kuijs, senior economist with the World Bank.

“The quantity of capital inflows (into China) is smaller than other countries in Asia, and the risks are still manageable,” Kuijs said.

Meanwhile, the FT, which is thankfully not blocked by the firewall, reports that “China tees up G20 showdown with US “:

I am currently in Mumbai, where I am attending a conference on “Policies for Growth and Financial Stability Beyond the Crisis – The Scope for Global Cooperation”. This morning, Duvvuri Subbarao, the Governor of the Reserve Bank of India, gave an intersting speech in which he addressed what he called “Frontier Issues on the Global Agenda”. In his speech, he emphasised how global cooperation is vital to reach a shared understanding on redressing imbalances, exchange rate flexibility and management of capital flows. Given the strength and pace of globalisation, he maintained that purely national solutions are not only inadequate but may indeed be counterproductive.

The Economist has pulished its latest Big Mac index (“Bun fight. Why China needs more expensive burgers”), according to which the Chinese yuan is undervalued by about 40%:

A WEAK currency, despite its appeal to exporters and politicians, is no free lunch. But it can provide a cheap one. In China a McDonald’s Big Mac costs just 14.5 yuan on average in Beijing and Shenzhen, the equivalent of $2.18 at market exchange rates. In America the same burger averages $3.71. That makes China’s yuan one of the most undervalued currencies in our Big Mac index, which is based on the idea of purchasing-power parity. This says that a currency’s price should reflect the amount of goods and services it can buy. Since 14.5 yuan can buy as much burger as $3.71, a yuan should be worth $0.26 on the foreign-exchange market. At just $0.15, it is undervalued by about 40%. The tensions caused by currency misalignments prompted Brazil’s finance minister to complain last month that his country was a potential casualty of a “currency war”. The Swiss, who avoid most wars, are in the thick of this one. Their franc is the most expensive currency on our list.

As a vegetarian, I am staying away from Big Macs anyway, no matter how cheap.

We have recently heard much about currency wars. China stands accused of undervaluing its exchange rate to gain unfair advantages for its export industry, causing other countries to also intervene in the foreign exchange markets or impose caps on capital inflows. In a piece for the East Asia Forum (“A regional solution to global imbalances: We need a Beijing Accord”), I make a call for a Beijing Accord. Instead of hoping for an agreement among the G20 countries or some kind of new Plaza Accord, it would be more effective to try to forge consensus on exchange rate policy among East Asian countries, which could be then presented to the G20. China, I argue, should invite its East Asian neighbours to Beijing before the G20 summit in Seoul and discuss a cooperative stance on exchange rate policy to help correct the imbalances that apparently exist between the East Asian region and the US as well as Europe.

The Economist pubished a piece on the positive and negative effects of currency intervention (“Trial of strength. Will today’s currency interventions hurt or help the world economy?”). The article highlights the problems with unilateral and unco-ordinated intervention, where all countries effectively seek to lower the value of their own currency:

As the recovery slows, a growing number of people worry about a descent into competitive depreciation, as countries try to grab a bigger share of global demand at others’ expense, a trend that could fuel protectionism. Optimists, however, argue there may be benefits from today’s fad for currency fiddling. One argument is that intervention may be a backdoor route to reflation. If central banks all print money to prevent their currencies appreciating and don’t mop up or “sterilise” that liquidity by issuing bonds, then their exchange rates might end up the same but the world will have had a monetary boost in the interim.

The truth lies in between. Although most of the intervening governments have the same goal—to stop their domestic currency from rising—their circumstances and motivations vary widely. China’s ongoing determination to fix the yuan is the least defensible and most distortive. Unfortunately, it is also the world’s most effective intervener. Thanks to a closed capital account (even if cracks are appearing) and government control over domestic banks, China has been able to buy vast quantities of dollars without fuelling inflation. The central bank issues bills to mop up the liquidity created from buying reserves, which obliging banks hold at low rates.

