11 Responses to “How China has managed to keep the renminbi pinned down”

Comments

1. Charles Wyplosz: Yes, market forces would have led to a real appreciation of the renminbi, but China is not a market economy. Should it? Eventually, it will, but not now.

   First, because you don’t change a winning horse. Its amazing performance is one more example that orthodoxy is not the only way to get an economy going, and maybe not the best way either. Indeed, China has taken a close look at Japan and South Korea, the previous regional economic miracles, and it sees how wonderfully the export-led strategy has worked. This strategy’s lynchpin is an undervalued exchange rate. The Chinese intend to travel a similar route and it will be very, very hard to convince them that it is the wrong way.

   There are costs to such a strategy, primarily the accumulation of foreign exchange reserves. Investing in low-yielding US Treasuries when the domestic rate of return is a multiple of what they get on their reserves is expensive. But can China currently invest domestically its huge savings, which stand at about half of its GDP? This is physically and practically impossible, so the deal is less rotten than it looks. It is in the Chinese people’s interest to consume more, so China should boost its consumption, but this is easier said than done. How do you do these things? China could and should encourage consumption by offering a decent welfare system, but this is something that takes years, or decades to do.

   The main reason why appreciating the nominal exchange rate is in China’s interest is that it is a better way of meeting the Balassa-Samuelson effect than through inflation, as Martin correctly notes. But inflation is China is not exactly a market phenomenon either, which may help explain why it has been subdued, at least according to official figures.

   The West’s pressure on China to let the exchange rate appreciate reminds us of the same pressure on Japan in the 1980s, when the exact same words were uttered as today, with the same nervousness in the US Congress. Now the European Union has joined the fray and violates WTO rules by charging a surcharge on shoes instead of applying to the Dispute Settlement Tribunal. Now as before, the West worries about China’s current account surplus. Does anyone seriously believe that a 20 per cent appreciation – the number indicated by Martin – will eliminate the surplus of a country that saves half of its GDP? It would be helpful to see just how this would work. Until the proof is administered, an appreciation of the renminbi is not even clearly in the West’s interest.

   Posted by: Charles Wyplosz | October 10th, 2006 at 10:31 pm | Report this comment
   

2. Paul Seabright: Last week’s forum oscillated intriguingly between the view that China’s current account surplus is a problem for China, and the view that it’s a problem for everyone. This was highlighted most sharply in the exchange between Fred Bergsten and Willem Buiter about whether or not the Europeans should be “mortified” if China dumps dollars for Euros (I’m with Willem on this one – “bring ‘em on”, as someone said in another context).

   This week Martin again points out correctly that “Sterilisation – the sale of domestic securities to mop up the excess liquidity generated by official intervention in foreign currency markets – is not merely feasible, but even highly profitable, if one is prepared to ignore the risk of a large ultimate capital loss.” The capital loss for China would be of course a gain for everyone else – chiefly for the US Treasury but for a number of others too. China has been generously buying American assets that no-one thinks are worth the price the Chinese are paying for them. Why therefore are we worrying?

   This suggests that the “problem” China creates for the rest of the world is like the problem of a rich and generous uncle who’s getting on and whose generosity won’t last for ever. Or, to stretch the metaphor a bit, like a rich and generous uncle who is particularly happy to back my internet start-up company that no-one else will touch with a bargepole. Is this good for me or bad? Good, say I; bad, say my wiser friends. Such friends might advise the uncle to find more deserving recipients of his money, while advising me to learn a useful trade that will support me when the money tap turns off. A compromise solution might be a trust fund.

   What’s the analogue of a trust fund in the international context? There isn’t one – or rather, there are only various imperfect mechanisms of stewardship of funds with a potential asset-liability mismatch in the long term. But it might be helpful if economists said more loudly and more clearly, when speaking to US and European politicians, that the problem isn’t the Chinese surpluses as such – it’s only what happens when they dry up.

   Posted by: FT Forums | October 11th, 2006 at 9:12 am | Report this comment
   

3. Andrew Smithers: “Rising inflation and falling profits in the rest of the world are among likely consequences of a rising real renminbi.”

   Martin and I agree on the basic analysis as set out in his 11th October, 2006 column, from which a number of key questions arise.

