China Revaluation Will Lower Chinese Wages, Prices.
You may have noticed by now that there is a sharp difference in opinion among economists about the impact of yesterday’s yuan revaluation on the US and China. I will start you out with my view, as given in the following statement I gave a Gannett reporter yesterday.
“We are playing with fire,” China’s economy is going to slow. You cannot diddle with a currency without affecting interest rates in both places, economic growth, prices and wages. What this change is going to do is raise interest rates, lower U.S. growth, lower China growth and lower China’s prices and wages.”
My point is that by forcing China to stop buying Treasuries we are also likely tightening Chinese monetary policy, which will ultimately push Chinese wages and prices even lower. Not an American dream scenario. The chart below shows China’s foreign reserves (mainly US Treasuries) and China’s bank reserves. The link is not an accident.
A lot of economists will see this differently. They will see a drop in the dollar against the yuan as reducing US export prices in China and increasing Chinese import prices here which, over time, would reduce imports and increase exports, raising GDP. What’s the difference in the thinking?
There are two main fault lines in the thinking about all this–issues where you have to stand on one side or the other. The first is whether you are focused on agregate demand or on the capital markets. The second is whether you are focused on the trade accounts or on the capital accounts. Here’s what I mean.
Most of what you read about macroeconomics focuses on who–consumers, businesses, government, foreigners–is spending how much money. Spending more money is good; spending less money is bad. To these guys, cheapening your currency is almost always “good” for the economy. I think this approach is a load of crap. It never works.
I like, instead, to focus on the capital accounts for a simple reason. Size matters. Our $11 trillion GDP last year is dwarfed by our $155 trillion balance sheet. Or, as James Carvell would have said, “It’s the assets, stupid.” This line of thinking forces you to focus on the capital stock (which determines productivity) rather than on spending. And it forces you to focus on who wants to hold the existing assets, not on who wants to buy the new assets (flows of funds analysis of saving, budget deficits) when thinking about interest rates. I have used this framework since the Reagan days and made a lot of money with it. It works.
The second point has to do with global capital markets. My good friend Robert Mundell won a Nobel Prize not long ago for teching the economics profession that you cannot diddle with currency markets without having an impact on domestic monetary policy. I wrote about this yesterday. Essentially, it means that when China buys a US Treasury Bill in order to hold their currency fixed, as they have been doing in recent years, they pay the seller with a check issued by the central bank. The seller deposits the check in his bank, which increases Chinese bank reserves by the same amount. The bank then loans the money to a customer which ultimately increases the Chinese money supply, stimulating growth and pushing wages and prices higher.
Revaluing the yuan and shifting to a basket of currencies is certain to reduce Chinese purchases of foreign assets, including US Treasuries. That’s why US bond yields increased yesterday. It also means China’s bank reserves will shrink. (Some will say this won’t happen because the Bank of China will “sterilize” this effect by simultaneously buying Chinese government securities in their domestic bond market. I say they can’t do it–the Chinese government bond market is not big enough to allow this to happen.) I don’t think creating a gorilla competitor with even lower wages and prices in china is what we had in mind here.
Mostly I am concerned about monkeying with a situation as fragile as Chinese growth, credit markets, and politics. they have their hands full already. There were riots in the suburbs of Shanghai earlier this week and lots of recent violent incidents in rural areas. They have almost as many migrant construction workers as we have people. Doesn’t seem to me that China blowing up would be a good thing for any of us.
More to come on all of this later today.
JR
“As you read the article it is worth remembering that China has experienced peasant revolts about every fifty years for the past 6000 years. They are 7 years overdue.”
50 years fall in line with the 48-60 year cycle. Could this mean that China also, for the last 6000 years follows the 60 year cycle?
You have a good blog site. Could you post on it more often?
Some how, I get the impression that you at least consider “the 60 year cycle”, if not more, the 13 year business cycle.
You mentioned the 1994 pegging of the Yuan to the Dollar. That effected the economy of Thailand in 1995, the Thai stockmarket in 1996, that lead to the floating of the Thai Baht in 1997 and the crash of 1997.
Considering the 13 year business cycle, China is due to crash around 2007. That is just about in line with your estimet.
I think that the comming economical crash of China may coinside with the comming “recession” in America and Europe. This may inturn lead to a world wide “recession”, if not worse.
What are your thoughts on this?
Dr. Rutledge,
While I agree that revaluing the Renminbi upwards will be deflationary or disinflationary for China, all else being equal, and that one of the consequences may be political unrest inside China, I cannot agree that that means we should not demand revaluation. It is not our fault that the China’s leadership is attempting to solve its employment problems by mercantilist manipulation of exchange rates, and the longer and more extensively they engage in that practice, the more destructive the likely outcome.