For most emerging economies, however, intervention is more about coping with volatile capital flows. Thanks in part to rock-bottom interest rates in the rich world, foreign capital is flooding back into emerging economies. By intervening, emerging-market central banks restrain the pace at which their currencies appreciate. But they do so at a price. In countries with freer banking systems than China’s, sterilisation becomes increasingly costly the more reserves are bought. But if the intervention is not sterilised, the added liquidity fuels inflation.

In the rich world, where demand is weak and deflation a risk, the calculus is different. Unsterilised intervention is seen as a route both to counter excessive currency strength and to combat deflation (the prime motive for Swiss intervention). In Japan’s case the first argument does not cut much ice. Thanks to Japanese deflation the yen, in real effective terms, is below its average value since 1990 […]. The second rationale has some merit provided the Bank of Japan really does resist the urge to mop up any liquidity. But it could achieve the same reflation, without the political risks of unilateral intervention, in other ways.

There certainly is a need for discussing these interventions within the G-20. However, since most of the intervening economies — including China and Korea, and since recently also Japan — are in East Asia, it would be more effective to try to forge consensus on this issue among the East Asian countries. China’s exchange rate policy has an enormous effect on the exchange rate policy of the other East Asian countries, and unless China appreciates, the others will feel compelled to continue intervention to maintain relative comeptitiveness vis-à-vis China and each other. And although China has a genuine interest in reducing dependency on the dollar, it fears that an appreciation would badly reduce its exports and hurt domesitic growth and employment. Game theorists would call this situation a Nash equilibrium. A coordinated appreciation among East Asian economies would take away pressure from China, since its most important export competitors would also appreciate and hence relative competitiveness among them would be maintained. Before the G-20 summi in Seoul, China should invite its East Asian peers to Beijing and discuss such a joint appreciation. 25 years after the Plaza Accord, the time is ripe for a Beijing Accord.

I’m in Beijing this week for a conference on Regional Financial and Regulatory Cooperation, which is starting tomorrow. Over the past two days I’ve met several colleagues to hear their views on the state of the Chinese economy and the Chinese financial sector. Most Chinese economist I talked to seem pretty optimistic regarding China’s growth prospects and the government’s ability to respond to potential disruptions in the banking sector. Hence it was refreshing to meet today with Michael Pettis, a Professor of Finance with Peking University’s Guanghua School of Management, who is very skeptical on China’s investment-driven and export-dependent growth model.

In his last FT column (“Wen is right to worry about China’s growth”), Martin Wolf summarises Michael’s argument as follows:

[…], between 1997 and 2009, [Chinese] gross investment rose from 32 per cent to 46 per cent of GDP, while household consumption fell from 45 per cent of GDP to a mere 36 per cent. This must be the lowest share of consumption in any significant economy ever. In a country with hundreds of millions of poor people, it is even shocking. Meanwhile, the rising investment rate has been the main driver of growth. In the early 2000s, “total factor productivity” – increases in output per unit of input – were also important. But the contribution of higher efficiency has been waning.This, Prof Pettis argues, is a “souped-up version” of the Asian development model we saw in Japan and South Korea in earlier decades. The characteristics of this production-oriented approach are: transfers from households to manufacturing, via low interest rates on savings, repressed wages and a depressed exchange rate; very high investment; rapid growth of exports; and high external surpluses. China is “Japan plus”: its investment rate is higher, trade surpluses larger, rate of consumption lower and exchange rate intervention bigger.

This has been an extraordinarily successful development model, but, notes Prof Pettis, it eventually runs into the constraints of “massive over-investment and misallocated capital”. He continues: “In every case I can think of it has been very difficult to change the growth model because too much of the economy depends on hidden subsidies.” Moreover, China’s scale will shift the price of imports, particularly raw materials, against it, so accelerating the decline in profits.

