Time to Devalue the RMB?

Europe’s underlying problem is not budget deficits or even unsustainable debt.  These are mainly symptoms.  The real problem with Europe is the huge divergence in costs between the core and the periphery – in the past decade costs between Germany and some of the peripheral countries have diverged by anywhere from 20% to 40%.  This divergence has made the latter uncompetitive and has resulted in the massive trade imbalances within Europe.

Trade imbalances, of course, are the obverse of capital imbalances, and the surge in debt in peripheral Europe in the past decade – debt owed ultimately to Germany and the other core countries – was the inevitable consequence of those capital flow imbalances.  While European policymakers alternatively sweat and shiver over fiscal deficits, surging government debt, and collapsing banks, there is almost no prospect of their resolving the European crisis until they address the divergence in costs.  Of course if they don’t resolve this problem, the problem will be resolved for them in the form of a break-up of the euro.

The best resolution, and the one Keynes urged without success on the US in the 1920s and 1930s, is that Germany take steps to reverse its trade surplus.  It could boost disposable household income and household consumption by cutting income and consumption taxes, and as German household income grows relative to the country’s total production, the national savings rate would automatically drop and the trade surplus contract and eventually become a deficit.  Or Germany could engineer a massive increase in infrastructure spending.

If Germany doesn’t do either, and especially if it imposes austerity, there must be a surge in unemployment for many years within Europe as German excess capacity meets dwindling demand in peripheral Europe. This surge in unemployment will force the peripheral countries into the unenviable choice either of absorbing that surge in unemployment themselves, or of forcing the unemployment back onto the core countries by abandoning the currency that is at the heart of their lack of competitiveness.

The historical precedents – and much of the commentary coming out of Germany – suggest that Germany will not take steps to reverse the trade surplus.  Countries that run large and persistent trade surpluses never seem to understand that their surpluses are mainly the consequences of domestic policies that generate additional domestic growth by absorbing foreign demand.

On the contrary, they usually insist that the surpluses are the consequences of domestic virtue, and they see no reason to give up being virtuous.  Surpluses, they seem to believe, are the way God rewards them for their enviable behavior, and as their surpluses decline – an inevitable consequence of the malaise affecting their trading counterparts – they actually try to limit the decline and do all they can do to prevent it from becoming a growing trade deficit.

But this violates simple arithmetic.  Trade deficit nations have received capital inflows for many years from surplus nations as the automatic counterpart to their deficits.  If the surplus nations ever hope to get repaid – i.e. to reverse those capital flows – then it must be obvious that the trade imbalances must also reverse.

Spain, for example, can only support net capital outflows if it is running a current account surplus.  Germany can only receive net capital inflows if it is running a current account deficit.  If Spain wants to repay its debt to Germany, and if Germany hopes to have its Spanish loans repaid, this can only happen if the former runs a current account surplus and the latter a current account deficit.

When should imbalances reverse?

The Germans, however, will argue that now is not the time for them to run a trade deficit, which would be the main way of running a current account deficit, presumably because their debt burden is rising, and so cutting taxes or increasing infrastructure investment will weaken their credit at exactly the wrong time.  They need to continue running surpluses for a few more years, they will insist, to protect themselves from the impact of the European crisis.

This is insane.  Countries cannot run surpluses forever, just as they cannot run deficits forever.  For debt not to build up to unsustainable levels in the deficit countries, both deficits and surpluses must ultimately be reversed.

When is the best time to do so?  Obviously the best time to do so is before the debt becomes unsustainable and there is a financial crisis.  If we have already passed that point, however, as we clearly have, when is the next best time to reverse the trade imbalances?

The answer should be obvious – right now.  If the present is not the right time to reverse European trade imbalances so as to allow the deficit countries to earn the wherewithal to support capital outflows, then when will it ever be the right time?  And by the way, as long as we are concerned about protecting German’s credit, if Spain cannot run a trade surplus, it cannot repay the debt it owes to Germany.  This also is just arithmetic.

This means that German reluctance to put into place policies that reverse the trade imbalances within Europe is illogical.  As the market has already indicated by its panic over European credit, German credit will be far more seriously damaged by defaults in the peripheral countries than by a cut in domestic income and consumption taxes, or by a surge in domestic infrastructure investment.

To make matters worse, it seems that not just debt prices but also credibility are in free fall.  Here is an astonishing quote from Christian Noyer, the Governor of the Bank of France and an ECB policymaker, according to an article in Saturday’s Telegraph:

“The downgrade [of France] does not appear to me to be justified when considering economic fundamentals,” Mr Noyer said in an interview with local newspaper Le Telegramme de Brest.  “Otherwise, they should start by downgrading Britain which has more deficits, as much debt, more inflation, less growth than us and where credit is slumping,” he went on.

This was followed by the no less astonishing comments by François Baroin, French finance minister, who said: “The economic situation in Britain today is very worrying, and you’d rather be French than British in economic terms.”

Wow. This kind of fighting among countries is childish but unfortunately all too predictable given the historical precedents.  The English probably started the fight with some skeptical comments by Mervyn King, the Bank of England governor, about the health of the euro (not that he was wrong, just very indiscreet), but the French response has been a little out of control.