   (1) It seems unlikely that China can for long postpone having either a rising nominal exchange rate or rising inflation. Whichever choice it makes, the result will be, ceteris paribus, an increase in inflation in the rest of the world. To offset this it is likely that the equilibrium level of output will need to be lower than before and a period of below trend growth will be needed. Such periods are typically ones of falling profits. By pegging its exchange rate China has probably contributed to the current high level of profits in the rest of the world and, as this reverses, profits are likely to fall.

   (2) The impact on past profits will have been asymmetrical. While allowing the total level to rise through temporarily suppressing inflation, China has driven down the relative profitability of traded goods and services compared with non-traded ones in the rest of the world. If, as seems likely, the capital/output ratio of traded products is higher (worse) than those of non-traded products, higher investment will be needed in the rest of the world for the same level of output growth to be possible.

   This will be particularly acute in the US and UK which have, over the past decade or more, been the two G5 countries which have invested least and grown most rapidly. This has been accompanied and probably made possible by large and rising current account deficits, as non-traded output, with a relatively low capital/output ratio, has grown at above trend rates. The easing of current account imbalances thus requires slow growth of consumption in the US and UK, not only to finance the rise in savings that this requires directly, but also to finance a shift to higher domestic investment, without which the growth rates will decline as the capital output ratio rises.

   (3) I am intrigued by Martin’s third chart. Can China really have achieved the massive sterilization shown? If so how? What distortions and consequences has this had for the domestic economy?

   Posted by: Andrew Smithers | October 11th, 2006 at 11:25 am | Report this comment
   

4. Willem Buiter: How much is the renminbi undervalued? I would like to raise the possibility that, despite its impeccable internal consistency, the Balassa-Samuelson (BS) effect-based arguments that the renminbi is seriously undervalued, may indeed be BS.

   Let’s start from the BS numbers cited by Martin. The IMF guestimates that Chinese productivity growth in industry has on average been about three percentage points a year faster than in services since 1979. Let’s assume that industry is traded or tradable and services are nontraded or nontradable (increasingly a stretch, but less so perhaps for China than for many other countries). What matters for the BS effect is the difference between the Chinese productivity growth differential between traded and nontraded goods and that same differential in the rest of the world, say one percentage points a year on average. The difference between these two productivity growth differentials then averages two percentage points a year. To get the number for average annual BS real appreciation, we have to multiply this one percentage point by the share of non-tradable goods and services in production. Chinese exports are rising rapidly as a share of GDP, and may be around 35% by now. The import share is lower (there is a near 7 percent of GDP trade deficit) but also rising fast. Exportables exceed actual exports; actual imports can be a poor guide to import-competing production, which is what matters for the BS effect.

   I would be surprised if today nontradable production were to be more than one third of Chinese GDP; the average over the period since 1979 was of course lower. The future share of nontradables is likely to be lower than today’s. Perhaps a one percent average annual real exchange rate appreciation can be squeezed out of the BS effect for China, if we start from the IMF numbers. Over a 27-year period this would produce a real appreciation of about 31 percent.

   To compare this number with what we have actually seen, we have to know two things. First, was the starting value of the real exchange rate in 1980 close to its equilibrium value? Answer: I have no idea, nor do I have any sense of the direction of any bias.

   Second, is the BS presumption that for economies in the process of real catch-up and convergence, productivity growth in the tradable sector systematically exceeds that in the non-tradable sector and does so by more than the differential observed even in mature industrial countries, correct for China? Answer: first, I am comfortable with the notion that more competition encourages productivity growth. Tradability means being exposed not just to domestic, but also to global competition; this part of the BS mechanism ought to work in China, just as it does everywhere; second, the initial gap between the productivity levels in the traded and nontraded sectors and best-practice in the global economy also matters. It is in my view quite likely that, for a former centrally planned economy (with its complete disdain for and ignorance of, the market service sectors), the initial productivity gap would have been even larger in the nontradable sectors than in the tradable sectors. This goes against the BS effect. Also, thanks to dimensions of globalisation other than trade, best-practice foreign expertise, technology and skills can be brought to bear on nontraded sector productivity even when the non-traded status of these sectors is maintained. This can be done through FDI, through the internet, through the return of the expatriate Chinese community and through other globalisation mechanisms that are not captured by the traded-nontraded dichotomy.

