The Singapore Economic Review, Vol 50, Special Issue(2005)463-474 o World Scientific Publishing Company World Scientifi CHINAS NEW EXCHANGE RATE POLICY WILL CHINA FOLLOW JAPAN INTO A LIQUIDITY TRAP RONALD L. MCKINNON Department of Economics, Landau Economics Building Stanford University Stanford, CA 94305-6072, USA McKinnon @stanford. edu Todays American mercantile pressure on China to appreciate the renminbi against the dollar is eerily similar to the American pressure on Japan to appreciate the yen that began over 30 years are some differences between the two cases, but downward pressure on Chinese interest exchange risk could lead China into a zero interest rate liquidity trap much like the Japan has suffered since the mid-1990s Keywords: Exchange rates; China; Japan; interest rates; liquidity trap: deflation. 1. Introduction On July 21, 2005, China gave in to concerted foreign pressure some of it no doubt well meant-to give up the fixed exchange rate it had held and grown into over the course of a decade. The US Congress had threatened, and still threatens, to pass a bill that would impose an import tariff of 27.5%o on Chinese imports unless the renminbi was appreciated and pressured the US Administration to retain China,s legal status as a "centrally planned economy(despite its wide open character) so that other trade sanctions -such as anti dumping duties- could be more easily imposed. True, the actual appreciation since July 21 of the still tightly controlled renminbi has been trivial-less than 3%. And it is much less than the 20%o to 25% appreciation called for by vociferous American critics of Chinas foreign exchange policy. But the move signaled that further appreciations had become more likely in the guise of achieving greater exchange rate Aexibilit American pressure on China today to appreciate the renminbi is erily similar to American pressure on Japan that began almost 30 years ago to appreciate the yen against the dollar There are some differences between the two cases, but downward pressure on interest rates from foreign exchange risk could lead China into a zero-interest liquidity trap much like the one Japan has suffered since the mid-1990s I Many lodged in the Institute for International Economics in Washington, DC. See the articles by Fred Bergsten, Morris Goldstein, Nicolas Lardy, and Michael Mussa in Bergsten(2005)
March 20, 2006 11:33 WSPC/172-SER 00215 The Singapore Economic Review, Vol. 50, Special Issue (2005) 463–474 © World Scientific Publishing Company CHINA’S NEW EXCHANGE RATE POLICY: WILL CHINA FOLLOW JAPAN INTO A LIQUIDITY TRAP? RONALD I. MCKINNON Department of Economics, Landau Economics Building Stanford University Stanford, CA 94305-6072, USA McKinnon@stanford.edu Todays’ American mercantile pressure on China to appreciate the renminbi against the dollar is eerily similar to the American pressure on Japan to appreciate the yen that began over 30 years ago. There are some differences between the two cases, but downward pressure on Chinese interest rates from foreign exchange risk could lead China into a zero interest rate liquidity trap much like the one that Japan has suffered since the mid-1990s. Keywords: Exchange rates; China; Japan; interest rates; liquidity trap; deflation. 1. Introduction On July 21, 2005, China gave in to concerted foreign pressure — some of it no doubt well meant — to give up the fixed exchange rate it had held and grown into over the course of a decade. The US Congress had threatened, and still threatens, to pass a bill that would impose an import tariff of 27.5% on Chinese imports unless the renminbi was appreciated, and pressured the US Administration to retain China’s legal status as a “centrally planned” economy (despite its wide open character) so that other trade sanctions — such as antidumping duties — could be more easily imposed. True, the actual appreciation since July 21 of the still tightly controlled renminbi has been trivial — less than 3%. And it is much less than the 20% to 25% appreciation called for by vociferous American critics of China’s foreign exchange policy.1 But the move signaled that further appreciations had become more likely in the guise of achieving greater exchange rate flexibility. American pressure on China today to appreciate the renminbi is erily similar to American pressure on Japan that began almost 30 years ago to appreciate the yen against the dollar. There are some differences between the two cases, but downward pressure on interest rates from foreign exchange risk could lead China into a zero-interest liquidity trap much like the one Japan has suffered since the mid-1990s. 1Many lodged in the Institute for International Economics in Washington, DC. See the articles by Fred Bergsten, Morris Goldstein, Nicolas Lardy, and Michael Mussa in Bergsten (2005). 463
