Learning to Float
Yu Yongding
2011-03-29
Learning to Float
BEIJING – Despite shaky economic fundamentals, US government securities are usually regarded as a safe haven. Whenever a crisis erupts, the value of US Treasury bonds gets a boost. Indeed, US Treasuries were among the few assets that did not decline during the global financial crisis in 2008-2009.
But the safe-haven status of US government securities is an illusion. They are safe only in the sense that no one can stop the Federal Reserve from operating its printing presses at full speed.
The market value of Treasuries depends on a wide range of factors. Now it is essentially sustained by a Ponzi scheme, with the Fed’s policy of “quantitative easing” keeping the price of Treasuries artificially high. But, at end of the day, no currency can defy the laws of economic gravity. The market price of Treasuries eventually will fall to levels dictated by US economic fundamentals.
For decades, China has been investing its vast savings abroad, waiting for greater efficiency in domestic investment allocation before starting to dissave. China usually holds US Treasuries to maturity and re-invests the principal and proceeds. What matters is not variations in the book value of these reserves, but rather their real value in terms of purchasing power when China decides to cash in.
We do not know what the People’s Bank of China (PBOC, the central bank) is doing at the moment in the bond market. What we do know is that China should have begun exiting gradually from US government securities long ago.
But, according to US Treasury data, China’s holdings of US government securities totaled $1.16 trillion at the end of 2010, accounting for roughly 60% of the overall increase in foreign official holdings of US government debt. China’s holdings of US Treasuries increased by $351 billion between June 2009 and June 2010 alone, the largest jump on record.
The accuracy of these data is debatable. But they seem to show that, despite sharper rhetoric in Sino-US relations, China has continued lending to the US in order to keep its export machine going and avoid booking large foreign-exchange losses.
It may be too late to do anything about China’s existing stock of US treasuries without causing a serious political and financial backlash. But China should at least stop increasing its holdings. Since 2009, China’s trade surplus has dropped significantly, which many in China hail as progress in rebalancing. Yet China's 2010 trade surplus was still $183 billion; its current-account surplus soared 25% from 2009, to $306.2 billion; and its balance-of-payments surplus last year totaled more than $470 billion – the bulk of which must have been invested in new holdings of foreign-exchange reserves.
Needless to say, these surpluses reflect a gross misallocation of resources. Above a certain limit, China’s stockpiles of US treasury bonds imply welfare losses, not to mention the capital losses that the country almost certainly will suffer.
Is China destined to see the value of its savings evaporate? Given the trade and current-account surpluses, the PBOC must intervene in currency markets, buying the dollar and selling renminbi, to prevent – or moderate – the appreciation of the renminbi exchange rate. But such interventions inevitably translate into more holdings of US government securities.
To stop this accumulation of foreign-exchange reserves, and thus minimize China’s welfare and capital losses, the simplest solution would be for the PBOC to call a halt to intervention. But this implies that China must allow the renminbi to float freely, and thus to appreciate. But nobody knows by how much. China’s official position is that the renminbi is not seriously undervalued. In that case, the government should not fear the end of intervention.
Indeed, some Chinese authorities also maintain that renminbi appreciation would have no significant impact on China’s trade balance because they believe that China’s trade surplus is a reflection of excess saving and hence has nothing to do with the exchange rate. If so, there would be no need for China to worry about even a large jump in the renminbi’s exchange rate.
The true risk lies in the possibility that the renminbi is significantly undervalued and that appreciation would have a major impact on China’s trade balance. In that case, China would have to accept an export slowdown and an increase in unemployment in order to avoid huge capital losses on its dollar reserves.
Currently, the government is trying to slow the GDP growth rate, and job shortages are emerging in coastal areas. With the fiscal position still strong, the government should be able to help enterprises and workers that suffer undue pain from the renminbi’s appreciation.
Moreover, while exchange-rate policy is not an instrument for dealing with China’s domestic inflation, renminbi appreciation would certainly help the government meet its goal of keeping the annual rate below 4% in 2011. Indeed, the increase in foreign-exchange reserves has been the single most important monetary source of inflation, as the PBOC has run into trouble sterilizing the inflows. The end of intervention in currency markets would allow the PBOC to shrug off the burden of sterilization and concentrate on fighting inflation.
Ending central-bank intervention in currency markets is a complex issue. The devil is in the details. But, under any circumstances, the economic and welfare costs of China’s slow pace in adjusting the renminbi’s exchange-rate are too high and will increase by the day. It is time for China to seriously consider allowing the renminbi to float freely, while reserving the right to intervene when it must, and tighten the management of cross-border capital flows (permissible under last November’s G-20 agreements).
Yu Yongding, currently President of the China Society of World Economics, is a former member of the monetary policy committee of the Peoples' Bank of China and former Director of the Chinese Academy of Sciences Institute of World Economics and Politics.
