Exchange Rates Are Relative Prices: China Edition

Or Part Two: The Real Reason Why I Feel Snarky This Week

Last week, an article by Prof Xiao Geng and our very own Tan Sri Andrew Sheng appeared on Project Syndicate (excerpt):

China’s Lonely Fight Against Deflation
…the current battle over the renminbi’s exchange rate reflects a tension between the interests of the “financial engineers” (such as the managers of dollar-based hedge funds) and the “real engineers” (Chinese policymakers).

Foreign-exchange markets are, in theory, zero-sum games: the buyer’s loss is the seller’s gain, and vice versa. Financial engineers love speculating on these markets, because transaction costs are very low and leveraged naked shorts are allowed, without the need to hedge an underlying asset. The exchange rate, however, is an asset price that has huge economic spillovers, because it affects real trade and direct-investment flows....

This is a mix of a witch-hunt, denial of economic theory and reality, flawed analysis, and historical revisionism. It's perhaps a blessing (and telling) that this appeared under the business and finance section, and not under economics.

Take two countries. Assume Country A only produces apples, and Country B only produces oranges. The (real) exchange rate of apples to oranges is, for the sake of argument, one apple to two oranges. Let's say improvements in production technology (productivity) result in the ability of both countries to produce apples and oranges doubles. Given the increase in supply of both, what's the exchange rate between apples and oranges? Exactly the same as before - one apple to two oranges.

What happens if you have an exogenous increase in the demand for oranges? Then the real exchange rate will appreciate for Country B, as they will need to supply less oranges for a single apple. What happens if there is an exogenous increase in the supply of oranges? Then the real exchange rate will depreciate for Country B, as they need to supply more oranges for a given apple. The same would be true (but flipped) if the demand or supply of apples changed.

What happens if there is a simultaneous and symmetrical increase in the demand for both apples and oranges? Then there would be no change in the exchange rate, and the same would apply for a simultaneous decrease in the supply of both.

That's the fundamental flaw in the article's argument - exchange rates are in reality relative prices, not absolute ones. Exchange rates are NOT asset prices, which implies an underlying supply and demand function. Rather, they are a vector of TWO sets of supply and demand functions, using my apples and oranges analogy. In a multi-product world, the matrix expands by the size of the production set in each country. Second is that there is a difference between the market exchange rate (dollars and yuan) and the real exchange rate (apples and oranges). Thinking of exchange rates in unilateral terms ("my country and my country alone"), is an unsound basis for this type of analysis.

Here's an example of this flawed reasoning:

For example, short-sellers portray sharp declines in commodity and oil prices as negative factors, even though lower energy prices actually benefit most consumers – and even some producers, by allowing them to compete with their oligopolistic counterparts. It is estimated that lower oil and commodity prices could add some $460 billion to China’s trade balance, largely offsetting the loss in foreign-exchange reserves in 2015.

You should see the problem immediately - as a consuming country, China does indeed benefit from lower energy prices, but then so does everyone else. If you're looking at the USDCNY exchange rate, the USD ought to be favoured, as the US is both a bigger importer of energy (about 60% more oil imports in 2012), and has a higher energy intensity of GDP. In other words, the gains to the US are bigger than the gains for China, which should result in upward pressure on the USD vis-a-vis the CNY. China (and the Yuan) gains in absolute terms, but not in relative terms. The same goes for any producing country - they might gain in absolute terms (not a given by any means), but they lose out big time in relative terms because any net gains they might have would be a pittance against that of a consuming economy. All other things being equal, their currencies should therefore depreciate (or come under devaluation pressure).

Going back to the root of the matter, as in my second oranges example above, China has built up over capacity in many tradeable areas of the economy, such as steel and cement. For the markets to clear, the REAL exchange rate HAS ALREADY fallen. What the Chinese authorities are doing in their misguided attempt at "stability" of the Yuan exchange rate, is to create a dangerous wedge between the nominal (market) exchange rate and the real (goods) exchange rate.

Much as Tun Mahathir did during the Asian Financial Crisis, the article tries to paint financial speculators as the main reason behind this pressure for the Yuan to devalue. The inconvenient and unpalatable truth is that it is mainly domestic actors - real people, real companies - who are applying the most force. The latest BIS report tracks down some of the outflows from China: three-quarters of the outflows from July-September last year was due to withdrawal of overseas Yuan deposits and US Dollar debt repayments by companies. Not exactly shadowy evil hedge fund managers gleefully rubbing their hands at their latest victim.

That's not all. The outflows began long before the financial markets actually caught on in 2014 - large illicit outflows, especially via trade mis-invoicing which the BIS is probably not tracking, has been a common feature of capital flows from China over the whole of the past decade. GFI estimates China lost US$3.8 trillion between 2000-2011, well before the opening up of China's financial system. Those outflows are really coming to the fore now, as foreign fund managers have pulled back and stopped accommodating these outflows with their offsetting capital inflows.

The attempt at revisionism doesn't stop there:

Fortunately, China’s authorities have long understood that a stable renminbi exchange rate is critical to national, regional, and global stability. Indeed, that is why they did not devalue the renminbi during the Asian financial crisis.