464 The Singapore Economic Review 2. From Japan to China Bashing To understand the origins of the foreign exchange risk that could eventually lead to a zero- interest-rate trap, consider first the earlier mercantile interaction between Japan and the United States, and then the recent trade disputes between China and the Us Figure 1(courtesy of Kenichi Ohno) shows that Japan's bilateral trade surplus, largely in manufactures, with the United States began to grow fast in the mid-1970s, peaked out at about 1.4% of US GNP in 1986, and remained substantial subsequently. Somewhat arbitrarily, I demarcated the period of intense"Japan bashing"by many Americans and Europeans as falling between 1978 and 1995. Japan bashing"came to mean the continual threat of US trade sanctions on Japanese exports unless Japan ameliorated competitive pressure on impacted American industries. Typically, these trade disputes were resolved by Japan's agreeing to serially impose temporary export restraints on steel, autos, televisions, machine tools, semiconductors, and so on, coupled with allowing the yen to appreciate. Indeed, the yen did appreciate episodically all the way from 360 to the dollar in 1971 Just before the Nixon shock) to 80 to the dollar in April 1995 By 1995, the Japanese economy had become so depressed by the overvalued yen(endaka fukyo), that the Americans relented and Secretary of the Treasury robert rubin announced a new" strong dollar"policy. The Us Federal Reserve Bank jointly intervened with the Bank Japan an+ China 10 Gope 1. Bilateral Trade Surpluses of Japan and China with the US, 1995-2004(proportion of US Source: Kenichi Ohn The syndrome of the ever-higher yen is described in McKinnon and Ohno(1997)
March 20, 2006 11:33 WSPC/172-SER 00215 464 The Singapore Economic Review 2. From Japan to China Bashing To understand the origins of the foreign exchange risk that could eventually lead to a zerointerest-rate trap, consider first the earlier mercantile interaction between Japan and the United States, and then the recent trade disputes between China and the US. Figure 1 (courtesy of Kenichi Ohno) shows that Japan’s bilateral trade surplus, largely in manufactures, with the United States began to grow fast in the mid-1970s, peaked out at about 1.4% of US GNP in 1986, and remained substantial subsequently. Somewhat arbitrarily, I demarcated the period of intense “Japan bashing” by many Americans and Europeans as falling between 1978 and 1995. “Japan bashing” came to mean the continual threat of US trade sanctions on Japanese exports unless Japan ameliorated competitive pressure on impacted American industries. Typically, these trade disputes were resolved by Japan’s agreeing to serially impose temporary export restraints on steel, autos, televisions, machine tools, semiconductors, and so on, coupled with allowing the yen to appreciate.2 Indeed, the yen did appreciate episodically all the way from 360 to the dollar in 1971 (just before the Nixon shock) to 80 to the dollar in April 1995. By 1995, the Japanese economy had become so depressed by the overvalued yen (endaka fukyo), that the Americans relented and Secretary of the Treasury Robert Rubin announced a new “strong dollar” policy. The US Federal Reserve Bank jointly intervened with the Bank -0.5 0.0 0.5 1.0 1.5 2.0 2.5 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 Japan China Japan + China China Bashing Japan Bashing Percent of US GDP Figure 1. Bilateral Trade Surpluses of Japan and China with the US, 1995–2004 (proportion of US GDP) Source: Kenichi Ohno. 2The syndrome of the ever-higher yen is described in McKinnon and Ohno (1997)
hina's New Exchange Rate Policy 465 of Japan several times in the spring and summer of 1995 to stop the yen,s going ever higher Since then, the yen has fluctuated widely(perhaps too much so), but has never again gone so high as 80 to the dollar- and Japan bashing more or less ceased. Nevertheless, Japan has still not fully recovered from its lost decade of the 1990 Now China bashing has superseded Japan Bashing. China's bilateral trade surplus with the United States was insignificant in 1986, but then began to grow much more rapidly than Japans after 1986. By 2000, Figure I shows that Chinas was as large as Japan's bilateral surplus, and by 2004, it was twice as large. However, Japan, with its still much bigger economy in 2004, had an overall current account surplus(measured multilaterally) of USS172 billion and China's was"only"US$70 billion. Nevertheless, a large and growin bilateral trade surplus concentrated in competitive manufactures with the United States has triggered US threats of trade sanctions and demands for currency appreciation-pressure that China had felt for a least four years before giving in last July Interestingly, in Japan's great high-growth era