Recently in Economics--China Category

Meanwhile, on the other side of the Pacific...

From Reuters:

BEIJING (Reuters) - China's high January and February readings for inflation have increased the pressure on the government to take action to counter price rises, Commerce Minister Chen Deming said on Wednesday.

Annual consumer inflation jumped to 8.7 percent in February after hitting 7.1 percent in January, the worst in more than 11 years.

I didn't see anyone else reporting this. (Via Reuters)

BEIJING (Reuters) - China raised its benchmark interest rates on Thursday for the sixth time this year, in the latest in a series of tightening steps to contain inflation and prevent the world's fourth-largest economy from overheating.

...

China is battling inflation of 6.9 percent, an 11-year high, which until now has been driven by soaring food prices but has shown worrying signs of spilling over to the broader economy.

A few days ago, it was the required reserve ratio, as the Wall St. Journal reported on December 10:

BEIJING -- In its first move since officially shifting to a tight monetary policy last week, China's central bank said it would raise the share of deposits that banks must keep on reserve for the 10th time this year to help cool the economy.

The increase in the required reserve ratio, which will rise by a full percentage point, could signal an acceleration in Beijing's efforts to bring the country's high inflation rate, and the threat of economic overheating, under control following a key meeting. The Central Economic Work meeting, which laid out economic policy priorities for 2008, ended Wednesday.

Rising inflation in China may be one of the most underreported stories out there right now. It's very simple. The Chinese government is finding out that when you open up capital markets, you make it harder to sterilize the currency interventions necessary to maintain control over their exchange rate. And it is this simple fact that has for years led me to believe that China can only wait so long before they approach something that resembles a floating exchange rate.

Early in this decade, shortly after it was announced that the Olympics would be in Beijing, I told people that 2008 might be the year.

So then there was this from Bloomberg yesterday:

Dec. 20 (Bloomberg) -- The yuan rose for a third day against the dollar as the U.S. Treasury refrained from naming China a currency manipulator in its semi-annual review of exchange rates.

Treasury Secretary Henry Paulson reiterated yesterday that China should let the yuan appreciate at a quicker pace and said gains since the currency's link to the dollar was scrapped in 2005 are ``not fast enough.'' Paulson was in China last week as part of talks to urge the nation to increase flexibility in the yuan to offset lopsided trade and help slow China's economy.

"It's good China wasn't labeled a manipulator,'' said Liang Futao, an analyst at Shenyin Wanguo Research and Consulting Co. in Shanghai. "The government may keep allowing the yuan to rise next year to help reduce import prices and ease inflation.''

The yuan advanced 0.1 percent to 7.3694 per dollar as of the 5:30 p.m. close in Shanghai, from 7.3768 yesterday, according to the China Foreign Exchange Trade System. The yuan has gained 6 percent this year, adding to the 3.4 percent pace in 2006.

So how much do YOU think the yuan will appreciate in 2008? More than 6 percent?

I think it is very telling that the U.S. did not label China a "manipulator" and that the rhetoric has cooled, albeit slightly. Sometimes the best clue is from the dog that didn't bark. If I were negotiating with China, knowing the importance of saving face in the Chinese culture, I would definitely back off if I thought that there was a chance that they were about to do give a little of their own accord.

It has always been my prediction that the yuan would appreciate when it is in China's best interest to do so, and that the Olympics in 2008 might signal a particularly good time for a significant change. With inflation building due to the opening of credit markets, it looks like things are happening right on schedule.

John Palmer reads this article in The Economist on Chinese inflation and points out the four... count them, four... things they missed.

UPDATE: Thomas Palley also has a post on Chinese inflation that gets it right.

Seems like just a month ago. Oh, right, it was just a month ago. Via China Daily:

China's central bank raised the benchmark interest rates on Tuesday for the fourth time this year in an effort to prevent the economy from overheating and curb accelerating inflation.

The one-year deposit rate will increase 27 basis points to 3.60 percent, while one-year lending rate will rise by 18 basis points to 7.02 percent, effective on Wednesday, the People's Bank of China said in a statement on its website.

And it won't be the last, either. Real interest rates are still negative.

The inflation rate is also higher than the deposit rate, indicating a loss of purchasing power if people put their money into banks.

The low interest rate policy has somewhat encouraged an exodus of bank savings to the country's skyrocketing stock market, which has soared more than 80 percent so far this year on top of a 130 percent rally in 2006.

Somewhat? Make no mistake. Policymakers are concerned about this, and rightly so.

Compared to Friday the news is that there isn't much news on the liquidity front. The Fed today injected only $2 billion. That effectively takes out nearly all of what they put in on Friday. There still is an extra $12 billion or so from a 14 day repo that took place last Thursday. But the upshot of all of this is that according to CNBC the fed funds rate is trading at or just a little higher than the target.

In other words, nothing too out of the ordinary, and the Fed might just be content to let the funds rate sit a little bit higher today. It's as if they are telling the market not to count their chickens before they are hatched when it comes to that rate cut the street has been calling for. Everybody and their brother is talking about moral hazard, and rightfully so. It is still my opinion that a rate cut is not desirable and would only be used if something like what happened on Friday turned into something close to a true global meltdown.

But it didn't. Mr. Bernanke won this one. He stared down the analysts calling for a rate cut and didn't blink. He did exactly what was required of him and the Fed. Simply put, the funds rate started trading above the target on Friday. So the Fed injected the liquidity to get it back down to the target. Full stop. Nice job.

As I watched CNBC this morning, I also began to get a fuller sense, as did anyone else who was listening carefully, of what was really happening. I heard one of the analysts say that the leverage in the hedge funds had dropped dramatically and that a significant amount of cash had been injected into those funds. That, of course, is exactly what needed to be done, and when you step back and think about it, everything that happened on Friday starts to make sense. A lot of people were in some pretty risky positions and got out of those positions and onto firmer ground. Of course, on Thursday and Friday, without knowing what was really going on it looked like more of a panic. If it is true that the leverage has decreased, then there should be less of a chance of something like that happening again, or worse.

Are the hedge funds and the other big financial firms hunkered down to weather any more fallout from subprime delinquencies? We can hope so. And if it is so, it is largely because of the Fed's injection of liquidity on Friday that made that process take place in a more orderly fashion. When the final story is written, that action may look pretty heroic. But like all good heroes, the Fed would say they were just doing what needed to be done.

Of course, hearing that July retail sales were up more than expected also helped everyone get off to a good start today. But I want to call your attention to some other news, which I think will be the most under-reported story of today.

China's inflation rate now stands at 5.6% with food prices rising around 15%. Why mention that in the context of what the Fed is doing? Because just as the Fed has to be on guard for deflationary pressures being transmitted internationally, they need to be on guard from inflationary risks overseas. Higher prices from China are already showing up on our shores. The Fed needs to make sure that we don't end up importing inflation from China.

Of course that was far from our minds on Friday, and rightfully so. However, with that danger passed, at least for now, we need to keep an eye on the other risks out there.

In my macro courses, I point out that the required reserve ratio is seldom changed in the U.S. It is a blunt instrument for conducting monetary policy. In a stable and well-regulated monetary system, there really isn't much reason to touch it. However in systems marked by tremendous change and growth raising the reserve ratio can be an effective way to attempt to restrain the growth of credit and prevent inflation pressures. Hence, China has raised their required reserve ratio five times already this year.

Make that six. Effective August 15, the required reserve ratio for most large banks will be 12 percent, a half-percent increase. From China Daily:

The central government has vowed to prevent the economy from overheating; and the central bank said the hike in the reserve requirements was aimed at "strengthening management of liquidity in the banking system and control excessive growth in money supply and credit".

The broad measure of money supply, or M2, grew by 17.1 percent year on year in June, which was higher than the target of 16 percent set by the central bank for this year.

The latest step follows the raising of benchmark interest rates by 0.27 percentage point on July 20 and cutting the tax on interest income from 20 percent to 5 percent in a coordinated move to reduce liquidity and stabilize the blistering economy.

"The liquidity situation has become more and more serious," said Zhao Xijun, finance professor at Renmin University of China.

Indeed. The expectation is that the required reserve ratio will need to be increased even further just to keep up with the growth of liquidity resulting from their large trade surplus.

