Thursday, October 25, 2012

Romney's wrong on China

I've said it before, and I'll say it again: Romney is dead wrong when he criticizes China for allegedly selling us stuff at a discount. Mark Perry does an excellent job explaining why we should be thrilled if indeed China is selling us stuff at artificially low prices. But as I explained last summer, there is no reason to think that China is undervaluing its currency in the first place.

This is such an important issue that it bears repeating. I've updated some charts to make my point clear.


As the chart above shows, the Chinese yuan has been rising against the dollar ever since 1994. The Chinese are demonstrably not undervaluing their currency, they are continuous revaluing it. They have been forced to do this because of the tremendous inflow of capital to the country, which in turn has been driven by the world's desire to invest in this rapidly growing and dynamic economy. Since China's monetary policy is geared towards pegging its currency against the dollar, a net inflow of dollars and other currencies to the country obliges the central bank to buy the extra currency, thus adding to its forex reserves and expanding its monetary base. This is the way that capital inflows get turned into yuan and help the economy grow. But as the chart also shows, forex reserves swelled to over $3 trillion by last year, way more than enough to credibly back China's currency and its money supply. 

For the past year, there has been no net addition to China's reserves, which means that there is no longer a net inflow of capital to China. This could be one sign that the currency is properly valued, and/or it could be a sign of a diminished desire on the part of foreigners to invest in China, and/or diminished investment opportunities in China, and/or a greater desire on the part of Chinese to invest abroad. Whatever the case, the central bank is no longer buying foreign currency to keep the yuan from rising, but they are still allowing the yuan to appreciate. This is not the behavior you would expect from a currency manipulator. If anything, the Chinese seem to be "manipulating" their currency higher against the dollar, not lower. And they might be doing this in order to proactively deflect criticism from misinformed and misguided politicians in the US.


This next chart shows the real value of the yuan against a large basket of currencies, as calculated by the BIS. Since it was first pegged to the dollar in 1994, the yuan has appreciated in real terms by 64%! Even supposing the yuan was purposefully undervalued in 1994, it is hard to believe that it is still undervalued today. 


By pegging the yuan to the dollar, China effectively outsourced its monetary policy to the Federal Reserve. On the surface, both countries have the same monetary policy, so both should have the same inflation rate, and that is indeed what has happened, as the chart above shows. China has been living under a US-influenced monetary regime for almost 20 years now, and its economy has had plenty of time to adjust. If the yuan were still undervalued, as Romney and even Obama claim, then Chinese inflation should be higher than US inflation, but it's not.

Anecdotal evidence suggests that on the margin more companies are finding it cheaper to produce goods in the US than in China, and that's part of the reason for the stability of China's reserves over the past year. It all adds up to evidence of a sort of equilibrium having been attained between the value of the yuan, the relative price levels in China and the US. The yuan has successfully compensated for the different level of productivity and specialization in each country.

There is nothing here to worry about, with one big exception: if the US tries to start a trade war with China to force it to revalue its currency even more, then we are all going to be in big trouble. The US could suffer from rising inflation (demanding a stronger yuan is equivalent to wanting a weaker dollar), while the Chinese could suffer from deflation. It's the politicians, not the Chinese, that pose the biggest threat to the US economy.

18 comments:

Public Library said...

Good post Scott. Romney's foreign policy is frightening. He seems to lack basic macro understanding. In addition to the China rhetoric, his flawed assumptions about gas prices falls into the same bucket described above.

brodero said...

Hopefully Romney's view is just political move to get votes in Ohio....

The Roller said...

Hells bells, mate, Mitt of all people knows quite well that the name of the game is competitive currency devaluation. So, similar to our current President, this is a political tune to garner votes from those who profit from current exchange rates, or do not know better.

Mitt Romney is more about the problems with Chinese counterfeiting of products.

Scott Grannis said...

I can only hope that his economic advisors, who are good, will persuade him to refrain from taking action against China. I think Obama's advisors did the same with him, and if so, that would be the only good advice he received and took.

Bruce Bennett said...

Do you have any way to get this post to Romney? I am trying to get it to him.

Dan said...

How would a stronger Yuan affect US exports? Would a weaker dollar make it more attractive for foreign countries to buy goods and invest in the US?

