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May 22, 2007

Too Much Ado About The Yuan Peg?

Over at Angry Bear, pgl provides a rundown on a bit of a blogworld dust up over the consequences of Chinese exchange rate policy.  The first fighting words were issued by Dartmouth's Matthew Slaughter. From the Wall Street Journal Online:

... the dollar-yuan peg are misplaced. Economic theory and data are very clear here on two critical points. Controlling a nominal exchange rate is a form of sovereign monetary policy. And monetary policy, in turn, has no long-run effect on real economic outcomes such as output and trade flows.

Gotta say that makes an awful lot of sense to me, but Brad DeLong nonetheless takes exception:

... Matthew Slaughter's assertions are based on his assumption that full long-run monetary and price-level adjustment has already taken place, yet the pace and magnitude of China's reserve accumulation (and Japan's) are very strong signs that the PBoC and the BoJ are blocking monetary and price-level adjustment--and that is the problem.

Brad and pgl both cite the cogent analysis of knzn:

What the People’s Bank of China is doing is... attempting to cool the economy by raising interest rates.... It is trying to keep exports strong by keeping the currency weak, and at the same time, it is trying to reduce domestic demand by tightening domestic monetary policy. As a result, it is accumulating a huge, huge, huge quantity of dollar-denominated assets, and this rate of accumulation is clear evidence of a policy conflict.

The conflict might be a bit more obvious if things were going in the other direction. If China were trying to peg the yuan too high rather than too low, while at the same time trying to stimulate, rather than cool, its domestic economy, it would be losing reserves rapidly. The process couldn’t continue, because it would run out of reserves. Then it would be forced either to abandon the peg or to tighten the domestic money supply dramatically. Because the process is now going in the opposite direction, there is no “crisis”, but otherwise what we are seeing is the exact inverse of conditions that would normally have led to a foreign exchange crisis.

Good stuff, from both Brad and knzn.  But I'm somewhat puzzled why they are so exercised by Slaughter's comments.  Says Brad:

To state that if we assume that the problem doesn't exist then we conclude we don't have a problem is just not very helpful. And not one in a hundred readers of the WSJ op-ed page will be able to diagnose just how Slaughter's piece is a misleading tautology.

Adds knzn: 

Of course, when a country does have a foreign exchange crisis, we don’t read economists saying that it is just “sovereign monetary policy” and nothing to worry about. When the process happens in reverse, though, apparently central banks can find plenty of apologists for their unsavory policies.

I'm failing to see as much conflict as all the spilled typing suggests.  I would not myself characterize an exchange regime, fixed or otherwise, with a word like unsavory -- or distasteful, yucky, stinky, or with any other such value-laden language.  knzn makes the point that is worth making which is, if markets are allowed to work, unsustainable pegs won't be sustained.  In the case of an overvalued currency, the whole scheme ultimately collapses for want of foreign currencies with which to intervene.  In the case of an undervalued currency, monetary creation results in the inflation that depreciates the value of the currency, which solves the under-valuation problem. I think Matthew Slaughter agrees.

Furthermore, I certainly agree that there may be lots of ups and downs along the road to long-run neutrality of monetary policy, as Professor DeLong indicates. But I don't see anything suggesting that Professor Slaughter has it wrong in the larger scheme of things.  Writes the former:

This policy conflict could end in one of several ways:

    1. A sudden large burst of inflation in China, as the PBoC finds that it can no longer maintain both the current exchange-rate peg and a stable effective money stock, and sacrifices the second to the first.
    2. A sudden large rise in the value of the yuan, as the PBoC finds that it can no longer maintain both the current exchange-rate peg and a stable effective money stock, and sacrifices the first to the second.
    3. Slow and gradual versions of (1) and (2) as holders of nominal yuan assets in the first case and nominal dollar assets in the second let their wealth be gradually but substantially be eroded without ever taking steps to cut their losses.
    4. Something more unpleasant.

Items 1-3 on that list sound to me an awful lot like the nominal adjustments emphasized in the Wall Street Journal piece.  What's more, I don't think Matthew Slaughter is quite as sanguine as suggested by either knzn or Brad DeLong:

Put it this way: In a counter-factual world where over the past decade China allowed the yuan to float against the dollar, the U.S. would still have run a large and growing trade deficit with China. The real economic forces of comparative advantage that drive trade flows operate regardless of which nominal prices central banks choose to fix.

