Discussion by Pascal Jacquinot (ECB)

1. The Transmission of Shocks to the Chinese Economy in a Global Context: A Model-Based Approach by J. Baillu, P. Blagrave, O. Kamenik and D. Laxton Discussion by Pascal Jacquinot (ECB) Jerusalem, 27 October 2009

2. Why China does matter? • China is the world’s second largest economy, still behind the US but ahead the euro area and Japan. • Its GDP has grown by 8.9% in 2009q3 (on yearly basis). • Its investment has grown by around 25% over the past ten years and 33% in 2009q3. • China saves over 50% of its national income. • Growth sustainability: China that constitutes an unprecedented story of economy development is foreseen regaining its pre-industrial revolution status as the first largest economy!

3. Why China does matter? • China is playing a key role in the most recent policy debates: • Increases in the prices of energy and other commodities: the strong growth in China (together with other emerging economies) may be source of upward pressure on inflation. • Risks of outsourcing manufacturing activities in China. • International capital flows through China’s large scale purchases of US Treasury bonds.

4. Why China does matter? • Global Imbalances: China’s large current account surplus and accumulation of foreign asset reserves. Even if the US deficit started to correct, partly in response to the turmoil in the sub-prime mortgage market, the size of these imbalances remains large.

5. The key role of exchange rate • Straub & Thimann (2009) using an global DSGE model stressed: • The model-based results indicate that persistent current account surpluses in China cannot be rationalized by the occurrence of permanent technology and labour supply shocks. • The understanding of the macroeconomic adjustment process in China requires to mimic the effect of potential inefficiencies. These inefficiencies can be potentially seen as a by-product of fixed exchange rate regime…

6. The key role of exchange rate • A large number of contributions address the issue of the valuation of the RMB, mostly pointing to a large undervaluation. • The challenge (already considerable for advanced economies with deep and liquid markets): assessing China’s equilibrium exchange rate (economy in a transition process with short data record). • Some economists are arguing that an exchange rate change will not have an impact on the current account surplus, which is essentially driven by high domestic savings.

7. The key role of exchange rate • The exchange rate regime is related to inefficiencies in the financial sector (interest rate regulation, massive requirement reserves or obligation to bank to purchase sterilised bills) and thus contributes to current account surpluses. • More flexible exchange rate regime would allow to advance financial liberalisation and development that might contribute to higher domestic absorption and thus a less inflated current account surplus.

8. The modelling strategy • DSGE models vs. more reduced form models. • The strategy largely depends on the use of the model: forecasting or policy analysis. Fitting the data or telling a nice story. • Projection exercises need estimation and regarding the quality of the Chinese data: Bayesian techniques are the most appropriated. And the model should be easy to handle (small size). • The problem is the quite limited number of variables and shocks.

9. The modelling strategy • For policy analysis (structural reforms) a more detailed model is needed: the global DSGE strategy. • Advantages: some important features that may be important for emerging economies such as the tradable sector, the share of agents that do not have access to financial markets can be easily introduced. • Problem: difficult (if not impossible) to estimate: calibration. • Financial channels are still inexistent in global DSGE. • Alternative solution: taking parameters for US, EA and Japan from estimated DSGE and imposing his own view on China’s parameters.

10. The modelling strategy • GPM is closer to the first strategy but has the undeniable advantage of being simultaneously a global model and estimated. • It’s a nice compromise between sophisticated micro-founded DSGE models and very simple semi-reduced form models (where some ad-hoc features can also be added for the financial aspects). • GPM has four behavioural equations where all variables are defined in deviation from their steady-states. • Estimated using Bayesian techniques. • This version: GPM-G3 (US, EA and JP) expended with China

11. GPM-China • Compared to the benchmark model: • IS curve in open economy: with foreign partners output gaps and bilateral exchange rates. The same in both. • Phillips curve: extra oil-price inflation term. • Monetary policy reaction function: deviations in the nominal exchange rate from its time-varying target. • UIP: an additional term to capture the effects of movement in the equilibrium exchange rate on current and expected exchange rate.

12. GPM-China • Compared to the benchmark model (cont.): • No labour market (Okun’s law / NAIRU) nor financial market (Bank Lending Tightening variables): no reliable data. • Exogenous stochastic processes driving unobserved (equilibrium) variables: the rate of change of the equilibrium exchange rate depends on its own lagged value and the deviation of the growth rate of potential output from its steady state (to mimic productivity growth in the tradable sector). Instead of a random walk for the advanced economies.

13. GPM-China • Questions (or clarifications): • How do you capture (if possible) some stylised facts such as: a very high saving ratio due to precautionary motives (high unemployment rate, no social security) or financial regulations (the absence of financial markets)? • How do you deal with the change of regime in the monetary policy moving from a dollar pegging (abandoned in July 2005) to a controlled exchange rate strategy? Via the extra exchange rate term? • But how did you set the exchange rate target? • The oil price is a random walk. Does it imply that a boom in China has no impact on the oil market?

14. Estimation • Estimations are rather convincing: • More persistence in the output gap, less forward-lookingness in the Phillips curve. • The difficulty to estimate the monetary policy rule. • But are results very sensitive to: • The choice of the priors (a comparison of prior and posterior distributions would also be informative)? • The data de-trending? • Strong assumption: independence of shocks?

15. Results • Impulse responses are also rather convincing. Even if the behaviour of the Chinese exchange rate is sometime difficult to understand. • A couple of extra simulations would have also been quite interesting: the impact of a Chinese demand (or potential output) shock on the US economy.

16. Conclusion • A very appealing paper that I liked very much regarding the challenge to model (in a very convincing way) China. • Thank you very much…