Those lines left me near speechless. It was China's 1994 devaluation that set the stage for the Asian Financial Crisis, by rendering at a stroke every other regional currency uncompetitive and overvalued. It is no accident that the crisis only really abated after the most affected currencies (the Ringgit, the Rupiah and the Won) had returned to their pre-1994 cross rates against the CNY. It is no accident that BNM coordinated the floating of the Malaysian Ringgit in 2005 with the PBOC's floating of the Yuan. Piously stating that China refrained from devaluing during the AFC, is like telling everybody they really should learn how to swim after giving them rocks to carry.

Lastly, the article misrepresents the choices facing China:

Nowadays, financial engineers increasingly shape the exchange rate through financial transactions that may not be linked to economic fundamentals. Because financial markets notoriously overshoot, if the short-sellers win by pushing exchange rates and the real economy into a low-level equilibrium, the losses take the form of investment, jobs, and income. In other words, financial engineers’ gain is real people’s pain.

...and...

Similarly, China’s growth slowdown and the rise of non-performing loans are being discussed as exclusively negative developments. But they are also necessary pains on the path to supply-side reform aimed at eliminating excess capacity, improving resource efficiency, and jettisoning polluting industries.

...and...

Past experience has taught China’s real engineers that the only way to escape deflation is through painful structural reforms – not easy money and competitive devaluation....

If, as I contend, exchange rates are relative prices and not absolute ones, than nominal currency "stability" is a mirage. The actual market rates of exchange are meaningless: true stability is achieved when the nominal exchange rate mirrors the real exchange rate. The wedge between the China's nominal and real exchange rates has been recognised by almost everybody, from the speculators to the man on the street. The choice here really is how to close that wedge, and who bears the pain.

The article misconstrues the impact of an exchange rate devaluation - I fail to see how devaluation pushes the real economy into a "low-level equilibrium". Most of the costs of a devaluation are borne by importers and by the loss of real income across the whole economy. But the lowering of the price level implied by a devaluation also realigns the nominal exchange rate with the real exchange rate implied by China's overcapacity. Jobs lost will be regained, and investment and income gains should resume.

Most people think of this as competitive devaluation, and that it's a zero sum game. If everybody devalues, then nobody gains, right? But China is starting off from the point of the Yuan being overvalued in the first place - in other words, it's already taking on more than its fair share of the costs of global adjustment (a point that the article is trying to make, rather poorly). Pursuing currency "stability" by anchoring the Yuan on the US Dollar has really achieved the opposite - as the USD appreciated over the past two years (and it's gone up by over 20% in trade weighted terms), it has progressively made China's nominal-real exchange rate wedge greater and harder to tackle. The recent switch to a currency basket does not help, given the pre-existing misalignment.

Conversely, taking on "painful" structural reforms means that instead of realigning the nominal to the real exchange rate, China is trying to realign the real to the nominal exchange rate. In other words, close factories, fire workers, and redeploy capital. The two issues I have with this are: the costs of adjustment are disproportionately borne by the companies that have to be closed down and the workers who've lost their jobs; and second, that this takes considerably more time and is far riskier in socio-political terms. A currency devaluation would share the pain more bearably across the whole economy, and would impact high income and middle income households more, as they will have had more access to foreign goods. But that doesn't change the relative internal cost structure of the economy. An adjustment of real supply however means the impact would fall more on lower income households, and directly threatens the stability of the financial system.

If markets were truly perfect and adjusted painlessly to changes in prices, there wouldn't be any real difficulty. If the Yuan was overvalued by 10%, then China's problem could be solved by Chinese companies cutting prices by 10% and every worker taking a 10% pay cut. The illusion of exchange rate stability would be made real. But in the real world, contracts - whether to supply goods or to supply labour or to take on debt - are defined in nominal, not real, terms. Not many companies can afford to unilaterally cut prices or wages; not many workers can afford to take a pay cut; and banks certainly would lose most or all of their capital if their loan book was marked down by 10%. In a sticky price/sticky wage world, a 10% pay cut would in reality turn out more like 10% unemployment - most people would keep their jobs and their wages, but some would lose both entirely. The required cut in capacity is achieved by putting people out of work, and keeping them out of work.

Really, what it boils down to is this: should China use fiscal policy or monetary policy? Don't believe the illusion that China is trying to do both. It's really only a binary choice.

Under the fiscal policy choice: the government should bail out affected companies, support workers until they can find new jobs, and backstop the financial system (up to and including recapitalisation). Monetary policy stimulus won’t be (and hasn't been) effective, as policy easing will at best only hold the line against capital outflows (something I’ll try to cover this week).

It will take years before a real fundamental recovery can proceed.

Under monetary policy: the Yuan should be floated, interest rates and reserve ratios cut, and the PBOC should backstop the financial system (up to and including recapitalisation). Fiscal policy stimulus won’t be effective, as government borrowing and spending would only crowd out private spending, although the government can certainly focus on long run supply side reforms.

It will take months before a real fundamental recovery can proceed.

Either way, China has to pay the piper, and there's no avoiding the pain.