By Economic Forecasts & Opinions | 26 March 2010
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 to 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 for 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 or horizontal axis to achieve the equilibrium. Frankel believes it is in China's own interest to let 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 or vertical axis) is necessary, but not sufficient, to address external imbalances while maintaining internal balance.
A satisfactory resolution of global imbalances will require an exchange rate adjustment (Y or vertical axis), plus an expansion of domestic demand relative to investment (X or horizontal axis) in surplus economies (e.g. China) and an increase in saving relative to investment in deficit economies (e.g. the U.S.). External and internal balance can only be simultaneously achieved at the point where the two lines intersect.
Krugman Rebuffed By Mentor
So, based on the Swan diagram and economic statistics, Krugman's assumptions regarding China seems flawed— overlooking 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 refuted by experts from his own and other 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,
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Edward's "black swan" call is partly based on a major concern 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.
From 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 widely 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 aligning 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."
Quotes Du Jour:
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China: The Coming Costs Of A Superbubble
By Vitaliy N. Katsenelson | 16 March 2010
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The world looks at China with envy. China's economy grew 8.7 percent last year, while the world economy contracted by 2.2 percent. It seems that Chinese "Confucian capitalism"— a market economy powered by 1.3 billion people and guided by an authoritarian regime that can pull levers at will— is superior to our touchy-feely democracy and capitalism. But the grass on China's side of the fence is not as green as it appears.
In fact, China's defiance of the global recession is not a miracle— it's a superbubble. When it deflates, it will spell big trouble for all of us. To understand the Chinese economy, consider three distinct periods: "Late-stage growth obesity" (the decade prior to 2008); "You lie"! (the time of the financial crisis); and finally, "Steroids 'R' Us" (from the end of the financial crisis to today).
Late-Stage Growth Obesity
About a decade ago, the Chinese government chose a policy of growth at any cost. China's leaders see strong gross domestic product (GDP) growth not just as bragging rights, but as essential for political survival and national stability. Because China lacks the social safety net of the developed world, unemployed people aren't just inconvenienced by the loss of their jobs, they starve; and hungry people don't complain, they riot and cause other political unrest.
Remember the 1994 movie "Speed"? A young cop (Keanu Reeves) had to save passengers on a bus that would explode if its speed dropped below 50 m.p.h. Well, China is like that bus with 1.3 billion people aboard. If the Communist Party can't keep the economy growing at a fast enough clip, the result will be catastrophic.
To achieve high growth, China kept its currency, the renminbi, at artificially low levels against the dollar. This helped already cheap Chinese-made goods become even cheaper. China turned into a significant exporter to the developed economies.
Normally, if free-market economic forces were at work, the renminbi would then have appreciated and the US dollar would have declined. However, had China let this occur, demand for its products would have declined, and its economy wouldn't have grown at the roughly 10 percent a year of the past decade. The more China sold to the United States, the more dollars it accumulated, and thus the more US Treasuries it bought, driving our interest rates down. US consumers responded to these cheap goods and cheap home loans by going on a buying binge.
However, companies and countries that grow at very high rates for a long time will inevitably suffer from late-stage growth obesity. Consider Starbucks: In 1999, it had 2,000 stores and was adding 1.8 stores a day. In 2007, when it had 10,000 stores, it had to open 5.5 stores a day in a desperate bid to keep growth rates up. This resulted in poor decisions and poor quality— a recipe for disaster.
[[§oAnd Toyota!?!§c: normxxx]]
In China, political pressure for full employment has led to similar late-stage growth obesity. In 2005, China built the largest shopping mall in the world, the New South China Mall: Today it's 99 percent vacant. China also built a lavish district in a city called Ordos: Today, it's a ghost town.
You lie!
All good things come to an end, and great things come to an end with a bang. When the financial meltdown erupted in 2008, US and global banks started dropping like flies. Countries everywhere suffered contraction.
Even China.
During the crisis, Chinese exports were down more than 25 percent, tonnage of goods shipped through railroads was down by double digits, and electricity use plummeted. Yet Beijing insisted that China had magically sustained 6 to 8 percent growth. China lies. It goes to great lengths to maintain appearances, including censoring media and jailing those who write 'antigovernment' articles. That's why we have to rely on available hard data (such as electricity consumption) instead.
Steroids 'R' Us
Today the global economy is stabilizing, thanks to Uncle Sam and other "uncles" around the world. But the consumers of Chinese-made goods are still in debt, unemployment is high, and banks aren't lending. You might think the Chinese economy would be growing at a lower rate. But no, it is growing again at nearly 10 percent, as though the financial crisis had never occurred.
Though this growth appears to be authentic— electricity consumption is back up— it is not sustainable growth, because it is based on an unprecedented stimulus package and extraordinary government involvement in the economy. In the midst of the financial crisis, in late 2008, Beijing fire-hosed a $568 billion stimulus into the Chinese economy. That's enormous! As a percentage of GDP, it would be like a $2 trillion stimulus in America, nearly triple the size of the one Congress passed last year for the US [[§otwo-thirds of which is still unspent§c: normxxx]].
It gets even more interesting. Unlike Western democracies, whose central banks can pump a lot of money into the financial system but can't force banks to lend or consumers and corporations to spend, China can achieve both at lightning speed. The government controls the banks, so it can make them lend, and it can force state-owned enterprises (one-third of the economy) to borrow and to spend.
Also, because the rule of law and human and property rights are still underdeveloped, China can spend infrastructure project money very fast— if a school is in the way of a road the government wants to build, it becomes a casualty for the greater good. Government is horrible at allocating large amounts of capital, especially at the speed it is done in China. Political decisions (driven by the goal of full employment) are often uneconomical, and corruption and cronyism result in projects that destroy value.
To maintain high employment, China has poured money into infrastructure and real estate projects. This explains why, in 2009, new floor space doubled and residential real estate prices surged 25 percent. This also explains why the Chinese keep building new skyscrapers even though existing ones are still vacant.
The enormous stimulus has exacerbated problems that already existed, threatening to turn China into a less shiny but more drastic version of debt-riddled Dubai, United Arab Emirates. What happens in China doesn't stay in China. A meltdown there— or even a slowdown— would have severe consequences for the rest of the world.
It will tank the commodity markets, for one. Demand for industrial goods will fall off the cliff. Finally, Chinese appetite for our fine currency will diminish, driving the dollar lower against the renminbi and boosting our interest rates higher. No more 5 percent mortgages and 6 percent car loans.
No Shortcuts To Greatness
We look at China and are mesmerized by its 1.3 billion people, its achievements of the past decade, its recent economic resiliency, and its ability to achieve spectacular results on the fly. But we have to remember that economic bubbles are usually just a good thing taken too far. The Chinese economy is no exception. Its long-term future may be bright, but in the short run we've got a bubble on our hands.
Everyone wants a shortcut to greatness, but there isn't one. China has been trying to bend the laws of economics for a while, and with the control it exerts over its economy it may seem that it's succeeded. But this is only a temporary mirage, which must be followed by a painful reality. No, there is no shortcut to greatness— not in personal life, not in politics, and not in economics.
See also Chinese Miracle?; China: The World’s Next Great Economic Crash; China's Stimulus Working – Perhaps Too Well.
See TEOTWAWKI— aka, an "Epochal Event" for a thorough exposition of what was to come on the eve of catasterophe— August, 2008— which included a large piece of analysis by Vitaly.
Vitaliy N. Katsenelson is a portfolio manager/director of research at Investment Management Associates in Denver. He is the author of "Active Value Investing: Making Money in Range-Bound Markets."
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