Don't Bet on the Renminbi

Posted July 30, 2008

Rumor has it that hot money is betting on a sharp appreciation of the renminbi. China’s official reserve assets seem to accumulate at ever increasing rates, and recent increases are not accounted for by the trade surplus and net foreign direct investment. It appears there’s money coming in, but why would speculators be betting on a big-time revaluation? It doesn’t fit with macroeconomic fundamentals.

The fundamentals rest with the domestic relationship between saving and investment. The difference is the trade imbalance since saving not channeled into domestic investment becomes a capital outflow and a capital outflow is financed by export revenues not spent on imports. In a span of just six years, China's national saving rate rose by a dramatic 12 percentage points of gross domestic product, from 38% in 2000 to 50% in 2006 (see nearby graph). From an already high level then by international norms, it went stratospheric. The investment rate was also high and rose in parallel until 2004. During this stretch, the saving/investment gap ran at about two and a half percent of GDP. Then the investment rate flattened out at around 43% while the saving rate pushed inexorably upward, and correspondingly the trade surplus soared.

My own research shows that most of the increase in the saving rate can be explained by China's extremely high GDP growth rate in the post-2000 period (www.lkyspp.nus.edu.sg/wp/wp08_08.pdf). When countries experience breakneck growth in income, consumption as a general rule tends not to keep up. Also contributing to China’s rising saving rate is a falling dependency ratio as saving is higher among those in their working years versus the young or the elderly.

The exchange rate has played a passive role in this story. The peg in place at the outset of the post-millennial growth surge dates essentially to 1994. Exchange rate unification at that point established a rate that was in line with market forces, yielding a small, arguably prudent, surplus in the trade account (i.e., a small gap of saving over investment as visible in the nearby graph). Indeed, in the wake of the Asian financial crisis a few years later the Chinese government made much of holding the line against devaluation. For a decade, the pegged exchange rate was a boon to trade and investment because it provided stability, not because it distorted the market. To have prematurely revalued the currency would have choked off exports and stimulated imports at a cost of slower income growth and job creation.

The growth spirt post-2000 was stupendous, beyond what the official figures reveal (a claim that is empirically supported in the paper referenced above). But with growth of this order came the saving rate increase and hence, when investment was administratively restrained in 2004, the gaping trade imbalance. Until the 2004 juncture, a peg at 8.3 had been credible. With the mounting trade surplus though, the exchange rate came under pressure. The Chinese government’s response to that pressure has been to move gradually away from a peg and develop the institutional structure for market-based exchange rate determination. In that context, the central bank has been caught holding the bag, absorbing surplus foreign exchange inflows as the trade surplus widened and private investment inflows stepped up. There was not a deliberate policy stance to run up the trade surplus by leaps and bounds and accumulate massive foreign reserves. It just turned out that way given the existing peg and phenomenal GDP growth.

Growth momentum was sustained through a feedback loop to the U.S. economy. The accumulation of forex reserves in China had its counterpart in a capital inflow to the U.S. Such an inflow tends to push up the value of the U.S. dollar which undermines U.S. exports and boosts U.S. imports. This slows down the U.S. economy. The ready antidote to a threat of slowdown is monetary stimulus which there was in full and which found an outlet in rising asset prices. This made Americans happy to go on consuming. The bottom line was the U.S. kept growing and buying Chinese goods and China kept growing and lending money to the U.S. For awhile both sides enjoyed strong growth and increasing wealth. The problem, we found out belatedly, was that the U.S. financial system was not capable of allocating burgeoning investment funds effectively, and the fallout from that spells the end of the cycle.

There are Chinese observers who blame U.S. monetary policy for the imbalances and the whole upward spiral which bore the seeds of its own collapse. And Americans of course blame China's "artificially low" exchange rate. Actually, the forces were symbiotic and both sides enjoyed the boom times while they lasted.

The inevitable slowing of China’s growth rate will only gradually contribute to a decline in the saving rate. But there are policy measures that can be brought to bear with very substantial prospects for pushing the saving rate down, and these measures are worthwhile for intrinsic reasons as well. Such measures include: building the social welfare system; improving the financial system; and absorbing profits from SOEs in the fiscal budget.

Increased fiscal spending on social welfare programs has an expansionary impact, and this at a time when the economy is already showing signs of rising inflation. This is where the exchange rate finally comes in. There is a role for currency appreciation within the broader scope of macroeconomic policy now where there had not been previously, in my view, strictly for purposes of reducing the trade surplus. In combination with expansionary fiscal policy used to stimulate domestic consumption, currency appreciation acts to divert resources out of tradable goods production (less exports and import substitutes) and into social welfare service provision. In this way inflation is kept in check despite the increased fiscal spending. However, the appreciation called for in this context is modest and gradual, and as such should not be cause for any onslaught of speculative capital.

Ms. Calla Wiemer, a Ph.D. in economics and longtime specialist on the Chinese economy, lives in Los Angeles and is writing a macroeconomics textbook for Asia.