This is old news, but here it is anyway. On Friday, China announced an increase in their benchmark interest rate. Via the Wall Street Journal:

From Saturday, the benchmark one-year lending rate will rise by 0.27 percentage point to 6.84%, while the benchmark one-year deposit rate will rise by the same margin to 3.33%, the People's Bank of China said. The changes will help "regulate and stabilize inflation expectations, and maintain stability in the price level," the central bank said.

While that language was broadly similar to statements the central bank made announcing rate increases in March and May, the reference to controlling inflationary expectations is new. That may show the central bank wants to prevent the recent surge in food prices from causing broader inflationary pressures, such as a demand by workers for higher wages to compensate for higher food prices.

In addition, the Chinese government cut a tax on interest which increases the effective rate of return experienced by depositors.

Two observations are in order. First, this will not be the end of the rate increases. The temptation to use a phrase like "measured pace" is hard to ignore. Second, as the Chinese continue to slowly let the yuan appreciate and move toward freer capital markets these pronouncements from the People's Bank of China will become as important and interesting for the global economy as press conferences from the ECB and statements from the Fed.

James Pethokoukis asks Minxin Pei about recent problems with the quality of Chinese goods. Here is one question and answer that speaks volumes.

Pethokoukis:

The average American probably thinks of China as having an all-powerful authoritarian government. How easily can it institute changes that would improve product quality?

Pei:

China has a strong, authoritarian central government only in name. In reality, power in China is diffuse and decentralized. Beijing can issue orders, but it cannot expect its orders to be carried out by local officials. At the local level, officials with real power are often connected with manufacturers through family ties or economic connections. Producers of shoddy, fake, or outright dangerous goods are often protected by local officials whom they have bribed or given shares in their firms.

China is also so large that enforcing strict quality rules requires a much larger bureaucracy. Therefore, it is not easy for Beijing to impose changes that would improve product quality very quickly. However, crisis can spur action. Right now , Beijing feels it is under siege, so it is taking steps to address the quality issue. The real challenge is to introduce durable reforms. Otherwise, the quality problem will be back in two or three years.

Go read the rest.

Don Boudreaux scores the first hit, and it's a beauty.

I suspect that if someone proposed to Dani Rodrik that he explore the wealth-creating potential of state-level protectionism, he would refuse. He would likely (and correctly) say that it's ridiculous on its face to suppose that such protectionism would make the people of Tennessee as a group wealthier over time. If my suspicion is correct, then to what would Rodrik himself attribute his out-of-hand dismissal of the notion that Tennessee tariffs might well make Tennesseeans richer? Would he realize to his chagrin that he is a benighted, faith-based non-scholar? Or would he instead understand that the case for an extensive, market-driven division of labor is so strong -- and that the political border that separates Tennessee from other states is so economically meaningless -- that it would be as pointless for a serious economist to explore the economic potential of Tennessee protectionism as it would be for a serious oncologist to try to cure a patient of cancer by bleeding that patient with leeches.

Dani Rodrik battles back.

Let me confirm Boudreaux's suspicion that I would indeed be against imposing intra-state trade restrictions in general (or to be more precise, that I would have a strong presumption against them). So the question he asks is an important one. Why then do I not take an equally strong position against trade restrictions in international trade?

The answer is that the parallel is misleading in this context. The two situations are alike only in the limiting (and counterfactual) case where government-imposed tariffs are the only transaction costs blocking economic exchange across international borders. In reality, national borders demarcate political and legal jurisdictions, which means that there remain plenty of transaction costs which block economic convergence. Capital flows are hindered by sovereign risk and the absence of international regulation and lender-of-last resort functions, which create the kind of syndromes that I often discuss in this blog. Labor mobility is severely restricted. And differences in regulatory regimes impose severe transaction costs (estimated by Jim Anderson and Eric van Wincoop to be of the order of 40% in tariff equivalents) on international trade. In the presence of these transaction costs, free trade in goods (in the sense of zero import tariffs) is in general incapable of achieving rapid economic growth and economic convergence in poorer nations of the world. If you do not believe this, just ask the Mexicans.

Within this U.S., economic convergence is achieved because there is a common constitution, a federal judiciary, nation-wide financial regulation, and free flow of labor. This ensures that a lagging region (such as the South until recently) catches up by a combination of capital coming in and labor moving out. Neither of these channels are operative in a world economy that is divided into nation-states. Removing restrictions on international trade in goods, services, and capital simply does not do it. Trade ends up being too small, and capital flows in the wrong direction (from poor to rich countries).

Integration normally proceeds (e.g. the European Union) from free trade area or customs union, to monetary union, to political union. Europe is trying to make the last step, and it's not an easy one. Here in the U.S., the framers of the constitution were smart enough to establish the fledgling country as a customs union and monetary union. This was in order to form a more perfect political union that that Articles of Confederation was unable to deliver.

Unfortunately, this does not stop the states and localities from pursuing other policies (wooing multinational factories, establishing tax-increment financing districts, etc.) that do with a series of knife cuts a bit of what a tariff would do with a hatchet blow.

Such behavior, when done by all, would result in something that resembles the suboptimal outcome of a prisoner's dilemma. There are, however, probably some asymmetries that would lead to some states winning a tariff war with other states. California vs. Hawaii would probably not be a fair fight, for example. Whether Tennessee has that sort of bargaining power is left to the reader to contemplate.

That there are strong arguments and historical precedent for the usual progression of these economic unions plays into Boudreaux's stand. It would be self-defeating to move backward.

And similarly, Rodrik's position is that where the political (and even monetary) unions do not exist, there is no reason to presume the same prohibition on trade protection you would expect in a political union like the U.S. He can't resist one more jab at Boudreaux.

There is of course the option of global federalism (creating a U.S. or an EU at the global level)--but that does not seem a realistic option anytime soon. I doubt that Don Boudreaux would go for it in any case.

Brad DeLong scores it a knockout for Boudreaux.

The knockout punch, of course, is that Dani Rodrik's country whose "labor force that is producing at low levels of productivity" is doing so because it has lousy political institutions: it lacks the "constitution... judiciary, nation-wide financial regulation, and free flow of labor" that have underpinned economic growth in the rich post-industrial core. The poor country is poor because its government is incompetent, and corrupt.

And yet Dani wants--in this situation--to enhance and extend the role and powers of the poor-country government by asking it to implement an active protectionist industrial policy because "there exists a bunch of arguments having to do with learning and (domestic) market failures under which subsidization of tradable activities could speed up your economic growth."

Certainly many countries are poor because their government is incompetent and corrupt. But I find it hard to accept this as a blanket statement. So does Rodrik, who responds:

No, the argument that poor countries are and remain poor because their governments are incompetent and corrupt is one of the absurd reductionisms of the day which I do not believe in and have written against. The point I made was that a poor country would have the real prospect of converging in living standards with rich countries if international economic integration were near-total (involving free labor mobility, truly integrated capital markets, and a transnational set of regulatory, legal and political institutions that underpin this integration). In the absence of these, trade liberalization does not get you there. You are in a second-best world and you need to think appropriately. The idea that developing countries cannot employ industrial policy in such a world to good effect is downright silly.

Here is a thought experiment: does anyone really believe that China would have grown as fast as it did if it had removed all its tariffs and trade restrictions in 1978, instead of liberalizing strategically and sequentially--first in agriculture, than in industry, then on the export side, and only later in the 1990s on the import liberalization side? There are many reasons why the Chinese strategy worked, but one of them is that it protected employment while industrial capabilities were being built up.

Rodrik's notion of the second-best is one that I employ frequently when I think about reasons why protection has been implemented by countries. While I understand the concept and am sympathetic to the notion, my mind always comes back to the fact that it is difficult to remove protection once it is in place--vested interests being what they are. Hence, I am much more disposed to allowing a country to go slowly and deliberately (like China is in many respects) toward a goal of more openness than I am to allowing a country to take steps backward and impose additional protection.

Completely free trade is neither necessary nor sufficient for fast growth initially. Free trade is necessary but not sufficient for broader and deeper economic integration. Those are two different goals, but they are both goals that many countries have for themselves. And both are reasons why free trade should be pursued, but not necessarily in its extreme form right away. Rodrik is correct that unilateral free trade does not make integration happen (not sufficient), but I would have liked him to address the desirability of multilateral free trade for further integration down the road.

