Tuesday, January 31, 2006

The Chinese currency question

I just updated the Monitoring the Chinese Currency Regime page. At the outset of this effort, I hadn't appreciated the value of monitoring as much as I do now. The way this works is that data for August, September and October 2005 were closely examined and a model was formed for this `history period', where we know it's a peg to the USD (there is no basket peg, despite claims to the contrary) with miniscule currency flexibility (despite claims to the contrary).

From 1 November 2005 onwards, we have been in the `monitoring period', where new data is compared against the model for the history period. This is a great simplification for the human mind. One doesn't have to rummage in the full set of statistical tests. It is enough to just look at the picture on the web page and you know whether something has changed.

When we had embarked on this work, I thought that the Chinese currency regime was actually evolving, so that in just a few days, the monitoring procedure would reject the null. Even doing updates once a week felt like a long time, because I thought it was a moving target. In the event, remarkably enough, the Chinese have been on one currency regime from 1 August 2005 onwards. When something changes, the monitoring will pick it up!

The world continues to buzz with the consequences of China's pegged exchange rate, and views about what should be done next. Faltering US GDP growth likely hurts deep thinking about the situation: it is likely to encourage short-termism in both the US and in China. In the meantime, the problems with global imbalances seem to only get worse every day.

On 20 January, Morris Goldstein and Nicholas Lardy wrote an important piece in the FT, titled A New Way to Deal with the Renminbi, where they offer a specific proposal to break the existing logjam through four steps:

  1. They ask that in a few months, China does a 10-15% appreciation.
  2. They ask that China substantially increase currency volatility.
  3. They say China should do a fiscal stimulus to partly/full counteract the business-cycle effects of currency appreciation. I.e., they want a bigger G to compensate part or all of the reduction in X-M.
  4. They say China should retain capital controls for now.

What would our monitoring procedure detect? If currency volatility is unchanged, but there is faster appreciation, this will show up as a bigger intercept. If there is a shift away from the USD to a genuine basket peg, which will look like higher CNY/USD volatility, then this will show up as a structural break in the coefficients of other currencies in the regression. Finally, if the peg to the USD continues, but there is greater flexibility around this peg, then it will show up in the monitoring procedure as a higher sigma.

The last point is similar to what Raghuram Rajan has been emphasising: that the open capital account and a flexible exchange rate are distinct policy decisions, and one doesn't have to embrace both at once. Raghu has also emphasised that if abrupt convertibility comes about, there can be a flight of bank deposits from households who don't trust the local currency, and that can bring about a macroeconomic crisis. I disagree in one key respect. China has a massive current account. For all practical purposes, I believe that when a country has a large current account, capital controls are ineffective, because people are able to move 10% to 20% of GDP in or out of the country through overinvoicing/underinvoicing when they have views about currency fluctuations. So Yes, this might not be as big as a flight of the domestic monetary base, but even `retaining existing capital controls' pretty much entails massive capital movements.

Goldstein & Lardy rightly emphasise at the end: Admittedly, this is not an elegant plan. But if it would break the existing logjam in addressing global payments imbalances, it merits consideration. I agree. Atleast it is a plan.

Will the world bite? I believe not. Global imbalances and global warming are similar in that the Nash equilibrium of every-country-for-itself doesn't yield a very good solution. Going beyond the Nash equilibrium requires some mechanisms for negotiations and sharing-of-pain. I worry that the world does not have the political capacity to solve the present situation, that there will be no new Plaza Accord. In the past, large economies were all in the West, where certain shared values, shared goals, and political homogeneity were able to overcome joint problems. This is the first time that a large totalitarian country is deeply embedded in the world economy. (The USSR was a different kettle of fish altogether - it wasn't as big as we think, and it didn't particularly trade).

So I worry that, as Jabba the Hut would say, "there will be no bargain". We'll then just meander on to a painful end, without Plaza Accord II or Kyoto II style solutions. In the meantime, I think we should just tighten our seat-belts by buying out-of-the-money puts on the S&P 500.

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