In China, a rising rate of investment is needed to maintain a given rate of economic growth. At some point, investment will stop rising and growth will slow. China will then face the Japanese challenge: how to sustain demand as the required rate of investment collapses. If, for example, the gross investment needed to sustain a 10 per cent rate of growth is 50 per cent of GDP, then the rate of investment required to sustain 6 per cent growth might be just 30 per cent of GDP. With its massive dependence on investment as a source of demand, any decline in expected growth threatens a huge recession.

One answer would be another government-driven investment surge, however low the returns. The more attractive answer is faster growth of consumption. There is evidence of that during the past two years. But, as Prof Pettis notes, for consumption to grow consistently faster than GDP, household disposable income must also do so. Yet if this is to happen, income must be shifted from the corporate sector. That implies a squeeze on profits, through higher interest rates, higher real wages or a higher exchange rate. But that increases the risk of an investment collapse, with dire consequences for demand. As Prof Pettis argues, in China “growth is high … because consumption is low”. Rebalancing the economy towards household consumption could undermine the ability to sustain growth itself. If so, China is on an investment treadmill.

We also discussed another aspect of China’s unsustainable growth strategy, namely environmental degradation and its hidden costs, which, if taken into account, would reduce the Chinese growth rate significantly. Arguably, environmental pollution has contributed to a lowering of the consumption rate since more pollution affects people’s health negatively, which is increasing the likely costs of future healthcare people have to cover themselves, hence driving up the savings rate.

I would have loved to download and read some of Michael’s recent papers on this, but it seems his website is not accessible in China, which means that I have to wait until I’m back in Berlin on Saturday.

Btw, Michael is also running a record label in Beijing, called MAYBE MARS which produces exiting Chinese bands. They have a couple of videos on the label website. My favourite one is for the song “Mogu Mogu” from a band called Carsick Cars.

US lawmakers and the US government are raising pressure on China to let the yuan appreciate. The New York Times writes:

The Obama administration increased its criticism of China’s economic policies on Thursday, as Treasury Secretary Timothy F. Geithner told Congress that China had substantially undervalued its currency to gain an unfair trade advantage, tolerated theft of foreign technology and created unreasonable barriers to American imports.

But the election year anger from lawmakers seemed to surpass even Mr. Geithner’s tougher posture. Lawmakers expressed impatience with the administration’s familiar reliance on persuasion and negotiation, saying such tactics had yielded little.

In a testimony before the hearing on China’s Exchange Rate Policy of the US House of Representatives last week, Fred Bergsten argued that the sharply increasing trade imbalances between the US and China make it considerably harder for the US to reduce unemployment and achieve a sustainable recovery.

China’s currency remains substantially undervalued, importantly due to that country’s massive intervention in the foreign exchange markets, and is a major cause of its large and growing trade surplus. It has risen by less than 1 percent since the announcement of a “new policy” in June 2010.

China let its exchange rate rise by 20 to 25 percent during 2005–08. Our goal should be to persuade it to permit a similar increase over the next two to three years. This would reduce China’s global current account surplus by $350 billion to $500 billion and the US global current account deficit by $50 billion to $120 billion.

Elimination of the Chinese misalignment would create about half a million US jobs, mainly in manufacturing and with above-average wages, over the next couple of years. The budget cost of this effective stimulus effort would be zero.

The Chinese government responded predictably. Quote NYT:

In Beijing, a spokeswoman for the Foreign Ministry said that China would not respond to pressure and that a revaluation of the currency, the renminbi, would do little to affect the United States trade deficit with China. But the renminbi strengthened by 0.27 percent to end trading at 6.72 per dollar Thursday as the government appeared to belatedly permit the greater currency flexibility it had promised in June.