Or, to answer Boudreaux (albeit in a way that he probably didn't intend), Tennessee would not do itself any favors by unilaterally abstaining from offering incentives to companies to locate there. But reducing state level competition of that sort would benefit everyone.

There's a big difference between China going slowly towards reform and the U.S. wanting to punish China for going too slowly.

UPDATE: Brad DeLong responds to Dani Rodrik. He's responding to Rodrik's comment about China.

...The fact that China's government had been so bad before 1978 meant that there were enormous problems and enormous opportunities for a government that was both competent and (relatively) benevolent--in the sense of wanting to see the economy grow rapidly if that could be accomplished without endangering its hold on power.

and...

...A lot of human resources and infrastructural capital was wasted becuase Deng Xiaoping did not dare risk the political consequences of the economic process of shifting resources out of the old Soviet-style industrial sector. I think he was right--from his perspective at least--to initially limit market manufacturing to the south. However, the logic is not economic but political.

No and yes. There is no disputing that the political motivation was real. But DeLong also notes the mass unemployment that would have occurred had the breaking down of the Soviet-style industrial sector happened more quickly. I think even a benevolent social planner who was immune to revolution would hesitate to put that in motion. Ultimately, I think this one is both economic and political, but if DeLong's point is that it was the political constraint and not the economic one that was binding I would not disagree. Furthermore, there is no doubt that the second best argument can be abused by governments that don't want to face up to their own shortcomings. DeLong's example of Peron's Argentina would qualify.

Of course now we've moved so far away from Boudreaux's original challenge that anything further deserves a new post. The lesson is that second best considerations can be legitimate, but because industrial policy--whether in five year plans or "temporary" tariffs--are hard to remove once in place, it is important to resist the temptation to apply the argument everywhere. Yet it seems to me that had China gone full-tilt for liberalization in 1978, they would look different today, and I'm not convinced it would be better.

In this excellent post, Brad Setser looks at the growth of reserves of foreign central banks, particularly in Brazil, Russia, India, and China (often referred to as the BRICs), and says that they are "simply too big not to matter".

Their central bank is trying desperately to stay one step ahead of inflation. Interest rates are bound to continue to increase as well. Will they pull the strings taught enough and in time?

(Wall St. Journal article)

In today's Wall Street Journal:

Today, for the first time, Citigroup Inc., HSBC Holdings PLC, Standard Chartered PLC and Bank of East Asia Ltd. intend to begin accepting deposits in yuan from Chinese individuals, and offering loans as well. Until now, China's tight controls over foreign banks have made it impossible for them to offer those basic -- and much coveted -- services.

The article goes on to outline the various hoops that the banks had to go through before being allowed to open themselves up to domestic deposits. Mainly that they were required to establish a legally incorporated holding company in China for regulatory purposes.

This, of course, is just one more step in the continuing story of China's road to financial modernization and openness. This particular step is one that was discussed here and on macroblog back on Feb. 24, 2006. The Nattering Naybob was not impressed. But here we are 14 months later, and it has begun. Four foreign banks can try to tap into a $2 trillion market. Is it a good investment? Marginally, perhaps. It is risky, and a lot of other banks are choosing to stay on the sidelines for now. But let us not forget that for the overall health of and hopes for the Chinese economy it is necessary.

Kash finds a different China story, but it's not hard to tie them together.

This piece by Bloomberg today could really have been written any time in the past five years. But I'm starting to wonder if China's economic growth is not reaching the point where China's monetary policy is going to have to adjust considerably. If China's central bank does indeed take significant steps to cool the economy, then it may be the case that we're soon going to stop reading stories like this one.

The Bloomberg piece is titled: "Paulson May Be Unable to Get China, U.S. Off Collision Course"

But Kash is, I believe, a little premature in calling this the "last chapter".

I've long thought that China's exchange rate will only be changed significantly when it is in China's interests to do so. The easiest way to imagine a yuan appreciation being in China's interests is a) if it would help cool down an overly-hot economy, and b) if the domestic economy (or perhaps better put, its social structure) is strong enough to handle the inevitable income and job losses that will follow in some of China's export industries. Condition (a) is clearly met at this point, I think. What we need now is some confidence that condition (b) is not out of reach, either.

I have voiced similar sentiments, but my concerns have been more for the banking system. I would suggest a condition (c) that the banking system is strong enough to survive a shake-out as yuan appreciation renders a large chunk of the loan portfolio worth less, if not worthless. Their banking system has been insulated and isolated from global financial competition for a long time. It will only improve when it is forced to compete and accept the possibility of failure. Today's news is good in that having some large new (and most importantly, experienced) players in the market will continue to push them in the right direction. Ultimately, it is necessary. But I'm not totally convinced in the system's ability to withstand a downturn. The monetarist inside me can't help but be a little nervous about that.

That said, today's news is a net plus for China, and the global financial market, in the long run.

China just wrapped up a major policy conference. We know a little about what was discussed. The rest, I presume, will be gradually revealed as piecemeal reforms such as we have seen for the last several years.

China Daily reports:

Among the key initiatives announced by Premier Wen Jiabao at the two-day National Financial Work Conference which is held every five years were:

The three policy banks, which are State-owned lenders that concentrate on meeting the country's economic goals instead of profitability, will be commercialized, starting with the China Development Bank. The other two are the China Export and Import Bank and the Agricultural Development Bank of China.

Agricultural Bank of China (ABC) will be restructured. ABC is the only one of the "Big-Four" State-owned banks not listed.

"ABC will strengthen its role as a financial service provider for farmers and county-level businesses," Wen said, adding that the restructure would be across the board and the bank's businesses would not be split.

The government will push for innovation in providing financial services for rural areas and build a multi-tier rural financial structure.

The bond market will receive special attention in the development of the capital market with an emphasis on corporate bonds.

From the U.S. point of view, it seems that they buried the lede.

Managers of the country's huge foreign exchange reserves are encouraged to "explore new means and extend channels" for the use of the money.

The Wall Street Journal didn't miss it:

Global financial markets are likely to zero in on what the weekend meeting means for China's dollar policy. Mr. Wen said nothing about selling dollars, but currency traders are hypersensitive to any signs Beijing is losing its appetite for the U.S. currency. Wang Qing, an analyst at Bank of America in Hong Kong, said the message of the conference is twofold: Beijing intends to encourage imports in a bid to erode its currency reserves, and it is planning to create an entity that will invest a portion of the reserves. For markets, "this might rekindle this talk of diversifying the reserves" away from dollar-denominated assets such as U.S. Treasurys, Mr. Wang said.

Indeed. But the Chinese clearly have their own reasons for doing something. In a related story at China Daily:

Excess liquidity has mainly been blamed for the country's runaway investment, and the central bank has raised commercial banks' reserve requirements four times and interest rates twice since April 2006.

Zhou Xiaochuan, governor of the central bank, said earlier this month that the PBOC does not rule out taking more measures to dampen liquidity.

The bank said yesterday that it would "continue to follow a prudent monetary policy and resort to multiple monetary policy tools" to achieve sound economic growth.

The central bank said the flexibility of the renminbi exchange rate regime has significantly improved since the path-breaking foreign exchange reform in July 2005.

"The role of the market will be further promoted in the setting of the renminbi exchange rate."

China Daily columnist You Nuo sees the result of modernization:

Not all the Financial Work Conference's policy proposals have yet been released to the public, as the nation's key financial institutions are still holding their own meetings to set their work agenda for the year that has just begun.

But whatever the specific policies, the stage is already set for China's domestic capital market to show unprecedented liquidity and become one of the world's main magnets for investor money.

Rumor abounds in Chinese-language financial newspapers about millions of US dollars pouring into the Chinese stock market, now partially open to overseas investors.

And yet...

Having said all this, it will be for the benefit of the entire world if the central government in Beijing can handle its "financial work" with new concepts and new skills. Despite the old name, Beijing's financial work is vastly different now from just two years ago, and increasingly changing. There will be a day, not far from now, when the renminbi is fully convertible and the A-share market completely open to international investors, including all the hot money that can easily throw a careless government into a helpless state.

Indeed.

NY Times:

SHANGHAI, Jan. 5 — China’s central bank said late Friday that it had raised the reserve requirement ratio for banks, the fourth increase in six months, to further tighten the nation’s money supply.

