Hank Paulson, U.S. Treasury Secretary, lamented in a recent speech that U.S.-China economic relations require taking a long-term view, and that this is difficult in Washington, “a town where short-termism is the order of the day.”¹ China is on course to allow greater exchange rate flexibility. U.S. pressure may have provided some encouragement in getting the journey started but, in the short-term, external hectoring is as likely to lead to slower progress as it is to lead to faster progress.

Three thousand miles west, Newport Beach is a town where taking a long-term outlook is a fundamental part of PIMCO’s investment process.² Over the next three to five years, we expect a faster pace of Chinese currency appreciation than the barely noticeable crawl witnessed over the past two years. U.S. protectionist risks cloud the near-term outlook. Over the secular horizon we expect a pace of appreciation at least equal to the 4% annual rate currently priced into offshore non-deliverable forward contracts – and probably much faster later in the period – because this will be in China’s best interest. The costs of maintaining the very tightly-managed exchange rate regime outweigh the benefits. The adjustment will have important implications for global financial markets and the positioning of PIMCO portfolios.

Since China formally ended its currency peg to the U.S. dollar in July 2005, the currency has appreciated by about 6%.³ To put that 3% annual pace of currency appreciation into perspective, it is worth noting that over the same period Chinese productivity has been growing at a 9% rate.

The slow pace of currency appreciation stands in contrast to the Chinese leadership’s stated goal of promoting more balanced growth which relies less on exports and more on domestic consumption, and its goal of curbing excessive investment growth. The host of administrative industrial policy-type measures the authorities have taken to try to achieve the adjustment, while de facto pegging the exchange rate, have not worked.

Exports and investment are booming, consumer spending continues to shrink as a share of economic activity, and gross domestic product is growing at an 11% rate – which the authorities acknowledge is unsustainable. In the first five months of this year, the Chinese trade surplus was 80% larger than in the first five months of 2006.

The Chinese current account, which was close to balance at the start of the decade, ballooned to 9% of GDP last year and is set to exceed 10% of GDP this year, according to International Monetary Fund forecasts (Chart 1). The required intervention to prevent China’s currency, the renminbi, from appreciating has resulted in staggering foreign exchange reserve accumulation (Chart 2), with reserves rising to about $1,200 billion March of this year. The role of the People’s Bank of China is subjugated to managing the exchange rate.

Impossible Trinity
China faces what economists call the impossible trinity. In theory, a country can choose two of three between a fixed exchange rate, autonomous monetary policy and free capital movements. Since China has extensive capital controls, in principle it can fix the exchange rate and still run autonomous monetary policy. But in practice, capital controls are porous. The choice therefore collapses into one between a fixed exchange rate and autonomous monetary policy. Not an impossible trinity, but an unwholesome duality. 

To prevent the renminbi from appreciating against the U.S. dollar, the People’s Bank of China must buy the U.S. dollars that enter the country in the form of trade and investment, which means printing the renminbi to do so. To date the PBoC has been fairly successful in “sterilizing” its foreign exchange market intervention by issuing bonds to domestic banks to mop up the liquidity created and avoid a surge in the money supply. But as the current account surplus and foreign exchange inflows balloon, it becomes more difficult to control the impact on domestic liquidity. And forcing the domestic banks to buy the sterilization bonds at artificially low interest rates does nothing for the health of the banking sector.

Mopping up official financial flows is difficult enough. Over time, “hot money” flows that evade China’s capital account controls are likely to become harder to handle. As trade and investment flows rise, it becomes easier for companies and investors, anticipating the inevitable rise in the currency over time, to evade the capital controls. This highlights why the tri-lemma is really more of a dilemma. The PBoC is reluctant to raise interest rates more aggressively since this would serve to encourage more hot money flows. It is not at all obvious where the neutral interest rate is for China’s economy, but it is a very good bet that it would be much higher than current levels.

Repeated increases in commercial bank reserve requirements have been the central bank’s main policy tool, and the repeated moves at least suggest seriousness of intent. But as Chart 3 shows, raising the reserve ratio has had very little impact indeed since the commercial banks collectively hold reserves above the required ratio. Actual reserves have been above required reserves going back to 2000. There is no discernable trend in actual reserves and you need to be creative to argue that the PBoC raising the required reserve ratio has had any impact whatsoever to date.

Other administrative measures appear to have been equally ineffective, based on macro data. This illustrates the broader point that, as an economy grows in size and complexity, the efficacy of administrative controls declines.

If the Chinese administration’s goal is to reduce reliance on exports and to promote domestic consumption, then the obvious thing to do is to allow a faster pace of currency appreciation. This can be achieved far more quickly than other long-term goals such as development of the financial system or greater capital account convertibility. There is also ample room for government spending, notably social spending to provide the basics of a social safety net, in order to encourage a decline in the very high level of household precautionary savings and in turn to boost consumer spending in the economy.