of the 1950s and 1960s, its manufactured exports to the United States grew even more rapidly than in subsequent decades, much like Chinas today. But back then, Japan had roughly balanced trade(no saving surplus) with the rest of the world. Because Japans imports of both primary products and manufactured goods, many from the United States, also grew rapidly, Americans broadly tolerated rapid increases in manufactured imports from Japan. Painful restructuring in American import competing industries were offset by export expansion, often in manufacturing. So pressure for net contraction in American manufacturing was minimal because there was no overall American current account deficit However, the situation changed dramatically in the late 1970s and 1980s when the US first began to run large overall current account deficits including large bilateral trade deficits with Japan(Figure 1). These overall deficits were widely attributed to an American Ro. ng shortage from large US fiscal deficits: the famous twin deficits of the era of President Ronald Reagan in the 1980s. Heavy US international borrowing, largely from Japan, could only be transferred in real terms by the United States'running a deficit in tradable goods or services-and Japan's principal export was manufactures. America ran a large trade deficit in manufactures, leading to a net contraction in the size of its manufacturing sector. Because political lobbies in American import competing sectors hurt by Japanese competition became stronger than those in the shrinking export sector, Japan bashing became more intense in the 1980s before peaking out in 1995 In the new millennium, Chinas emergence as a major trading nation has coincided with a new round of war-related deficitspending by the US federal government, and surprisingly low personal saving by American households -perhaps because of the bubble in US residential real estate. This American saving deficiency results in an enormous overall current-account deficit of about 6% of American gDP in 2004 and 2005-much bigger then the combined current account surpluses of Japan and China. Why then is China bashing in the US now so much more intense than Japan bashing or Germany bashing when the latter two countries still have larger manufactured exports and larger overall current account surpluses than Chinas? Because of the idiosyncratic
March 20, 2006 11:33 WSPC/172-SER 00215 China’s New Exchange Rate Policy 465 of Japan several times in the spring and summer of 1995 to stop the yen’s going ever higher. Since then, the yen has fluctuated widely (perhaps too much so), but has never again gone so high as 80 to the dollar — and Japan bashing more or less ceased. Nevertheless, Japan has still not fully recovered from its lost decade of the 1990s. Now China bashing has superseded Japan Bashing. China’s bilateral trade surplus with the United States was insignificant in 1986, but then began to grow much more rapidly than Japan’s after 1986. By 2000, Figure 1 shows that China’s was as large as Japan’s bilateral surplus, and by 2004, it was twice as large. However, Japan, with its still much bigger economy in 2004, had an overall current account surplus (measured multilaterally) of US$172 billion and China’s was “only” US$70 billion. Nevertheless, a large and growing bilateral trade surplus concentrated in competitive manufactures with the United States has triggered US threats of trade sanctions and demands for currency appreciation — pressure that China had felt for a least four years before giving in last July. Interestingly, in Japan’s great high-growth era of the 1950s and 1960s, its manufactured exports to the United States grew even more rapidly than in subsequent decades, much like China’s today. But back then, Japan had roughly balanced trade (no saving surplus) with the rest of the world. Because Japan’s imports of both primary products and manufactured goods, many from the United States, also grew rapidly, Americans broadly tolerated rapid increases in manufactured imports from Japan. Painful restructuring in American importcompeting industries were offset by export expansion, often in manufacturing. So pressure for net contraction in American manufacturing was minimal because there was no overall American current account deficit. However, the situation changed dramatically in the late 1970s and 1980s when the US first began to run large overall current account deficits — including large bilateral trade deficits with Japan (Figure 1). These overall deficits were widely attributed to an American saving shortage from large US fiscal deficits: the famous twin deficits of the era of President Ronald Reagan in the 1980s. Heavy US international borrowing, largely from Japan, could only be transferred in real terms by the United States’ running a deficit