The modest move, which takes effect this month, increases the reserve ratio by half a percentage point, to 9.5 percent. Analysts said it was the government’s latest warning that too much money in the financial system could ignite inflation and perhaps fuel a stock market bubble.

The reserve requirement is a blunt instrument of monetary policy. If open market operations are a scalpel, the reserve requirement is a chainsaw. That China is on such a trajectory with its reserve requirements says that they are clearly concerned about the inflation prospect. However, 9.5% is not extremely tight. In the U.S., the rate for most banks is 10% at the margin (see this table for details). That the Chinese economy has grown to an extent that higher reserve requirements are necessary is another encouraging sign that they are becoming a player in the international financial community. They are experiencing what the U.S. went through in the "roaring '20s." They are hoping to avoid their own 1929. Given the vigor with which money is flowing into China, I would not be surprised if they continue to tighten throughout the year ahead.

Kash points us to an interesting tidbit in the Wall Street Journal:

SHANGHAI -- China's central bank said it plans to absorb about $20 billion in cash in its latest effort to keep its economy from overheating. The move is meant to rein in lending without raising interest rates and to reduce liquidity in the country's financial system.

The People's Bank of China said Friday it plans to sell banks about 160 billion yuan, or $20.45 billion, of one-year bills in the yuan money markets today. The bills will yield 2.7961%. By placing the debt instruments with commercial banks, Beijing is reducing the amount of money banks have available to lend.

Kash's take:

...a bond issue of this size indicates that the financial pressure may be building on the PBOC to use the next obvious tool that would reduce the amount of yuan floating around in the Chinese economy: to allow the yuan to appreciate faster against the US dollar.

I agree with Kash. In the past, the Chinese were able to conduct operations like this behind the wall of capital controls. The capital controls allowed them to fix their exchange rate AND pursue independent monetary policy goals. Without capital controls (i.e. with a convertible currency), fixing your exchange rate to the dollar means subordinating your monetary policy to the U.S.. While that wall of capital controls has not entirely crumbled, it has been breached. For example, there was this announcement in July 2005 which was followed by a revaluation just a few days later. Unless these massive currency flows (caused by China's rapidly growing export sector) are sterilized, inflation is sure to follow. Higher interest rates are one possible approach, but given the fragility of the banking sector, it is not a particularly welcome prospect. Currency appreciation (or even revaluation) is another. Most likely, they will need both.

As always, the trick is to pull this off without causing a speculative run. Since the yuan is moving against the dollar, and the rate of appreciation appears to be picking up, they probably see things as moving more-or-less on course.

If they decide to move faster, it will be to try to quell their own inflation threat, not to respond to certain U.S. senators.

UPDATE: It is worth remembering that Secretary Paulson and Chairman Bernanke will be visiting China in a couple days. I'm guessing that these developments will be on the agenda at some point.

In today's NY Times, Joseph Stiglitz takes on the topic of the hour. Most of it you have probably heard elsewhere. This part is not always mentioned:

Imagine that the Bush administration suddenly got religion (at least, the religion of fiscal responsibility) and cut expenditures. Assume that raising taxes is unlikely for an administration that has been arguing for further tax cuts. The expenditure cuts by themselves would lead to a weakening of the American and global economy. The Federal Reserve might try to offset this by lowering interest rates, and this might protect the American economy — by encouraging debt-ridden American households to try to take even more money out of their home-equity loans to pay for spending. But that would make America’s future even more precarious.

Yes, there is a tension between the fiscal and monetary authorities in cases like this. That is an important point to make, and is not always made. Stiglitz has a simple solution, however.

There is one way out of this seeming impasse: expenditure cuts combined with an increase in taxes on upper-income Americans and a reduction in taxes on lower-income Americans. The expenditure cuts would, of course, by themselves reduce spending, but because poor individuals consume a larger fraction of their income than the rich, the “switch” in taxes would, by itself, increase spending. If appropriately designed, such a combination could simultaneously sustain the American economy and reduce the deficit.

"If appropriately designed...," is a deus ex machina. This paragraph, I think even the most adamant proponents of tax increases would admit, makes a number of assumptions. One important one would be that the increase in taxes at the high end of the distribution does not reduce saving even further (since he laments our lack of savings earlier in the piece). It also assumes that the tax change would cause enough new spending by "poor individuals" to offset whatever change in consumption and savings occurs at the high end. I suppose one could postulate a Keynesian model and mathematically determine how to change taxes at different income levels--thus the phrase "if appropriately designed". I am understandably skeptical of either party's ability to do the math and appropriately design the new policy. I would also apply the Lucas Critique to any proposed model.

So the title of the piece, "How to Fix the Global Economy," is perhaps too ambitious. It's not that simple, even at the textbook level. Unfortunately, it is hard to fix the global economy in 1000 words--harder still when you have to expend half of your word budget rehashing the yuan issue. He makes an excellent point on the fiscal vs. monetary conflict but reduces the solution to one paragraph that raises more questions than it answers and makes some rather heroic assumptions about our ability to model the effects of these policies as well as our ability to design and implement them. The debate continues.

UPDATE: The debate does indeed continue. Mark Thoma, Greg Mankiw, and "knzn" all weigh in. Thoma notes that it is the difference in maginal propensities to consume (for individuals with different levels of income) that matters. True. Mankiw argues that average propensities differ, but that "...the evidence for substantially different marginal propensities is much weaker." Being charitable and granting the benefit of the doubt that there may be some difference in MPCs, I'm still left with the feeling that those MPCs (and the differences between them) are not policy-invariant (my original objection invoking the Lucas Critique). I would be very wary of attempts to fine tune progressivity to this objective. If you want to argue for more progressivity for other purposes, that's one thing. But this argument doesn't convince me. (Greg Mankiw makes a similar statement.)

Postscript: In this post, I referred to posulating a Keynesian model. That is not to say that I think that a Keynesian model would be the one I would opt for in addressing this issue, but because it seemed to best fit the argument that Stiglitz was making (the focus on the MPC in formulating tax policy). Just wanted to clarify that.

Probably one of the more frequent comments from the Chinese on the yuan is that they do not have a timetable for revaluation. Yet the gradual appreciation of the currency continues--too gradual for some tastes, but appreciation nonetheless.

What if they did have a timetable? Well it would be a little like the Fed telling us what short term interest rates will be in January. If it is credible, it would anchor expectations and force the rebalancing of millions of dollars in various portfolios. Having no timetable means that the uncertainty remains and keeps a lid on speculation.

It is that last part that is particularly important to the Chinese. What we see as currency manipulation is their attempt to discourage speculation. Hence, now that the yuan appears to be revaluing a little faster in recent days, it may be the beginning of a new phase of their transition to a more flexible currency. The next phase may get interesting, so says Bloomberg:

Sept. 28 (Bloomberg) -- The yuan's gain may slow, after the biggest monthly advance since a link to the dollar ended last year, on speculation China's central bank will engineer two-way moves in the currency, Royal Bank of Scotland Plc said.

China may have allowed the strengthening to undermine the case for U.S. tariffs on Chinese goods as two senators mull a vote on sanctions, said Hong Kong-based strategist Ben Simpfendorfer. Wider swings create greater potential losses for traders speculating on a higher yuan. A central bank spokesman declined to comment on whether it will buy or sell the currency.

``The central bank is hesitant to allow one-way movement'' in the yuan, Simpfendorfer said in an interview. ``The central bank wants to create more two-way risk to prevent speculation on appreciation building up. That's not what we're getting.''

Checking the archives, I first did a post on this aspect of the question back in March of 2005. It still seems relevant.

When I teach international macro, I spend a day on exchange rate forecasting and explain why it is better to be consistently on the right side of the forward rate with your forecast than it is to have a smaller absolute error on the wrong side of the forward rate. This is because the forecast relative to the forward rate determines whether you will go long or short on the dollar. Pick the wrong direction and you lose.

So I can intuitively follow what the the Bank of Scotland's analysts are thinking China might do. The may want to add some uncertainty even about the direction that the yuan might go in the short term (weeks) even though the long term trend (years) will certainly continue in the direction of appreciation. If they play it well, it could stem the tide of speculation be making it riskier to play off of short term forecasts of the spot rate.

Now that is a bit more manipulative than the current scheme.

While it certainly is possible that is what they are doing, I'm not convinced yet. I think it bears very close watching to see if they reverse course in a month. Certainly the current (i.e. last few days) of appreciation will not continue much longer, I wouldn't bet that they would necessarily reverse.

