China Needs Interest Rate and Exchange Rate Hikes
Why has China moved to raise interest rates? And is there any connection between its monetary policy actions, which surprised global markets, and whether China is willing to let its currency appreciate? Was this an either/or choice?
The answers to these questions are not simple, but first one needs to look at the record of China's actions. On October 19 the People's Bank of China (PBOC) raised benchmark one-year lending rates by 25 basis points (0.25 of a percent), from 5.31 to 5.56 percent. Other lending rates were adjusted as well, and deposit rates went up by zero (for demand deposits) to 60 basis points (for 5 year deposits). The move jolted financial, currency, and commodities markets. One fear was a slowdown in Chinese growth. Another was that the rate hike was a sign Beijing would not be letting the currency appreciate, since higher rates and a stronger currency would impel dangerous hot money inflows. Some observers even saw China's move as a preemptive strike on inflationary pressure that would arise from further US monetary stimulus known as "quantitative easing"—the so-called QE2—which economists say will lead to downward pressure on the dollar.
Is Beijing trying to inoculate itself from having to appreciate its currency with this rate hike, or is there another explanation?
China in fact has multiple economic pathologies to address simultaneously, because the domestic-oriented and export-oriented sectors of the economy are joined but distinct, like Siamese twins, and each needs policy attention. They certainly interact, but they have separate economic metabolisms. It is not a case of whether higher interest rates or exchange rates are the "right" choice for China: Chinese leaders view both as needed, and now.
The Obama administration and a growing chorus of countries that trade with China argue that exchange rate movement is needed to help moderate China's external imbalance. In fact, though little noticed, such appreciation has started: we've seen just shy of 3 percent appreciation against the dollar since June: over 12 months this pace would deliver 10 percent or better appreciation, which is essentially what the United States is calling for. Average movement of less than 1 percent per month would be gradual by our standards, but not slow by China's standards. This would be sufficient to help defuse the current currency frictions if (1) this were certain to happen; and (2) the US-China bilateral outcome was all that mattered.
But first, nobody in Washington trusts that this appreciation is certain to continue. China's modest renminbi movement only started in September under the threat of Congressional action, and many think the urgency would disappear if foreign pressure let up. It is not that the PBOC leadership would not stay the course; they would, and they have even set out a "current account cap" target of 4 percent of GDP as a goal at the International Monetary Fund (IMF) meetings earlier in October (the "cap" was announced by Deputy Governor Yi Gang). This is exactly what Treasury Secretary Timothy Geithner called for on the eve of the G-20 finance ministers meeting starting October 20, counseling his counterparts "to move toward a set of simple norms on exchange rate policy" and explore "whether we can commit to keep external imbalances to levels that are more sustainable, making allowances for different kinds of countries…" It was an encouraging sign of the way forward that the PBOC offered a current account metric for the first time and that Secretary Geithner described such a metric as what we need in order to create a standard reference for "fairness."
A major problem, however, is that the technocrats at the PBOC may have more in common with fellow officials abroad than they do with industrial planning mandarins at home. The PBOC has wanted to adjust exchange rates and interest rates for years, but they are not in charge of these decisions. It has taken the threat of international political pressure to assure that other vested interests in Beijing see the logic of policy adjustment as clearly as the PBOC does. This is ironic because 57 percent of China's exports—presumably the most powerful vested interest being protected—are shipped by foreign invested enterprises in China. But life is full of ironies.
So much for the hopeful signs. It will not be enough if the renminbi moves by 10 percent per year against the US dollar for two years, if that also means the renminbi is depreciating against most other currencies. If that development occurs, it would lead to global financial instability with a terrible price tag for the United States as much as anyone, 20 percent improvement against the renminbi or not! While rising 3 percent against the US dollar since June 19, the renminbi has, due to its dollar peg, depreciated against euro, yen, won, ringgit, Aussie, real, and most other currencies. This will end in tears, and the world's largest economy (which is still the United States) will pay the largest absolute price, even if it gets a modicum of depreciation against the renminbi. US policymakers understand that a solution that improves the US trade balance at the expense of the rest of the world is not a solution at all.
China has been blamed for going too slow on revaluation, but many in Beijing point to the country's moderating 2010 external imbalances compared to past years as a justification to wait and see before increasing the pace of renminbi appreciation. Other nations are understandably impatient with a "wait and see" approach. They insist on greater renminbi movement as insurance against those imbalances ballooning up again, and their views are equally valid. There is a simple approach that could bridge this strategic mistrust. If China manages to steer its current account surplus down to 4 percent of GDP by June 2011 with only the modest renminbi appreciation it says is necessary, the G-20 will throw a party. If the 4 percent current account surplus goal is not reached, Beijing should be prepared to undertake a "one-off" revaluation to make up any shortfall from the 15 percent trade-weighted appreciation that was indicated as of June 2010, while continuing the crawling appreciation apace.
