China: Choosing More Debt, More Unemployment, Or Transfers by Michael Pettis, Global Source Partners

Special points to highlight in this issue:

  • In 2016 the PBoC will evaluate the change in the value of the RMB not just in dollar terms but increasingly in terms of a wider basket of currencies. We should not discount the possibility, however, that after a quarter or two of dollar strength or stability, the dollar will begin to weaken. The US current account deficit may be forced to grow substantially because of irresponsible trade policies, primarily in Europe but also in much of the rest of the world, and if it gets large enough to undermine the US recovery it could easily cause the dollar to fall.
  • The decision about the value of the RMB has become so politicized that predicting the direction of the Chinese currency has become harder than ever, but should Beijing choose to devalue by 10-15% over the next two years, we should be very aware of the potentially destabilizing impact on net capital outflows from China. There may be enough confusion on what drives inflows and outflows that the impact of currency weakness may be the opposite of what Beijing expects.
  • Given the depth of China’s economic imbalances and the difficulty of reforming the financial sector, every policy choice Beijing faces is ultimately a choice between a rising debt burden, rising unemployment, or increased wealth transfers from the state sector to the government sector.

China: Choosing More Debt, More Unemployment, Or Transfers

In this Christmas issue of the newsletter I hope to show why with every economic policy decision it must take, Beijing effectively must choose between a rising debt burden, rising unemployment, and greater transfers from the state sector to the household sector. If we think of China systemically, and recognize explicitly how the response to one set of problems in the rebalancing process will necessarily affect another set of problems in that same rebalancing process, as we consider adverse changes to the Chinese economy or the impact of policy decisions we will find that nearly every consequent scenario that is not implausibly unlikely involves one of these three: a rising debt burden, rising unemployment, or greater transfers from the state sector to the household sector.

Before explaining why this emerges from any systemic understanding of the Chinese economy, I want to turn first to a different but not completely unrelated matter. In the December 7 issue of this newsletter I suggested that the RMB’s membership of the SDR would increase the dollar weighting of the SDR, something the IMF wouldn’t want, as long as the RMB continues to be set primarily in relation to the dollar. One way to assuage IMF concerns might be to re-orient the RMB from tracking the dollar to tracking a basket of currencies:

One unexpected consequence of SDR membership for the RMB is, ironically, an increase in the dollar weight in the value of the SDR. This is because the value of the RMB is highly correlated with the value of the dollar, and together they comprise a larger share of the SDR than the dollar did before the RMB joined the basket. This higher weighting is something the IMF doesn’t want to see if the SDR is ever to serve as a useful unit of account.

I am only speculating, but if the PBoC were to set the value of the RMB in terms of a basket of currencies, as it officially claims to do, and not just in terms of the US dollar, this problem could easily be resolved. It would also protect the RMB from rising during periods of dollar strength, which are often also periods of weak global demand.

My guess is that in a few weeks or months we might begin to see statements from the IMF about the heavier dollar weighting in the SDR and the adverse consequences for hedging and diversification purposes. This might be the signal for the PBoC to detach the RMB from the dollar while still controlling the trade consequences. The RMB in that case would still be pegged, but it would be pegged to a diversified basket, rather than to the dollar.

On December 11 the PBoC announced that it might do just that. According to the Financial Times:

China has paved the way for a further weakening of its currency by announcing changes in how it measures the renminbi’s value. The move, announced on Friday, has raised investors’ alarm at the prospect of a new currency war — just as the US prepares to raise interest rates.

As markets gear up for next week’s Federal Reserve meeting, the People’s Bank of China signalled it would measure the level of the renminbi (or yuan) against a basket of currencies rather than just the US dollar.

The PBoC, it seems, is preparing itself for another change in the currency regime, although technically, as Beijing will no doubt point out, this isn’t a change at all but simply a reaffirmation. Nearly one month after announcing, on July 20, 2005, that the PBoC would change the currency regime from a dollar peg to floating regime, the PBoC announced that “a basket of currencies would determine the exchange rate of the renminbi”, according to China Daily.

At that time Beijing was responding with the change in its currency regime to pressure from foreign trade partners, the US most vocally, to change policies that had left China with twenty years of rising trade surpluses and with what at that time seemed a huge hoard of central bank reserves. China’s foreign currency reserves amounted then to $711 billion, and it was only much later that this has begun to seem an almost negligible amount, as reserves subsequently climbed to $4 trillion, in 2014, before dropping by nearly $500 billion in the past year.

In that announcement the PBoC governor listed the currencies that would comprise the basket:

…the basket should be composed of currencies of the countries to which China has a prominent exposure in terms of foreign trade, external debt (interest repayment) and foreign direct investment (dividend). And the weights respectively assigned to these currencies should also be consistent with the proportional importance of these countries in China’s external sector.

China’s major trading partners are the United States, the Euro land, Japan, Korea, etc., and naturally, US dollar, euro, Japanese yen and Korean won become major currencies of the basket. In addition, China also trades significantly with Singapore, UK, Malaysia, Russia, Australia, Thailand, and Canada, currencies of these countries are also important in determining China’s RMB exchange rate.

In the end, for reasons that were never discussed, the RMB discontinued its dollar peg but as it slowly began to appreciate the currency continued very clearly to be linked to the dollar. Less than a year after that announcement Ajay Shah, a professor at New Delhi’s NFPIP, analyzed the exchange value of the RMB with two colleagues and found “that in the early months after the announcement, the renminbi has remained pegged to the USD, with extremely limited currency flexibility. Despite claims to the contrary, there is no evidence of a peg to a basket.” That lack of evidence has continued to this day.

China