Friday, April 16, 2010

Nuances around China's currency appreciation

My friend Annetta sent me this:
So... I agree with him in principle, I just think he oversimplifies how "good" it would be for China to appreciate the currency. A currency appreciation that happens before you can gear up consumption in China just collapses their economy, which is largely the same reason why Japan has had a lost decade - they continued to structurally favor their export sector and didn't make an effort to stimulate consumption internally, so investment cratered downwards after a period of overinvestment but consumption never filled its place sufficiently to stimulate growth. This ties in, Paul, with your observation of "top down, highly structured, favoring the keiretsu"... Thus, the Japanese economy has been stagnant.
Think of this story:
You basically have a situation where people are saving in housing, stocks and government bonds/bank deposits. They're functionally not allowed to save elsewhere. The banks get into trouble as yuan appreciation happens because exporters get hit, and thus cant pay back the loans they took out for investment. People start losing jobs, and defaulting on real estate, meaning the real estate market craters as you see defaults on property owned by workers and companies, then as the prices drop, by anyone who bought with a mortgage. (Fortunately, many people pay cash there, but you still end up with a massive crushing of their savings). So note that you've just cratered exporters, which has crushed a lot of the stock market, and the resulting effect on workers leads to real estate popping. A LOT of savings just got wiped out, people unemployed, and banks in trouble. Worse, the government needs to print cash to bail out the banks, making everyone who had money in banks or bonds relatively poorer as inflation happens and interest rates go up. Finally, all your foreign "hot money" gets out, pushing everything down further and making it worse. Thus, as all three mechanisms of savings get hit, consumption craters instead of rising via the income effect. The Chinese economy, currently 40% of GDP in construction, gets WALLOPED.
What needs to happen for appreciation to not do that is a simultaneous shift towards consumption so that the exporters don't get crushed when appreciation happens - as in, the Chinese people need to spend to offset what foreign (US) consumers won't buy after appreciation. Social safety net is a small part of that, but a larger part of that is cultural and regulatory - what can and can't be sold, what can and can't be accessed, etc. I would love to hear more about that from people who know about it
The other problem you have is political - it becomes extremely appealing to become protectionist in that scenario to ensure the Chinese people buy Chinese goods and keep China's economy up, but exporters are still a large part of China's economy, which means you can't officially do that because the exporters would die in the retaliation. Instead, the Chinese government would have to implement an implicit protectionism with moral suasion and cultural nationalism directed at their people, instead of direct political protectionism. I'm sure China would be more than capable of pulling that off (national stand in line day?), but it also presents its own large set of difficulties for anyone trying to bring China into the world community and trying to get US private and public cooperation, which will remain vitally important if they want to continue their acquisition of technical knowledge. Remember, outsourcing to China becomes somewhat less appealing as the currency shifts, so a continued technological transfer from west to east relies on good relations with foreign companies. Rampant nationalism doesn't serve that purpose well, and could backfire. It's a very, very delicate line.
Now, why can't the US just go in and force the currency appreciation with import certificates or capital controls? After all, it should benefit us by closing our trade deficit (as long as the budget deficit can come down with it).
If you're Paul Krugman and you believe the US is headed for stagnation, then you can do it, because the massive inflation you'd see in China means they probably start spending their US dollars for international raw materials imports. In other words, they do our quantitative easing for us.
I disagree. I think the biggest difference between the US and Japan is that Japan had an investment bubble and we had a consumption bubble, and consumption can rebound faster than investment because investment is persistent and consumption is less so (when you build a railroad, it's there for 50 years. When you buy a TV, it's there for 5). Then, by implementing capital controls or import certificates, you face a situation where the US sees inflation and higher interest rates as more dollars are continually pumped into the economy with no sensitivity to interest rates. You also have to face down a very, very angry China, which I'm sure has a lot of geopolitical implications. The trade deficit needs to close, but that can't happen in one swoop, it needs to be gradual. Increasing the appeal of exportable goods (as in, keeping labor and capital costs low in the US, while maintaining technical excellence) and reducing oil consumption are both very valid and important ways of easing the shock to everyone - the US and China - in the short term.

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