At the current exchange rate, Chinese labor is underpaid in international terms by a factor more than ten. US workers are not the only victims — cogent arguments have been made that the mid-90s devalation from 5.7 yuan/dollar to 8.28 was one of the causes of the late-90s Asian financial crisis. If one believes that free markets are good, and that one of the reasons is that prices act as a signalling mechanism by which we communicate to each other how resources should best be allocated, how can you believe that it is good to forcibly distort the price of labor?
Does not proper operation of the theory of comparative advantage depend on smooth adjustment of exchange rates to accurately reflect the relative values of economic resources in both the trading countries?
Does not the gross manipulation of exchange rates by massive government intervention result in gross distortion of the US market demand curve for, say, large-screen plasma TVs, and the Chinese supply curve for same — and likewise for all Chinese products? How can this be good? This is basically just a variation on the vendor financing engaged in by Nortel and Lucent, which brought the telecom equipment market to grief.
Equally important, how is this sustainable? Some say that China has hundreds of millions of underemployed people who must be put to work outside the agricultural sector. But is seems that export manufacturing is currently employing only on the order of ten million. Are we going to see the Chinese trade surplus expand by a factor of ten? Are we to start running a $1.8 billion current account deficit with China?
Surely you cannot believe this possible — Smoot-Hawley II will be upon us long before we get there. Which is worse, Chinese disinflation/deflation or Smoot-Hawley II?
John, you’re a smarter man than I am, and I will have to read your China article several times to fully understand your novel point of view. I do agree that US real estate prices will suffer from reduced foreign purchase of long term debt. In addition, a lower dollar will push up inflation and increase the chance of higher interest rates by the Fed., which would, if translated into higher long term interest rates, also reduce real estate prices in the US.
For the moment my comments regarding China are:
I believe that the Chinese have been selling at the same prices for the last several years even as raw material prices have risen. I would guess that they could not raise prices to pay for increased commodity costs because of surplus capacity. I would guess that an increasing number of Chinese producers are not able to pay their debts, and that a growing number of Chinese producers are insolvent, along with their lending banks. In other words, China is headed for an oversupply crisis such as existed in SE Asia prior to the 1997 crisis. If so, following massive liquidation of producers, Chinese export prices will go down at some point, and eventually, after going up the yuan will go down again. I don’t see anything that the Chinese can do about this over-capacity except to hope that demand in Europe and the US will pick up the slack. However, the US and Europe have political problems with absorbing Chinese exports, and if the dollar falls (which I believe it will when the Fed stops raising interest rates), the US will have economic prolems in doing so. Much more probably, many millions of Chinese will be on the street without a job in several years–blaming their problems on any scapegoat they can find.
A related question is the one I have asked many financial people, but to which I have not yet obtained an answer:
The Ramseyer question–“what percentage of increase in the world living standard since the Great Depression of the 1930s is due to increased productivity and what percentage is due to increased borrowing?”
Thanks! Bill
John, thank you for your comments and the expectant results of the Chinese revaluing their currency this week. Want to also thank very much for your excellent calls on the ETF investments the last two weeks. Small Cap, EWY and especially EPP have made huge moves. Fortunately, I took your advice and made some cash. Thank you again for your great insight and investment ideas.
John:
Great Blog. Very interesting information concerning the recent developments in China and elsewhere. You’re perspective offers a wealth of information for amature economists and investors alike.
It is interesting to contemplate the effects that monetary policy on both sides can have on the economies of either trading partner.
I agree that we don’t want the economy of China to take off precipitacly in either direction: Up or down. Too much growth can be worse than too little growth so it is definitly best to take a go slow approach when making changes to monetary policy on either side of the trading relationship.
I wonder if the lower prices of Chinese goods will be offset by the slowing of the US economy as our own Fed seems hell-bent on fighting the inflation “phantom menace”.
I just don’t see the inflation out there. Our very liberal immigration stance in the US seems to be keeping a good lid on wage inflation (admittedly, it might be bouying inflation in other limited areas such as the housing market).
Keep up the great blog! You’re giving us a lot to think about.
John, thanks for the analysis. I do not have the familiarity with economics that you do, but my gut feeling is that altering the yuan/dollar peg will be destabilizing on the whole. I think you tend to agree. I wonder, though, whether this isn’t *precisely* what many US policy makers want. I can think of two reasons why they would:
1. They see China as a military threat, and the best way to protect against that threat is to retard their economic growth, or
2. They assume that China’s economy necessarily must crash at some point, due to the inherent insolvency of their (effectively state-owned) banking system. So they figure the sooner the better, because a fall from a shorter height is less damaging.
I would be curious to know whether you think US policy makers feel this way, and if they do, whether you agree with them.