The Global Credit Crisis and China’s Exchange Rate

The Global Credit Crisis and China’s Exchange Rate Ronald McKinnon Brian Lee Yi David Wang Stanford University Singapore Economic Review Conference August 6-8, 2009

Advantages of Stabilizing Yuan/Dollar RateA Potted History • 1995 to 2004 fixed rate nominal anchor: 8.28 Y/$ [McKinnon & Schnabl, Jan 2009] • July 2005 to July 2008, one-way bet on RMB appreciation: hot money inflows, buildup of official exchange reserves, loss of monetary control, disrupt forward exchange market [Wang 2009] • July 2008 to Nov. 2008, unwinding of dollar carry trade with sharp apprec.of $ effective ex rate, (Lee 2009), Y/$ rate reset at 6.83 through to present • 2009, monetary control regained with a massive expansion of bank credit to support fiscal stimulus for offsetting sharp fall in exports

Figure 1: China’s monetary policy and the yuan/dollar rate (1995-2009) Source: FRB

Figure 2: Foreign Reserves of China, Japan, Germany, and U.S.(2002-2009) Source: IMF and The People’s Bank of China

Figure 6: Bilateral Trade Balances of Japan and China versus the United States(percent of U.S. GDP, 1955 – 2008/1) Source: Kenichi Ohno, BEA

U.S Mercantile Pressure, I. • Acute Japan Bashing, 1978 to 1995 - Episodic trade disputes steel, autos, color televisions, machine tools, semi conductors - Resolution: Japan imposes “voluntary” export restraints and allows yen appreciation -Yen/dollar rate appreciates episodically from 360 in August 1971 to peak at 80 in April 1995, when U.S. announced a strong dollar policy • Japan financial system destabilized: bubble economy 1987-90 followed by a deflationary slump and low interest liquidity trap in 1990s (McKinnon-Ohno,1997)

U.S. Mercantile Pressure, II. • China Bashing: 2000 to ? -China surpasses Japan in 2000 as having the biggest bilateral trade surplus with the U.S -Unlike Japan, export surge is “across the board” in low value added manufactures. • Focus is primarily on appreciating the Renminbi: -Schumer-Graham bill of March 2005 for a 27.5% tariff on U.S. imports from China unless RMB appreciates (withdrawn October 2006, but new threat in 2007) -Section 3004 of U.S. Public Law 100-418: U.S. Secretary of Treasury must report twice a year on whether countries with trade surpluses are “manipulating” their currencies. Timothy Geitner’s congressional testimony January 2009 • RMB rises by 2.1% on July 21 2005, and begins slow upward crawl

One way bet: RMB appreciation July 2005 to July 2008 • Hot money flows into China • No private capital outflows to finance • China’s huge trade surplus (McK & Sch 2009) • Huge buildup of official exchange reserves: • government sole international intermediary • Massive sterilization: sale of central bank bonds, • increases in reserve requirements of com banks • Direct restraints on domestic bank credit • Still loss of monetary control with domestic inflationary pressure added to foreign

China’s Foreign Exchange Reserves Source: UBS

Figure 3: China’s Consumer Price Indices (Growth rate: % yoy) Source: EIU

120 115 110 105 100 July 2008 95 90 85 2000 2002 2004 2006 2008 Nominal Rate Dollar Yuan Effective Rate of the Renminbi Effective Rate of the U . S . dollar Figure 4: Renminbi and Dollar Exchange Rate Movements (2000-2008) Unwinding of Carry Trades Source: IFS and BIS

Figure 5: Commodity Price Indices (Jan 2002 =100) Source: globalfinancialdata.com Note: The commodity price index does not contain crude oil.

