The contrast of the past week has been telling. In the U.S., you’ve had the yawn-fest otherwise known as the debt ceiling debate. All too predictably, the Republicans caved because their politicians will be up for re-election soon enough whereas Obama won’t be (he can only serve two terms). It wasn’t hard to work out the endgame in advance, despite all the hoopla, and the markets nailed it from day one.
What’s received far less attention is the rise of the Chinese yuan to a 20-year high versus the U.S. dollar. That’s big news, comparable to the U.S. debt ceiling resolution. And it may have a hugely beneficial impact not only on China, but the rest of the world.
The reason for this is that significant yuan undervaluation was one of the key drivers behind the 2008 financial crisis. It allowed China to become an exporting powerhouse. For that to happen though, China needed willing consumers for its exported goods and it found them in developed markets, particularly the U.S. Given stagnant real incomes, American consumers were only too happy to rack up debts to pay for these goods. And those debts eventually brought the U.S., and the world, unstuck.
Now China is actively pursuing a strong yuan policy. The reason that it’s doing this is because the country’s exporters are strong enough to withstand a higher yuan. And more importantly, China knows that it needs to re-balance its economy, which has been over-reliant on exports at the expense of consumption. A stronger currency promotes consumption as it allows the Chinese to import cheaper foreign goods and enjoy less expensive overseas holidays.
A rising yuan is not only good for China though. It also goes a long way to removing a central problem in global trade: that of a significant trade imbalance between China and America.
Today I’m going to further explore why a rising yuan is such a big deal. But also why it isn’t a cure-all for China’s problems, or the world’s for that matter. The development should be welcomed though as genuinely good news in an otherwise downbeat global economic environment.
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Economic Fault Lines
At the outset, I must confess something: I’ve developed a bit of a man-crush. It’s embarrassing because I’m not naturally inclined to put people up on a pedestal. But India’s new central bank chief Raghuram Rajan deserves many of the accolades which he’s already received.
Rajan is relevant to the discussion because of his book, Fault Lines, published in 2011. Reading through the book this week, it does a great job of outlining the underlying issues which caused the financial crisis and remain threats to the world economy today.
For those that don’t know, Rajan is famous for warning of impending economic problems at the glamorous (at least by economist standards) Jackson Hole conference in 2005. His speech went down like a lead balloon then as Alan Greenspan was still at the height of his powers and the world could seemingly do no wrong. Or at least that’s what everyone thought, bar Rajan.
Anyhow, the book details a number of the key threads from the 2005 speech. It suggests that there were four primary causes for the 2008 crisis:
- Rising inequality and the push for housing credit in the U.S.
- Export-led growth and dependency of several countries including China, Japan and Germany.
- A clash of cultures between developed and developing countries.
- U.S central bank policy pandering to political considerations by focusing on jobs and inflation at any cost.
The first cause is fascinating as it’s one that few people have focused on. Rajan suggests that rising income inequality in America created the political pressure to push easy credit conditions. Everyone knows of the increasing inequality in the U.S. but Rajan has a unique take on it, placing the blame on a poor education system and inadequate social safety nets.
Technological progress has meant that the labor force requires ever-greater skills which the U.S. education system has been unable to provide. That’s resulted in stagnant paychecks for the middle class and growing job insecurity. Politicians have felt the pain of their constituents but fixing the education system is a long-term solution which they’ve been unwilling to promote. Instead, they’ve opted for short-term fixes. Namely, they created the conditions for easier credit so their constituents could afford things via debt which they couldn’t afford via their own incomes. That ultimately contributed to the subprime and housing crisis.
This brings us to the second cause for the 2008 meltdown: the export-led growth of several countries including China. Normally, debt-fueled consumption in the likes of the U.S. would push up prices and inflation there. Then the central bank would have to raise rates to stem the consumption.
But what happened prior to 2008 was that increased U.S. household consumption was met by exporters from abroad. China, Japan and Germany needed other countries to consume their excess supply of goods and the U.S. came to the party. It was a win for the exporters and a win for the U.S. as it kept a lid on inflation. That is until high household indebtedness in the U.S. limited further demand growth and everything eventually unraveled.
Rajan describes the third cause of the crisis as a “clash of systems”. Here, he examines what pushed many developing countries towards export-oriented economic models. And he suggests the 1997 Asian crisis played a key role.
Prior to the this crisis, Asian countries weren’t net exporters. Yes, they produced exports sold overseas. But their strong growth entailed substantial investment in machinery and equipment, often imported from the likes of Germany. That meant they often ran trade deficits, having to partially fund their investments via borrowing from abroad.
The financing for the investment mainly came from the developed world. Given the lack of transparency in many Asian countries, these financiers were only willing to lend on a short-term basis. When trouble hit, that short-term financing evaporated. And the Asian crisis ensued.