in tradable goods or services — and Japan’s principal export was manufactures. America ran a large trade deficit in manufactures, leading to a net contraction in the size of its manufacturing sector. Because political lobbies in American import competing sectors hurt by Japanese competition became stronger than those in the shrinking export sector, Japan bashing became more intense in the 1980s before peaking out in 1995. In the new millennium, China’s emergence as a major trading nation has coincided with a new round of war-related deficit spending by the US federal government, and surprisingly low personal saving by American households — perhaps because of the bubble in US residential real estate. This American saving deficiency results in an enormous overall current-account deficit of about 6% of American GDP in 2004 and 2005 — much bigger then the combined current account surpluses of Japan and China. Why then is China bashing in the US now so much more intense than Japan bashing or Germany bashing when the latter two countries still have larger manufactured exports and larger overall current account surpluses than China’s? Because of the idiosyncratic
466 The Singapore Economic Review way in which world trade, and Asian trade in particular, is organized, China's bilateral trade surplus with the United States is bigger and more noticeable to American politicians. Virtually all East Asian countries today have overall current account surpluses, and several ave bilateral trade surpluses with China. China buys high-tech capital goods and industrial intermediate inputs from Japan, Korea, Taiwan, Singapore, and European countries such as Germany -and also buys raw materials from many sources in Asia, Latin America, Africa, and elsewhere. China then transforms these inputs into a wide variety of middle-tech manufactured consumer goods for the Us market. Many of China's exports are from final processing industries, where valued added per good produced in China itself is not high because many of the components come from Asian neighbors and elsewhere However, Americans see the proliferation of"Made in China"labels in the huge influx of imported of consumer manufactures, and American politicians myopically blame China for being an unfair competitor. But China is merely the leading edge of a more general, albeit somewhat hidden, East Asian export expansion into the United States- which in turn reflects very high savings rates by Asians and abnormally low saving by Americans 3. Selective Restraints on Exports China bashing today primarily takes the form of pressuring China to appreciate its currency, or to let the yuan/dollar rate be more"flexible". China's ongoing accumulation of dollar claims from its trade surplus and inflows of foreign direct investment(FDI would lead to an indefinite upward spiral in the renminbi if it was floated. 3 By contrast, in the earlier 1978-1995 period of Japan bashing, American demands for a general appreciation of the yen were often coupled with the demand that Japan impose"vol untary"restraints on exports of particular products. Because past waves of Japanese exports into the world and American markets were successively concentrated in heavy industries such as steel, autos, televisions, semi-conductors, and so on -it made sense to soften the impact on different American import-competing industries by temporarily restricting Japans export growth in particular products. American industrial lobbies in heavy industries were concentrated and politically potent In contrast, recent Chinese exports into the American market have been low to middle ch products of light industry. Rather than being concentrated in particular heavy industries, ey are spread across the board, and protectionist lobbies for specific industries in the United States are not so ardent as in the earlier Japan-bashing campaigns. The one big exception is textiles and apparel, where Chinas position has been complicated by the expiration on January 1, 2005, of the international multi-fiber agreement(MFA)that had limited Chinese textile exports into world markets. However, as a matter of practical politics for relieving foreign distress, China could voluntarily, but temporarily, re-impose constraints on its own textile exports through tariffs or quotas -as per Japans earlier restraints on its exports- although neither were(are)legally obligated to do so 3See McKinnon(2005, Chapter 5)
