China’s real sin is not ‘currency manipulation’
WSJ editorial: China's real problem is not currency manipulation, it's sterilization. The U.S. should assist the Chinese in facilitating monetary reforms such as increased yuan convertibility by offering technical support and forming a currency swap arrangement to stabilize the yuan in the event of exchange-rate overshooting.
This piece did not mention who's the author, but I can smell Bob Mundell, the "father of Euro". Some real good economics there.
A bipartisan swarm pounded Treasury Secretary Timothy Geithner on Capitol Hill yesterday for not doing enough to stop China's supposed money mischief. The sessions made clear that pressure is building to impose punitive tariffs on Chinese goods if the yuan doesn't appreciate in value. While it's true that China's monetary policy is causing problems, the yuan is the wrong target and protectionism is the wrong tool to get Beijing to cooperate.
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First off, pegging the yuan to the dollar is not "currency manipulation" or "stealing American jobs." Hong Kong, Estonia and Bulgaria have fixed exchange rates and no one accuses them of underhanded tactics. But under their currency-board systems, inflows of foreign exchange directly lead to an increase in the money supply, and hence rising prices. That tends to constrain trade imbalances.
China's real sin is sterilization, which insulates its domestic economy from the money-creating effect of a currency board. When a company like GE invests in a Chinese factory, or a retailer like Wal-Mart buys Chinese-made goods, they exchange dollars for yuan. The Chinese government then buys those dollars with yuan. But instead of adding to the money supply, it removes those yuan from circulation by selling bonds and raising reserve requirements. Without a rise in the general price level, China's trade surplus with the world persists and grows as productivity rises.
Other emerging economic powers have used this approach—including the U.S. Milton Friedman's "A Monetary History of the United States" notes that from 1921-29, when the world used gold instead of dollars for monetary reserves, the nation's gold stock grew by about 50%, reflecting its trade surplus. Initially Washington was content to allow the money supply to rise. But from 1923 on, a policy of sterilization caused the level of high-powered money to remain stable, and wholesale prices fell 8% from 1925-29.
This short-circuited the self-correcting mechanism inherent in the gold standard, which is akin to a universal currency board since all currencies are pegged to gold. The U.S. should have seen an increase in the money supply, causing higher prices and over the long term tending to restore trade balance.
Instead the Federal Reserve wreaked havoc on countries trying to stay on or rejoin the gold standard, especially Britain, which was hemorrhaging gold. It was forced into a period of deflation and couldn't compete with the American export juggernaut. London responded with protectionism in the form of Imperial Preference, which contributed to the Great Depression, and the gold-standard system collapsed.
Likewise, Japan's use of sterilization in the late 1960s hastened the end of the Bretton Woods monetary system, while the East Asian tiger economies came a cropper in 1997 after overinvestment in their export industries annihilated profits.
China's growth potential means its share of world trade could get much bigger, and the distortions that much more damaging. Like the U.S. in the 1920s, China's rapid development without a sustainable monetary policy could topple the dollar system, especially since many countries in East Asia are also sterilizing their buildup of reserves to stay competitive with China.
There are interesting parallels between the 1920s and the 2000s. In 2003, China's dollar reserves began to grow like Topsy, Beijing stepped up its sterilization and the U.S. trade deficit burst its usual bounds of about 2% to 3% of GDP. As the provider of the world's reserve currency, the U.S. should naturally run a deficit in this neighborhood, but when the gap passed 5% alarm bells began to ring.
The challenges posed to central bankers have also been similar. China's purchases of U.S. Treasurys drove down bond yields in the West, lulling the Federal Reserve into a belief in the last decade that it did not need to tighten. While the prices of goods remained relatively stable, asset markets spiralled as misallocated capital cascaded through the world economy. Inflation appeared as stock market and real-estate bubbles, which created deflationary pressures after they burst.
So far, commitments to the World Trade Organization have prevented a post-crisis slide into protectionism. But the readjustment to long-run equilibrium that might have occurred under a better monetary system is still being thwarted. Washington is using fiscal stimulus to promote consumption rather than investment, while China has spent 15% of GDP on new investment instead of boosting consumption. Imbalances have only worsened.