Scott Grannis said...

Dan: a stronger yuan would make Chinese imports more expensive for everyone in the U.S. The argument in favor of that is that it might save some jobs in industries which compete with China. It would also make US exports cheaper for the Chinese. Those who understand trade policy and how economies work know that it is very difficult to stimulate an economy by weakening one's currency (a weaker currency dampens imports and supposedly increases exports, thus adding to GDP). A weaker currency creates upward pricing pressure, thus contributing to inflation, and it saps the foreign purchasing power of everyone in the US. It might help some industries, but at the cost of hurting everyone indirectly. Foreigners might want to buy more US-based assets because they would be cheaper, but when our government adopts a policy of competitive devaluation that tends to discourage most people from investing in dollar-based assets. In short, forcing a currency change is not likely to accomplish much in the long run, and could very well prove to be disruptive.

Scott Grannis said...

Bruce: Larry Kudlow is very vocal about this and I know the Romney people pay attention to his stuff, so it's very likely he has been advised that this is not a good position to adopt. Whether he really understands that or not is an open question.

Benjamin said...

Mitt Romney, for all of his wanton pandering to every last possible vote, strikes me as a very high IQ guy.

We print money in the USA and give it to people who send us goods and services in exchange. That is a great deal.

Later, they may buy something back from us, or invest in USA assets. Either way good for us. Oddly enough, if the Chinese buy more from us, that means some of our productive capacity is turned over to satisfying China demand, and our own living standards will go down.

My fear on Romney is different. I voted for Bush jr, the first time, thinking him to be a moderate MBA kind of guy. Instead, we got into two wars without end, cost $4 trillion and counting. Mandated ethanol boomed, and the federal deficit soared. Our financial system collapsed, housing busted, the stock market was cut in half. All while the GOP controlled DC.

Here comes Romney, again seeming like a moderate sort of MBA guy, a nice guy. But talking tough on Iran.

Now that is what is scary about Romney, not China.

steve said...

I find it extremely presumptive of you to think you academics know more than business leaders about running the US. Name the last economist who ran a successful business. As far as I know there are not any. same goes for countries. It is not the critic who counts...

Dr William J McKibbin said...

I wish I could attribute Romney's economic blusters to his "naietivity," but I seriously doubt that's the case -- we should assume that Romney says what he means, and means what he says -- for that reason, I would submit that Romney truly believes that his views on China are a problem for America's economy, and that Romney will act aggressively on those ideas regardless of what his potential advisors or anyone else suggests to him -- Romney is closet autocrat, make no mistake -- expect that Romney will do just what he says...

Gloeschi said...

Scott, why don't you calculate the purchasing power parity of the Yuan? This site finds the Yuan 32% undervalued: http://www.vectorgrader.com/indicators/ppp

Buddy R Pacifico said...

All those that favor markets must surely support a market for the yuan.

Unknown said...

Scott, I agree with your comments about the Yuan, but I don't understand this statement: "the central bank is no longer buying foreign currency to support the yuan" in the 3rd paragraph. How can buying foreign currency support the Yuan? Didn't you mean to say "the central bank is no longer buying foreing currency to keep the Yaun from rising too much?" Thanks.

Scott Grannis said...

Unknown: you are correct. I should have said "is no longer buying foreign currency to keep the yuan from rising." I will amend the post accordingly.

NormanB said...

When it costs a Chinese person living in Beijing $1,250 for an Ikea sofa that could be bought in Palo Alto, California for $750 even an economic dunce would have to assume something minipulative is occurring and since its happening somewhere else it can't be good for us in the long run.

sturdeebeggar said...

Scott,

No need to worry. Romney isn't going to do anything about banging on the Chinese about revaluing the yuan; and I think you know that. It's a campaign ploy to attract the "sway"able democrat voter in blue states that think currency levels are the reason they have lost manufacturing jobs to China, as opposed to their own closed shop, union mentality.

jimmy jam said...

its forex reserves and expanding its monetary base. This is the way that capital inflows get turned into yuan and help the economy grow. But as the chart also shows, forex reserves swelled to over $3 trillion by last year, way more than enough to credibly back China's currency and its money supply. china outsourcing