China's Pending Depreciation

As I prepare to begin grading final exams from my course on China's economy, let me start a series of posts stemming from my teaching this term, and from a lecture (ppt here) that I prepared for the Asian Studies program at James Madison University to my north, in Harrisonburg VA. (It's also my son's alma mater.) Here I focus on China's exchange rate.

China, as typical of many developing countries including in their day Japan and South Korea, engaged in financial repression, holding bank deposit interest rates low so as to hold bank lending rates low and thus to encourage investment. As initially capital-poor economies there's a certain logic to this, and it fit with the 1950s-1960s model of "Big Push" industrialization. This of course transfers resources from savers, who earn little on their accounts (often less than inflation), to investors. Maintaining the policy requires closing off foreign capital markets to domestic savers (and was typically accompanied by an exchange rate pegged to the US$). It also required restricting domestic options that would allow disintermediation. (In Japan, for example, domestic bond issues were severely restricted, and various policies discouraged the growth of the stock market.)

The early empirical work of Phyllis Deane and others on the British industrial revolution – with better data, now known to be wrong – seemed to show that it was accompanied by a big upturn in investment. That flawed view was carried over to W.W. Rostow's 1960 book, The Stages of Economic Growth: A Non-Communist Manifesto [which in fact employed a Marxist framework!], and was taken up across the "developing" world.

One side effect is the growth of "shadow" finance, and a quest for real assets that might offer returns commensurate with real GDP growth. (Think real estate!) That and related distortions are a topic for a later post. Here I focus on another side effect, undiversified portfolios.

Japan's case is a good example. As of the late 1970s, Japanese life insurers sat on a portfolio comprised of domestic stocks and long-term corporate loans (plus a dollop of primarily JGBs, government bonds). The issuers of these assets – and the people for whom they'd sold life insurance policies – also sat on top of a major tectonic fault, the source of the earthquake that leveled Tokyo in 1923, killing 110,000 people. They obviously had an incentive to diversify their investment portfolio against the next Big One. As Japan moved toward financial market liberalization (with major legislation passed in 1980), these insurers were initially allowed to move 5% of their portfolio into British and US government bonds. The timing was great: the initial handful of staff in London and New York bought bonds just before interest rates fell in those markets, generating wonderful returns that were amplified by a massive capital outflow that caused the yen to depreciate, giving them even better returns [my memory is that the first set of investments earned 50% – and being sent to open these overseas offices was already a signal that those people were on the radar screen of top management as up-and-coming executives]. To reiterate, the bottom line was capital outflow and yen depreciation: the yen briefly strengthened to Y180/US$ in 1978 fell to an average of ¥230/US$. Capital outflows eventually slowed (and US interest rates fell), and the yen began slowly appreciating (from ¥260 in February 1985 to ¥230 in September) and then shot up following the Plaza Accord to peak at ¥120 in December 1987 (by which time Japan's domestic real estate and stock market bubbles were building, another legacy of the end of financial repression).

China is poised to repeat Japan's experience. Shadow financing is collapsing; tales of ponzi schemes and other frothy behavior are rife. The stock market is ... stratospheric. Real estate prices are falling. And US interest rates are poised to rise. Furthermore, while the RMB has depreciated slightly against the US$ (the red line in the chart), the appreciation of the dollar against the Japanese yen and the Euro means that the "real" RMB (the blue line in the chart) has actually appreciated relative to its trading partners – to China the Euro zone matters slightly more than the US. This is the setting for a perfect storm, a scramble for the exit, which means the US dollar. If Japan's experience is any guide, the shift could be large (Japan's was 50%) and last for a half-decade.

Jeffrey Frankel points to evidence that the race for dollar assets is underway (his full blog post here, and his Project Syndicate post). China's foreign reserves are down from their peak (US$3.99 trillion to US$3.84 trillion, despite a continuing trade surplus), a current account outflow, with the Bank of China selling dollar assets to domestic holders of RMB. Absent this additional supply of dollars, the value of the dollar would rise – I append a basic S&D graph to illustrate the impact of this intervention.

As I've long warned [an earlier post], Congress should be careful what they ask for. If the Chinese stop intervening, all the forces point towards depreciation!