China’s long-awaited shift in currency policy is an important milestone on the road to global rebalancing. Yes, the initial 2% renminbi revaluation was small, and, in and of itself, will accomplish very little. But this was not the point of the 21 July action. By finally putting a flexible currency regime in place, the Chinese leadership has removed an important impediment to global rebalancing. That raises the probability of a “benign” rebalancing endgame.
China understands that a 2% currency adjustment is only a down-payment on a much larger revaluation. Yet my suspicion is that just as America’s Federal Reserve doesn’t know with great precision what the “neutral” federal funds rate is, Chinese authorities do not have a precise target for the RMB. While that introduces a certain ambiguity to the currency endgame, the good news is that Sino policymakers have finally activated the currency lever as a legitimate tool of macro stabilization policy. They know full well that external considerations — especially political pressures from the US, China’s largest export market — point to a much larger adjustment. But China will balance these external pressures against far more important domestic considerations — namely, sustainable economic growth, ongoing reforms, and stable unemployment.
The net outcome for the RMB is hard to predict with any great precision. I suspect the Chinese authorities — like America’s Fed — will adopt a “measured” pace toward subsequent currency adjustments — with a careful eye toward weighing the balance between domestic and external considerations. Inasmuch as domestic stability always remains of paramount importance for the Chinese leadership, subsequent moves are likely to be small and spread out over time. My guess is that a year from now, the RMB could be about 10% higher against the US dollar — stopping well short of what Washington’s most strident China-bashers are seeking (27.5%) but a major break from the decade-old peg. Given the new basket reference framework, appreciation of the broader trade-weighted RMB could be less than that against the dollar — depending, of course, on how the dollar fares in foreign exchange markets.
The global impacts of this development cannot be minimized. As a general rule, the most important thing to keep in mind is that currency adjustments need to be treated as relative price shifts. Accordingly, a revaluation of the RMB is likely to have more of an impact on the mix of global activity than on its level. At the same time, financial-market effects should show up more in the form of shifts in spreads between asset prices rather than in their absolute levels.
For China, that means a stronger currency will undoubtedly put pressure on its export-led growth dynamic. This conclusion could well apply to other Asian economies as well. Since the financial crisis of 1997-98, Asia has become an increasingly China-centric region. It follows that Asian currencies are likely to mirror adjustments in the RMB — precisely the market’s initial response to the 21 July move. If, in fact, Asian currencies continue to move in concert with subsequent RMB adjustments, the pan-regional export-led growth dynamic could also become increasingly challenged, in my view. This will heighten the pressure on China and the rest of Asia to stimulate domestic demand in order to compensate for a shortfall in external demand — facilitating a long overdue rebalancing of the pan-regional economy. This will also have the important effect of absorbing the region’s excess saving — especially for developing Asia, where the overall saving rate is estimated to have surged to 38.2% in 2004 relative to the 28.8% norm of the 1983 to 2000 interval.
This takes us to the other side of the rebalancing equation — namely, to the Asian-led financial flows that have become critical to the sustainability of America’s imbalances. With Asian currencies now in play and focus shifting to stimulus of the region’s domestic consumption, Asia’s so-called “saving glut” should be drawn down — thereby curtailing the external funding available for the massive US current account deficit. At the same time, China’s shift to a currency basket hints at a long overdue diversification of Asia’s enormous portfolio of official foreign exchange reserves. According to the Bank for International Settlements, pan-Asian reserves (including Japan) totaled $2.4 trillion as of February 2005 — fully 64% of the global total. The BIS also estimates that dollar-denominated assets accounted for about 64% of the world’s total foreign exchange reserves in early 2005 — well in excess of America’s 30% share in the global economy (at market exchange rates). These trends are not sustainable, in my view.
By abandoning its peg, China is sending a clear signal that its “natural” demand for dollar-denominated assets is likely to be reduced. Stephen Li Jen notes that China’s trade weights would imply only a 27% weight of the dollar in the new currency basket; adding in the still dollar-pegged Hong Kong currency would raise the dollar weight to about 50% — well below the current 64% portion that the BIS would impute to the dollar-denominated share of official reserves. Other Asian central banks have also been massively overweight dollars, and they are likely to rebalance their reserve portfolios as well. That’s especially true of the Bank of Korea, which has expressed such concerns several times in the past year. It is also true of the Bank Negra Malaysia, which was quick to dismantle its peg in favor of a basket system in the immediate aftermath of China’s 21 July move. Collectively, Korea and Malaysia held $272 billion in official foreign exchange reserves in early 2005 — amassing Asia’s third largest reserve pool behind Japan and China. Monetary authorities in both of these countries can now be expected to diversify out of dollars.
Dollar diversification could well set in motion adjustments that might prove quite vexing to America’s asset economy. Other things being equal, dollar diversification is tantamount to dollar depreciation. And that raises the distinct possibility that America’s creditors will then seek compensation in the form of an increased interest rate premium. The key in this instance is the pace by which that compensation is provided. Under the presumption of a gradual further revaluation of the RMB, that premium should be reflected mainly in the form of wider spreads, or yield differentials, between US- and non-dollar-denominated interest rates — precisely the markets’ reaction in the immediate aftermath of China’s 21 July action. In the event of a disorderly diversification out of dollars, both the level and the spreads of US interest rates could be adversely impacted. That would then put significant downward pressure on ever-frothy US property markets and on asset-dependent American consumers. While I would attach a low probability to the dollar-flight scenario, I would certainly concede that it shouldn’t be ruled out.An orderly RMB revaluation should not, however, lead to a back-up in the level of US interest rates. That possibility, in my view, is more dependent on domestic considerations such as the US inflation outlook. While many still believe that currency devaluations are inherently inflationary — an outcome that could well put pressure on the level of US interest rates — that impact seems to have diminished sharply in recent years.
Nor do I believe that this shift in Chinese currency policy will lead to higher levels of real world interest rates. At the margin, China’s new currency regime should temper its export-led growth dynamic and compound the downshift that might have arisen in any case from an “over-invoicing” of Chinese exports in the first half of 2005. Recent efforts to contain China’s residential property bubble work in the same direction. Without an offset from private domestic consumption, the case for a China slowdown remains very much intact. Consequently, if China still slows, as I suspect, there is good reason to believe that an increasingly China-centric Asian economy will be quick to follow — imparting a meaningful drag on world GDP growth. Moreover, a China-led Asian slowdown would curtail demand in the world’s most commodity-intensive region, thereby imparting a downward bias to commodity prices, including oil. Such an outcome has always been an important factor shaping inflationary expectations at the long end of the yield curve. In my mind, it has always made sense to bank on a China slowdown — very much consistent with our long-standing forecast of 7% real GDP growth in 2006. The shift in Chinese currency policy is very much in line with this presumption.
All this is good news for the benign strain of global rebalancing. By putting its currency into play, China tempers the threat of protectionism. At the same time, China is now conceding the downside risks to its all-powerful export trajectory, which, in conjunction with an investment slowdown, should temper its overheated excesses. As a result, China’s shift in currency policy could well swing the pendulum of global adjustment back to the United States, where asset-dependent consumption excesses remain a great source of concern. Spread considerations keep US rates biased to the upside. But I am not yet convinced that the overall level of real US interest rates is likely to rise enough to spark a more disruptive strain of global rebalancing. Given the unprecedented state of global imbalances, that could well be the best news of all.
By Stephen Roach, Morgan Stanley EconomisAs published on the Global Economic Forum