Diatribes of Jay

This blog has essays on public policy. It shuns ideology and applies facts, logic and math to social problems. It has a subject-matter index, a list of recent posts, and permalinks at the ends of posts. Comments are moderated and may take time to appear.

20 June 2010

Whither the Renminbi? Two Neglected Factors

Saturday a developed world battered by economic storms welcomed China’s announcement that it will soon get serious about currency reform. The news had two components. First, China said it would let its renminbi rise faster. Second, China implied that it would no longer peg the renminbi to any particular currency, as it now does to the dollar. Rather, China will use a basket of leading currencies―probably including the dollar, yen and euro―to adjust its exchange rates.

What the second point means is that China’s new policy will not affect all foreign countries equally. Some will gain and some will lose, relatively speaking. Which ones will gain the most and which ones will lose depends on the reasons for China’s apparent change in policy.

Unfortunately, our moronic Western media have been a Johnny-one-note on the subject for years. The main effect of a low renminbi, they tell us over and over, is to allow China to sell its manufactured goods cheap, thereby jump-starting its domestic employment and sucking manufacturing jobs from developed countries.

Of course there is truth in this point. But it’s not the only truth. By sticking monomaniacally to this single theme, Western media have missed others important points, namely, why now, and who will benefit most.

There are at least two other reasons, besides the balance of manufacturing and trade, why China might want to allow the renminbi to rise. These reasons help explain why now and who will benefit.

The first reason is something I touched on in an earlier post. Currency exchange rates are part of the means by which a nation adjusts its domestic money supply and thereby maintains a semblance of conservation of money without a precious-metal standard. In free-market nations, central authorities have little control over exchange rates, which international markets determine. But in China, which maintains its “peg” to the dollar by artificial means, currency policy is a de facto part of central banking policy.

Here’s how it works. China keeps the renmibi low as compared to the dollar by buying dollar-denominated assets, principally US treasury bills and notes. By financing our growing public and private debt, those purchases help keep our domestic interest rates low. That’s good for us in the short term, but not so good in the long term, as it encourages fiscal irresponsibility and discourages saving.

But what about China? All the money that China injects into our economy has to go somewhere. Where does it go? Right now, the US is a less attractive place to invest than at any time in the past. Our manufacturing is wilting, and our finance sector has overgrown our economy, accounting for up to 41% of all our domestic business profits during the last decade. In other words, lots of that Chinese money is going into our multinational banking system, after being funneled through the Fed as near-zero-interest-rate loans to our banks.

But where does it go ultimately? Well, according the basic principles of capitalist economics, it goes where the returns are greatest, i.e., where growth is greatest. Where might that be? You guessed it. Right back to China, which is now where all the world’s most robust industrial action is. The money also goes to other rapidly developing nations like India and Brazil. So as China invests in US assets, much of that investment comes right back to China because that’s where the action is. American taxpayers pay for this backflow twice: one in bailout schemes like TARP and a second time for interest on our international debt.

A significant portion of this money flows to China for two reasons. First, because China is the world leading industrializer, investment in it offers both the greatest potential return on equity and greater opportunity for market growth (the “two billion armpit” theory). Second, by keeping the renminbi low, China makes its already attractive business assets cheap compared to comparable foreign assets and therefore even more attractive.

China’s position as a chief global magnet for foreign investment is therefore no accident. It reflects a basic law of capitalist economics: money flows toward cheaper assets and greater returns.

The return flow of investment back to China might cause general inflation there. But that result is not especially likely. Foreigners don’t invest in or buy the same things that Chinese consumers do.

More likely, the return flow helps inflate bubbles in particular assets, such as commercial real estate and home markets in key internationalizing cities. Used as they are to international standards in commercial buildings and housing, foreign multinationals, their executives and middle managers go for desirable locations and high-quality construction in commercial cities like Shanghai and Guangdong, thereby bidding up prices for things like land, building materials and construction wages.

Both foreign multinationals and overseas Chinese returning to China to participate in the coming boom participate in this bidding process. The process is likely a significant factor in the Chinese real-property bubble, at least in selected cities that are foci of foreign investment. An artificially low renminbi helps inflate the asset bubbles by making the assets both cheaper to foreigners than to locals and more desirable compared to other alternatives for foreign investment.

The second neglected factor may help explain who will benefit. China is a serious country, with serious and intelligent industrial policy. It exaggerates little to say that China today is ruled by engineers and economists, while politicians and other miscreants who know nothing of value and promise everyone a free lunch run most of the developed world. So as China de-couples its renminbi from the dollar and attaches it in part to other currencies, who will benefit most depends on which country’s currency’s relative decline will most benefit China.