The U.S. Treasury and the IMF think revaluation of the yuan is the fix. But this would carry significant costs, and without reform of monetary policy it would be ineffective. As Beijing discovered from 2005-08, a rising yuan only attracts more "hot money" to be sterilized.
The better option is for the People's Bank of China to curtail sterilization and allow the price level to rise moderately. Such inflation is a natural and benign phenomenon in a developing economy as productivity rises. And because it is growing faster than its trading partners, Beijing should not fear running a trade deficit as it attracts investment and imports capital goods. It is not in China's interest to keep storing up monetary pressure that eventually creates a crisis.
There are signs that Beijing understands this. Reform to rebalance the economy is rumored to be on the agenda of the Communist Party's annual plenum meeting in the next few weeks. And the 12th Five Year Plan to be unveiled next month is supposed to focus on boosting household income, which has been suppressed in favor of industry, in order to encourage consumption.
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This is where U.S. leadership is essential. The U.S. should assist the Chinese in facilitating monetary reforms such as increased yuan convertibility by offering technical support and forming a currency swap arrangement to stabilize the yuan in the event of exchange-rate overshooting. More urgently, President Obama and Secretary Geithner need to damp down protectionist pressures, promising vetoes and refraining from new antidumping and other tariffs while working with Beijing to phase out sterilization.
The fragile world economy needs greater monetary coordination and reform, not protectionist ultimatums. The moment is ripe for leaders to cooperate to produce a more stable monetary system, if they—and Mr. Obama especially—have the wit to seize it.
Gold hit another record high
Gold at $1269.
(click to enlarge)
What’s behind recent move?
Why is Gold investor’s darling in current environment? ABC News reports:
My yardstick to judge whether gold is in asset bubble:
1) when everybody is buying, even your trash collector neighbor;
2) when everybody tells you, “This time is different”.
We are nowhere near that point. Not yet.
Big move in Yuan
Chinese currency, RMB or Yuan, has had some big move in the last few days, rising from 6.78 to 6.74 per US dollar. Link this to coming US election and Chinese policy makers are playing a precarious game.
French wine ‘bubble’ in China?
Andy Xie, former Morgan Stanley Asia economist, wonders about the question. This is quite an interesting phenomenon.
By ANDY XIE
China's impact on the luxury French wine market has been enormous. The French fine wine index (Liv-100 index) is up by roughly 37% from a year ago, 24% year-to-date, and its upward momentum remains strong.
Not many asset classes have hit new highs above their mid-2008 levels. In addition to fine French wine, gold and China's residential property sector reached new highs in 2009. But I can't recall any others. And among the three, French fine wines seem to have performed best.
There is little doubt that Chinese buyers, not Wall Street traders, are the force behind this positive trajectory for French fine wine. Bordeaux wine producers are all talking about China and Chinese buyers seem to dominate the en premieur for the 2009 vintage available from next year. In fact Chinese mainland buyers are increasingly pricing out buyers from Japan, Taiwan and Hong Kong in the quest for 'first growth' wines.
French wine is, of course, different from a Louis Vuitton bag. When you drink a bottle of wine, it is gone. You can store it as an investment, but the process is complicated and costly.
For most Chinese, investment is actually a secondary consideration. Drinking it now is more important. Yet this seems inconsistent with the dominant Chinese preference for accumulation. So the question is, why so much demand from China?
Like Japan in the 1980s, an important factor seems to be the need to lubricate business relationships. This phenomenon plays out across the world during rapid economic development. Successful economic development may require a little intoxication – when one sinks a lot of money into an under-developed economy, it needs courage.
The business drinking culture has been changing in China. Like elsewhere, liquor consumption (like baijiu) has been declining out of health concerns. So the need for alcohol in business entertainment has produced a unique Chinese phenomenon: massive demand for Chateau Lafite wine. Lafite is one of the five first growth wines from Bordeaux. France classified Bordeaux wines into first to fifth growth in 1855 for its World Expo. At that time four chateaux – Lafite, Latour, Haut Brion, and Margaux – were classified as first growth. In 1975 Mouton also qualified. The chateaux in some of the Bordeaux areas like Pomerol and St. Emilion do not participate in this classification system and have started their own, with some of their wines even more expensive than the five first growth wines. Nevertheless, the first growth label travels well, especially to a new market like China.