This week the U.S. government hosts Chinese officials for the second round of the Strategic Economic Dialogue. Treasury Secretary Henry Paulson and Chinese Vice Premier Wu Yi have framed the SED as a forum to address complex policy issues associated with the links between our two countries. In China, further capital-market reform is needed to support economic growth via better risk management and capital allocation throughout all sectors of the economy. Here at home, the large aggregate gains the U.S. has realized from freer trade and investment with China have also generated hardship, too. Many American workers, firms and communities have been hurt, not helped, by Chinese competition.

Issues like these are legitimate and real. But focusing on the dollar-yuan peg is a misplaced and counterproductive way to address them. Instead, let China continue to conduct its sovereign monetary policy and let the SED continue to engage the real challenges. Stop fixating on the fix.

I may be completely misinterpreting things, but it seems to me that the point is simply that the peg alone cannot be the biggest issue in the discussion.  I guess the disagreement here may be that the Slaughter piece puts more emphasis on the strains that trade-related adjustments in resource allocation inevitably bring, while pgl (and DeLong and knzn, I guess) are more concerned about distortions in resource allocation associated with questionable trade restrictions, capital controls, bad economic policy in the U.S., and so on.  Fair enough.  But none of that is about the yuan peg per se, and I think Matthew Slaughter was right to say so.   

May 22, 2007 in Asia , Exchange Rates and the Dollar | Permalink


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Well, Matthew seems to slide from the assumption "in the long run, money is neutral" to "we are in the long run" to "that China is getting its monetary policy wrong doesn't matter." And both Friedman and Keynes would disagree: monetary policy does matter a lot, and to analyze it in a model in which you have assumed it doesn't matter is not terribly productive.

Posted by: Brad DeLong | May 23, 2007 at 09:32 AM

The problem is not so much that the policy is unsustainable as that it is sustainable for an awful long time before it collapses. Because much of the intervention is sterilized, the real exchange rate adjustment can be put off for many years (and won’t necessarily take the inflationary form associated with Hume). The risk that it will take some unpleasant form increases with time. The yuan peg, partly sterilized as it is, is causing China to supply a credit junkie (the US) with cheap credit, and one has to be concerned about what the withdrawal symptoms will eventually be like.

Posted by: knzn | May 23, 2007 at 02:12 PM

I second knzn's point. I was also agitated by the argument that the SED should be about things other than the exchange rate peg. I personally think it should be mostly about the exchange rate. It seems to me that the need to maintain the exchange rate peg (and the myriad of policies that support it) limits China's ability to engage in say true banking reform, since it needs the banks to absorb its sterilization bills, and limits China's ability to stimulate consumption since stimulating consumption when exports are contributing so positively to growth would lead to overheating.

I also worry a bit that focusing on what slaughter calls the "real issues" will lead to over-emphasis on gaining market access for US financial firms -- and thus support a political economy where the existing winners from trade with china get even more w/o doing much more to help those who aren't winning.

finally, i objected to Slaughter's argument that China's growing trade with Europe over the past ten years proves the XR doesn't matter for trade flows. it seems to me that the strong acceleration in Chinese export growth to europe (and the rise in China's bilateral surplus with europe) after the rmb fell v the euro suggests that the nominal Xr matters. neither the RMB/ euro not the pace of Chinese export growth to europe has been constant since 97.

Posted by: bsetser | May 23, 2007 at 03:07 PM

Those "accumulations" from Brad's remark stir me to spillover:

"... Matthew Slaughter's assertions are based on his assumption that full long-run monetary and price-level adjustment has already taken place, yet the pace and magnitude of China's reserve accumulation (and Japan's) are very strong signs that the PBoC and the BoJ are blocking monetary and price-level adjustment--and that is the problem."

And the facilitating role of the transnational companies that allow GM (to pick the obvious durable good one, but there is also the larger and quieter carry traders in the case of Japan) to post significant profits from their Chinese plants? A role that appears may outlast the US consumer as the trade shift to the underfed European consumer may be long term.

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