   So I’m not so sure about the proposition that the Balassa-Samuelson effect implies that there is a significant real undervaluation of the renminbi.

   Posted by: Willem Buiter, London School of Economics | October 11th, 2006 at 11:23 pm | Report this comment
   

5. Willem Buiter: A few more thoughts on the evidence marshalled by Martin that China has become significantly more competitive in world markets and that the renminbi is significantly undervalued in real terms. My bottom line is that there is no good evidence of real undervaluation.

   • The astonishing growth of China’s exports and the soaring current account surplus. This is not evidence of competitiveness/real undervaluation at all. The current account surplus reflects the soaring of Chinese saving rates relative to Chinese investment rates. It’s about investment opportunities, intertemporal preferences and opportunities for intertemporal trade between residents of different countries.

   A reduction in the current account surplus need not be associated with any depreciation of the real exchange rate or worsening in the external terms of trade (relative to their current values), even if the driver of the falling current account surplus is a boost to domestic demand (due, e.g. to a fiscal boost), if the boost to demand coincides with a major shift of labour out of the non-traded into the traded sectors.

   Such a shift has been going on in China for the past 25 years and shows no sign of abating. Since a (soaring) current account surplus constitutes evidence neither in support of nor against improving competitiveness, neither does export growth. If it did, then so would import growth.

   • The fact that the source of Chinese foreign exchange inflows is now a current account surplus rather than relatively unstable short-term capital. This is not relevant evidence of undervaluation.

   China runs a large and growing current account surplus, for reasons discussed earlier. Whether this net increase in net foreign assets takes the form of an increase in foreign exchange reserves with no increase in gross foreign liabilities or an even larger increase in foreign exchange reserves combined with an inflow of foreign capital (stable or unstable, short-term or long-term) says something about portfolio preferences in China and abroad (in China mainly the portfolio preferences of the authorities). It has nothing to say about undervaluation.

   • The fact that the surplus in the basic balance is at least 10 percent of GDP. Again, not relevant to the competitiveness/undervaluation issue. Given the saving investment balance, this is again the reflection of portfolio preferences in China and abroad (another version of bullet point 2).

   • The scale of the currency intervention required to stop the renminbi from appreciation (and, I would add, the size of the stock of foreign exchange reserves, which is now touching one trillion US dollars in value). This is evidence not of excessive competitiveness or of real undervaluation, but of nominal undervaluation, that is, excessively tight monetary policy in China.

   The demand for renminbi is growing faster than the renminbi supplied through domestic credit expansion. The excessively tight monetary policy is masked by financial repression which keeps Chinese interest rates artificially low.

   This quasi-fiscal tax on holders of renminbi securities is also what makes sterilisation of reserve inflows financially sustainable (indeed profitable) for the Chinese monetary authorities. Market-driven nominal exchange rate appreciation (with unchanged domestic credit expansion) or increased domestic credit expansion at an unchanged nominal exchange rate would solve the ‘reserve flow problem’.

   Whether this would result in any real appreciation is an open question. My guess is that any lasting real appreciation of the renminbi would be slight – and appropriately so.

   Posted by: Willem Buiter, London School of Economics | October 12th, 2006 at 5:19 pm | Report this comment
   

6. Martin Wolf: If all the economists in the world were laid end to end, they still would not reach a conclusion. I thought of this line when I read the contributions so far in this week’s forum.

   I agree with Charles Wyplosz on the most important point of the analysis this week and last: the big issue is not the exchange rate, but the level of domestic spending. Where I differ from him is that I do not see why it should be so hard for the Chinese government to spend more.

   There are public services crying out for expansion. What is true is that appreciating the currency without expanding domestic spending would be very damaging indeed. Furthermore, China hardly needs more investment. So the necessary expansion is on consumption, including public consumption.

   Paul Seabright adds an important and little understood point. If China were committed to running a very large current account surplus forever, the rest of the world should just say thank you and enjoy the benefit of the unrequited capital outflow. But it is most unlikely that China is going to do any such thing. The adjustment when it stops might be quite painful.

