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April 18, 2005

Does the U.S. Want the Renminbi to Rise Now?

Daniel Drezner wrote:

danieldrezner.com :: Daniel W. Drezner :: The Bush administration gets says it's getting serious about the dollar: Looks like the Bush administration is shifting from passive-aggressive to aggressive in trying to get the Chinese to revalue their currency. Andrew Balls and Edward Alden have the story in the Financial Times:

The US administration is calling for China to move immediately to introduce a flexible currency, a marked shift in tactics after several years of patient diplomacy aimed at nudging China towards allowing the renminbi to float. A senior US administration official told the Financial Times on Friday: 'Action is needed now. This is a co-ordinated effort to get the message across.' The decision to demand prompt action by Beijing comes in the face of growing pressure from Congress over the burgeoning US trade deficit with China. Officials acknowledge they were shocked by a 67-33 Senate vote earlier this month to allow consideration of a bill championed by Democratic senator Charles Schumer that would impose a 27.5 per cent tariff on all Chinese imports if China does not revalue in the next six months.... The message is being delivered to China at all levels in advance of this weekend's Group of Seven meeting in Washington. China, which has been a guest at the past two G7 meetings, is not sending its finance minister and central bank governor to this weekend's gathering...

That last bit suggests to me that this pressure won't have an appreciable effect anytime soon. This will irritate the Bush administration but really irritate the European members of the G-7, who blame the United States and the Pacific Rim for the magnitude of current global imbalances.


Brad Setser wonders if the U.S. really wants the renminbi to go up by a lot, right now: a fall in China's (and other central banks') purchases of dollar-denominated assets reduces the value of the dollar and so boosts demand for U.S. firms in export and import-competing industries, and raises dollar interest rates, reducing investment. In our simplest finger-exercise models--teh ones I will teach next year in Econ 101b--the first effect dominates. But that is small comfort, for the score that the international monetary system appears to be playing off of these days bears little resemblance to finger exercises and much more resemblance to something like "Night on Bald Mountain."

Brad Setser's Web Log: First the President tells China that it is holding a bunch of worthless IOUs ...: And now he tells China it really should revalue, in far stronger language than the US (or the G-7) has used before. It seems like Tim Adams, the incoming Treasury Under Secretary for International Affairs, plans to get tough on China. Adams reportedly thinks that China has not rewarded Bush for keeping the rhetorical heat on China down during the campaign....

If I were part of the Bush Administration's economic high command, though, I would worry that China might take the hint. If China revalued (really revalued) and its reserve accumulation slowed, the US might find it a bit harder to find buyers for all the IOUs the Treasury is churning out, even as US 'soft patch' could widen the US deficit. And there might not be quite so much demand for Agency debt/ mortgage backed securities either....

[T]here seems to be pretty good evidence that the value of the renminbi does have an impact on China's export growth. Consider this: From 1996 to 2001, China's real exchange rate rose from 86 to 101, and its exports almost doubled, going from $174 billion to $301 billion. From 2001 to 2004, China's real exchange rate fell from 101 to around 90. China's export growth accelerated: China's export grew by 35% in 2003, 35% in 2004, and, according to the latest (March) data, are increasing by 33% y/y in 2005. China's exports are on track to more than triple between 2001 and 2006: rising from $310 billion to $1030 billion (China's end 2004 exports were around $740 billion). That's a much bigger increase than the increase in the five years that preceded 2001, when the renminbi generally was appreciating along with the dollar.... The fall in the dollar has not done wonders for US export growth, but it sure has had an impact on China.

A very large hedge fund (oops -- a well-respected investment bank) used more formal econometric techniques to arrive at the same conclusion. A recent Goldman study indicates that even a 10% rise in the renminbi's real value would cut the growth in China's exports by 15%. That has to happen at some stage: China is too big for its exports to keep growing at a 30% plus annual rate. And if a Chinese move made it a bit harder for the US to finance its deficits at current rates, that just might provide some of the impetus the US needs to start putting its own house in order...