This factor in turn depends on two things. First, China doesn’t want to lose its foreign markets. As the renminbi gains value compared to the dollar, for example, it becomes harder for American consumers and businesses to afford Chinese products. So markets for Chinese products in the United States decline.

But this factor becomes less important as China, in accordance with repeatedly declared policy, strengthens its domestic markets and increases domestic demand. As that happens, the other side of trade policy increases in relative importance: what does China want to buy abroad?

Does China want to increase the buying power of the renminbi just so its consumers can gobble up Western, overpriced, branded luxury goods just as Japanese youth do today? Unlikely: that would not be serious industrial policy. China is a serious country with no geriatric demographic problem and no demonstrable susceptibility to fads.

So what would/do China’s smart leaders want it to be able to buy more of? High-technology goods, especially for business, higher education, and technology itself. China wants to buy cheaply things available nowhere else that will make China’s economy―especially its manufacturing economy―ever stronger.

So here are the three key factors in China’s currency policy: (1) avoiding asset bubbles due to incoming foreign investment; (2) maintaining foreign markets for China’s manufactured goods; and (3) increasing China’s buying power with respect to things China’s smart leaders want China to have more of, in order to improve the prospects for China’s future still more. Factors (1) and (3)―the neglected ones―demand a high renminbi with respect to a target foreign currency. Factor (2)―the well-known and over-hyped one―demands a relatively low renminbi. Thus the two neglected factors oppose the well-known over-hyped one.

So which countries do these factors favor, especially the neglected ones?

At the moment, all three factors appear to favor the US and Japan. Both countries have been mired in recession for some time. Both are likely to stagnate for the foreseeable future, Japan because of demographics and high wages, the US because of financialization and abysmal governance. So while both the US and Japan are important markets for Chinese-made goods, China’s future growth markets lie elsewhere, in the developing world, especially in its most rapidly developing parts. As China’s own domestic markets and these developing markets grow, China’s reliance on US and Japanese consumers will wane. After all, the two countries together have about seven percent of the world’s consumers.

Factor (1), avoiding assets bubbles, also favors both countries, the US more than Japan. While both the US and Japan are rich countries, the US is more of a banking and finance center. Equally important, its multinationals have a huge cash hoard, which they have accumulated through cautious saving in their recovery from the 2008 crash. Some of these companies may return some of that cash hoard to their shareholders through stock buybacks and dividend increases. But undoubtedly many will chose to expand their business by investing more in the world’s best place to invest today: China. To avoid a destabilizing influx of foreign investment, China won’t want to keep its renmibi too low compared to the dollar and the yen.

Finally, there’s factor (3). Whose stuff will China’s smart and tenacious leaders want its citizens and businesses most to buy? Overpriced Gucci and Louis Vuitton handbags? Hardly. China will want its currency to be strong compared to currencies of countries that make and develop things that China doesn’t or can’t make itself. The principal beneficiaries will be the US, Germany, Japan and South Korea. The rest of the EU, which can’t keep up with Germany, will hold Germany back in this regard, increasing the risk that Germany might leave the EU, at least insofar as monetary union is concerned.

This analysis suggests that, while China’s new policy is by no means directed solely at the US, the US will be one of its principal beneficiaries. The renminbi will rise compared to the dollar not because our politicians demand it, but because that rise will be good for China.

The rise will be slow and steady, in accordance with China’s most sacred governing principle: stability. In the long run, the rise will be inflationary for both US consumers and businesses, as Chinese goods become more expensive and interest rates here rise due to China’s reduced interest in buying dollar-denominated assets to keep the renmibi low.

All this follows from a simple fact. China is now a serious country, with serious, well-informed leaders who consider very carefully the probable consequences of their acts.

We are no longer. Our President is a serious man. But Congress, our Supreme-Court majority, and especially our so-called “loyal opposition” are anything but serious. They treat serious issues of policy like candidates for a Mardi Gras or fraternity party, as grist for amusing one-liners. Pitting people like John Boehner, Mitch McConnell and John Roberts against Hu Jintao and Wen Jiabao, which is what our system does, is a bit like putting the average obese, drunken bum from the back streets of St. Louis in the ring against Muhammad Ali in his prime.

Until we start getting opposition leaders who are serious people and understand what is going on, our economic future will depend on the kindnesses of strangers like China. In particular, it will depend on whether their interests happen to coincide with our own.

Fortunately for us, in the short term (and maybe the medium term) those interests now do coincide. Whether we have the good sense and determination to exploit that short respite from national decline remains to be seen.

If not, China and other rapidly developing nations will suck us dry of high technology and higher education and go on to lead the human race to the stars. We will degenerate into a dysfunctional agrarian and money-handling society, rife with social discontent, having inherited “British disease.” Maybe it’s congenital.

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