Among the first growth wines, Lafite has taken on a life of its own, rising much quicker than the fine wine market as a whole, and other first growth wines in particular. For example, 2000 vintage Lafite has appreciated by about 550% in pound sterling since 2005, compared to 180% for the market as a whole. The most comparable wine to Lafite is Latour, and the price of its same vintage has risen roughly in line with the overall market. The price differentials between Lafite and other vintages of first growth wines are not as dramatic as for the 2000 vintage, but they are still large. Something special has happened to Lafite these past few years. That something is China.
Essentially, Lafite has become the unofficial Chinese wine for business entertainment. There are theories as to why, the most popular being that the Chinese translation is easy to say and sounds nice. I am not sure this is the best explanation. Drinking at business events in China is not really sophisticated; it is more about getting tipsy quickly. Guests are expected to be impressed by the price of expensive wine, and not the taste.
Is the Lafite phenomenon a bubble? As Greenspan has said, one can never be sure if a bubble exists until it bursts. It is possible that Chinese drinkers appreciate something in Lafite that other drinkers never did. Hence, as Chinese become richer and spend more on wines, Lafite benefits from this source of demand more than others. So the Lafite phenomenon may actually be a price revaluation, rather than a bubble.
An alternative scenario could be that other first growth wines will get the Lafite treatment over time. Chinese demand for Lafite is due to lack of knowledge about alternatives, so when Chinese drinkers become more sophisticated, the demand for other first growth wines will probably increase. This could be a rising tide that will gradually lift other fine wines.
The second scenario is possible, and it has to do with the French system for wine production and the laws that make it impossible for the great wine chateaux in Bordeaux to increase production. Bordeaux wine producers have to go for quality and high price rather than quantity. Hence, when a new source of demand comes, the price always goes up.
Indeed, the Lafite price is now so high that it has led to a large counterfeit industry. Some analysts estimate that 70% of the Lafite consumed in China is fake. I have personally experienced this on a few occasions, although the people who served me fake Lafite were unaware of its questionable provenance because they paid the same high price fetched by the genuine article. I could tell that the fake was good wine too, probably a good second growth poured into a Lafite bottle. Forgers have targeted the legendary 1982 vintage in particular. Many wealthy Chinese have bought large stocks of 1982 Lafite and the odds are most of it is fake. There are so few bottles of the real vintage left that it is highly unlikely to find several cases of the real thing.
When the Chinese economy matures in ten or 15 years and business entertainment declines in importance, Lafite prices may come under pressure. At this point demand will be mostly for self enjoyment and hence, more price sensitive. Japan has already gone through such a cycle.
A market is efficient when informed consumers make rational choices. An efficient market motivates producers to improve quality and control costs and this cycle leads to great brands that last.
The French wine market was like that, but I am afraid that Chinese demand is decreasing the market efficiency and may bring down great brands over time. When winemakers see prices resulting from propaganda, not quality, they will focus on marketing and decrease their investment in improving quality. It would be a tragedy if Chinese demand, by bringing easy money, brings down a French legacy that has lasted for five centuries.
Decipher the growth-return fallacy
For a while, I have lost track of my favorite column at Financial Times, “Short View”. Now I got it back working again in my RSS reader. Here is an interesting piece on the growth-return fallacy in investing.
Growth does not equal return. It all depends on your entry point or purchase price. Previously, I have introduced this simple idea in an interview with Jeremy Grantham. In practice, more often than not, you will find people rarely get it.
(click on the graph to play)
Fast Wage Catch-up in China
One of the hottest topics now in China is the fast rising wage of migrant workers. The recent news came that wage in China’s manufacturing sector nearly on par with Mexico.
