Wednesday, October 20, 2010
This commentary is crossposted with Angry Bear blog.
China took the world by surprise on Tuesday by raising bank lending and deposit rates for the first time since 2007. The story is, that restrictive monetary policy (i.e., raising rates) is needed to curb excessive lending, with an eye on mitigating inflation pressures. See this Bloomberg article to the point.
While restrictive monetary policy is needed, raising rates is not the only tool available to policy makers: China could allow their currency (CNY) to appreciate. With support from the fiscal sector, a broad CNY appreciation would improve prospects for global growth ex China via import demand. Instead, the higher domestic rates may crimp domestic demand, perhaps reducing inflation, but contemporaneously lowering import demand.
In my view, China's move yesterday should be viewed as competitive devaluation: reducing domestic prices in order to capture a competive edge. The currency war, as so-called by Brazil’s finance minister, Guido Mantega, is afoot; and China just confirmed its participation.
Textbook economics says that a central bank cannot have it all: independent monetary policy, a fixed exchange rate, and open financial markets (the impossible trinity). China has a fixed exchange rate (currently, it's effectively pegged to the USD, see chart below) with tightly monitored capital markets. This means that the Chinese economy effectively matches the "easy monetary conditions" of its counterpart, the US. Monetary policy in China is too loose.
Going forward, further accommodative monetary policy in the US will likewise loosen policy further in China; inflation pressures will be even more robust. But, large-scale asset purchases on the part of the Fed will likewise weaken the USD, which is positive for US exports and negative for US import demand.
All in all, policy makers in China are looking at the USD move with tunnel vision. If the CNY maintians its current trajectory (effectively flat), then any shift in relative prices based on the recent (or future) rate hikes will reduce the CNY real exchange rate (all else equal, of course) - that's competitive domestic devaluation.
The table has already been set.
Chinese policy makers have slowed the nominal appreciation. Think about what could be if the CNY had maintained its 2005-2008 trajectory, where the CNY appreciated against the USD nearly 20%. Using the compounded annual growth rate (CAGR) over the same period, where the CNY gained 0.5% on a monthly basis against the USD, the month-end September CNY would be valued 11% higher against the USD than it is now.
They slowed real appreciation, too. The real appreciation of the CNY against its trading partners – the real exchange rate accounts for both nominal appreciation and price differentials across countries – slowed from an average 0.4% monthly gain spanning the period 2005-2008, as measured by the CAGR, to just 0.05% since then. (I use the JPMorgan real exchange rate index, but the BIS makes similar data available free of charge.)
The Chinese authorities are fully aware of the economic value of external demand (exports). The media will say that China’s trying to “cool” domestic inflation by raising domestic bank rates; but that’s not the full story. In my view, what they’re really trying to do is to “cool” domestic inflation in order to shift relative prices and depreciate the real exchange rate, all to gain a competitive advantage in global goods markets.