China-US Currency Issues Jeffrey Frankel Harpel Professor Revised from CLD Progr

China-US Currency Issues Jeffrey Frankel Harpel Professor Revised from CLD Progr

China-US Currency Issues Jeffrey Frankel Harpel Professor Revised from CLD Progr

Kemp, Bob, Mid Day Host has reference to this Academic Journal, PHwiki organized this Journal China-US Currency Issues Jeffrey Frankel Harpel Professor Revised from CLD Program, June 8, 2010; CHINA FUTURE LEADERS, 10 a.m., Bell Hall, January 17, 2011 Topics to be covered (I) Historical timeline of exchange rate diplomacy (II) What is in China’s interest (III) What is in the interest of the US & Rest of World (IV) Shifting power relationships Appendices: U.S. Treasury biannual reports on currency manipulation The current account imbalances The internationalization of the RMB Technical appendices Historical timeline “I have listened to both sides of this debate. Here is what I think. I think those who call as long as a fixed exchange rate are right in the short run. And those who call as long as a floating exchange rate are right in the long run. How long is the short run, you ask You must underst in addition to . China is 8000 years old. So when I say, short run, it could be 100 years.” – Li Ruogu, Deputy Governor, People’s Bank of China, Dalian, May 2004

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Historical timeline of currency diplomacy 1973: End of Bretton Woods era. Major currencies switch from fixed to floating. The rest keep their pegs. 1977: IMF members agree that each shall “avoid manipulating exchange rates in order to prevent effective balance of payments adjustment or to gain an unfair competitive advantage over other members.” [Principle (A) of the “1977 Decision on Surveillance over Exchange Rate Policies,” in addition to Sect.1, Clause 3, of Article IV amended in 1978.] In practice, the IMF almost never pressures countries to revalue their currencies upward; It just pressures deficit countries to devalue. 1983-84: ¥/$ Agreement. 1985: Plaza Accord. Japan, US & others cooperate to bring down overvalued $, esp. vs. ¥ 1987-89: Louvre Agreement: $ depreciation halted. Big bubbles in Japan’s equity & real estate markets, followed by crash, & severe Japanese stagnation in 1990s. Timeline, continued 1988: The Omnibus Trade & Competitiveness Act m in addition to ates the US Treasury report to Congress biannually on whether trading partners were manipulating currencies. Section 3004 requires the Treasury to “consider whether countries manipulate the rate of exchange between their currency in addition to the US $ as long as purposes of preventing effective balance of payments adjustments or gaining unfair competitive advantage in international trade.” The US must hold talks with governments deemed to be breaking rules. In the first Reports to Congress on International Economics & Exchange Rate Policy, Korea & Taiwan PoC were found to be guilty of manipulation, while Singapore & Hong Kong SAR “got off with a warning.” China was named in early 1990s. Timeline, continued: Exchange rate Jan. 1994: China devalues its official rate, unifying its dual exchange rate system. 1997-98: East Asia crisis. China wins plaudits as long as keeping RMB (“yuan”’) fixed while all its neighbors are devaluing. 1995-2005: China continues to peg as long as 10 years at 8.28 RMB/$.

Timeline, continued: US pressure Oct. 2003: Treasury Secretary Snow begins to “browbeat” China to allow appreciation. Treasury Report: RMB merits concern & talks Speculators in financial markets start to bet appreciation. as reflected in either capital flows (see Prasad & Wei) or non-deliverable as long as ward price (see appendix graph). Feb. 2005: Senators Schumer & Graham propose first of bills to impose (WTO-illegal) tariffs of 27.5 % against all Chinese goods if China does not substantially revalue its currency. Subsequent versions, by Baucus-Grassley in addition to others substitute the phrase “currency misalignment” in place of “unfair manipulation” to ease st in addition to ard of proof. Timeline, continued: China’s macroeconomy 2004-07: Rapid growth puts China into Excess Dem in addition to . 2005-06: Despite large balance of payments surpluses, PBoC sterilization of reserve inflows prevents excessive money growth & inflation. 2007-08: Sterilization finally falters: Money becomes excessive. Inflation becomes a serious concern. Shanghai stock market experiences a bubble. Mid-2008 – early 2009: Worst of the global recession hits. China loses 26% of exports Growth slows; danger of overheating disappears. Mid-2009 – 2011: China resumes very rapid growth in response to domestic dem in addition to stimulus + renewed exports China is now a major engine of growth in world economy. Danger of overheating returns: esp. real estate bubble. Timeline, continued: Exchange rate July 2005: China announces a new policy, Immediate 2.1 % revaluation, Followed by “managed float”: controlled appreciation, supposedly against an unspecified basket of currencies. But, as often, de jure exchange rate regime de facto. Estimation of true regime reveals: $ link did not even begin to loosen until 2006. By 2007, implicit basket had shifted some weight onto other currencies, especially the €. RMB appreciates against the $ from 2006 to 2008, because € does.