And that is exactly what they want, isn't it?

Now before you go thinking that this is the kind of manipulation that we need to retaliate against, think again. When (and I do mean when) the yuan is finally floating at something approximating a free market value, the volatility of the yuan will have to approach that of the dollar, euro, and yen. Betting on appreciation cannot remain a sure thing forever. So if you are on the path to reform but you don't want to be led around by the financial markets, doesn't it make sense to try not to be too predictable? They need to be able to pull a rabbit out of a hat every once in a while--hence the title of this post, "currency sleight of hand". Watch what they do as well as what they say, because the two may not always agree.

It's unfortunate that it has to be this way (assuming the Bloomberg article turns out to contain a good prediction) because it does smack of manipulation. However it is not all that dissimilar to the communication dilemma faced by our own Federal Reserve. If you lay a timetable in front of the markets it does tie your hands. But although there is some similarity in the dilemma, the implications are different. While a clear communication strategy might lead the Fed towards a policy rule (which some would regard as a good thing), strict adherence to a policy rule is probably not in the best interest of a developing country which must balance so many policy goals. As we have seen so often, the stakes are rather high for developing countries.

It is going to be extremely interesting to see how this plays out. I'll be watching it closely. It certainly does seem reasonable for China to start widening the band. American's need to be aware that this means more volatility and more of an appearance of manipulation. So when the complaints start coming, just remember you heard it here first. Looking at the long view, this could turn out to be a very positive step. And while the politicians may spin the recent trend in yuan appreciation as a result of our tough talk by certain senators, I think that would be arrogant and naïve. The discussions between Secretary Paulson and the Chinese leaders are likely to have been a lot more nuanced--getting to the nuts and bolts of how to pull off the biggest feat of prestidigitation in currency history. That is, getting to the question of how to proceed with a substantial revaluation of the yuan without letting anyone see how you're doing it. At least I hope that is the case.

Postscript: The Bloomberg article concludes:

The yuan's 12-month forwards rose to the highest since at least 1998, suggesting traders are raising their bets on the currency's appreciation. One-year contracts show traders are betting the yuan will strengthen to 7.6445 in a year, compared with 7.6545 yesterday. That would mean the currency would rise 3.2 percent in that period.

Put that in the file to be revisited later.

UPDATE: See also Felix Salmon's post at Economonitor. There are a couple of nice items on the RGE main page about China as well.

Senators Schumer and Graham may be standing down... for now. (Reuters)

WASHINGTON (Reuters) - A Senate vote this week on a controversial bill threatening to impose steep tariffs on Chinese exports to the United States was put into doubt on Tuesday after the bill's authors said they were unsure whether to press ahead with the vote.

Sen. Charles Schumer, a New York Democrat, and Sen. Lindsey Graham, a South Carolina Republican, told reporters after a meeting with U.S. Treasury Secretary Henry Paulson they need to have further discussions before making a final decision on whether to hold a vote.

"He's certainly given us food for thought. There's no question about that," Schumer said.

Maybe he told them to read his speech. Elsewhere in the Reuters article....

There is no similar legislation in the U.S. House of Representatives, which would also have to pass it for it to become law. The Bush administration has opposed the Senate bill but has not explicitly issued a threat to veto it if it is approved by Congress.

And there is no way that the House will even think about this before the election or during a lame duck session. That would explain why the White House has not explicitly said they would veto the bill. There is no reason for the White House to give this the time of day right now. Of course they also might remember that...

The latest deadline is September 30, but the two senators have agreed four times since April 2005 to delay a vote.

Senators Schumer and Graham could own this issue for years to come. They appear to have settled into an equilibrium that serves their purposes.

James McGregor writes in the Wall St. Journal commentary:

So what should an insecure and out-of-sorts superpower and a paranoid and increasingly pugnacious aspiring superpower do to avoid a collision?

Hint

Read the article....

UPDATE: ....and this one too.

For part I, see here.

My focus was, as usual, on the merits of gradual rather than sudden yuan revaluation, and I come to that conclusion mainly from considering how fragile the Chinese banking system is and how a gradual revaluation really will help them in the long run. Yes, the yuan is undervalued. No, it should not remain that way forever. But I think that as Tyler Cowen suggests, it's a waste of political capital for American politicians to keep harping on it. When the yuan appreciates, it will not be because we told them to. I know we have big egos, but come on. Don't get me wrong. I understand why a hard line stance on the yuan makes sense politically. Therein lies the problem.

But Cowen also made some comments that I don't find as convincing when he downplayed the effect of a revaluation.

The belief is that if the dollar has less value in China, Americans will spend less on Chinese products to offset the prices they pay per item. But even if the numbers work out so that the flow of dollars to China diminishes, American consumers will pay higher prices and see fewer goods from China. Yuan revaluation is unlikely to benefit the United States, even if it does lower its trade deficit.

The trade effects of a revaluation of the yuan are unlikely to be large, in part because many Chinese exporters specialize in assembly. China sends out money buying components like semiconductors and turns them into finished goods, thereby running a trade deficit with East Asia. A new and higher value for the yuan would largely be a wash for these activities. With a stronger currency, China would have a harder time selling its electronic goods, but this would be offset by its greater purchasing power over the semiconductors. It would not do much damage to the Chinese competitive position.

See the discussions at numerous blogs: Brad DeLong, Brad Setser, Greg Mankiw. (Mankiw does not take Cowen's assertion about the small effect of a revaluation head on in his post. His post is more about the benefits to the U.S. of an undervalued yuan.) Cowen responds that he is still "skeptical" about yuan revaluation, and throws in another line that is more to the point I have been making:

My view is not that China should stay put on all matters of economic policy (see today's FT for an excellent article on the internal Chinese debate); rather my argument is that the U.S. won't do a good job micro-managing Chinese reforms.

Precisely. But I'm less skeptical about the effect that revaluation might have for the U.S. On that score, I fall somewhere between Setser and Cowen, probably leaning towards Setser. I just don't think that outweighs the substantial case for encouraging the Chinese to take a gradual approach--as long as they reach the goal in the end. And I think Cowen gets one more thing right:

The fundamental problem in the U.S., to the extent we have one, is our propensity to spend, especially given our long-run demographic position and our government's fiscal irresponsibility.

So when Brad DeLong says:

We should be moving toward Andrew Samwick's policy of a cyclically-appropriate on-budget government surplus in order to put downward pressure on domestic absorption, and we should be strongly advising the Chinese and others to shift from export-led growth and allowing their real exchange rates to adjust, in order to reduce the risks of a really unpleasant episode.

I can at least sign on to the first part.

From the NY Times editorial page:

Any move that makes the International Monetary Fund — and for that matter other major global institutions — look less like an old boys’ club is a good move. So the I.M.F.’s executive board began doing the right thing last week when it decided to give China, South Korea, Turkey and Mexico slightly larger voting shares — and promised them even more say to come.

A reapportionment is essential for bolstering the fund’s credibility. And it is long overdue. China represents about 15 percent of the world’s gross domestic product but has only a 2.9 percent voting share at the fund, which will grow to 3.7 percent. (Belgium, with less than 1 percent of the global economy, has a 2.1 percent share.)

...

The Bush administration, which championed the changes, is hoping that if China gains more of a stake in the global system it will have an incentive to behave more responsibly: allowing the yuan to strengthen against the dollar and reining in its export binge. China needs a more flexible currency, both for the sake of smooth trade relations — the system is pretty tetchy these days — and to gain more control over its economy. As long as China keeps the yuan artificially low, other Asian countries, eager to sell their own cheap exports, will too.

But the advice can’t stop there. The fund needs to take a closer look at who’s buying all those cheap goods and borrowing all that excess cash from China. China may be the enabler. But the United States needs to reduce its enormous trade deficit and its enormous budget deficit, to protect its economy and for the sake of global stability.

Ok, the sentiment is nice, but how much will these changes really affect the outcomes? Probably not much. It is, however, a step in the right direction. The makeup of the fund should evolve over time to reflect changes in the world economy. Decades from now we may want to enlist the help of a modern and developed China in the development of Africa. They will expect (and deserve) greater voice in those deliberations. We should welcome that.