   More important, running this policy is costly for China. This is where I do disagree with Charles. The export-led growth strategy that he describes cannot be the most efficient development path, at least when it involves such large capital outflows as today’s. I also suspect that, rational or not, the rest of the world is going to resist ever larger Chinese surpluses (in absolute terms, even if not in terms of shares of China’s gross domestic product). I don’t believe China can replicate the development strategy of South Korea (with a twenty-fifth of its population) or Japan (with a tenth). China is too large and will have to exit from export-led growth well before its neighbours did.

   This is all I could do today, since I had another column to complete. I am looking forward to grappling with the important points made by Andrew and Willem tomorrow.

   Posted by: FT Forum - Martin Wolf | October 12th, 2006 at 5:38 pm | Report this comment
   

7. Richard N. Cooper: Wolf as is usual provides a cogent analysis and poses policy choices, in this case for China’s authorities. I want to make two points, one mainly conceptual, one intensely practical.
   The conceptual point: the term “real exchange rate” unfortunately has two quite different meanings in the academic literature: 1) the price of non-tradable goods and services relative to the price of tradable goods and services; 2) the market exchange rate of a country adjusted for general movements of prices in that country and in its trading partners. Wolf clearly uses the latter concept in part of his article, but hints at the former in other parts of his article. They are not the same. I am informed that the price of haircuts, to use his example, has gone up greatly in China over the past 20 years, at least in urban areas, as has the cost of urban housing, both facts suggesting that China has experienced substantial appreciation on the first concept, contrary to Wolf’s claim of real depreciation (based on the second concept). The Balassa-Samuelson discovery applies to both concepts over a sufficiently long period of time, but it is not clear what this period should be expected to be.

   To the practical point: Wolf reports that China’s currency has been estimated to be undervalued by 20 percent. In making this report and not refuting it, he gives it credence, while falling short of actually recommending an appreciation by 20 percent. Yet China maintains tight controls on resident capital outflow. Does the estimate assume indefinite continuation of these controls? Indeed, what is the basis for the estimate? Given China’s high private savings rates and limited, low-yield opportunities for investment by most households, the latent demand for foreign assets must be very high. This is important. We do not complain about the large current account surpluses of Germany, Japan, the Netherlands, Sweden, or Switzerland, all of which are comparable to China’s in absolute terms or relative to GDP, presumably because they are nearly balanced by private capital outflows.

   Nor does Wolf ask the fundamental question: what would a 20 percent appreciation of the RMB in the near future do to China’s growth and employment, given the small margins alleged for China’s many export firms? A big slowdown in the Chinese economy is in no one’s interest, especially in view of the high import content of China’s exports. Why should China’s leaders want to run such a risk? What would be gained by foreigners in suggesting that they run such a risk?

   Posted by: FT Economist Forum | October 13th, 2006 at 3:09 pm | Report this comment
   

8. Martin Wolf: Andrew seems to believe that sterilisation is impossible for any extended period. The evidence is strongly against him. China has been able to sterilise much of the reserve accumulation at rates of interest below those in the US (the issuer of the currency against which the renminbi is effectively pegged.) I have already indicated in my column why this is so: Chinese households have savings well in excess of what the corporate sector needs, even at low interest rates; there are reasonably effective controls on capital outflows, which prevent savers from seeking higher returns abroad; Chinese households have virtually no alternative financial assets to bank deposits; and the Chinese economy is growing very fast and can support rapid growth of credit. Furthermore, I am not persuaded that China is important enough to the world economy to generate the effects Andrew envisages. China’s current account surplus is about half a per cent of world GDP. That cannot be enough to achieve the impact on the US and UK capital-output ratio he envisages. Of course, China is part of a bigger picture of surpluses and deficits.

   Moreover, it is not obvious how big is the effect China has on profits. Indeed, it is not even clear what the sign is: the Chinese fixed exchange rate and falling prices of exports would tend to squeeze the profitability of competing producers of tradeable goods around the world. Moreover, if China’s rise has had an effect on profits, it is far more likely to be via Stolper-Samuelson (so-called ‘factor price equalisation’) than via thwarted Balassa-Samuelson. In theory, the decline in China’s terms of trade (which is documented) would shift income against unskilled labour and in favour of human and physical capital in advanced countries, as their production shifts in the direction of goods and services more intensive in the latter.
   Willem Buiter and Dick Cooper raise important questions about the significance of the Balassa-Samuelson argument and the likelihood that the renminbi is, in fact, undervalued.