//http://www.project-syndicate.org/commentary/yu6/English
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Inflationary Angst
Harold James
2011-04-05
Inflationary Angst
PRINCETON – Can central banks contain inflation? We once thought they could. Over the past 20 years, central banks around the world, including the United States Federal Reserve, pursued price stability with remarkable success. But now, in the wake of the financial crisis, a tide of distrust is sweeping the world – including a new and widespread fear that central banks are incapable of controlling inflation.
In the US, the Tea Party has made a return to the gold standard a part of its platform, and Utah is debating making gold and silver coins legal tender. German inflation worries have pushed the government into a much harsher stance on debt relief in Europe. In China, fear of inflation is unleashing large-scale discontent.
Inflation fear was already present before the new challenges of 2011 raised questions about long-term energy prices. As pro-democracy protests shake Arab authoritarian regimes, the prospect of sustained conflict threatens a global economy still dependent on oil, while the aftermath of the Japanese earthquake and nuclear accident raises doubts about the security of nuclear energy.
The main anchor of central banks’ monetary policy over the past 20 years was an inflation-targeting framework that developed from academic interpretation of the problems involved in targeting monetary aggregates. After successful experiments in smaller economies, New Zealand in 1990 and then Canada in 1991, and later in Sweden and the United Kingdom, the conviction developed that the new approach represented a superior way of dealing with the problem of inflationary expectations.
The really large currencies – the dollar, the euro, and the yen – were never managed explicitly or solely on this principle. But central banks in both Europe and the US thought that a 2% annual inflation rate would be a desirable target (for the Europeans a desirable maximum).
There was always a problem in this approach, namely that the general price level is an abstraction. It is a useful in a context of overall stability; but, especially during crises or in the aftermath of large shocks, there are sharp movements of relative prices.
At these moments, it is easiest to accommodate the movements by letting all prices rise, but to differing extents. Some econometric attempts have been made to identify long-term cycles in both inflation and monetary growth. The economist Luca Benati has identified such surges of underlying inflation in the last decades before World War I, the late 1930’s, the late 1960’s, and the 1970’s. He also has found evidence of a pick-up in long-term underlying inflation in the UK and the US since the early 2000’s.
The debate in the 1970’s – the period of the last general inflationary surge – has become relevant again. At that time, it was often argued that price spikes for petroleum or other commodities were somehow “extraneous” to the system, and not a reflection of the real basis of monetary policy in the industrial countries. Consequently, analyses of inflation left out food and energy prices. Today, the debate is over “core inflation,” which excludes food and energy prices because they are too volatile.
But the oil-price shocks that came after 1973 were in part also a response to the major industrial countries’ monetary policy in the later 1960’s and early 1970’s. The real price of oil seemed to be lagging behind, and oil producers’ dramatic actions in 1973 were part of an effort to correct that. Other commodity prices had risen rapidly in the early 1970’s, in direct response to monetary easing in the US and elsewhere. Shortages of natural gas increased fertilizer prices, pushing up food prices. That led to protests in many poorer countries, and to a political determination to extract additional gains from other commodity exports.
As in the 1970’s, there are more links than may at first appear between the apparently new problems of 2010-2011. Food and energy prices are more likely to be affected by monetary policy. And they produce an economic basis for discontent – which played at least some part in triggering the protests of the “Arab Spring.”
Given that food and energy prices respond to monetary developments, and thus are not exogenous, the concept of “core inflation” obviously becomes problematic, to say the least. One consequence is that Fed officials now try to avoid it. Another way to approach it is to attempt to grasp changing consumer behavior analytically.
As a result, inflation is continually being redefined. In the UK, the consumer price index is being recalculated to include new products, such as electronic dating services. It is easy to suspect that this is not just a concession to changing social mores, but that it also reflects a desire to include as many declining prices as possible.
This is less radical than the method adopted by Argentina, where high levels of inflation are both a historical nightmare and a current challenge. There, the government, whose statistical agency puts annual inflation at 10%, is punishing private-sector economists who release much higher estimates – typically around 25% – with heavy fines. The finance minister claims that there is no “structural inflation.”
As the statistical manipulation that attends uncertainty increases, confidence is eroded. A better approach is to think of the longer-term story as being one of changes in relative prices, which are not well handled by a consumer price index.
That issue is especially acute in the wake of a generalized real-estate crisis. Until 2007, many people financed consumer purchases, whose prices were more or less stable, by borrowing against their houses, which were rapidly rising in value. Consumer goods therefore seemed to be getting cheaper.
Now, by contrast, food and gasoline prices are rising, owing to emerging markets’ ongoing boom, while house prices continue to plummet. It is when we worry about relative prices that we get most angry about monetary policy – and when central banks seem to offer no answer.
Harold James is Professor of History and International Affairs at Princeton University and Professor of History at the European University Institute, Florence. His most recent book is The Creation and Destruction of Value: The Globalization Cycle.
//http://www.project-syndicate.org/commentary/james52/English
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"Teach them to think. Work against the government." – Wittgenstein.
