naked capitalism

CCT says:

Yves,

I want to start off by saying I’ve been a loyal reader of the blog throughout the recent crisis, and appreciate your insights. You’re 100x times better at this than I, or anyone else I know, could be. But I have to say, the tone/content of some of the reports are starting to strike me as overly hysterical. The RMB issue is another example of this recent more extremist tone.

China held the RMB peg during the ‘97 Asian crisis (while also supporting Hong Kong), despite all expectations otherwise as the rest of Asia “raced to the bottom”… depreciating their currency at unbelievable rates.

It’s not clear to me that the crisis today, for the Asian countries at least, is substantially more serious than what we saw in ‘97. The idea that China would engage in a currency race to the bottom to cheapen exports by a few percentage points is simply not viable. I also doubt it’ll so severely affect American (or world) exports; the RMB only started appreciating versus the dollar 2-3 years ago.

I agree with the above, re: the significance of new domestic policies in China, vis-a-vis land-holding policies. Note that numerous Chinese city governments are rolling out real estate support packages, something that hasn’t been mentioned in most media as far as I can tell.

Yves Smith says:

CCT,

With all due respect, this situation now bears no comparison to 1997. The Asian economies in those days were FX reserve poor, and very dependent on hot money inflows. China now has the largest annual growth in FX reserves by far and is the biggest actor in the global imbalances story, which is a crucial element of the massive debt growth in the US and other advanced economies. You can argue whether the chicken came first, or the egg, but we could not have gotten in the mess we are in to anywhere near this degree had China not been maintaining a dollar peg as part of a mercantilist trade policy (which we were happy to accommodate, since cheap goods and cheap debt covered up for stagnant worker wages).

Every respectable economist agrees China needs to let the renminbi appreciate further to unwind global imbalances (this needs to be done in concert with other actions, but the renminbi appreciation is essential). China needs to move away from export dependence and develop more domestic consumption.

The policy has been for continued renminbi appreciation, and many expected a 5-10% one time revaluation (although the consensus is that a far larger revaluation would be necessary to bring the currency into alignment).

More recently, Nouriel Roubini has argued that it it now too late for revaluation, that China would instead opt for a continued rise, and let inflation do the rest (increases in domestic price levels will also reduce the competitiveness of goods, albeit slower and more unevenly than a revaluation).

Thus, the renminbi has looked like a one-way trade and had led to simply massive FX inflows in the first half of the year. Brad Setser and Michael Pettis, who are not prone to alarm, has been absolutely gob-smacked by the amount of money flowing into China in the first half of the year and both saw it as a very troubling development.

Now admittedly, the CIC forecast is one opinion, but it is far from implausible that China would stop letting the RMB appreciate to try to defend exports. But this would be a seemingly rational action that would be damaging externally, and possibly even internally.

In deflation as the UK and later the US showed in the Depression, and Sweden showed in its early 1990s banking crisis, devaluing the currency by a very large amount is part of the reflation program. Thus for China to stand in the way, merely by maintaining a harder peg and reversing its policy of letting the RMB appreciate, is tantamount to a race to the bottom.

And lest you think this alarmist, several professional investors have written me, each concerned about the US letting other currencies rise against the dollar, when we are the epicenter of the deflationary crisis and should be taking measures to drive the dollar lower, fast. Having the reserve currency gives us unusual luxury to do that. They too see a race to the bottom as inevitable, given how many countries are involved in the debt crisis and the need for them to set their currency values lower.

We quoted Michael Pettis’ Financial Times comment “Hot money poses risk to China’s stability” in July:

During the first halves of 2005 and 2006, the trade surplus, FDI and estimated interest on China’s reserves accounted for 80-90 per cent of the country’s reserve accumulation. In the first half of 2007, these components accounted for about 70 per cent. This year, however, their share has declined dramatically to 39 per cent from January to May…Because there are likely to be speculative inflows buried in the trade and FDI accounts, their true share is probably even lower.

The Asian financial crisis steeled Chinese policymakers to create safeguards against capital flight, and China’s massive reserves and capital controls are likely to prevent a rapid speculative assault on the renminbi. However, just because China may be less vulnerable to an external financing crisis does not mean that authorities are out of the woods… Under these conditions, the risks to the domestic banking system, rather than the currency, are likely to be more significant.

Also see this earlier post, “Scary Bad Increase in Chinese Foreign Currency Reserves” which again cites Pettis and starts:

In general, I’m not terribly fond of imprecise and emotion-laden terms such as “scary bad”. However, in this case, the more accurate description might be “mind-numbingly awful, pointing to increased financial instability.”

Anonymous says:

They are just getting a leg up.

With all the dollars that will soon be flooding the globe, we’ll be lucky if that’s all China does.