   Willem’s argument raises a similar question to the one we discussed a couple of weeks ago on US current account adjustment (see the forum on ‘A slowing US could brake the world’, September 26 2006): what is tradeable and what is non-tradeable nowadays? We can probably accept that all of industry is tradeable. That is 46 per cent of Chinese GDP after the recent revisions. But I am not convinced that any significant part of Chinese services production is tradeable. A good part of it consists of government services. Chinese financial services are barely tradeable either.

   I agree that the room to improve Chinese productivity in services has been (and remains) very large. But I assume (boldly, I admit) that the IMF estimates of past relativity productivity growth, based on Chinese statistics, take this into account. I also believe that the share of tradeables in GDP is as likely to fall as to rise in the long run, in current prices, as it has done in high-income countries. The reason for this is that the relative prices of tradeable goods and services, which are also the goods and services in which productivity can be increased most rapidly, tend to decline on a secular basis (this is just the real exchange rate effect again).

   This offsets the tendency for output of tradeable goods and services to grow faster than output of non-tradeable services, in constant prices in a country at China’s level of development.

   To cut a long story short, assume that the share of tradeables is 50 per cent of GDP and the relative prices of non-tradeables should rise 2 per cent a year faster than they do in the rest of the world, for the reasons Willem indicates. Over 25 years prices of non-tradeables should rise by a little over 60 per cent relative to those of tradeables more than they do in the rest of the world. With these weights, the overall Chinese price level should rise by 30 per cent relative to the rest of the world’s. I am not clear whether this is the same answer as Willem’s. But it seems to suggest that there should have been a secular appreciation that we have not, apparently, seen.

   Of course, there are reasons for questioning the practical significance of this argument.

   First, the Chinese price data are certainly poor and may ignore relevant costs. This is, I believe, the core of Dick Cooper’s first point above. If the items that generate a higher domestic price level (namely, rising prices of non-treadeables) are not included in the price indices used to estimate the real exchange rate, the measures employed are inappropriate. Of course, if the domestic price index used is broad enough (ie. it includes relevant non-tradeables), the two measures that Dick discusses move in the same direction: that is, an appreciation of the real exchange rate, defined as the price of non-tradeables relative to that tradeables, will also show up as an appreciation of the real exchange rate, defined as the domestic price level relative to the foreign price level.

   Second, some argue that China has something close to an unlimited supply of labour at a constant opportunity cost (in the rural sector). So real wages should not be rising much, if at all. But the Balassa-Samuelson effect should still work, provided there is competition in the production of all goods and services, since the unit labour costs will be falling faster in tradeables than in non-tradeables.

   Third, the Balassa-Samuelson argument ignores the cost of capital. If relatively rapid productivity in tradeables is predominantly the consequence of faster capital accumulation there, relative unit costs, properly defined, may not be falling at all.

   Is it all ‘BS’, as Willem suggests? I think not. But I agree it is just one argument for the proposition that China’s real exchange rate is becoming increasingly undervalued. I suggested several others that may well be more important.

   This brings us to the further arguments Willem and Dick Cooper have marshalled that there is no undervaluation of the renminbi. These are, I think, the following: first, a current account surplus is the consequence of excess savings not of an undervaluation of the real exchange rate; second, the scale of the currency intervention required to keep the exchange rate down is an indication of excessively tight monetary policy and so of nominal, but not real, undervaluation; third, the official accumulation of assets is merely a substitute for the suppressed desire of the Chinese to acquire foreign assets. If those controls were lifted, the currency might even depreciate in real terms.

   I agree fully that the fundamental driving force here is the excess of domestic savings over investment. That is why I discussed the sources of this in the previous week’s column (Why Beijing should dip in China’s corporate piggy bank? October 3rd 2006). I agree, too, that in the presence of tight controls on capital outflow, it is impossible to be confident that intervention is excessive. It would be quite different if China had no exchange controls and still intervened on this scale (though, in those circumstances, sterilisation would be harder). And I certainly agree that any measurement of the extent of undervaluation is highly uncertain and depends, above all, on what one assumes about policy.

