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Alternative sterilization tecniques: A comment on Prasad and Rajan

Alternative sterilization tecniques: A comment on Prasad and Rajan. Ricardo Hausmann Kennedy School of Government Harvard University. The problem. Large balance of payments surplus in China Capital controls prevent residents from reallocating assets abroad

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Alternative sterilization tecniques: A comment on Prasad and Rajan

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  1. Alternative sterilization tecniques:A comment on Prasad and Rajan Ricardo Hausmann Kennedy School of Government Harvard University

  2. The problem • Large balance of payments surplus in China • Capital controls prevent residents from reallocating assets abroad • Sterilization creates a fiscal cost and a risk to the balance sheet of the public sector

  3. The proposed solution • Partial flexibilization of the capital account • Allow close-end funds that invest abroad

  4. Advantages • Allows the government to maintain control over the volume of capital outflows • May permit a more orderly stock adjustment • May protect a weak financial system • Transfers the risks and rewards directly to the private sector • Allows for a reduction in the external imbalance by reducing the capital account surplus

  5. Comments • Not relevant for Latin America at this time • Capital accounts are open already • More flexibility is always better. • The government can always set the amount back down to zero. • Incentives may have the wrong time profile • Demand will be low (high) when expectations are for the RMB to appreciate (depreciate)

  6. Comments • If fund managers actively manage exchange rate risk, the effects on the currency market may be mute • Conflicted virtue (the opposite of original sin) may become an issue • Not a critique of the scheme itself

  7. The Chinese external imbalance What causes it? What to do about it?

  8. China’s external imbalance • China has a current account surplus of some 4 percent of GDP • It also has an FDI surplus of another 4 percent of GDP • Potential round-tripping of 2 percent of GDP • In addition, it has speculative capital inflows in anticipation of revaluation • Reserves have been accumulating very fast • Money supply and sterilization bonds are also growing very quickly • There are international political pressures for appreciation • What should China do?

  9. China’s external surplus China: Current account balance and inward FDI

  10. Analysis • A current account surplus involves an excess of domestic savings over investment • Investment is at world record levels • The country suffers from excess-savings, or insufficient consumption

  11. China’s investment rate is almost at world record levels (2003) TCD 55 AZE CHN VNM AGO NIC Gross fixed capital formation (% HTI KOR IRN MOZ CZE GRC SVK ESP ZMB THA DZA JPN KAZ HND SYR BLR MAR MLI BGD GEO TUN DOM CHL NGA IND ECU AUT ROM HUN KHM LKA UZB MYS HKG GHA JOR ETH UGA RWA UKR SEN IDN DNK BGR BEL MEX NPL ITA PRY BFA ISR TZA POL RUS BEN PHL FIN MDG PER DEU SAU CMR BRA GTM EGY YEM SLV GBR ZAF SWE TUR ARG KGZ PAK COL NER ZAR BOL KEN SLE BDI TJK VEN GIN MWI CIV 8.82839 6.25014 10.2997 lpppgdp

  12. External and internal balance depreciation Over-heating Surplus External Balance Unemployment Surplus Over-heating Deficit Real Exchange Rate Full employment Unemployment Deficit Demand

  13. Where is China? Where should it go? depreciation Over-heating Surplus External Balance Unemployment Surplus Over-heating Deficit Real Exchange Rate Full employment Unemployment Deficit Demand

  14. What should macro policy do? • A real appreciation by itself risks generating unemployment and deflation • Inflation is running at 1.8 percent (March 2006) • …In spite of the rise in commodity prices and energy • It needs to be complemented with an expansion of demand • This could come from monetary or fiscal sources • The banking system is already very leveraged • …and would allocate the resources in the most prosperous areas where there is good collateral • Fiscal policy can be targeted socially and regionally

  15. An expansionary demand policy? • Is China over-heating? • Over-heating vs. over-investment • Excess demand vs. excess supply • Slow vs. fast policies • Exchange rate is a fast policy • Fiscal policy is much slower to put in place • If appreciation needs to be allowed to happen, it better be preceded by the adoption of the fiscal expansion

  16. Conclusion • Real appreciation may be hard to avoid • …but it should be accompanied by a fiscal expansion • The resources should be used in the context of a development strategy that maintains growth and deals with social and regional imbalances

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