Nouriel Roubini has a much stronger view that he expresses, um, frankly: for the U.S. to push for China to revalue the renminbi by 20% is for the U.S. government to shoot itself in the head:

Nouriel Roubini's Global Economics Blog: April 2005 Archives: [I]s the US really serious about demanding that China revalue its currency or is the US outright clueless and masochistic? The first rule of good manners - and finance as well - is that you should not bite the hand that feeds you. In the case of the US, for the last two years about three quarters of the US fiscal deficit has been financed by foreign central banks (mostly China and Asia), 100% of the US fiscal deficit has been financed from abroad (as US residents have not increased by a penny their net holdings of US Treasuries) and about 80% of the US current account deficit has been financed by foreign central banks (again mostly China and Asia). Last year China accumulated $200 billion of forex reserves, mostly in US dollar assets, and it is still accumulating them at the same rate this year.... [R]educed supply of financing of the US twin deficits from China/Asia would lead... to a sharp increase in the US long term interest rate, thus leading to a fall in housing prices, in equity values and in the price of a wide range of other risky assets such as high yield bonds, i.e. a hard landing.

How much would US long term rates increase...? [W]e argued at least 200 basis points... two anecdotes are more powerful.... Recently, when an obscure Korean government document sent to its congress had a line about diversification... the DJ index fell 1.6%, the US bond market tanked with the 10yr yield up 15bps and the dollar fell sharply.... [W]hen the Japanese PM Koizume spoke - or mispoke? - about diversifying the Japanese forex reserves a similar shock wave affected US stocks, bonds and the dollar....

[W]hat would happen on the day when China - followed on cue by the rest of Asia as what prevents Asians from moving their effective dollar pegs is the Chinese peg - were to announce that it will... reduce its accumulation of dollar reserves? The answer is simple... financial Armageddon.... Thus... [do] the US authorities really... really mean what they say or are they clueless?... There are at least three interpretations....

  1. Talk is cheap and the posturing is aimed at containing protectionist pressures in the US....
  2. The US authorities are really clueless or masochistic....
  3. Wishful thinking that a Chinese revaluation alone would solve the US current account problems....

There is a view out there... folks at the Fed... fall of the US dollar... would have little effect on US interest rates and that the beneficial effects by themselves of such a dollar fall on US demand and net exports would have a positive effect on US economic growth (see the Greenspan February speech and the more recent one by Bernanke).... A variant of this... is that... a reduction of the US fiscal deficit is... likely... moderate Republican senators will not vote for making the US tax cuts permanent... the AMT... [is] a stealth tax increase and... Social Security privatization is already bust....

But such wishful optimism... has little basis in the data or... Washington. The US current account has worsened rather than improved since it started to fall in 2002 ; and this is not due just to J-curve effects (that last 6-12 months, not 28 months) and is not just due to high oil prices (as non-oil imports are still growing at a very fast rate).... [T]he moderate Republicans in Congress voted for a 2006 budget that was even more loaded with new budget busting tax breaks.... Reducing the deficit by half by 2009 by freezing non-defense discretionary spending to 2005 levels for 5 years is something that not even a single Republican congressman - 'conservative' in theory but more piggish in practice when it comes to pork barrel spending - would vote for....

So, which interpretation is the correct one?... a combination... the Administration knows that its talk is cheap and it is trying to stop Congress from slapping tariffs on China... the administration... must also be really clueless and playing with fire by pushing so hard China to revalue early... there is also plenty of delusional wishful thinking that a Chinese move alone, together with miracoulous deficit reduction - falling like manna from the sky with no policy action on taxes - would reduce the US twin deficit....

Maybe unconsciously - and this may be the fourth freudian interpretation - the administration really wishes to be woken up from its own delusional dreams and rejoin the 'reality-based community' where most the world resides...

Now a fall in the dollar could have little effect on U.S. interest rates if a dollar fall was accompanied by a Federal Reserve declaration that it was focusing on internal balance, and the Federal Reserve adopted a definition of "internal balance" that was to peg the nominal yield on the Ten-Year Treasury at five percent per year.

The life of a central bank governor would then become very exciting indeed.

It would become especially interesting if it is indeed the case, as Brad Setser reports, that this is taking place because "Tim Adams reportedly thinks that China has not rewarded Bush for keeping the rhetorical heat on China down during the campaign." In order for the U.S. to attain a soft landing U.S. national savings needs to rise relatively swiftly and the dollar has to decline slowly and gradually--so that nobody ever thinks it is about to collapse--a half-step behind the change in the exchange rate. The U.S. doesn't need anything that decreases the chances of a soft landing. Yet the word is that Treasury Undersecretary for International Affairs to be Tim Adams doesn't get this: that he is treating pressure for the revaluation of the renminbi as a move in the political game--as a way of punishing China's government for not being grateful enough to George W. Bush--rather than as the economic equivalent of pouring gasoline on a powder keg.

Posted by DeLong at April 18, 2005 02:16 PM