   I would make the following further points. First, China’s excess savings are themselves a policy choice (on which more below). As I already pointed out in the previous week’s column and the subsequent discussion, a large proportion of the savings are, directly or indirectly, government savings. Unless one believes that Ricardian equivalence (which we discussed in the previous week’s forum) applies in China, which I do not, the gross savings rate is a policy variable, not a datum.

   Second, the prevention of credit expansion in response to the reserve accumulation also tends to constrain spending (particularly investmentspending) and so sustain the excess saving. So, again, the savings surplus is a policy choice.

   Third, the high level of savings is a policy choice designed, in large part, to preserve export competitiveness and the trade surplus.

   Yet, finally, I also accept that the suppression of the capital flows make estimates of the market level of capital flows very uncertain. But this cuts both ways. If China’s capital market were open in both directions, the capital inflow from the rest of the world would also explode upwards. After all, this is the world’s economic frontier. What is remarkable, I would argue, is how small the gross inflow into China is, not how big.

   The big point, though, is that my perception of what is driving the present situation is rather different from Willem’s. China’s savings rates are being driven by the balance of payments, at the margin, not the other way round. In other words, I agree with the Deutsche Bank view that China’s authorities, in effect, ensure that domestic savings are large enough to accommodate the export surplus generated at the present real exchange rate.

   The aim of policy is, in effect, to support export competitiveness and export-led growth. I also think that China should spend more at home, again for reasons I have explained previously. Finally, I suspect (though I may be wrong on this) that if China were to spend substantially more at home, there would be a change in relative prices, with the prices of non-tradeables rising relative to tradeables, either via a nominal exchange rate appreciation or domestic inflation.

   I agree, however, that it is possible that a substantial rise in domestic absorption might be accommodated without much in the way of a real appreciation of the exchange rate. We would not know until China tried.
   And I agree, as I will be arguing further in my next column, that it is domestic absorption, not the exchange rate, that is the big issue. I agree also with Dick that China must not take policy decisions likely to slow its economic growth. I agree, finally, with Dick that if the best thing for the Chinese to do with their marginal income now is to purchase foreign assets instead of increase domestic spending, then the current policy is perfectly sensible.

   Posted by: FT Forum - Martin Wolf | October 14th, 2006 at 9:02 pm | Report this comment
   

9. Robert Wade: Wolf explains China’s undervalued exchange rate as the result of emphatic government efforts to achieve it, against the powerful economic forces which in normal circumstances check an increasingly undervalued rate. There is a strong case, he argues, for the government to allow the exchange rate to appreciate and absorb the surplus savings in the form of higher domestic demand - in the interest of the Chinese people.

   All this is well and good, but here - as in his other columns on China’s external economic strategy - I think he underestimates the Chinese government’s political calculations, and more specifically, its use of the exchange rate and foreign exchange reserves as tools of statecraft.

   The government is keenly aware that as the US becomes less able to assert leadership (hegemony) over “allies” by means of the expensive and undermining-of-the-Constitution “War on Terror”, the US government will probably (after the next presidential election) re-invoke the rise of a “peer competitor” - China, perhaps Russia - as the overarching security threat against which it must lead the allies.

   China’s external economic strategy is calculated in part to deter US threats. Giant holdings of US dollars give it an economic atom bomb, so to speak. Huge investments by US firms give it US corporate allies able to lobby in Washington against US aggression.

   This should be part of the explanation of such apparently irrational behaviour as the government intervening to stop real exchange rate appreciation. Intervention may be against the “interest of the Chinese people” as Wolf understands it, but Wolf’s “interest” is a consumption interest and the government is balancing higher domestic consumption against a much wider foreign security interest - or so I surmise.

   Posted by: FT Economist Forum | October 16th, 2006 at 12:12 pm | Report this comment
   

10. Jeff Frankel: When thinking about which way an exchange rate ought to move, we tend to think either completely inside the Balassa-Samuelson compartment, or completely outside of it. When we think outside of it, we recognize that the exchange rate can be temporarily pulled away from its long-run equilibrium value by such factors as discrete devaluations, fluctuations of larger anchor currencies, monetary expansion (including overshooting) and speculative bubbles.