Inflation is not a big problem, but it is certainly picking up. Maintaining the nominal currency peg and allowing a marked rise in inflation is one way to achieve real currency appreciation, though why the Chinese leadership – focused on maintaining stability – would see this as preferable to a faster pace of nominal currency appreciation is unclear. And while consumer price inflation is not yet a problem, asset price inflation certainly is. Chart 4 shows the stock market’s incredible rise into bubble territory. One advantage of the central bank regaining control over monetary policy and raising interest rates is that commercial banks would then be in a position to offer savers a higher rate on their deposits.
 

If the authorities want to regain control over growth and investment spending it makes sense to allow the central bank to run monetary policy based on the domestic economy rather than the maintenance of the exchange rate regime.

Pointing in the Same Direction
China’s announcement of a wider band for daily exchange rate movements on May 25 looked like a symbolic gesture ahead of the second round of the U.S.-China Strategic Economic Dialogue in Washington. Since China officially ended the dollar peg in July 2005 it hardly ever tested the outer regions of the +/- 0.3% daily band in which it was allowed to fluctuate versus the dollar. So the PBoC’s announcement of a new +/- 0.5% daily band was not seen as something that is of much importance when it comes to forecasting currency movements over the next six months.

But the fact that the widening exchange rate band was announced at the same time as the latest round of monetary policy tightening was at least of some symbolic importance. An exchange rate peg undermines a country’s ability to run autonomous monetary policy. On this occasion, at least symbolically, exchange rate policy and monetary policy were working in the same direction.

There is no doubt that China’s development model has been an astounding success and that the currency peg, and openness to foreign direct investment, have played a role. As Chinese officials point out, the stability afforded by the currency regime has facilitated the absorption of rural workers into the urban economy. Looking back to the Asian financial crisis 10 years ago, by maintaining its currency peg China made an important contribution to global stability by not making a bad situation worse. But the familiar challenge with successful fixed currency regimes is the exit strategy. The lesson of history is to do so from a position of strength, rather than being forced into it during a period of weakness.

The risk of domestic overheating and asset market bubbles is one of the costs of the exchange rate regime. China faces inevitable large losses on its enormous U.S. holdings owing to the inevitability of renminbi appreciation over time. Maintaining the exchange rate pegs means that U.S. dollar-denominated assets will have to grow rapidly, even with diversification of new investment flows into other currencies and to assets other than U.S. Treasury bonds.

A further result of the currency regime is the U.S. protectionist threat. China’s exchange rate regime is not the cause of the U.S. trade deficit. But the currency regime and accumulation of foreign exchange reserves does make a large contribution to global imbalances. And part of the reason that other Asian countries have been so reluctant to allow their currencies to appreciate against the U.S. dollar is their unwillingness to allow greater currency appreciation against the Chinese renminbi. Thus, Asia as a whole has barely participated in the U.S. dollar’s depreciation since 2002.

With the buildup well underway for U.S. elections next year, no U.S. politician is going to lose any votes for attacking China on the trade issue. Foreign exchange market intervention and the build-up of reserves serve as red rags to a bull.

U.S. Playbook
Mr. Paulson brought some Wall Street know-how with him to Washington but the Treasury’s playbook has not changed. Just as the Chinese currency has emerged as a high profile matter in the U.S., in China demonstrating the leadership’s sovereignty over its own currency decisions is politically-charged. This is the reason U.S. hectoring will not lead to a faster pace of appreciation. China also has a political cycle of its own. Any radical change in approach ahead of the Communist Party’s 17th Party Congress is unlikely

The Treasury playbook has been to try to keep the noise to a minimum by emphasizing the importance of U.S.-China economic relations beyond the question of the exchange rate. A faster pace of renminbi appreciation to date would have undoubtedly made this an easier strategy to sell in Washington. As it is, the administration has been forced to get a little more aggressive, including the lodging of a number of complaints with the World Trade Organization. The Treasury, in its latest semi-annual Congressionally-mandated currency report stopped short of naming China a currency “manipulator.”⁴ Opinions differ on the importance of the report (some people don’t see it as much more trouble than it’s worth) but it is fairly obvious that branding China with the “M-word” is not going to lead to faster progress on the currency.