I'm less sure about the argument that this will give the Chinese the "incentive to behave more responsibly." First of all, the American political definition of "responsible" in this situation is to allow a faster (immediate?) revaluation of the yuan. If you have done any amount of reading on China and know the first thing about the banking situation you know that the American political definition of responsible does not mesh with what the Chinese know that they need. Many economics blogs, including this one, have chronicled that story for some time, so I don't need to repeat it. Tyler Cowen sums it up quite well, also in the Times today. Cowen makes an additional point that is relevant to the Times editorial:

The Chinese keep the yuan low, relative to the dollar, by buying up United States Treasury securities; as of early 2006, the Chinese central bank held up to $470 billion in Treasury securities. This huge accumulation of relatively low-yielding assets is the investment strategy of risk-averse bureaucrats, but it may bring longer-term benefits. Those assets can someday be sold or otherwise transferred to underdiversified Chinese financial institutions. The accumulation gives the Chinese a stake in American prosperity and signals that the Chinese are committed to long-term participation in the global economy. On the American side, the Treasury market is more liquid and the budget deficit can be financed at lower cost.

Yes, you heard that right. Chinese ownership of U.S. assets signals a commitment to long-term participation in the global economy. One might even say that it would give them an incentive to "behave responsibly." In the long run, that is going to be as significant, if not more so, than a token increase in their IMF voting rights.

From China Daily, a source that I cite here occasionally and that we should all read more often.

The UN Conference on Trade and Development (UNCTAD) said on Thursday that China's renminbi revaluation should continue gradually rather than abruptly so as to maintain economic stability.

In its annual Trade and Development Report, the agency said China has played "a vital role" in helping the economic growth of other developing countries.

"Since the beginning of the 1990s, China's domestic demand and its imports have grown very strongly indeed, and the country has played a vital role in spreading and sustaining growth momentum throughout the developing world," the report said.

Such a process should not be derailed, and therefore, renminbi revaluation should continue gradually rather than abruptly, taking due account of regional implications, it noted.

Oh, and there's also this little bit...

The UNCTAD also praised China's sharp economic growth in recent years, indicating China's characteristic growth, which highlights a government role in the market, could be a model for poor countries.

The report said governments of developing countries should "take a pro-active stance in macroeconomic and industrial policies to accelerate private investment and technological upgrading and to stimulate the creative forces of markets."

The hands-off policy and total reliance on market forces, as promoted by international financial organizations and lenders in the 1980s and 1990s, has proved to be a failure for many developing nations, it said.

A new and expanded MITI? I'm not sure I like that idea. Now, of course it's no secret that I have long argued for a gradual adjustment of the RMB as opposed to a sudden revaluation. Ronald McKinnon sums up the situation well in his recent contribution to the Wall Street Journal. But while it is sensible to manage the appreciation to bring a developing (and long isolated) currency in line with the rest of the world slowly so as not to cause havoc in the quick-to-punish-slow-to-forgive financial markets, I wouldn't extend that to other matters such as industrial policy. Indeed, isn't the greater part of China's success a result of more flexible and free markets than 20 years ago? Isn't the problem in many other developing countries the fact that property rights are not assured and governments circumvent the market?

While China's gradual approach in nearly all facets of economic reform have certainly been more successful than efforts in the former Soviet Union, the important thing is that they keep moving in the right direction. The key is that the Chinese government's role in the market, while still significant, is less than it was previously and that is what unleashed the most amazing growth process our generation has seen. The message to developing countries should be to look at where China is going, not where they have been. Don't give kleptocracies another reason to strengthen their hold on their economies.

Let's draw a distinction. Managing the currency is about giving the financial markets a firm base on which to form expectations. A gradual move towards full flexibility builds confidence. Managing the processes of innovation and industrial development with a heavy hand will not win you points with foreign investors. The last paragraph I quoted above is certainly a criticism of the "Washington Consensus". But you can avoid making those mistakes without turning back the clocks on progress towards freer markets with "industrial policies". The failures of the "Consensus" were a result of many things, not the least of which was its one-size-fits-all approach. The botched implementation created the instability it tried to avoid. Just because the "Consensus" failed does not imply that the path to freer markets is impossibly blocked. Indeed a little more sensible handling of monetary and currency issues in developing markets would go a long way towards promoting the stability that is necessary to unleash the creative process in industry. UNCTAD gets it half right and half wrong.

UPDATE: This would be a good time to point out the NY Times review of Joseph Stiglitz's new book.

UPDATE 2: Tyler Cowen agrees that the U.S. should stop pushing for yuan revaluation. (NY Times)

China discovers that as they integrate into the global capital market, their interest rates will tend to follow those in the rest of the world. But read a little deeper and find that it's not exactly the standard textbook situation. (NY Times)

HONG KONG, April 27 — China's central bank raised lending rates on Thursday for the first time in a year and a half, in a move by Chinese leaders to rein in the world's fastest-growing economy.

The action aims to slow a spectacular surge in investment and it may potentially brake China's voracious appetite on world markets for oil and other commodities.

With interest rates already climbing in the United States and the European Union, and with monetary officials starting to tighten policy in Japan, China seems to be joining the world's central bankers in trying to gain control of speculation that has driven up prices of assets like gold and real estate.

...

"It is easy to borrow money," said Jack Lee, a manager at the Guangchan Conveyor Idlers Company in east central China, which had an 80 percent jump last year in its sales of conveyor belt rollers and is now buying more equipment to open a second production line next year.

China's boom in lending and investment, which has contributed to the country's rapidly rising exports, pushed growth in China's economy to 10.2 percent in the first quarter. That was high even by China's extraordinary standards, and so strong that President Hu Jintao himself warned on April 16 that the country needed efficient, high-quality development and not "excessively rapid economic growth."

...

The effectiveness of somewhat higher interest rates in slowing growth, however, remains to be seen. The People's Bank of China, the central bank, said that it was raising the benchmark lending rates on one-year loans by 27-hundredths of a percentage point, to 5.85 percent. It was the same size increase as on Oct. 28, 2004, the last time China raised rates. That increase was the first in nine years.

...

But the central bank did not change bank deposit rates. By raising lending rates while leaving deposit rates untouched, the government will allow banks to widen their profit margins to cover losses on loan defaults.

Moreover, by isolating deposit rates, China's move is unlikely to address calls by industrialized countries, including the Group of 7 last weekend, for China's currency to gain in value. One-year bank deposits earn just 2.25 percent in China, and leaving that rate unchanged makes it slightly less attractive for foreign investors to pump money into China and therefore bid up the value of the yuan, the Chinese currency.

Let us not forget that the capital markets in China are not yet totally free of controls.

Also covering the story, Reuters gets some choice quotes:

"It's another example of the Chinese using market instruments to deal with market conditions in their economy," Treasury spokesman Tony Fratto told reporters.

"From that perspective, it's positive, though it's clear that China's ability to use market instruments like the interest rate are somewhat limited because of a lack of flexibility in the currency," he added.

Federal Reserve Chairman Ben Bernanke said later that allowing the yuan to move more freely would give Beijing even more independence in setting monetary policy.

"It's a very large country, they need to have an independent monetary policy. They can't really run independent monetary policy without a flexible exchange rate," he said.

Lorenzo Bini Smaghi, the European Central Bank board member responsible for international relations, called the Chinese move a step in the right direction. Asked in Florence, Italy if more hikes were needed, he replied: "Yes, and they'll do it."

Bernanke's statement becomes more true every time another part of the wall of capital controls is dismantled. As the Chinese move closer to full convertibility, they will need to get those rate in line with the rest of the world. That would imply that more rate hikes are a pretty safe bet. It probably won't be another 18 months before the next one.

UPDATE: The Wall Street Journal has more:

"The underlying problem is the currency," said Hong Liang, chief China economist for Goldman Sachs, who added that the small size of the interest-rate increase made it more likely Beijing would pick up the pace of currency appreciation. China's exchange rate, of course, has been a hot political issue in the U.S. for years, with fierce criticism from manufacturers, unions and others that the yuan is too weak and gives Chinese companies an unfair advantage.

Even if the interest-rate move has little effect on the yuan's strength, according to U.S. economists it signaled that Beijing is increasingly willing to rely on market forces to adjust its economy. Regulators could simply have slowed lending by telling banks they had to keep more money in reserve; instead, they sought to use interest-rate policy much as U.S. or European central bankers would have done.