    When we think inside the Balassa-Samuelson theory, we do what Martin does, and assume that the country lies right on the Balassa-Samuelson equilibrium relationship: if China is growing 7 per cent per year faster than its trading partners, it ought to experience a corresponding trend of appreciation. A common econometric estimate of the coefficient is .4 (for example, Rogoff, 1996*, or Frankel, 2006**). The prediction would then be real RMB appreciation at 2.8 per cent per year (.4*7 per cent)

    But this leaves out the reality that, as strong as the relationship between income per capita and the real exchange rate is, any given country at any given time is likely to lie rather far off the Balassa-Samuelson equilibrium line – due again to such factors as discrete devaluations, fluctuations of larger anchor currencies, monetary expansion, and speculative bubbles.

    The tendency for the real exchange rate to regress back to the equilibrium line is often as important a prediction of the Balassa-Samuelson theory as the prediction that the currency will move along the line if the country grows faster than its trading partners, even though the latter is typically the only effect that is noticed. Prices in China are about 1/10th the level of prices in the US.

    Some of the gap can be explained by the fact that real incomes in China are about 1/8th he level of the US – but not all. The RMB is still undervalued by about 40 per cent, judged relative to the Balassa Samuelson line.

    The average tendency is that one can expect about half of such gaps to be closed per decade, which implies real appreciation of 20 per cent over the coming decade, or an average rate of 2 per cent per year. One should add this to the predicted movement along the line (2.8 per cent per year, if Chinese growth remains 7 per cent above US growth), to get an estimate of total future RMB appreciation: about 4.8 per cent per year. For a large country like China, better to let this real appreciation take the form of nominal appreciation than inflation.

    One should not rely too much on any one calculation. But as Martin notes, other criteria go the same way: the Chinese surplus in both its current account and its capital account; its level of reserves, which has just broken the $1bn mark; and the lesson of history that it is better to ‘jump’ from a peg to a float at a time when the demand for the
    currency is strong than to wait for some future crisis when one is “pushed” to do so by a speculative attack.

    * Rogoff, Kenneth, 1996, “The Purchasing Power Parity Puzzle, J. Economic Literature, 34: (2) June 1996, 647-68.

    ** Frankel, Jeffrey, 2006, “On the Yuan: The Choice Between Adjustment Under a Fixed Exchange Rate and Adjustment under a Flexible Rate,” in Understanding the Chinese Economy, edited by Gerhard Illing (CESifo Economic Studies, Munich). Revised from NBER Working Paper No. 11274, Apr. 2005.

    Posted by: FT Economist Forum | October 18th, 2006 at 5:39 pm | Report this comment
    

11. Martin Wolf: Jeff Frankel makes the important point - implicit in my initial column, but elaborated by him here - that China’s real exchange rate is now significantly undervalued relative to the movement predicted by the Balassa-Samuelson relationship (for interested readers, there is a good article on the underlying economic relationships here ). Thus one would now expect both an appreciation back to the B-S trend-line and then rapid appreciation along it. The sum of these effects, he argues, gives an expected real appreciation of the renminbi of 4.8 per cent a year over the next two decades.

    Jeff’s calculations are presumably based on a regression estimate for a large number of countries of the speed of convergence between purchasing power parity exchange rates and market exchange rates as relative real incomes (at PPP) rise. This seems to suggest faster expected appreciation for China than its relative productivity growth of manufactures and services against the same relationship in the rest of the world, which was analysed in previous discussions in the forum. Obviously, one can reasonably ask whether China is a “normal” country and so whether regression relationships of this kind should hold. Given its vast labour surplus and correspondingly slow expected rise in real wages, it may not be at all normal. Nevertheless the direction of the argument is exactly the same: China’s real exchange rate should be appreciating more than it is; and it is probably now significantly undervalued.

    I agree strongly with Jeff that appreciation of the nominal exchange rate would be a better way to make this adjustment than allowing substantially higher inflation in China than in the rest of the world. This is particularly true if the latter would include a big jump in the initial price level, to deal with the current undervaluation relative to trend

    Posted by: FT Forum - Martin Wolf | October 19th, 2006 at 3:02 pm | Report this comment
    

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