March 20, 2006 11:33 WSPC/172-SER 00215 466 The Singapore Economic Review way in which world trade, and Asian trade in particular, is organized, China’s bilateral trade surplus with the United States is bigger and more noticeable to American politicians. Virtually all East Asian countries today have overall current account surpluses, and several have bilateral trade surpluses with China. China buys high-tech capital goods and industrial intermediate inputs from Japan, Korea, Taiwan, Singapore, and European countries such as Germany — and also buys raw materials from many sources in Asia, Latin America, Africa, and elsewhere. China then transforms these inputs into a wide variety of middle-tech manufactured consumer goods for the US market. Many of China’s exports are from final processing industries, where valued added per good produced in China itself is not high because many of the components come from Asian neighbors and elsewhere. However, Americans see the proliferation of “Made in China” labels in the huge influx of imported of consumer manufactures, and American politicians myopically blame China for being an unfair competitor. But China is merely the leading edge of a more general, albeit somewhat hidden, East Asian export expansion into the United States — which in turn reflects very high savings rates by Asians and abnormally low saving by Americans. 3. Selective Restraints on Exports China bashing today primarily takes the form of pressuring China to appreciate its currency, or to let the yuan/dollar rate be more “flexible”. China’s ongoing accumulation of dollar claims from its trade surplus and inflows of foreign direct investment (FDI) would lead to an indefinite upward spiral in the renminbi if it was floated.3 By contrast, in the earlier 1978–1995 period of Japan bashing, American demands for a general appreciation of the yen were often coupled with the demand that Japan impose “voluntary” restraints on exports of particular products. Because past waves of Japanese exports into the world and American markets were successively concentrated in heavy industries — such as steel, autos, televisions, semi-conductors, and so on — it made sense to soften the impact on different American import-competing industries by temporarily restricting Japan’s export growth in particular products. American industrial lobbies in heavy industries were concentrated and politically potent. In contrast, recent Chinese exports into the American market have been low to middle tech products of light industry. Rather than being concentrated in particular heavy industries, they are spread across the board, and protectionist lobbies for specific industries in the United States are not so ardent as in the earlier Japan-bashing campaigns. The one big exception is textiles and apparel, where China’s position has been complicated by the expiration on January 1, 2005, of the international multi-fiber agreement (MFA) that had limited Chinese textile exports into world markets. However, as a matter of practical politics for relieving foreign distress, China could voluntarily, but temporarily, re-impose constraints on its own textile exports through tariffs or quotas — as per Japan’s earlier restraints on its exports — although neither were (are) legally obligated to do so. 3See McKinnon (2005, Chapter 5)
hina's New Exchange Rate Policy 467 4. The Exchange Rate and the Trade balance Although temporary restraints on particular export products, whose rapid growth disrupts markets in importing countries, are all well and good, America's demand that China appre- ciate its currency against the dollar is as unwarranted now as the earlier pressure on Japan to appreciate the yen. A sustained appreciation of a creditor countrys currency against the world's dominant money is a recipe for a slowdown in economic growth, followed by even tual deflation, as Japan found to its sorrow in the 1990s. But the net effect on its trade surplus is indeterminate. Nevertheless, a reading of the recent financial press and writings of many infuential economists on both sides of the Pacific Ocean suggests that a major depreciation of the dollar is needed to correct the current account and trade deficits of the united states For this purpose, they argue, East Asian countries should stop pegging their currencies to the dollar. Especially China should substantially appreciate the renminbi and then move to unrestricted floating This mainstream view rests on two crucial presumptions. The first is that an apprecia- on of any Asian countrys currency against the dollar would significantly reduce its trade surplus with the United States. The second is that a more flexible exchange rate is needed to fairly balance international competitiveness. But under the regime of the international dollar standard, neither presumption holds empirically. Consider the effect of the exchange rate on the trade balance first If a discrete exchange rate appreciation is to be sustained, it must reflect relative monetary policies expected in the future: relatively tight money and deflation in the appreciated country and relatively easy money with inflation in the country whose currency depreciates. There are three