The magnitude of daily movements vs. $ increased in the spring of 2006, May 2008: Chinese leaders hear exporter complaints of competitiveness difficulties. Mid-2008-April 2010: yuan re-pegs $ 6.84 RMB/$ 20% stronger, vs. $, than 2005. Timeline, continued: Exchange rate The RMB rose against the $ as long as 2 years, but returned to peg in mid-2008 $/RMB €/RMB €/$

Timeline, continued Oct. 2006 – IMF Article IV consultation finds RMB “undervalued.” 2007: US Treasury temporarily passes hot potato of exchange rate complaints to IMF, which gets m in addition to ate as long as exchange rate “surveillance.” 2008: Though financial crisis originates in US, “flight to quality” temporarily raises dem in addition to as long as $. 2009: Chinese leaders, as long as the first time, express concerns that their vast holdings of US treasury bills may not be well-invested. Pres. Obama & Secy. Geithner seek to reassure. 2009: Chinese warnings Premier Wen worries US T bills may lose value. Urges the US to keep its deficit at an “appropriate size” to ensure the “basic stability” of the $ (again on 11/10/09). PBoC Gov. Zhou, proposes replacing $ as international currency, with the SDR (March 09). Timeline, continued 2010 Winter 2010: Pressure mounts – International pressure on Beijing to appreciate; Congressional pressure on US Treasury to find China guilty of currency manipulation in its biannual report due April 15. But Chinese say they will never bow to pressure.

April 2010 – Collision is averted: Treasury postpones manipulation report. June 19 – PBoC announces it will “increase the renminbi’s exchange-rate flexibility,” though subsequent appreciation is small. So both sides save face as long as the moment. September 27 – Brazil Finance Minister Mantega warns of “Currency Wars”: Each country intervenes to push its currency down in ef as long as t to gain trade advantage, collectively futile. November 8, G20 Summit in Seoul – China criticizes US Fed’s monetary easing (“QE2”) as an example of currency wars. Jan. 2011: Preparations as long as Obama-Hu summit Jan.14: Geithner notes that – including higher China’s inflation – RMB is appreciating at 10% per year. That suggests US lower priority on the currency issue Vs. IPR, North Korea & other issues.

Appreciation + inflation WSJ 1/22/11 5% nominal appreciation per annum + 5% inflation differential 10% real appreciation per annum September-December 2010 Data sources: The Economist, BLS, CEIC, Thomson Reuters Global Macro Monitor (II) From China’s viewpoint, Countries should have the right to fix their exchange rate if they want to. True, the IMF Articles of Agreement in addition to the US Omnibus Trade Act of 1988 call as long as action in the event that a country is “unfairly manipulating its currency”. But Few countries have been as long as ced to appreciate. Pressure on surplus countries to appreciate will inevitably be less than pressure on deficit countries to depreciate. I support retiring the language of “manipulation.” Usually, it is hard to say when a currency is undervalued. Don’t cheapen the language that is appropriate to WTO rules. China should do what is in its own long-term interest.

What is in China’s interest My view: mutually-beneficial bargain, between equals As part of G-20 process E.g., China agrees that: its exchange rate is part of the problem, it will cooperate to lower the RMB/$ rate in a gradual manner, in addition to of course it won’t dump US treasury bills. In exchange, US agrees that: its low national saving rate is part of the problem, it will cooperate to reduce the budget deficit, in addition to of course it won’t close off the US market to Chinese goods. But perhaps a bargain isn’t even necessary; It is in China’s own interest to begin appreciating the RMB. Five reasons China should let RMB appreciate, in its own interest Overheating of economy Reserves are excessive. It gets harder to sterilize the inflow over time. Attaining internal in addition to external balance. To attain both, need 2 policy instruments. In a large country like China, expenditure-switching policy should be the exchange rate. Avoiding future crashes. RMB undervalued, judged by Balassa-Samuelson relationship. 1. Overheating of economy: Bottlenecks. Pace of economic growth is outrunning: raw material supplies, in addition to labor supply in coastal provinces Also: physical infrastructure environmental capacity level of sophistication of financial system. Asset bubbles. Shanghai stock market bubble in 2007. Inflation 6-7% in 2007 => price controls shortages & social unrest. All of the above was suspended in late 2008, due to global recession. But it is back again now; skyrocketing real estate prices.

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Attempts at “sterilization,” to insulate domestic economy from the inflows Sterilization is defined as offsetting of international reserve inflows, so as to prevent them from showing up domestically as excessive money growth & inflation. For awhile PBoC successfully sterilized until 2007-08. The usual limitations finally showed up: Prolongation of capital inflows <= self-equilibrating mechanism shut off. Quasi-fiscal deficit: gap between domestic interest rates & US T bill rate Failure to sterilize: money supply rising faster than income Rising inflation (admittedly due not only to rising money supply) 2. Foreign Exchange Reserves Excessive: Though a useful shield against currency crises, China has enough reserves: $2 ½ trillion by April 2010; & US treasury securities do not pay high returns. Harder to sterilize the inflow over time. New York Times Jan 12, 2011 Foreign exchange reserves held by the People’s Bank of China are approaching $3 trillion in 2011. New York Times Jan 12, 2011 The Chinese money supply has almost doubled in the last 3 years, contributing to a rapid growth aggregate dem in addition to as reflected in nominal GDP Source: HKMA, Half-Yearly Monetary in addition to Financial Stability Report, June 2008 The Balance of Payments rate of change of as long as eign exchange reserves (largely $), rose rapidly in China over past decade, due to all 3 components: trade balance, Foreign Direct Investment, in addition to portfolio inflows Attempts to sterilize reserve inflow: While reserves (NFA) rose rapidly, the growth of the monetary base was kept to the growth of the real economy – even reduced in 2005-06. Successful sterilization in China: 2005-06 were remarkably successful in 2005-06. High reserve growth offset by cuts in domestic credit => steady money

Does the Balassa-Samuelson relationship have predictive power Typically across countries, gaps are corrected halfway, on average, over subsequent decade. => 3-4 % real appreciation on average per year, including effect of further growth differential . Correction could take the as long as m of either inflation or nominal appreciation, but appreciation is preferable.

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