FairEconomist says:

I don’t see the renminbi depreciating. It’s taking a staggering investment by the Chinese central bank just to keep it from soaring – hundreds of billions in renminbi sale/dollar purchases per year. I think China is about to have a lot less dough to throw around and that means appreciation for the renminbi, not depreciation.

Anonymous says:

The impending lease arrangements for land are not radical in the least; it merely makes de jure practices that have been de facto in certain areas, if not most of the countryside, for many years now.

In a previous career I worked in China; I was there from 2001-2006. Most of the time was spent in Harbin and Shanghai setting up franchise operations for the regions. I married a woman from the west of Zhejiang, and spent approximately 30 days in the village several miles west of Tai Hu.

My father-in-law has rented land in the area from both the state as well as from other villagers for many years. The contracts have run as short as a season (typical for crop land) to 3 years (for rights to river/lake use for aquaculture) to 30 years (land holdings to build homes). Speaking with others in the area I learned that this was common practice in Western Zhejiang. While I have no concrete proof, I doubt this practice is unique or special to the country.

It would probably not accelerate movement to the city as renting of one’s land holding, legal or otherwise, has been a common practice for many years. However, the ability to rent an individuals plot for long term may allow for the potential of a modern day enclosure movement as small plots (about 1/6 th an acre personal holdings) are rented long term (30 years or so) to local land barons…

Peterpaul

Lune says:

Yves,

I’d like to raise 3 points.

Firstly, not being an expert in the Chinese financial world, I’m wondering how close to the government CICC is. Chinese officials have been desperate to try to tamp down expectations of RMB appreciation for at least the past year, if not longer, in order to curb hot money inflows. It wouldn’t be out of the realm of possibility for the officials to lean on friendly firms to start putting out reports that bolster the government’s objectives. I don’t mean to impugn CICC’s independence without evidence, so I’m curious if others have info about just how independent CICC’s report really is.

Secondly, I’m curious as to exactly how China would engineer a depreciation. As others have noted, China has tried mightily to limit appreciation, at enormous costs to its own economy including inflation and asset/investment bubbles. While the unwinding of speculative investment vehicles such as hedge funds in the ongoing credit crunch may ease hot money inflows, that is only a part of China’s currency surplus, which is fundamentally built on its imbalanced trade flows.

To expect China to reverse its currency flow in order to depreciate its currency when in the past few years China has barely been able to limit appreciation to its stated goal of 7%/yr would call for a radical retooling of its economy and/or massive intervention above and beyond its current injurious practices. I don’t see either occurring within such a short time span as predicted by CICC’s report.

Thirdly, while imploding hedge funds may currently be leading to a flight of money out of China, don’t be surprised if all of a sudden, people see RMB appreciation as the next “sure thing”. The commodity bubble has been pricked, and the Treasury bubble is likely close to its peak. Who’s to say a RMB bubble won’t be next…?

Anonymous says:

One other point to the points above is that there are probably big losses in SAFE’s USD investment portfolio which have not been disclosed and will need to be faced up to. I have heard estimates of 400 bn.

This is logical as there are still vast amounts of subprime losses (based on the IMF figures) which remain unaccounted for.

I suspect that when this get out (and it will probably be leaked rather than an official announcement which will make it worse) some of that hot money may disappear anyway.

Yves Smith says:

Lune, EvilHenryPaulson,

To Lune’s points (which largely addresses EHP’s issues):

First, if China wanted to lower expectations for RMB appreciation to punish or discourage speculators, one would think they’d be talking it up, or having favored sources talk it up in the Chinese press, later to be denied in official circles. For instance, academics known to consult to the government are perfect for plausible deniability (and they, rather than research reports, have in the past been the preferred outlet for trial balloons and early signals). The fact that CICC’s’ call is so isolated isn’t consistent with a strategy to change views.

Second, since the dollar is momentarily rising and imports from China are falling (haven’t checked, but assume the trade deficit with China is contracting), that means a lower level of intervention is needed to achieve the desired outcome.

And specifically regarding hedge funds, it is not easy to buy RMB. The fact of sustained trade surpluses means there is not a lot of currency floating around outside the country (you need sustained deficits to do that). And China has fairly tight controls over its banks and currency exchange. If you read the link I provided above, and other stuff from Pettis and Setser, a lot of the hot money flows were classified as FDI and in other categories because that was how they could get the money in.

Third, you are looking as if the choice is “more inflation versus less inflation” when the officialdom is going to frame it as a choice between two evils: more inflation or more unemployment. We tend to regard as more unemployment as a choice to be avoided until inflation becomes completely intolerable. I see no reason why the Chinese would view their choices any differently, particularly since unemployment tends to hit certain regions and sectors harder, and concentrated groups of unhappy people has greater potential for explosive outcomes that spreading the pain broadly, which inflation would tend to do.

