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China: A Tale of Three Swan Songs
By Economic Forecasts & Opinions
The United States, the European Union and others have long been critical of China's renminbi / yuan regime. Many U.S. lawmakers complain China's currency is undervalued by as much as 40% and undercutting the competitiveness of U.S. products.
Internationally, China is under growing pressure--especially from the United States--to appreciate the value of the yuan. Chinese leaders contend that the yuan's role in trade balance is limited, and asked nations to loosen the restriction on the import of products instead.
Two Diverging Swan Diagrams
This yuan-induced heated debates prompted two prominent economists to reference the age-old Swan diagram. However, each came up with a different position for China. The Swan diagram is generally used to represent the situation of a country with a currency peg. The concept was developed by Trevor Swan in 1955.
The two diverging swan images are also reflective of the clashing views regarding currency between China and the U.S. In this case, beauty is really in the eye of the beholder. While both economists agree that China’s currency is undervalued, they diverge on the approach of the issue.
Krugman (The U.S.) – Bow or Tariff!
Paul Krugman’s NY Time blog, dated March 11th, made a case for China being “clearly in the lower zone: a trade surplus at levels that is raising international tension, plus inflation.” (Diagram 1)
Krugman (and the U.S. government) believes China to be in the lower quadrant, and that all balance will be restored through price and a yuan adjustment by the Chinese. This also implies China’s domestic consumption is close to equilibrium; whereas according to the IMF estimates, China will not qualify an OECD membership till 2010 when its average per capita national income catches up to $20,000.
Part of Krugman’s recommendation is for the United States to declare China a currency manipulator, and impose a 25% countervailing duty on Chinese exports unless China bows to the demand of appreciating the renminbi / yuan.
In addition, Krugman is under the notion that the surging deficit of the U.S. is, in effect, being “domestically financed.” He then challenges China to unload its U.S. debt holdings as it would be “an expansionary policy for the United States.” (Note: An “expansionary policy” typically leads to currency devaluation and consumer inflation.)
Frankel (China) – Two Policy Instruments
However, in a January, 2010 presentation, Jeffrey Frankel, Harpel Professor, Harvard University--also Krugman’s MIT schoolmate--suggested China was actually in the upper quadrant citing “China is now in the overheating and surplus quadrant of the Swan Diagram.” (Diagram 2)
Frankel believes between 2002 and 2007, China crossed from the deflationary (left) side of internal balance (ES: excess supply, recession, unemployment) to the inflationary (upper) side (ED: excess demand, overheating), and again in 2009, has now moved upward in the “Swan diagram.” (Diagram 2)
Frankel’s “China 2002” point is probably representative of where China sees itself. That is, there could be some currency undervaluation, but the balance of payments surplus would be primarily the result of insufficient domestic demand.
This is also partly supported by China’s trade surplus having increased even while the yuan was appreciating by 20% from 2005 to 2008. This position thus entails longer-term strategic policy measures to expand along the X / horizontal axis to achieve the equilibrium.
Frankel believes it is in China’s own interest letting the yuan appreciate to cool off the overheated economy, trim excess reserves and avoid future crashes. Thus, he recommends using two policy instruments: real exchange rate and spending. This, he concludes, would lead to a gradual yuan appreciation together with an expansion of China’s domestic demand, and the development of neglected sectors such as health, education, housing and finance.
Swan Diagram Says Bilateral
Right now, various data points suggest China is either in the left or upper quadrant of the Swan diagram, as Frankel proposes. Nonetheless, the diagram also illustrates a key point that is often overlooked. In general, exchange rate adjustment (Y / vertical axis) is necessary, but not sufficient, to address external imbalances while maintaining internal balance.
A satisfactory resolution of global imbalances will require a combination of exchange rate adjustment (Y axis), expansion of domestic demand / investment (X / horizontal axis) in surplus economies (e.g. China), and increase in saving relative to investment in deficit economies (e.g. the U.S.).
External and internal balance can only be simultaneously achieved at center point where the two lines intersect.
Krugman Rebuffed By Mentor
So, based on the Swan diagram and economic statistics, Krugman’s assumption on China seems flawed and have overlooked the important inter-relationship between the real domestic demand and exchange, and is most likely not in the best interest of either country.
While Krugman is all too eager to wage an all out trade war against China, his views are also being widely rebuffed by experts from different disciplines including JP Morgan Asia Chairman Steven Roach, and Jagdish Bhagwati--Krugman’s professor at MIT--who admittedly is “no fan of China.”
The Coming Black Swan – Yuan Devaluation
The debates among the economists echo verbal clashes between the American and Chinese government leaders. Interestingly, by positioning China in the upper quadrant of the Swan diagram, Frankel seems to suggest a coming yuan devaluation, which is part of “the next black swan scenario” warned by Societe Generale strategist Albert Edwards last November.
According to Edwards,
“China will aggressively devalue the yuan following a deep 2010 downturn coupled with escalating trade wars. . . . China will be heading into trade deficit throughout 2010.”
Edward’s black swan call is partly based on serious concerns about the sustainability of a global recovery.
Expect More Trade Deficit From China
Now, part of Edwards’s prediction is already beginning to emerge. On Sunday, Commerce Minister Chen Deming said China is likely to see a trade deficit in March. Last year, the yuan was steady, but customs data indicates China's trade surplus contracted 50.4% from a year earlier in the first two months this year to $21.76 billion.