Figure 8: Unwinding the yen and dollar carry trades (effective exchange rates, 2006=100) Source: BIS

Table 1: Returns on carry trades (2000-2007) Source: Brian Lee (2009) Note: (a) For funding in dollars, the return is the average for Brazil, Mexico, and Canada. (b) For funding in yen, the return is the average for Australia, Korea, and New Zealand. (c) Trough to peak for the yen’s effective multilateral exchange rate. Caution: The unwinding of the carry trades in 2008 may not fully explain these exchange rate appreciations.

Dollar carry trade unwinds and “accidental” stabilization of the RMB since July 2008 • Credit crunch summer and fall of 2008 dries up short-term finance for dollar, yen, and commodity carry trades • Surprise dollar appreciation, July to Nov 2008, of approx • 20% against all currencies except the Japanese yen with a general fall in commodity prices. • PBC stops gradual (and predictable) appreciation of RMB, and stabilizes at 6.83 yuan/dollar. • Hot money inflows stop, some private outflows, minimal increases in official exchange reserves. PBC regains monetary control • Massive domestic credit expansion: cuts in reserves required of commercial banks while lifting credit ceilings, reductions in deposit and loan interest rates • Domestic spending largely offsets collapse in exports

Figure 9: China’s Nominal Trade (in billions of U.S. dollar, monthly) Source: China Customs Statistics Information

Figure 10: China’s interest rates (%) Source: UBS

Figure 11: China’s New loans to non-financial institutions (RMB bn) Source: UBS

Figure 12: China’s M2 and Bank Lending (Growth rate: % yoy) Source: UBS

Loans for 15 large U.S. banks Source: Wall Street Journal

M2 growth around the world Source: SCB

Violation of interest parity conditions and breakdown of China’s forward market mid 2007 to mid 2008 • Open Interest Parity (OIP): E(∆S) = it(yuan) – it(dollars) , where S = yuan/dollar • Covered Interest Parity (CIP): ft = it(yuan) – it(dollars) where f = (F – S)/S is forward premium on dollars OIP breaks down when the interest differential is less than expected appreciation because of fall in US rates CIP breaks down when SAFE had to impose controls on financial capital inflows, i.e., borrowing in dollars • Result: China’s exporters can’t cover dollar earnings forward, thus tightening credit constraint

Figure 13: Interest Differentials versus Percentage Changes in the Yuan/Dollar Exchange Rate (2002-2009) Source: Datastream. Note: OIP is Open Interest Parity.

Figure 14: Forward Rate vs. Forward Rate from Covered Interest Parity (yuan/dollar,6 month) Source: Wang (2009)

Figure 15: Percentage Deviation From Covered Interest Parity (yuan/dollar, by maturity) Source: Wang (2009)

Reducing China’s Saving-Investment Surplus Increase share of household disposable income in GDP in order to increase private consumption • reduce personal income and sales taxes • increase government transfer payments • increase dividend payouts from enterprises • Increase government social expenditures. Stimulate household spending • increase consumer credit • abolish one-child policy? Objectives (1) Reduce China’s trade surplus (2) Counter cyclical downturn in China and rest of the world • Caveat: Stabilize exchange rate (Mundell-Fleming)

Figure 16: Investment, Savings and Current Account of China(as a percent of GDP) Source: EIU

Figure 17: China’s Labor Income and Operating Surplus (Share in GDP(%)) Source: UBS

Table 2: China’s Economic Positions in 1997 and 2007 Source: UBS Note: The NPL ratio is 2.8% for four largest commercial banks, Dec 2008.

Conclusion:Countering the Global Cyclical Downturn in 2008-09 • New U.S. fiscal stimulus is problematic: weak domestic financial institutions, and trade deficit would increase • China now a big actor on the world stage with stronger public finances and much stronger banking system • To stimulate the U.S. and world economies, the primary fiscal stimulus should be in China and other surplus Asian economies—and possibly Germany. • Nov 2008, China announces a half trillion dollar fiscal stimulus—now supported by rapid bank credit expansion • U.S. quid pro quo: No more China bashing on exchange rate, or through antidumping duties, and other policies

The Global Credit Crisis and China’s Exchange Rate