And there is a faction in the government which is keen to halt RMB appreciation, and its influence is growing. From a September post:

The Bank of China buys lots of dollar investments to keep the yuan from rising. However, as we all know, the yuan has been permitted to appreciate somewhat. Note that this means the value of those holdings in local terms has fallen.

This is the bizarre bit. The Finance Ministry is mad that the central bank lost money on its dollar investments and wants no more yuan appreciation. This of course commits it to even greater dollar purchases, which guarantees that its eventually currency losses will be all the greater.

And these quote came from a New York Times article cited in the post:

The central bank has been the main advocate within China for a stronger yuan. But it now finds itself increasingly beholden to the finance ministry, which has tended to oppose a stronger yuan. As the yuan slips in value, China’s exports gain an edge over the goods of other countries.

He said the officials blamed the United States and believed the controversial assertions set forth in the book “Currency War,” a Chinese best seller published a year ago. The book suggests that the United States deliberately lured China into buying its securities knowing that they would later plunge in value.

There is more in the article, but you get the drift. The Chinese get upset now if they take losses on their dollar holdings, which is inevitable if they let the RMB rise.

Richard Kline says:

So peterpaul, agreed that de jure there has been active leasing of land plots for twenty years. In that respect, the transition is not ‘radical.’ The legal standing of these has been, to put it mildly, vague. Furthermore, it has been my impression that such leasing has, in fact, _not_ been spread around to the country as a whole but concentrated in a few test areas where the government could snuff it out quickly if it so chose, specifically in the east, such as in Zhejiang and Anhui. (I would be interested to hear hard evidence to the contrary if it is available.) It is my impression also that lease-bundling has been encouraged in some urban locations to facilitate development.

The real point of impending reforms is to give solid legal standing to sub-leasing ones own lease rights for the long-term. This may have two effects. One the sub-leasor gets a modest but steady cash flow to finance something else they want to do with their life and time which is not tied to the location in which their family was born. They may or may not migrate, but those who do will come moderately better financed rather than incipient shantytown dwellers, something of signicant importance. The other, and really more important issue, is that sub-leasees have the incentive to actively invest and develop the landholding since they have longer term time frames and solid rights to what they create. Now in much of the country, local officials can stick in their oar and palm at any time, at least for a shakedown to look the other way but even worse to try to snatch away developed plots for themselves or their cronies. _Clear title_ is essential for investment. Your father-in-law sounds like an enterprising sort who knows well the ‘lay of the land’ in his district, and has nothing to fear from the local powers that be. That is not the case in many other places. Outright sale of lease rights would be far more radical, with larger systemic effects, not all of them necessarily desirable. I would be more surprised to see this in the near future, but who knows?

Anonymous says:

CCT said ; I’m still of the opinion that of all the possible crisis focal points out there, China’s currency is a non-story.

I completely agree with this, and a quick look at a chart will show hardly any movement in the exchnage rate compared to current account deficit countries such as Aussie dollar, New Zealand dollar and Turkish Lira (now that really is a bubble in the process of bursting!). Equally though US Treasuries are also not a bubble. Bubble conditions occur when investors hold large long positions. However most investors are short US Treasuries. Take a look at PIMCOs Total return bond fund – not a single US Treasury. Look at failed trades in US repos which are currently running at 4.5 TRILLION. Thats becuase the banks are net short of US Treasuries. Thats a big mistake in my opinion. If you look at Fed custody holdings central banks have been selling US agency paper recently and buying large amounts of US Treasuries. I cant prove that the Chinese are doing the same but it would seem odd for them to be unhappy with losses whilst at the same time stepping up purchases of Fannie and Freddie paper.

Anonymous says:

Nothing is impossible, but it is just not very likely. I am happy to stick to my view that AUD, NZD, TRY are more likely to go down a lot that the RMB which will gain from here against US dollar. Current levels are 0.6757, 0.6090, 1.5264 and 6.8245.

fresno dan says:

Wonderful post and the comments and discussion were most elucidating. I agree that the Chinese will keep their currency low come hell or high water. We have our irrational beliefs (the completely rational economic agent) and the Chinese have their merchantilist beliefs – with human belief systems, no amount of data can refute them.

Anonymous says:

What can’t go on will stop. And that applies to the Chinese Wirtschaftswunder (economic miracle) as well. What’s more, what better time than now?

We don’t seem to understand these things very well, we don’t even seem to have gotten the last time round sorted out. I’ve begun reading Kindleberger’s “Great Depression” (I know, there may be other books that are better, but I have to start somewhere), and he makes a lot out of falling commodity prices and global imbalances involving US foreign lending as the setting for what happened at the end of the 1920s.

Isn’t it odd that we have had the same in the past years – falling (commoditised) consumer article prices and global imbalances involving chinese (also japanese etc) lending?

It was the USA as source of the falling prices and global lending that got clobbered last time. Could it be that this time it will be China that will get well and truly clobbered?