Monday, January 31, 2011

Real Apprecation In China, One Way or the Other

Just last week I noted that because of QE2 a real appreciation in China will occur one way or the other: either its currency will appreciate faster or its domestic prices will soar.   The former seems unlikely because of China's commitment to its export-driven growth strategy.  Consequently, China will most  likely stay tied to the Fed's QE2 monetary policy via its crawling peg and continue to allow domestic prices to soar.   I also mentioned that this real appreciation should contribute to a rebalancing of the global economy.  As if on cue, the New York Times reports the following yesterday:
HONG KONG — Inflation is starting to slow China’s mighty export machine, as buyers from Western multinational companies balk at higher prices and have cut back their planned spring shipments across the Pacific.

Markups of 20 to 50 percent on products like leather shoes and polo shirts have sent Western buyers scrambling for alternate suppliers. But from Vietnam to India, few low-wage developing countries can match China’s manufacturing might — and no country offers refuge from high global commodity prices... The trend, if continued, could ease tensions by beginning to limit America’s huge trade deficit with China.
This is an interesting article throughout, but the one thing it fails to do is connect China's high inflation to the Fed's monetary policy.  It is no coincidence that inflation is accelerating now.


  1. In my little industrial neighborhood, I have neighbors in the garment and cabinet industry.

    Both report that getting shipment from China today is more expensive, and that sellers want larger minimum orders than five years ago.

    I thik there will be spillover into Thailand, and othernations.

    But long-run, we may actually see manufacturing return to US. If the last remaining large and cheap manufacturing platform goes upscale, the US looks more and more like the default platform.

    Yeah, India, but they have a terrible bureacracy.

  2. David,

    I am still bothered by something that has been said earlier here.

    As I explained to Bill Woolsey somewhere, I travel some internationally, and the world economy just does not look like one that is short of money to me. Possibly two years ago, but not now.

    There are shortages of raw materials rapidly developing all over, and the prices of these raw materials are being bid up to high levels. The Chinese are everywhere frantically trying to secure raw materials to keep their factories running.

    Shortages and rising prices for producers goods do not imply excess demand for money globally.

    Further, if my observation is true, I will agree with you that this inflation will show back up here in the U.S. soon, and cause prices to rise commensurate with what we are already seeing overseas. Yes, demand will increase for U.S.-made consumer goods, but these will quickly be bid up to parity with the imports.

    The problem is that prices in the United States may rise more quickly than expected. Demand for money, especially regionally and locally, is a highly non-linear function. If there is a reservoir of dollars out there, the dam could break quickly. If this occurs, the American public could respond to this in some non-intuitive ways.

    There might be temporary forced savings at first, which could look to the Fed like a leveling off of spending and/or CPI, which might be accomodated by more injection of high-powered money. Or it could set off an immediate flight to assets, whichs bids up prices of increasingly scarce consumer goods even faster.

    In more technical parlance, as long as the dollar is the world reserve currency, the changing *boundary value* is the base money created by the Fed. The demand for money balances and credit are *initial value problems*, that creates the local and regional velocity of money.

    If there is a bunch of money added, the level of lake tends to rise, despite the waves on top going up and down.

    Now, I'm sure you will say if my scenario happens, then the Fed can contract the money supply by reversing course. Certainly it should, maybe it can, but maybe it won't. Especially if it means disinflation and recession.

  3. DB: Jeffrey Frankel had an article on this, "Balassa Samuelson & the renminbi"
    It was in 2006, so might be worth updating.

  4. What about sterilization? QE2 and its effect on Chinese inflation shouldn't be a problem if, for every yuan the PBOC creates to buy more dollars, the PBOC later buys it back through sterilization bills. Which they are doing.

  5. JP:

    Sterilization has a host of serious side effects.

    Picture the Titanic. One compartment floods, then the next, then the next. The distortions caused by sterilization will eventually spill inflation over into the domestic Chinese economy (which is happening now). Sterilization is a patch that can keep the ship from flooding for a while, but not indefinitely.

  6. JP Koning,

    The rise in inflation indicates China is not fully sterilizing all all the monetary stimulus being imported from the Fed.

  7. DB: So... real appreciation in China, one way or the other (unless they fully sterilize).

  8. JP:

    Yes, but even with sterilization there is a limit as it imposes fiscal costs.

  9. I am probably preaching to the choir, but I think those interested in what is happening here would do well to go back and re-read Leland Yeager's seminal work International Monetary Relations (1966,1976).

  10. It would be interesting to know what the fiscal costs are and why you think these costs impose limits.

    The increased allowance of yuan in international transactions could affect things too. If Chinese exporters can get paid in yuan by the IKEAs of the world, then the PBoC need print less yuan for dollars.

  11. Strange then that the US' expansionary monetary policy pre-crisis did not force China into real appreciation. A mix of stringent capital controls and effective sterilization has worked in the past, why shoudln't it going forward?

  12. Henry
    Couldn´t resist commenting on your comment. The fact was that pre crisis - mid 07 to mid 08, MP was not expansionary at all, quite the contrary! That´s a major reason for the crisis being so "devastating".


    A decent discussion worth reading.