China’s manufacturing wages nearly doubled during 2003–2008, while wages went up just 25 % in Mexico. The average wage of a Chinese manufacturing worker in 2002 was less than half the average wage paid to his or her Mexican counterpart. That difference narrowed to just 20 % by 2008. Singapore-based electronics-maker Flextronics re-ports that China’s current wage levels already match Mexican levels. This is due in part to the fact that Mexican wage growth has stalled since 2007.
Chinese manufacturing sector wages have risen 24–30 % this year, partly in response to strikes. Despite higher wage costs, China still offers substantially cheaper production opportunities than the US or Europe, and has a huge and burgeoning domestic market. If Chinese real wages continue to rise sharply, it is likely companies will continue to move production inland from coastal southern China to take advantage of lower production costs. International companies could also seek production opportunities in countries that offer a superior cost advantage to China.
However, the significance of China’s domestic market for foreign companies operating in China is important. A survey by the American Chamber of Commerce in China found that over half of US firms in China operate solely to serve China’s domestic market. Only a fifth of firms reported they were in China primarily for export reasons.
I have dealt with the same issue a few times in the past, such as post here, and here. In my view, the rising wage is not to be afraid of – most people are worrying about China losing its competitive edge to other developing countries. However, the development experience of most East Asian countries proves that the rising wage is a great force to incentivize firms to upgrade their technology and pushes the country out of its current low-value-added industries, into the industries with more technological component. This is good news for both Chinese workers and China's long term growth.
Fan Gang, professor of economics at Beijing University holds the similar view. He even doubts the supply of cheap labor has been drained out. There were many factors in the past few years that have had impacts on the supply of Chinese migrant workers. Here I list a few, 1) agricultural subsidies; 2) sharply increasing investment in western provinces; 3) the effect of one-child policy started to play; 4) a positive income shock from selling land to governments and real estate developers and coincides with Chinese housing bubble.
Economist Magazine also runs a similar analysis. Here I include a couple of interesting charts.
Chad Bown goes to Washington
Chad Bown of Brandeis' economics department goes to White House and serves as sr. economist on President's Council of Economic Advisers (or CEA). Chad is a no non-sense trade economist. I am happy for his appointment.
The new CEA will be headed by Austan Goolsbee. And here is the video interview of Brandeis’ Cathy Mann on this change of President’s economics team.
America is “almost surely in for a long slog”
Recent research by Vernon Smith et al. shows "all the postwar recessions and the Great Depression leads to the following empirical proposition: If there is no recovery in housing expenditures, confirmed by a recovery in consumer durable goods expenditures, then there is no economic recovery."
In the Great Depression and in every recession since, recovery of residential construction has preceded recovery in every other sector, and its recovery has been far larger in percentage terms than the recovery in any other major sector.
Applied to the Great Recession, it appears that those who see signs of a recovery may be grasping at straws. What one should hope is that this time it is different from every one of the past 14 U.S. downturns, but those who believe this have the weight of past experience against them.
We looked at all the major expenditure components of Gross Domestic Product in percentage deviations from their levels in the fourth quarter of 2007, officially declared as the start of the Great Recession by the National Bureau of Economic Research.
The onset of and decline during this recession were like previous recessions, though its course has been deeper and longer. By quarter four of 2007, sales of new homes had fallen without interruption for nine straight quarters and expenditures on new residential construction had fallen for seven quarters—strong lead time signals of the looming distress. New home sales recovered briefly in 2009 but have now declined for three quarters. Residential construction expenditures have essentially been flat for five quarters. Consumer durables spending at best has stabilized, up slightly from its low in the fourth quarter of 2008.
The average increase in new residential construction in the first year following the previous 10 postwar recessions has been 26.3%. The largest increase in residential construction followed the 1981-82 recession, when it increased 75.5% as monetary policy was relaxed. In the past year, residential construction has increased 6.3%. This is the slowest rebound in residential construction in any sustained recovery from a postwar recession.
No currently debated policy will likely change this situation, as the market is saturated with foreclosed houses and homeowners suffer from $771 billion in negative equity. This fact needs to be confronted: We are almost surely in for a long slog.
Mr. Gjerstad is a presidential fellow at Chapman University. Mr. Smith is a professor of economics at Chapman University and the 2002 Nobel Laureate in Economics.
Link to the full text of the research paper