Indeed. The effect will be small, probably almost undetectable, but it is a sign of things to come.

Brad DeLong reads John Tamny. Fortunately it wasn't during his morning coffee, or he would have probably had to clean the monitor.

Tamny:

To begin, just as Chinese authorities fix the yuan's value, so too do U.S. authorities fix the dollar's value. As the Journal's George Melloan noted in a recent editorial, "no currency actually 'floats.'" As opposed to commodities set by market forces, currencies today are merely paper concepts controlled by central banks through the creation of and extinguishment of that paper.

That the above is true calls into question Lindsey's assertion that the "Chinese clearly undervalue their exchange rate."

DeLong:

The above is not true. If it were true, it would not "call into question" Lindsey's assertion. This year it looks like China will spend $250 billion trying to keep the value of the renminibi low: that's the reason for Lindsey's assertion.

Actually, it gets worse. Tamny continues...

Regarding the exchange of goods between the two countries, Lindsey argues that the supposedly undervalued yuan creates “losers,” specifically the “American producers of goods that are now made in China.” Implicit here is the flawed assumption that changes in currency values impact the real price of anything.

In truth, as 18th century philosopher David Hume wrote, “the greater or less plenty of money is of no consequence” in trade since the price of commodities always adjusts to any changes in a currency’s value. Nixon Treasury Secretary John Connally articulated the same in pointing out that money itself “cannot produce, increase efficiency, or open markets abroad.”

If China adheres to Lindsey’s compromise and revalues the yuan upward, the imported commodity inputs used to create the goods they sell us would simply become cheaper in nominal terms. Conversely, U.S. producers would hardly gain from a devaluation of the dollar given the same market forces that apply to the Chinese in what is a world economy.

Correcting the errors here is an undergraduate exercise and is left to the reader. The upshot of his claim is that the value of the yuan is of no real consequence. Keep that in mind as he continues...

Lindsey also argued that in “resisting revaluation, [Chinese president Hu Jintao] is making China poorer.” More realistically, Mr. Hu is intimately aware of what happened to Japan the last time the U.S. political elite engaged in one of its periodic protectionist episodes. The “revaluation” we forced on Japan through the 1985 Plaza Accord caused it to sink into a 15-year deflation from which it is only now in recovery.

Can't have it both ways, Mr. Tamny. Either currency values have real effects or they don't. One of the things that Tamny is forgetting is that capital controls throw a wrench into Hume's price-specie flow mechanism. So, while China has been slowly removing the capital controls, Hume's mechanism is unlikely to work perfectly. He's also glossing over a lot of monetary economics here.

Tamny concludes...

Rather than engage in wealth-reducing currency revaluations, the U.S. and China should seek a tight link between the two in order to ensure the kind of stability that will cause our trading relationship to continue to grow.

The yuan is undervalued. The undervaluation of the yuan has had and continues to have real effects. I'm not sure why Tamny wants to deny this. I'm not sure why he wants to "seek a tight relationship" between the dollar and the yuan when market forces are pushing in the other direction. That seems like a losing battle, and one that relies on inconsistent logic. I continue to assert that while the yuan is destined to become less undervalued, the risks associated with moving too quickly outweigh the risks of moving too slowly. Protectionism isn't the answer, but the status quo is unacceptable as well. That China held its exchange rate fixed against the dollar for so long was, I believe, an important factor in their rapid growth. But they are entering a new stage of development--one in which a hard peg is not necessarily the best option. A gradual adjustment to that next stage is in both our interests. Denying that to score political points is no better than proposing a tariff to achieve the same ends. A mature trade relationship with China will have a flexible exchange rate. Hopefully we will avoid repeating some past mistakes on the way there.

UPDATE: PGL at Angry Bear has more.

From Reuters:

SHANGHAI (Reuters) - China relaxed its capital controls on Friday to make it much easier for individuals and companies to buy foreign currencies and invest abroad.

The move will permit President Hu Jintao to tell President Bush when they meet next Thursday that China has made another notable move toward a market-driven exchange rate.

"The deregulation is a concrete step fulfilling the central bank's commitment to gradually ease China's capital controls," said Li Yang, an economics professor who is a former member of the central bank's monetary policy committee.

Under rules announced by the central bank and the foreign exchange regulator, Chinese banks will be allowed to pool yuan deposits and convert them into foreign currencies for investment in overseas bonds.

...

It follows a series of other moves to build a two-way market for foreign exchange. These include the introduction of a system of market-makers, who constantly stand ready to buy or sell the yuan, and the development of derivatives so banks and firms can hedge new-found currency risk.

"Just as central bank officials have been saying, what really counts is reform of the foreign exchange formation mechanism rather than the level of the exchange rate. This move is a vital part of that reform," said economist Yi.

Underscoring the reform drive, China said on Friday it would launch interbank trading in currency swaps on April 24.

Depending on the pace of liberalization, the easier foreign exchange rules provide a juicy business opportunity for Chinese banks and money managers.

"You're giving banks a huge opportunity. They already have a huge depositor base, so marketing is going to be very easy," said economist Stephen Green with Standard Chartered Bank in Shanghai.

Green rated the significance of Friday's announcement at five on a scale of one to 10. "It's giving them the tools they need to start allowing liquidity to move offshore. They've driven a wedge through the capital account," he said.

Faithful readers will note that this is just the latest in a series of events that began last summer even before the actual revaluation. This one also comes with a date (April 24) for the next step. Each step is necessary for this reform to work in the long run, and each step represents real progress. Of course people will want to make the connection between these events and the upcoming state visit, but it seems to me that the visit is not the most important driver here. The precise timing of an announcement like this (any announcement of any substance would suffice) today is no coincidence. However, this is a process that the Chinese know is going to take months and years to see to completion, and it is in their interest to start down that path and move very deliberately. I have long held that the Olympics in 2008 are going to be an important reason for China to promote openness that goes in both directions. Money will need to flow in and out and not remain trapped behind capital controls. Yet they know that this needs to be managed very carefully to avoid too much volatility. For Americans, this is election year politics. For the Chinese, the stakes are higher. Stories like this will continue to trickle out every few weeks for some time to come.

For a summary of what has happened so far, check out all of my China posts.

Senators Schumer and Graham are backing off. (NY Times)

"We came back from China with a real feeling that the Chinese realized that pegging their currency is not only bad for America, but bad for China as well." Mr. Schumer, Democrat of New York, said. "We hope there will be real movement in the coming months."

...

"The small progress we have seen needs to continue," Mr. Graham said today, referring to a 3 percent appreciation of the yuan in the last eight months. "I'm willing to abandon the need for tariffs if the Chinese embark on real reform. We're not there yet."

They plan to delay the vote until the last scheduled day of the session. (Pocket veto, anyone?) It probably won't come to that anyway. None of the coverage of this has said anything about a similar bill in the House. The closest thing I could find on the House side is HR 3004 introduced in June of last year. I'm not sure that either body wants to hammer out the details in conference at the last minute. Sound and fury, etc., etc. Still,...

...they said they reserved the right to bring the measure up sooner if the Chinese slow down the appreciation of its currency.

We'll see. Senator Schumer seems to be doing everything he can to back down without coming out and saying it was a mistake. This must be tiring to the Chinese, but they can't totally ignore it either.

Let's see how the state visit in April turns out.

UPDATE: Menzie Chinn discusses the possible effects of revaluation in this excellent post.

NY Times editorial:

Maybe the chance to talk face-to-face with Chinese on their home turf is what it took to make Mr. Graham and Mr. Schumer realize that just as trade is a two-way street, so too are sanctions. If lawmakers actually went ahead with the Schumer-Graham bill, which would impose 27.5 percent tariffs — a staggering amount — on Chinese goods, they would be accomplishing little to cut American unemployment, while hurting poor Americans who rely on inexpensive goods and poor Chinese whose livelihoods depend on making those products.

The Schumer-Graham bill is based on a fundamental misunderstanding of the root cause of America's economic problems. No question, the United States trade deficit and the loss of American manufacturing jobs are very serious. But most of the imbalance with China is caused by Americans' insatiable appetite for Chinese imports for which there are few domestic substitutes. While it's unfortunate that the textile industry has all but faded away in this country, the fact is that few American factories make things like low-priced apparel any longer.

...

