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July 27, 2005

Whither the Yuan?

The best debate on the yuan I have seen is this Econoblog by Nouriel Roubini and David Altig:

WSJ.com - Whither the Yuan?: July 21, 2005 6:38 p.m.: China's decision to lift the yuan's peg to the dollar marks a modest but important first step in overhauling its strict currency regime. The yuan has been strengthened, effective immediately, to a rate of 8.11 yuan to the U.S. dollar -- compared with the 8.28 yuan it has been set at for more than a decade -- and the currency will now be allowed to trade in a tight 0.3% band.... WSJ.com asked economist bloggers Nouriel Roubini and David Altig to take a closer look at the news and the numbers....

Nouriel Roubini writes: Last week I predicted... that China would revalue the peg to the U.S. dollar (by a small amount close to 3%-5% rather than a larger 10%-15% move), that it would move from the peg to the U.S. dollar to a basket peg and that it would create a fluctuation band around this basket. That is indeed what happened today... the band around the basket is still very narrow.... [T]he move is too small: It is too small to make a dent on the Chinese trade surplus or on the U.S.-China bilateral trade balance... the move won't appease those in Congress who want to pass protectionist legislation... the move may lead to even more speculative capital inflows into China from investors who will bet on further Chinese revaluation....

But this small move is a beginning of a much larger currency regime change in China and Asia.... In the past I warned against biting the hand that feeds you as the U.S. was aggressively pushing for a large Chinese revaluation while, at the same time, needing such Chinese and Asian cheap financing of its twin deficits. If a modest 2.1% currency move increases U.S. long rates by 0.07 percentage points, consider the implication of a 15%-20% move in currency values in China and Asia over time. It could get ugly for the U.S. unless the U.S. seriously tackles its fiscal deficit....

David Altig writes: Nouriel, not surprisingly, puts his finger on one of the key issues: How close is the new yuan-dollar exchange rate to the value it would take if allowed to float freely? In other words, how many shoes are yet to drop?... Owen Humpage and Pat Higgins... find that, although the Chinese central bank has increased the pace of foreign exchange reserves over the past year, much of this activity has been "sterilized."... [W]hile the Chinese central bank has been increasing the supply of money to accumulate dollar assets on the one hand, they have at the same time been engaging in domestic operations to reabsorb that liquidity with the other hand. The end result has been that the pace of money creation in China -- monetary base growth, specifically -- has not been accelerating, even as the central bank has appeared to intervene more and more to sustain the peg.

Why is this interesting? Because, again roughly speaking, sterilized exchange rate operations have no effect on the value of the currency, outside of a short window of time.... One possibility is that the value of the Chinese currency hasn't been, and so isn't now, as far away from its "fundamental" value as many people think. The second possibility is that the Chinese fixed exchange rate regime has been held together by the chewing-gum-and-chicken-wire device of capital controls. The latter possibility means that the announcement that China plans to loosen capital controls... is at least as big a story as today's announcement....

Nouriel writes: David, correctly, points out the role of sterilized intervention in China. One of the reasons China decided to change its currency regime is that this intervention was leading to two serious financial costs and vulnerabilities for China: 1. Piling up more and more U.S. dollar foreign exchange reserves would lead to severe capital losses for China... once the Chinese currency was allowed to appreciate.... Not moving the peg would have implied intervening and accumulating even more forex reserves over time -- to the tune of over $200 billion a year lately -- and thus even larger capital losses for China down the line.... 2. The forex intervention has been -- as suggested by David -- only partially sterilized (only 50% of it lately).... This increase in the Chinese monetary base has led to excessive liquidity creation in China....

As for the loosening of the capital controls, such liberalization will not -- in the short run -- lead to significant capital outflow out of China and prevent appreciation pressures. The reason is as follows: With the currency move today there is now a greater likelihood that the Chinese currency will further appreciate over time. Thus, international traders and investors, Chinese expat communities in Asia and foreign firms doing investments and FDI in China will have an even greater incentive to bring capital into China to obtain large capital gains once the Chinese currency moves even further. So, liberalization of capital outflows won't help in the short run....

The systemic consequences of this currency realignment throughout Asia and the world could be radical and have significant impacts on U.S. long-term interest rates, on U.S. financial markets and on the U.S housing bubble.

David writes: I remain less convinced than Nouriel that we have a firm notion of how much further the Chinese currency will appreciate or how much effect liberalization of capital controls will have on exchange-rate dynamics. We simply don't know how private decision-makers in China will respond when offered the opportunity to freely move their own financial capital about the world. I don't find it at all implausible that private accumulation of dollar assets could put a pretty good dent in whatever reduction we see from the central bank.

