Lecture 15: Problems/Applications

of discretionary policymaking

• Targets & instruments revisited

• Practical difficulties of policymaking

• Managing emerging market inflows• Example of the 1990s• Example of China 2003-2012

ITF-220 - Prof.J.Frankell

Targets & instruments revisited

• When we first showed the need to have as many independent policy instruments as goals, monetary & fiscal policy were not independent.

• Now, with capital mobility, they have somewhat independent effects on external balance, provided that is defined as BP=0 (rather than TB=0).

• The reason: they have opposite effect on capital flows, because they have opposite effects on interest rates.

• => Even with a fixed exchange rate, the proper combination of monetary and fiscal policy can attain internal & external balance at the same time.

In theory, there exists a precise mix of monetary & fiscal policy that will hit both internal & external balance.

●

●

TD balanced by KA surplus

ITF-220 - Prof.J.Frankell

Practical difficulties of policymaking

Lags: between the change in a policy instrument and the response in the economy

Uncertainty with regard to: • the current position of the economy (“baseline”)• future disturbances (“shocks”)• correct model (e.g., multipliers)

Expectations on the part of the public

Political Constraints

ITF-220 - Prof.J.Frankell

EmergingMarkets.org

Capital flows to Emerging Markets rose rapidly 2003-07,were set back temporarily in global financial crisis of 2008-09

Alternative Ways of Managing Capital InflowsA. Allow money to flow in (can be inflationary)B. Sterilized intervention (can be difficult)

C. Allow currency to appreciate (lose competitiveness)D. Reimpose capital controls (can impede efficiency)

ITF-220 - Prof.J.Frankell

Exchange Market Pressure on Latin America continued in 2011

Peru still accumulated reserves; Colombia was the free-est floater

Goldman Sachs Global Economics, Global Viewpoint 11/09. 6/22/11; at https://360.gs.com

ITF-220 - Prof.J.Frankell

ITF-220 - Prof.J.Frankell

Attempts at sterilization where emerging markets have faced large inflows

• In early 1990s, Colombia, Korea, Indonesia and others tried for a year or two and then gave it up.

• In the past decade, China successfully sterilized for quite awhile, starting in 2003.

ITF-220 - Prof.J.Frankell

Recall recent example of sterilization against money inflows: China, 2003-2010

Total reserve money in China has increased less rapidly than foreign reserves

Data: CEIC Source: “Sterilization in China: Effectiveness and Cost,”

Chenying Zhang 2011, Wharton School, U.Penn, Fig.3, p.44.ITF-220 - Prof.J.Frankell

Sterilization of foreign reserves Sterilization of foreign reserves:Decreases in PBoC’s domestic assets

offset increases in foreign assets

Source: Zhang, 2011, Fig.7, p.47.

Increase in China’s required reserve ratio

Source: Zhang, 2011, Fig.6, p.46.

ITF-220 - Prof.J.Frankell

ITF-220 - Prof.J.Frankell

In 2007-08 China had more trouble sterilizing the reserve inflow

• PBoC began to have to pay higher domestic interest rates – and to receive lower interest rate on US T bills – => “quasi-fiscal deficit” or “carry problem” for central bank.

• Inflation became a serious problem in 2007-08.– True, global increases in food & energy prices

were much of the explanation.– But

• Appreciation is a good way to put immediate downward pressure on local prices of agricultural & mineral commodities.

• Price controls are inefficient and ultimately ineffective.

Fxtimes.com

China’s tightening of banks’ lending rates & reserve

requirements by 2007 had failed

to head off overheating.

By 2010-11, inflation was again

accelerating.

But the 2008-09 recession did it instead.

15Source: Gwynn Guilford — Sept. 6, 2013

Rate of increase of housing prices in 4 major Chinese cities (year-on-year)

China’s housing prices took off again in 2013.

End of Lecture 15: Problems/Applications

of discretionary policymaking

ITF-220 - Prof.J.Frankell

Appendix 1: Examples of sterilization of inflows, from the early-1990s

(1) Central bank sells sterilization bonds during period of sterilization

ITF-220 - Prof.J.Frankell

Examples of sterilization of inflows, early-1990s (2) Interest rates are high during period of sterilization, fall thereafter.

ITF-220 - Prof.J.Frankell

Examples of sterilization of inflows, early-1990s(3) Reserves rise rapidly during sterilization period; slow down thereafter

ITF-220 - Prof.J.Frankell

Appendix 2: Five reasons China warranted a more flexible exchange rate regime, in its own interest

• Overheating of economy in 2007-08: …=> appreciation– Wasn’t relevant in 2009 slowdown. But was again in 2010-12.

• Excessive reserves ($3 ½ trillion as of 2014)– Though a useful shield against currency crises, by now China has enough reserves– Harder to sterilize the inflow over time.

• Attaining internal and external balance.– To attain both, need 2 policy instruments. – In a large country like China, the expenditure-switching policy

should be the exchange rate.– Along with expenditure-increasing policies (2009).

• Avoiding crash: – Experience suggests it is better to exit from a peg in good times,

when the BoP is strong, than to wait until the currency is under attack.

• RMB undervalued, judged by Balassa-Samuelson relationship.

ITF-220 - Prof.J.Frankell

Longer-run perspective:Balassa-Samuelson relationship

• Prices of goods & services in China are low– not just low judged by Absolute PPP (.23 relative to the US),

– but also low by standards of Balassa-Samuelson relationship estimated across countries (which predicts .36).

• The RMB is undervalued in this specific sense.– 2000 estimate was 35%

• before 2007 statistical revisions by IPC project.

– Now undervaluation estimate more like 15%.