Aside from the fact that Mr. Noyer seems to have a limited concept of sovereign credit (France is not being considered for downgrading because of its explicit government deficits or its high inflation), these various statements should worry anyone who believes that the European crisis cannot be resolved without cooperation among European policymakers.  If they are so obviously squabbling, the skeptic in me wonders whether they really believe they can resolve the crisis, or whether they have already given up and are now preparing to assign blame.

Time to devalue the RMB?

There isn’t nearly as much (at least visible) antagonism and undermining behavior among Chinese policymakers, but I worry that there is nonetheless the same lack of logical thinking among them in regards to their “right” to a trade surplus – although at least they are not facing massive defaults in the countries to whom they have lent.  As China’s trade surplus declines dramatically, more and more people within the country are calling for interventionist steps to halt the decline, including depreciating the RMB, or at least halting its appreciation.

The rapid contraction in China’s trade surplus, they say, is evidence that China is rebalancing too quickly.  Already the Ministry of Commerce is issuing warnings.  This article is from Friday’s People’s Daily:

China’s trade will face ”very severe” conditions in the first quarter next year, a spokesman for the Ministry of Commerce said yesterday.  “The external economic climate will become very complicated next year, and net exports are set to slow,” Shen Danyang said.  “We will further accelerate reforms to achieve a better balanced trade and make overall trade remain a positive contribution to the economy. 

For trade to make a positive contribution to growth, of course, China must maintain a trade surplus – in a world of stagnant demand, only net demand from trade, that is a trade surplus, can contribute to growth. Trade deficits reduce demand, and I suspect that in spite of long insisting that the US trade deficit has not been negative for US growth, the Ministry of Commerce is unlikely to be as forgiving of a Chinese trade deficit.

But we would have to ask the same question of China as we would of Germany: if now is not the right time for China to run a trade deficit, when its reserves are sky high, when rebalancing the Chinese economy away from investment to consumption is more urgent than ever, when global imbalances have thrown the world into crisis, when will it ever be the right time?

Not next year, apparently. There is developing in Beijing, I think, almost a panic about global economic prospects and the impact of the European crisis on China.  This panic is going make the rebalancing process harder than ever because a Chinese rebalancing almost necessarily requires a rapid slowdown in growth as investment decelerates sharply long before a rise in consumption can take up the slack. Weakness in the export sector makes the slowdown all the more costly.

Certainly the focus of the very important central economic work conference that ended this week suggests that maintaining growth is the key. Here is Saturday’s description in the People’s Daily:

China’s economic objective in 2012 will be to seek relatively fast growth while maintaining stable consumer prices, said a government statement issued yesterday, wrapping up the three-day central economic work conference.

“The theme of next year’s economic and social development is to make progress while maintaining stability, which means to maintain basically steady macroeconomic policy, relatively fast economic growth, stable consumer prices and social stability,” the statement said.

That sounds pretty reasonable.  However the Financial Times’ version of the story, perhaps not surprisingly, is a little more explicit:

China’s ruling Communist party wrapped up its most important economic meeting of the year with an agreement to focus on maintaining fast economic growth in the midst of what it described as an “extremely grim and complicated” global outlook. The annual three-day Central Economic Work Conference for top Communist officials sets policy for the coming year and this meeting clearly signalled that the leaders of the world’s second-largest economy are concerned about a slowdown in growth.

“Growth has replaced inflation as Beijing’s top policy concern,” said Qu Hongbin, co-head of Asian economics research at HSBC. “The economy is likely to slow further, calling for more aggressive easing measures.”  At the same conference last year, China’s leaders explicitly named taming inflation as the key policy goal for 2011.

The slowdown in growth is worrying an awful lot of people in Beijing and with all this concern, of course there is a lot of attention on trade policy.  Will the RMB appreciate or depreciate in 2012?  Within China many are going to argue that the rapid decline in the trade surplus, coupled with unmistakable evidence of flight capital, means that the PBoC should devalue the RMB.  Others within China will argue that debt levels and domestic imbalances are so worrying that the RMB should continue appreciating in order to speed up the pace of rebalancing.

If this were the whole extent of debate, it would be pretty easy to guess that the former side would win, but of course there is also international pressure.  Foreigners are going to argue that China’s maintaining a trade surplus will simply subtract from foreign growth, and given higher unemployment and lower growth in the US, Europe, and much of the developing world, China has no natural right to insist on a trade surplus at their expense.

With the trade environment getting worse all the time, I suspect that international pressure is ultimately going to decide the issue.  If China depreciates it will almost certainly set off furious retaliation – and remember, surplus countries always lose trade wars.  Deficit countries often win, at least in the near term.

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About Michael Pettis 166 Articles

Affiliation: Peking University

Michael Pettis is a professor at Peking University's Guanghua School of Management, where he specializes in Chinese financial markets. He has also taught, from 2002 to 2004, at Tsinghua University’s School of Economics and Management and, from 1992 to 2001, at Columbia University’s Graduate School of Business.

Pettis has worked on Wall Street in trading, capital markets, and corporate finance since 1987, when he joined the Sovereign Debt trading team at Manufacturers Hanover (now JP Morgan). Most recently, from 1996 to 2001, Pettis worked at Bear Stearns, where he was Managing Director-Principal heading the Latin American Capital Markets and the Liability Management groups.

Visit: China Financial Markets

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