Exclusively from Michael Pettis’ newsletter.
The currency is merely one among several factors that are part of the rebalancing process to which Beijing is committed. The fact that the gap between nominal GDP growth rates and the base interest rate has fallen from 11-13 percentage points, just three or four years ago, to 2-3 percentage points today, and probably even less, will have had a far greater positive impact on China’s external and internal rebalancing than the appreciation of the currency.
In this light there are at least two arguments in favor of further currency devaluation and four against, and ultimately whether or not the PBoC reverses the country’s currency regime reflects the political process of weighing these arguments. The main arguments that favor devaluation are:
1. Devaluing the RMB will subsidize producers in the tradable goods sector at the expense of Chinese households. The subsidy to producers should cause them to expand production and employment and, in so doing, boost Chinese GDP growth.
2. China experiences significant speculative inflows designed to arbitrage China’s higher interest rates and appreciating currency. Because these inflows cause excessively rapid money and credit creation as they are monetized by the PBoC, a credible commitment to devalue the currency over the long term will sharply reduce the monetary pressure on the PBoC.
The main arguments against devaluation are:
1. The most important and perhaps only sustainable way to rebalance domestic demand away from investment and towards consumption is to increase the household income share of GDP. An undervalued currency is one of the mechanisms that put significant downward pressure on the household income share of GDP, and revaluation helps the rebalancing process. If the PBoC were to begin devaluing the RMB, it would require higher interest rates, faster wage growth, or increases in other transfers from businesses and the state sector to households in order to accomplish the same amount of rebalancing. All of these have costs.
2. Devaluing the RMB will spur growth and employment if Chinese unemployment or underemployment is high, as it was during the 1990s and the early part of the last decade, but it is much less obvious that it will do so under conditions of low unemployment, which is the case as of now. If it only causes wages to rise, as the tradable goods sector competes for workers, higher wages might raise household income only enough to offset the impact of higher import prices. A cheaper currency might only transfer income from households-as-importers to households-as-workers and transfer growth from the non-tradable goods sector (governments and services) to the tradable goods sector.
3. A credible commitment to devalue the RMB over the medium term will not only reduce speculative inflows but may even reverse them, meaning that combined with the significant flight capital China is experiencing, net inflows on the capital account might become significant net outflows. After twenty years of monetary expansion underpinned by huge net inflows, China’s banking system would have to operate under radically different conditions.
4. In a world of structurally weak demand, growing trade surpluses underpinned by aggressive intervention in the currency markets might expose China to serious criticism from its trade partners, and surplus countries are very vulnerable to trade.