In my view, it will be of limited use trying to pressure China to reform its exchange rate regime. The key message that Chinese policy makers need to understand is that it is in their own interest to de-peg from the dollar in order to make progress in reforming their monetary policy. In a recent paper with James Reade on the Chinese monetary policy and the dollar peg (for a preliminary version click here)  we argue that capital controls and the use of monetary instruments other than the interest rate have enabled China to exert relatively autonomous monetary policy. Nonetheless, we argue that the People’s Bank of China would be able to develop and pursue a more efficient monetary policy mix if it could make effective use of the interest rate tool, which at present is sidelined by the exchange rate peg. Reformers within the Chinese government have been arguing along this line, but thus far China’s leadership has been reluctant to reform. In China’s own interest, monetary and exchange reform should advance rather sooner than later.

After months of verbal intervention, Japan intervened today in the foreign exchange market for the first time since 2004. The yen had reached a 15 years hight against the dollar, threatening to stunt the nation’s economic recovery.

According to Bloomberg, “[t]he yen tumbled past 85 per dollar for the first time in almost two weeks, before trading at 84.87 per dollar as of 2:25 p.m. in Tokyo. The currency had climbed more than 11 percent against the dollar from mid-May through yesterday, reaching a high of 82.88 earlier today. The benchmark Nikkei 225 Stock Average jumped 2.6 percent to 9,543.75.”

The FT writes:

Yoshihiko Noda, the finance minister, told reporters that the yen’s sharp gains from Tuesday – following Prime Minister Naoto Kan’s victory in his Democratic party’s leadership battle – were “a problem that could not be overlooked” given that the Japanese economy has suffered some difficulties, including its ongoing struggles with deflation.

“In order to restrain excessive moves in the currency market, we earlier carried out currency intervention,” Mr Noda said. He added that he was prepared to take further action, including further intervention, if necessary and that overseas authorities had been contacted.

The FT discusses implications of the Japanese intervention for the dollar-yuan debate:

Japan’s intervention is likely to heighten tension around the already charged issue of China’s persistent intervention to hold down the renminbi, which was set to be one of the most contentious issues at the forthcoming meeting of the G20 group of countries in Seoul.

The US is disappointed that China has allowed the currency to rise by less than 1 per cent against the dollar after its decision to unpeg the renminbi in June. This week, Congress will hold a series of hearings to investigate the options for blocking Chinese imports or having the currency intervention declared illegal by the World Trade Organisation.

Japan’s intervention is likely to complicate the debate. Several G20 countries, including the US, feel that they are under competitive threat from China’s currency policy. But the fact that Japan is intervening against its currency – at a time when the yen is not particularly strong in real terms – will make it hard to point at China as the one major economy that is manipulating its exchange rate.

Tetsufumi Yamakawa, head of research at Barclays Capital in Tokyo, said Japan’s intervention “at least, would give a good excuse to China for not moving by claiming that the Japanese authorities are manipulating the currency [as well].”

He said that this consideration probably had put Tokyo off intervening for such a significant amount of time.

Speaking before Tokyo’s intervention, Fred Bergsten, director of the Peterson Institute think-tank in Washington and an advocate of litigious and legislative confrontation with Beijing, said that the US needed to organise a coalition of countries, including Japan, to put pressure on China at the G20.

I don’t see why the Japanese intervention would provide support to the Chinese in the undervaluation debate of the yuan. Japan can gardy be labelled a currency manipulator because of this intervention. As pointed out by the FT, the last time that the finance ministry ordered the Bank of Japan to intervene was in 2003-04 for a period of 15-month. China, in contrast, has mainatined a tight peg to the dollar since 1994, with a brief relaxation between July 2005 and July 2008, when it let the yuan appreciate by 21 percent against the dollar. In July 2008, in the face of the global nancial crisis, China returned to the tight peg against the dollar, now at 6.8 yuan to the dollar.

In my view the Japanese intervention should rather be seen as a response to Chinese undervaluation. On this, see also the comments that the Japanese finance minister Yoshihiko Noda made a few days ago about China’s increase in purchases of Japanese government bonds.