Of course a cap of 4 percent of GDP on China's current account imbalance is just a starting point, given China's growth rate and future size. A 4 percent surplus in 2011 will mean roughly $260 billion. But 4 percent would grow to $400 billion in 2015, or—with the expected exchange rate increase—more than $500 billion in dollar terms! Clearly the world will have a hard time living with this "moderated" level of Chinese external surplus when what it is a percentage of—China's GDP—is growing so prodigiously.
Quarterly and September China economic data do not settle the question of whether we can have faith in China's surpluses moderating. The trade balance grew in the third quarter over the second, so some advisors stress that China's global imbalances are roaring back. But within the third quarter, September was less than August, which was less than July. Others are thus comfortable that China's external imbalance is not now worsening and are wary about suggesting that it is. The Seoul G-20 meeting will have to live with a very ambiguous picture of where China's trade balance is headed.
Even if China's trade surplus moves sideways, another contributor to the current account surplus is mushrooming: cross-border investment income. Throughout the 1990s and up through 2004, China was a net payer of investment income to the world. This reflected the growing foreign direct investment position inside China, which was profitable, and the dearth of Chinese investments (direct or portfolio) abroad. Since 2005, and with increasing magnitude, China has been a net investment income earner, first and foremost from interest of US Treasuries. China's gross investment income was $100 billion in 2009, and its net was $40 billion. This reflects both the growth of China's outward investments and the diversification, over time, from low return to higher returning assets. This will inflate China's external imbalances and become a new focus of concern in the near future.
Coming back to the relationship between the October 19 interest rate hike and the prospects for renminbi appreciation, why were rates hiked if not as a signal that Beijing was not going to succumb to appreciation pressures, given the obviously greater danger of hot money flows following appreciation in a higher interest rate environment?
As noted earlier there are multiple, intertwined Chinas, and thus its actions cannot be analyzed as driven by one centrally focused policy objective. The domestically oriented sectors, especially energy-intensive heavy industry and real estate, seriously need better capital discipline, regardless of the case for renminbi appreciation. Rebalancing China's growth toward domestic sources of demand requires fundamental reform of the financial incentive system, starting with the pricing of money. Capital formation is concentrated in nonlabor-intensive sectors and that—not the threat of lower trade surpluses—is the source of China's employment problems.
In addition, a stronger renminbi doesn't mean China will export less. Rather it suggests that China will import more foreign-made goods as domestic investment shifts to industries that use higher-value products and pay higher salaries. Beijing's employment justification for refusing to permit renminbi appreciation cannot be reconciled with all the other policies that put nonjob-creating heavy industry at the head of the line for everything. And since the marginal product of these heavy industries is often exported, the Chinese can't argue (mercantilistically) that by establishing heavy industry at the commanding heights of the economy, China is creating the job opportunities downstream. The economy is beyond saturated with heavy industry.
Real estate is the other manifestation of ill-priced options in Chinese financial intermediation. This is true on the supply side, in that an inordinate amount of speculative development is being funded by the market, with pervasive local government support and encouragement (because that is the only way local government can pay its bills). And it is doubly true on the demand side, where negative real interest rates (deposit rates minus inflation: average is negative over the past decade, and stands at –1.0 percent now, after the October 19 rate hike!), a closed capital account, and equities markets that can't be trusted. These factors leave households few alternatives to buying speculative apartments 25 miles from city centers using their retirement savings. So 0.25 percent is just the beginning of the tightening that is needed. Private enterprises are paying 10 to 20 percent for capital, and the PBOC could raise the benchmark lending rate to 8 percent but give the two-thirds of the economy that is not state owned equal access to bank lending at that rate. Such a step would be a huge discount for the private sector, and hugely job creating.
The latest data show a modest slowing of fixed-asset investment, especially in property, but only very modest. This is a soft landing, consistent with the gradual exhaustion of stimulus injected into the economy starting two years ago next month. And inflation remained steady in September at 3.6 percent (versus 3.5 percent August), merely 1.1 percent excluding food and energy. But Beijing is clearly worried both that the cycle of investment misallocation is not done and needs further diligence, and—as everyone on the street in China knows—that inflation is higher than reported and is leading to social anxiety. In sum, there is both a near-term prudential motive and a longer-term structural imperative informing PBOC's initiative to hike rates now. And they have signaled, as clearly as I can imagine, intent to continue "gradual" appreciation (e.g., 10 percent per year). So there is no need to conclude that the rate hike crowds out exchange rate action.