China’s stated policy is to try to share the earnings from its economic boom with its people, especially in rural areas. As discussed earlier, this seems a logical step for China to take as it is moving to increase consumer demand--the horizontal axis--on the Swan diagram.
More trade deficits resulting from increasing imports could be expected as China pushes through its wealth redistribution at home.
Great Recession to The Greatest Depression?
Meanwhile, under election-year pressure, US senators from both sides of the political aisle unveiled legislation this week that would impose tough new penalties on China if it failed to revalue its currency. It is also widley speculated that the US Treasury Department is likely to label China as a currency manipulator in a report due in mid-April.
So, ironically, Krugman, who sings a different swan song from Frankel, also places us right into part of Edward's vision--escalating trade wars --via his trade barrier recommendation.
The continuing mixed signals from various economic data points suggest the world is not quite out of the woods of a double dip recession, which indicates part two of Edwards’ scenario of “a deep 2010 downturn” could materialize.
It seems stars are alighing so that Edwards' entire prediction could come to pass ending with China aggressively devaluing the yuan. This would no doubt wreak havoc in the commodities, currency as well as stock markets, plunging the Great Recession into the Greatest Depression.
It’s just as the old saying goes, “Be careful what you wish for, you may get it.”
Quote Du Jour:
"Sadly, my remarkable MIT student Paul Krugman has joined the ranks of the ...Democrats and the labor unions ..which will embrace any argument that advances their anti-trade agenda." ~ Jagdish Bhagwati
“We should take out the baseball bat on Paul Krugman ...We’re lashing out at China rather than tending to our own business, which is raising U.S. savings." ~ Steven Roach
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I get the impression that many people, at least the author of this piece, accept that either Krugman or Frankel are correct in their analysis. I assume both are specifically wrong, and one or both could be right by accident. In shor, I feel this piece is silly. Remember, Krugman was originally a big supporter of "globalization" and his Nobel is largely for theorizing about why U.S. trade with places like China would benefit both; Frankel is less of a political hack, but also a traditional "globalization" is good economist (i.e., his basic assumption is that economic 'openness' is good in all cases).
In the final analysis it's all about pricing. The Chinese have signficantly undervalued their currency relative to the dollar (i.e., in purchasing power parity terms). In addition, and as Koenig admitted, the real rate of interest (much like the prelude to the stagflation years) is and has been negative. In short, we pay people to borrow. Think for a moment about that one, we pay people to borrow. Therefore, it is unlikley the dollar itself is correctly priced (i.e., even ignoring the yuan). So the USD isn't correctly priced, nor is the yuan. Is China in the left botttom, top right, of whatever quadrant presupposes that theoretical graph is corrrect? Wrong question, and probably not a very useful theoretical graph. Note, both axes (and academics) assume 'prices are right' or just incorrect for a moment in time and we can just tweak our way back to equilibrium. Sure, an equilibrium where we pay people to borrow and one currency is pegged to another to the other in order to export one country's unemployment onto one or more others (and grab technology). In short, I wouldn't buy into their analyses because their assumptions are typically wrong; and what I'd first look for before theorizing about how many angels can dance on the head of a pin is: (1) for China to stop undervaluing, and (2) the U.S. to stop paying people to borrow. Once #s 1 & 2 are complete, I'll happily talk about your graph, but my guess is at that point it would be irrelevant.
What?
Edward Alberts is absolutely correct, the Chinese will devalue as if their asses are on fire.
They have no choice but to decouple from the hard and getting harder crude oil- pegged US dollar. It is devalue or face a deflationary crash starting in real estate/banking. Better for them to have inflation so that the Party insiders can see their (bad) debts inflated away..
Ironically, the Chinese trade advantage has not been so much cheap money as cheap labor. Decoupling from the dollar will have the effect of raising Chinese workers' pay which will give the effect that Krugman desires. This would be both the outcome of Chinese policy - to create domestic consumers for Chinese goods - as well as an outcome of yuan devaluation/inflation.
Since China has enough dollars in reserve to import crude oil fuel for a little while, they can afford for domestic prices and wages in yuan to rise without having to face a crippling energy crisis.
The longer- term danger to the US is that China will soon need more dollars and will get them by selling its Treasury hoard. China, Japan and the US Treasury Department will all be looking for cash at the same time. I suspect that even with the accelerating deleveraging that is just beginning will still see US Treasury yields rise significantly.
The US establishment's noise about the RMB is more about regaining the Chinese dollar surplus rather than anything else.
The key to look for is dollars circulating within China. If that happens then Chinese hyperinflation is underway.
China has been buying commodities at a frenzied rate over the past year and anecdotal reports show stockpiles in iron ores, coal, copper, oil, etc. Perhaps they are planning a devaluation event knowing that they are poised to survive the disruption and prosper in the aftermath.
Good thinking
The "swan's" diagram does not answer the question. It does not show what happens to the change in the structural (!!!) unemployment when one of the trading "partners" abuses so called "export growth model for over two decades.
In particular, I don't believe there is a working model that addresses that economic "phenomena." Historically, while there was a large number of countries that used "export growth model" for their economic development, none continued using it after reaching such a significant size of the global GDP as China did.
The only historical precedent would be England 200 years ago, where they forced their colonies to buy their produce. And while the decline of India during the 19 & 20 century from being an economy # 2, is more of coincident rather than correlation, it parallels to what has been happening to our working class.
And of cause the major sinister reason Mr Paul is pushing for harsher trade has less to do with him learning the true picture and more to do with his realization that there won't be any significant growth in employment due to "traditional methods" & continued outsourcing.