ITF-220 - Prof.J.Frankell

Estimation of B-S relationship for 2000

• For every 1% increase in real income/capita (relative to US), prices increase .4% (relative).

• China’s estimated residual is .15– Using revised ICP stats.– Subramanian (2008).

loginc00

Fitted values logRER00 CHN

6.17768 10.6917

-2.15096

.370385

CHN

Frankel (2006)118 countries, PWT

Real appreciation

• The RMB’s real appreciation against the $from 2009 to 2012 amounted to 12%,

• reducing the degree of undervaluation by roughly half,• depending on whether one measures it against the $

or against all currencies.

• More is expected, as China’s relative wages continue to rise.

• In any case, China’s real exchange rate is already closer to this measure of equilibrium than are most countries’ exchange rates (Cheung, Chinn & Fuji, 2010).

China Adjusts, 2009-12

• Various measures suggest that China has achieved a major share of the needed trade adjustment since 2009:

• Its trade surplus peaked at $300 billion in 2008, and declined thereafter.

• Substantial real appreciation of the RMB has brought it closer to equilibrium. – Some nominal appreciation +

– Some price inflation and, especially, wage increases.

Adjustment of relative prices

• The famous “China price”:

– Ever since China rejoined the world economy 3 decades ago, its trading partners have been snapping up exports of manufacturing goods,

– because low Chinese wages made them super-competitive on world markets.

• But in recent years, relative prices have adjusted– following the laws of market economics.

Adjustment of relative prices, continued

• The change in relative prices is reflected as real exchange rate appreciation.

– This comprises, in part, nominal appreciation

– and, in part, Chinese inflation.

– Government officials would have been better advised to let more of the real appreciation take the form of nominal appreciation ($ per RMB).

– But since they didn’t, it showed up as inflation instead.

– See charts below: • appreciation, against the $ and other currencies.

Appreciation versus the US $, 2005-12

0.9

1.0

1.1

1.2

1.3

1.4

1.5

2005 2006 2007 2008 2009 2010 2011

CNY/USD,2005M06=1

nominal

real

The RMB rose against the $ during 2006-08, but temporarily returned to peg in mid-2008.

Appreciation vs. index of currencies, 2005-12

0.95

1.00

1.05

1.10

1.15

1.20

1.25

1.30

1.35

2005 2006 2007 2008 2009 2010 2011

CNY Index,2005M06=1

Real valueof CNY

Valueof CNY

China’s trade balance

The surplus peaked in 2007, and then fell.

Source: Reserve Bank of Australia (June 2013)

China runs a deficit in primary products, offset by a surplus in manufactures.

30

China’s trade balance

The bilateral surplus with the United Statesis as big as ever – which has no economic importance,

but is politically sensitive.

The natural adjustment process was delayed.

• 1st, because the authorities intervened to keep the exchange virtually fixed against the dollar, in the years 1995-2005 and 2008-2010.

• 2nd, workers in China’s increasingly productive coastal factories were not paid their full value. – The economy has not completed its transition

from Mao to market, after all.

• As a result of these two delaying mechanisms, Chinese continued to undersell the world.

But then two things happened.

• 1st, the yuan was finally allowed to appreciate against the $ during 2005-08 & 2010-11, by 25% cumulatively

• =17% + 8%. • Though less against other currencies.

• 2nd, labor shortages began to appear => China’s workers at last won rapid wage hikes. – Major cities raised their minimum wages

sharply over each of the last 3 years: • 22% on average in 2010 & 2011;

• Meanwhile another cost of business, land prices, have risen even more rapidly.

Chinese wages have been rising

33Source: “China’s wage inflation,” Aug. 28, 2013

Real appreciation

• The RMB’s real appreciation against the $from 2009 to 2012 has amounted to 12%,

• reducing the degree of undervaluation by roughly half,• depending on whether one measures it against the $

or against all currencies.

• More is expected, as China’s relative wages continue to rise.

• In any case, China’s real exchange rate is already closer to this measure of equilibrium than are most countries’ exchange rates (Cheung, Chinn & Fuji, 2010).

5 types of adjustment are gradually taking place in response to the new high level of costs

in the factories of China’s coastal provinces:

• 1st, some manufacturing is migrating inland, – where wages & land prices are still relatively low.

• 2nd, export operations are shifting to Vietnam or Bangla Desh – where wages are lower still.

• 3rd, Chinese companies are beginning to automate, – substituting capital for labor.

• 4th, they are moving into more sophisticated products, – following the path blazed earlier by Japan, Korea, & other Asian tigers

• in the “flying geese” formation.

• 5th, multinational companies that had in the past moved some stages of their production process to China, out of the US or out of other high-wage countries, are now moving back.

• All five of these ways of reallocating resources represent the economic process operating as it should.

• None of this comes as news to most observers of China.

• Many Western politicians are unable to let go of the syllogism that seemed so unassailable just a decade ago:– (1) The Chinese have joined the world economy; – (2) their wages are $0.50 an hour; – (3) there are a billion of them, and so – (4) their exports will rise without limit:

“Chinese wages will never be bid up in line with the usual textbook laws of economics because the supply labor is infinitely elastic.”

• But it turns out that the laws of economics do eventually apply after all -- even in China.

Expansion of the services sector.

This 6th dimension of adjustment still lags behind,

• despite the consensus in favor of it.

• China has had great success in manufacturing– especially via exports.

• Now it needs to help the other side of the economy catch up: services, via domestic demand– Housing, retail, education, environmental quality,– health care, pensions, social safety net.

• Some of this could be done via government spending– especially with the economy in slowdown in 2014,– as China did in 2009; but that was mostly heavy investment.