I am going to stick with Ben Bernanke's position (or my version of it): The really important question is whether, when the dust settles, the Asian taste for saving outside of Asia will persist. If it does, it is hard to conjure up a scenario in which a good fraction of that saving won't continue to flow in the direction of the U.S. If it doesn't, there probably isn't enough that can be done via fiscal deficit reduction to stave off the effects on the U.S. economy that Nouriel fears.... But the market, today at any rate, has responded in a fairly orderly manner....

Nouriel writes: I beg to disagree. If China were to liberalize its capital account... and stop intervening, the Chinese currency could appreciate by more than 20%, minimum. Think of it: China has a current-account surplus that is now growing to more than 4-5% of its GDP; it also has long-term capital inflows in the form of FDI that are another 2-3% of GDP; and on top this, last year it had hot money capital inflows that were another 5% of its GDP. Each one of these three forces leads to a currency appreciation; and this is why China was forced last year to intervene to the tune of $200 billion in forex-reserve accumulation to prevent the yuan from appreciating....

The hard part for China and the rest of Asia will be now to manage the massive speculative inflows of capital that are betting on further appreciations of the yuan and other Asian currencies. As the extensive coverage today of the news and blogosphere comments on the China move on my RGE Monitor suggest, markets are now expecting that China will now allow further upward movements of the yuan and of other Asian currencies....

As for the impact on the U.S., this depends on the factors that have caused the bond conundrum. Unless one believes -- a la Bernanke -- that such a conundrum is explained only by a persistent global savings glut, the impact of this change in currency regime in China and Asia on the U.S. financial markets could be serious. The effect of Chinese and Asian intervention on U.S. long rates is hard to measure but estimates range between 0.5 and 1.5 percentage points....

[W]hile I agree with David that a sharp reduction in the Asian and world appetite for the U.S. assets would be painful for the U.S. even if the U.S were to make a significant fiscal adjustment, the lack of such fiscal adjustment would inflict greater pain than otherwise....

David writes: I'm not so much disagreeing with him as much as cautioning that the web of effects that may arise from broad financial reforms are so complex that I wouldn't place very big bets on any particular outcome.... In the overall scheme of things, if you put any faith at all in markets' ability to provide best guesses of such things, the expected magnitude of RMB-appreciation looks pretty moderate.... [F]orward foreign exchange contracts were suggesting a total appreciation of about 8% over the next twelve months.... [I]t does indicate where those with their money on the line see the process heading.... It is in the interest of the Chinese central bank and the Chinese government to maintain a pace of reform that is consistent with an orderly transition....

Nouriel writes: [T]his is the beginning of a much larger currency move that, over time, will lead to a managed float a la Singapore and to significant capital account liberalization. I venture to guess that over the next 12 months, the Chinese currency will be allowed to appreciate by more than 10% and that other Asian currencies... will also follow.... [T]he large accumulation of U.S. dollar reserves by foreign central banks to the tune of over $500 billion a year may unravel.... This would... force the U.S. to make significant and painful adjustments to its private and public savings droughts, droughts that much more than a global savings glut explain why the U.S. external balance has been worsening over time. Then, U.S. private spending, both consumption and investment, may have to fall sharply -- driven by higher U.S. interest rates and a bursting of the housing bubble -- relative to U.S. output to make room for an improvement of U.S. net exports....

Finally, I am concerned about the financial consequences of an uncoordinated global rebalancing, where the lack of policy coordination between the U.S., China/Asia and Europe may lead to significant financial markets' volatility. There is now a huge incentive for hedge funds, prop desks and other highly leveraged institutions to try the Asian Currency Revaluation bet and go for a currency kill in Asia.... The stakes are so high that traders/investors may want to test how far they can collectively push such currencies and make significant capital gains on this speculative attack. Herding behavior and momentum trading are typical of financial markets, and the Chinese move today is a signal that it's open season on trying to push up a wide range of Asian and other currencies.... In 1998, Russia's currency crisis triggered the LTCM crisis and a 10% plus move of the Yen relative to the U.S dollar in a matter of three days....

David writes: Nouriel says "policy makers and regulators may want to be wary of systemic risks associated with such large capital flow movements." There are certainly no truer words than those, and over time I have become convinced that the truly important work of central bankers is to handle those episodes when the feared meltdowns come a'calling. It is interesting, then, that Nouriel references the 1998 Russian/LTCM crisis, which was the back-breaking straw piled on the 1997 Asian currency crisis. If I had to choose one example of a case where severe stress in global financial markets was weathered just fine, that would be a good candidate....

None of this is to claim that it's time to fall asleep at the wheel. Nor is it to claim that there aren't some tough adjustments ahead. We may well be at the beginning of an upward climb in long-term interest rates that many of us have long expected, and the reversal of the current-account deficits that all of us knew would come sooner or later. And though I am not much convinced by Nouriel's worst-case scenarios, I'm glad he's out there reminding us to not forget about them.

Posted by DeLong at July 27, 2005 11:03 AM