Due to the crisis, Asian countries decided to cut back on debt-fueled investment. Instead, they focused on boosting exports by maintaining undervalued currencies. In other words, they went from being net importers to substantial net exporters, thereby creating the conditions for a global glut in goods.
Finally to the fourth cause of the 2008 downturn. Rajan says U.S. central bank policy poured fuel on the flames. The bank pandered to politicians wishes by keeping interest rates too low for too long. They did this to maintain high employment, one of the bank’s two central mandates. Note that keeping people in jobs was critical to assuage the masses given the stagnant incomes and inadequate social safety nets in the U.S. But low interest rates, ably aided by greedy financiers, helped create the credit bubble.
Rajan believes the four underlying causes for the 2008 crisis are still with us today and they need to be addressed if we’re to avoid further trouble.
Let’s now draw the discussion back to the significance of a rising yuan.
The Impact on China
The undervaluation of the Chinese yuan didn’t only contribute to the global problems which precipitated 2008. It also created enormous issues within China itself, many of which are still with us.
I’ve argued previously that China’s 50% devaluation of the yuan in 1994 was a critical event in recent economic history. It was one of several devaluations and resulted in a significantly undervalued yuan. That undoubtedly aided in China becoming the world’s largest exporter. The country’s entry into the World Trade Organisation in 2001 also kicked things along.
But an undervalued yuan created a long list of problems for China, including:
- An over-reliance on investment and exports at the expense of consumption. An undervalued yuan meant more expensive imports and more expensive overseas holidays, among other things.
- Negative real interest rates. Keeping an undervalued currency via a peg to the dollar meant sterilising excess yuan creation and maintaining rates below the dollar interest rate in order to avoid huge losses on dollar reserves. That pushed people out of low-yield bank deposits into stocks and property, creating bubbles in these areas.
- A side effect from the policies was that state-owned banks tended to lend mainly to state-own businesses as they were deemed less risky. This starved the private sector of funds and ultimately made them less competitive. It also led to alternative financing, such as the recent phenomenon of “wealth management” products.
These issues haven’t disappeared. Far from it. But the underlying issue – an undervalued yuan – is being addressed.
Welcoming a Rising Yuan
The above provides some context to the yuan rising to 20-year highs versus the U.S. dollar over the past week. It represents a dramatic change in Chinese policy. The country’s leaders know that the export-led economic model which has powered China over the past two decades isn’t sustainable. A stronger yuan will help re-balance the economy, with consumption becoming a larger contributor to growth.
Chinese leaders are also in the process of addressing other related issues. You should to see more on this at a key meeting of Communist Party leaders next month.
As I outlined in a previous post, likely reforms at this meeting include:
- The central government taking over key expenditure functions of local governments, including social security, compulsory education and parts of healthcare. The thinking is that there’s a substantial skew in revenue and expenditures of central and regional governments. Currently, local governments account for 52% of total fiscal revenue but 85% of expenditure. Spending at the local government level has spiked from 46% of total to the current 85%. That’s why these local governments have had to borrow money and why they’ve resorted to off-balance sheet vehicles.
- Local governments at the provincial level being allowed to issue bonds. And this financing will replace the problematic local government finance vehicle (LGFV).
- Financial liberalisation – interest rate liberalisation and RMB internationalisation.
- Hukou (resident-ship reform) being opened to small and medium-sized cities as well as a relaxation of the one-child policy.
A stronger yuan and related reforms can help put China on a more sustainable economic path. But it can also assist the global economy. With China consuming more of its production, that may mean less goods being sent overseas. That could go some way to addressing the current oversupply in goods. In other words, it could remove a key impediment to a global economic recovery.
More Work to Be Done
All of this isn’t to suggest that China is out of the woods . It isn’t. For instance, the GDP figures of the past week show that debt-funded investment remains the key driver to growth. That needs to change and further reform is required.
I’m not as optimistic as some commentators are that the transition to a new economic model will happen fast enough to prevent serious short-term pain for China. But I’m not as pessimistic as others who suggest China will go the way of Japan, which encountered similar issues as a dominant exporter in the 1980s but failed to re-balance its economy. It’s likely that China still has some time to avoid the fate of Japan.
And though a rising yuan reduces some of the global economic imbalances highlighted by Rajan, significant imbalances still remain. Japan is trying to export its way out of deflation by turning the yen into toilet paper. Germany is also committed to its export-oriented model. That means the global supply glut is unlikely to rapidly diminish, even if Chinese export growth slows from a higher yuan.
At the other end of the spectrum, reform in the U.S. is as elusive as ever. Central bankers there seem determined to reflate debt-driven consumerism. The politicians are happy to go along with this as it placates disgruntled voters, whose real wages haven’t risen over the past 20 years and worry about losing their jobs. The debt ceiling debate largely ignored these inconvenient truths.
In sum, the world’s economic problems remain acute but a stronger yuan is a welcome step forward.
