China Revaluation Will Lower Chinese Wages, Prices
(7/22/2005)
China Revaluation Will Lower Chinese Wages, Prices.
You may have noticed by now that there is a sharp difference in opinion among economists about the impact of yesterday’s yuan revaluation on the US and China. I will start you out with my view, as given in the following statement I gave a Gannett reporter yesterday.
“We are playing with fire,” China’s economy is going to slow. You cannot diddle with a currency without affecting interest rates in both places, economic growth, prices and wages. What this change is going to do is raise interest rates, lower U.S. growth, lower China growth and lower China’s prices and wages.”
My point is that by forcing China to stop buying Treasuries we are also likely tightening Chinese monetary policy, which will ultimately push Chinese wages and prices even lower. Not an American dream scenario. The chart below shows China’s foreign reserves (mainly US Treasuries) and China’s bank reserves. The link is not an accident.
A lot of economists will see this differently. They will see a drop in the dollar against the yuan as reducing US export prices in China and increasing Chinese import prices here which, over time, would reduce imports and increase exports, raising GDP. What’s the difference in the thinking?
There are two main fault lines in the thinking about all this–issues where you have to stand on one side or the other. The first is whether you are focused on agregate demand or on the capital markets. The second is whether you are focused on the trade accounts or on the capital accounts. Here’s what I mean.
Most of what you read about macroeconomics focuses on who–consumers, businesses, government, foreigners–is spending how much money. Spending more money is good; spending less money is bad. To these guys, cheapening your currency is almost always “good” for the economy. I think this approach is a load of crap. It never works.
I like, instead, to focus on the capital accounts for a simple reason. Size matters. Our $11 trillion GDP last year is dwarfed by our $155 trillion balance sheet. Or, as James Carvell would have said, “It’s the assets, stupid.” This line of thinking forces you to focus on the capital stock (which determines productivity) rather than on spending. And it forces you to focus on who wants to hold the existing assets, not on who wants to buy the new assets (flows of funds analysis of saving, budget deficits) when thinking about interest rates. I have used this framework since the Reagan days and made a lot of money with it. It works.
The second point has to do with global capital markets. My good friend Robert Mundell won a Nobel Prize not long ago for teching the economics profession that you cannot diddle with currency markets without having an impact on domestic monetary policy. I wrote about this yesterday. Essentially, it means that when China buys a US Treasury Bill in order to hold their currency fixed, as they have been doing in recent years, they pay the seller with a check issued by the central bank. The seller deposits the check in his bank, which increases Chinese bank reserves by the same amount. The bank then loans the money to a customer which ultimately increases the Chinese money supply, stimulating growth and pushing wages and prices higher.
Revaluing the yuan and shifting to a basket of currencies is certain to reduce Chinese purchases of foreign assets, including US Treasuries. That’s why US bond yields increased yesterday. It also means China’s bank reserves will shrink. (Some will say this won’t happen because the Bank of China will “sterilize” this effect by simultaneously buying Chinese government securities in their domestic bond market. I say they can’t do it–the Chinese government bond market is not big enough to allow this to happen.) I don’t think creating a gorilla competitor with even lower wages and prices in china is what we had in mind here.
Mostly I am concerned about monkeying with a situation as fragile as Chinese growth, credit markets, and politics. they have their hands full already. There were riots in the suburbs of Shanghai earlier this week and lots of recent violent incidents in rural areas. They have almost as many migrant construction workers as we have people. Doesn’t seem to me that China blowing up would be a good thing for any of us.
More to come on all of this later today.