channels through which this necessarily tighter monetary policy imposes deflationary pressure in a creditor economy that appreciates First, there is the effect of international commodity arbitrage. An appreciation works directly to reduce the domestic currency prices of imported goods whose world market prices are more or less fixed in dollars. (The pass-through effects of an exchange rate change for countries on the periphery of the dollar standard are much stronger than in the United States itself. And because domestic exports are seen to be more expensive in foreign exchange the fall in foreign demand for them directly bids down their prices measured in the domestic currency. This fall also indirectly reduces domestic demand elsewhere as the export and mport-competing sectors contract. Second, there is a negative investment effect. A substantial appreciation makes the coun- try look like a more expensive place to invest, particularly in export or import competing activities. This applies most strongly to foreign direct investment(FDI) as well to purely national firms looking to compete in foreign markets. Even foreign investment in domestic nontradables, service activities of many kinds, will be somewhat inhibited because most potential foreign investors are capital constrained. That is, they are limited by their equity positions or net worth and an exchange rate appreciation will require more equity in mCkInnon and Ohno(1997)
March 20, 2006 11:33 WSPC/172-SER 00215 China’s New Exchange Rate Policy 467 4. The Exchange Rate and the Trade Balance Although temporary restraints on particular export products, whose rapid growth disrupts markets in importing countries, are all well and good, America’s demand that China appreciate its currency against the dollar is as unwarranted now as the earlier pressure on Japan to appreciate the yen. A sustained appreciation of a creditor country’s currency against the world’s dominant money is a recipe for a slowdown in economic growth, followed by eventual deflation, as Japan found to its sorrow in the 1990s.4 But the net effect on its trade surplus is indeterminate. Nevertheless, a reading of the recent financial press and writings of many influential economists on both sides of the Pacific Ocean suggests that a major depreciation of the dollar is needed to correct the current account and trade deficits of the United States. For this purpose, they argue, East Asian countries should stop pegging their currencies to the dollar. Especially China should substantially appreciate the renminbi and then move to unrestricted floating. This mainstream view rests on two crucial presumptions. The first is that an appreciation of any Asian country’s currency against the dollar would significantly reduce its trade surplus with the United States. The second is that a more flexible exchange rate is needed to fairly balance international competitiveness. But under the regime of the international dollar standard, neither presumption holds empirically. Consider the effect of the exchange rate on the trade balance first. If a discrete exchange rate appreciation is to be sustained, it must reflect relative monetary policies expected in the future: relatively tight money and deflation in the appreciated country and relatively easy money with inflation in the country whose currency depreciates. There are three channels through which this necessarily tighter monetary policy imposes deflationary pressure in a creditor economy that appreciates. First, there is the effect of international commodity arbitrage. An appreciation works directly to reduce the domestic currency prices of imported goods whose world market prices are more or less fixed in dollars. (The pass-through effects of an exchange rate change for countries on the periphery of the dollar standard are much stronger than in the United States itself.) And because domestic exports are seen to be more expensive in foreign exchange, the fall in foreign demand for them directly bids down their prices measured in the domestic currency. This fall also indirectly reduces domestic demand elsewhere as the export and import-competing sectors contract. Second, there is a negative investment effect. A substantial appreciation makes the country look like a more expensive place to invest, particularly in export or import competing activities. This applies most strongly to foreign direct investment (FDI) as well to purely national firms looking to compete in foreign markets. Even foreign investment in domestic nontradables, service activities of many kinds, will be somewhat inhibited because most potential foreign investors are capital constrained. That is, they are limited by their equity positions or net worth — and an exchange rate appreciation will require more equity in 4McKinnon and Ohno (1997)