Protectionist pressure in the U.S. Congress is a significant source of risk to the fairly orderly global rebalancing that forms a central part of PIMCO’s global forecast for the next few years. The pot threatens to boil over with the U.S. unemployment rate expected to rise following a year of below-potential growth in the U.S.⁵

Yet there are some encouraging signs. The bill introduced by Senators Baucus, Grassley, Schumer and Graham has plenty of bark, but the bite is not as bad as it might have been. It is a far more moderate bill than the Schumer-Graham legislation it replaced, which sought a swinging tariff on all Chinese imports in the absence of greater movement of the exchange rate. Indeed, it is this greater moderation that means there is a greater chance of the bill or something similar being passed by both the House and Senate with two-thirds majorities.⁶

The bill would replace the currency manipulation judgment the Treasury makes (or rather declines to make) in its currency reports to Congress to one of “misalignment.” Given the facts, it is hard to see how Treasury could possibly conclude that the currency was anything other than misaligned. But beyond that, the bill adds up to an invitation for the administration to get tougher with China as part of a very long process, with ample opportunity for the administration to decline the invitation.

The other part of the Treasury playbook has been to ask the International Monetary Fund to play a more prominent role in defusing U.S.-China bilateral tensions by shifting to the multilateral plane. By definition, global imbalances are a matter of multilateral rather than bilateral concern. The IMF’s recent announcement that it will take a more proactive approach on global currency issues is a very welcome one. But you don’t have to be a cynic to think the announcement came a little late in the day.⁷

The IMF does not have a great deal of leverage in its dealings with China and other Asian governments, whose foreign exchange accumulation means it’s unlikely they will need to borrow from the IMF any time soon. The fund does have great experience, expertise and technical skills to bring to bear. The sad thing is that the out-dated governance structures of the fund make it so much more difficult for the fund to play the role of trusted adviser. And the attitude on reform of the U.S. and the fund’s other large shareholders suggests that anyone hoping for significant change should not hold their breath.

Secular Outlook
PIMCO’s secular outlook is for a gradual rebalancing of global growth and less reliance on the U.S. consumer. Part of this process will involve a rise in Asia’s domestic demand growth relative to overall GDP growth. We also anticipate stronger domestic demand growth in oil exporting countries as oil surpluses are converted to domestic investment. We expect that Chinese currency appreciation and broader Asian currency appreciation will play an important part in this process.

A faster pace of currency appreciation in China is likely to lead to broader Asian currency appreciation, because part of the reluctance of other countries in the region to allow their currencies to appreciate against the dollar reflects the pressure of competition from China. Yet China is not the only country in which the costs associated with tightly managed exchange rates and U.S. dollar reserve accumulation outweigh the benefits. Reserve accumulation is unlikely to grind to a halt but we expect it to continue at a slower pace. We also expect continued diversification at the margin toward higher return assets and away from U.S. assets.

The Chinese currency offshore non-deliverable forward market provides one way for PIMCO portfolios to position for an expected faster pace of renminbi appreciation. More broadly, as part of an overall positive view on emerging market currencies based on improved fundamentals and healthy global growth, we are taking on exposure to other Asian emerging market currencies in anticipation of a broader regional adjustment. Strong global growth, a reduced pace of foreign exchange reserve accumulation on the part of Asian official investors, and less recycling of petrodollars is expected to put upward pressure on global real interest rates as the “subsidy” to real rates in the U.S. and other countries is reduced and eventually removed.

The pace of Chinese currency appreciation will be determined in Beijing. The difference in time horizons between the Chinese leadership and U.S. law-makers makes U.S. protectionism remain a significant risk to the outlook.

But the conclusion Mr. Paulson came to in his speech applies to China’s domestic economic management as well as to external risks. “The greater risk for China is in moving too slowly, not in moving too quickly.”

Andrew Balls
Senior Vice President
June 22, 2007
andrew.balls@pimco.com 

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¹Paulson, Hank (2007). “China and the Strategic Economic Dialogue,” Remarks at the Heritage Foundation Lee Lecture, June 5, 2007.

²For a full account of PIMCO’s 2007 secular forum, see Bill Gross’s May/June Investment Outlook, “How We Learned to Stop Worrying (so much) and Love ‘Da Bomb’”.

³The July 2005 announcement was accompanied by an initial 2.1% step revaluation, so the cumulative appreciation has been about 8%.

⁴Department of the Treasury (2007). “Semiannual Report on International Economic and Exchange Rate Policies.” June 13, 2007.

⁵McCulley, Paul (2007). “Requiem for a Princess,” Global Central Bank Focus, May 23, 2007.

⁶A Presidential veto can be over-ridden by 2/3rds majorities in both houses in both the House and Senate.

⁷Rato, Rodrigo (2007). “Keeping the Train on the Rails: How Countries in the Americas and Around the World Can Meet the Challenges of Globalization.” Speech by Rodrigo de Rato, Managing Director of the International Monetary Fund at the International Economic Forum of the Americas Conference of Montreal, Montreal, Canada June 18, 2007.