Thus far the Bush administration has resisted calls to accuse China of currency manipulation, but Treasury Secretary John Snow last month hinted that could change. That too, would be a mistake. The administration has done a fair job so far in its tap dance around America's relationship with the world's fastest-growing economy. Now is not the time to slide back into election-year shortsightedness.

I still think that the way is being prepared for the Senate to back off without losing too much face. The spinning has only just begun.

Senators Schumer and Graham are in China. Things are progressing as you might expect.

BEIJING (Reuters) - U.S. senators threatening China with sanctions unless it revalues its yuan said on Wednesday that letting the currency float would solve problems in both countries.

...

"We have been made aware of the problems here in China, we're well aware of the problems in America, and we do believe that letting the currency float will help solve the problems -- one country needing more consumption and one country needing more investment and production," [Sen. Charles] Schumer told reporters.

...

"What we're trying to look for is a process that is not responding to political pressures, but one that is responding to economic reality, because I do believe ... that it's in the best interest of the Chinese people to allow a market-based currency," said [Sen. Lindsey] Graham.

The senators were not looking for a timetable or specific goal, Schumer said, but wanted to be convinced that China is moving in its own way toward letting the currency float.

He said he was not convinced that was happening.

If not a timetable or a specific goal, then what?

The Senate Finance Committee is also working on a bill aimed at addressing trade irritants with China as an alternative to the Schumer/Graham initiative, but there were no details of the legislation.

The details will come later when it is time for the Senate to save face. I would expect that to happen around the time of the Chinese president's trip to Washington. Everyone will want to be able to declare victory.

Let me go on record once again that I do think the yuan is undervalued and that an appreciation is inevitable. The only questions are how and when. Slow and steady seems to be the approach. Seeing as how they will get one chance to get it right, that seems sensible. Our rattling of the tariff sword in this particular instance at this particular time is less sensible to me. It is election year politics, pure and simple.

UPDATE: The Wall Street Journal has the latest on the Sentators' trip.

"We are more optimistic that this can be worked out than we were in the past. But whether it will be, we're not certain yet," Mr. Schumer told reporters after three days of meetings with senior Chinese officials, including the central-bank chief and the commerce minister.

If you look at the story from a couple of days ago, you have to ask what it was that made them more optimistic. Timetable? Specific goals? Other? Or is this, well, you know...

Mr. Graham said he was struck by the magnitude of China's problems -- for example, unemployment -- and how those issues weigh against sharp changes in currency policy. "I am more sensitive now than I was before to how hard it will be to move toward a floating currency," Mr. Graham said. But, he added, "I am more committed than ever to make sure that occurs," to ensure "harmony" in U.S.-China relations.

There's your sound bite. I, too, would like the increased flexibility to occur at a pace that is sensible given China's domestic policy concerns. That's what I've been saying all along.

The Senators can now return home and work on the speeches in which they tone down the tariff talk and claim victory. But if you think that the Senators' trip will change very much, you are more optimistic than I.

But I'll bet it was a great photo op.

UPDATE 2: Sestina has a comment to this post with a link to a Stephen Roach article on this issue. Roach gets it right and gets a quote that I didn't see in the MSM.

The yuan continues to move, though not fast enough for some (Reuters)

SHANGHAI (Reuters) - China's yuan hit its highest level to the dollar on Thursday since its July revaluation, as dealers said market players took advantage of signs of increased tolerance from the central bank for a stronger currency.

The rise came ahead of a key visit to Beijing next week by two U.S. senators who have said they were inclined to proceed with a vote on a bill threatening China with sanctions.

The yuan traded at its post-revaluation high of 8.0348 in early trade, up a marginal 0.04 percent from its close of 8.0377 on Wednesday when the currency scored its biggest one-day gain of 0.12 percent since its revaluation.

The currency has now appreciated a further 0.94 percent since Beijing revalued it by 2.1 percent on July 21 and freed it from a dollar peg to float within managed bands.

...

But dealers said there was no immediate impact from news of the mainland visit by Sen. Charles Schumer, a New York Democrat, and Sen. Lindsey Graham, a South Carolina Republican.

Both senators said they will head to Beijing next week to hear firsthand what China was doing about its currency before making a final decision on a bill threatening the country with a 27.5 percent tariff on its exports to the United States.

I see a photo op coming. In Chinese culture, saving face is very important--as it is in American politics. Wouldn't a bi-partisan trip to China make it easier for the Senate to back down on the tariff issue?

"The market has gotten accustomed to such political talk and is more likely to wait for a concrete outcome from Washington," said a dealer from another foreign bank.

Smart.

PGL (Angry Bear) points us to Darda's piece in the National Review Online:

The neo-mercantilist flat-earth society, which includes members of both parties, doesn’t seem to understand that a fixed (and now sliding) peg for the Chinese yuan simply means that China outsources its monetary policy to the Fed. This is no different from the benefits many countries have achieved by scrapping their own currencies in favor of the dollar. It is telling that the anti-China crowd in Congress has not taken aim at other dollar-linked or dollarized countries with destructive tariff proposals or charges of currency manipulation. Where are the tariff threats or cries of currency manipulation against Ecuador, El Salvador, East Timor, Panama, Lebanon, Hong Kong, Saudi Arabia, Kuwait, or Malaysia, all of which either use the dollar as legal tender, fix their currencies to it, or manage them in a tight band against it? Fixity is the antithesis of manipulation, not the cause of it. Apparently a passing grade in Economics 101 isn’t a prerequisite for ascending to the U.S. Senate.

As Nobel Laureate Robert Mundell recently argued, an appreciation of the yuan could impose deflationary pressures on the Chinese economy, fan tensions in rural areas, and cut China’s growth rate. The result likely would be slower Chinese growth and lower incomes, which would cut the demand for U.S. exports — precisely the opposite of the intended effect. While a modest appreciation of the yuan probably would carry few risks given the dive in the dollar’s value during the last few years, a significant appreciation would surely be deflationary.

It is also quite telling that the strongest advocates of yuan appreciation (or tariffs on Chinese goods) never advocated a devaluation of the currency when China was dragged into deflation by the steady appreciation of the greenback. In other words, the protectionists in Congress want it both ways, which means they are both inconsistent and wrong.

PGL agrees with Darda two respects: his disdain for trade protection and his respect for Robert Mundell. But in the comments to his post, PGL says that Darda gets it wrong in saying a fixed exchange rate is not manipulation. As I stated here, I'm of the opinion that it's not manipulation as well.

For me it comes down to this. China made a decision over a decade ago to fix its currency to the dollar. This was before the massive explosion of growth and before the Asian financial crisis. They have managed one of the most successful hard pegs in the region, and it probably saved them a lot of grief during the crisis of 1997-98. On the other side of the crisis, they kept that peg right where it had always been. The stability of the currency was, no doubt, part of the reason that so many firms wanted to invest there in spite of the strict capital controls. Yet, the fact that they had kept such a hard peg for so long began to work against them. With all that growth, people recognized that this exchange rate would not work forever. Revaluation is inevitable, but when?

It was at that point that this situation became a game theory exercise.

Most people also realize that a large sudden revaluation would be bad for China. This is a gradual process. Too gradual for some tastes. But I can't fault the Chinese for erring on the side of caution. I might fault them a little for things like this... I won't say I'm totally happy with the way things are progressing. But I don't think a 27.5% tariff is the answer. That's short term thinking for a long term problem.

I will say that Darda's complaint "Where are the tariff threats or cries of currency manipulation against Ecuador, El Salvador, East Timor, Panama, Lebanon, Hong Kong, Saudi Arabia, Kuwait, or Malaysia...?" is a little disingenuous. Comparing China to East Timor? Please. The stakes are higher with China, and I think we have a right to dialogue with them about the pace of reform. But I don't like using protectionist rhetoric to get them to dialogue. Maybe some people think that talking tough on tariffs will force the Chinese president to listen to us when he visits Washington in April. I'm not convinced by that argument. On the contrary, it could backfire.

To sum, the yuan is undervalued, revaluation is inevitable and we should work with them to make sure that it happens at a pace that promotes stabilization in the region. But to threaten tariffs when China is moving in the right direction (and when just 4 months ago the Treasury seemed satisfied with the process) sounds like we're playing election year politics with a process that will necessarily play out over a much longer horizon. Justifying it by calling them "currency manipulators" doesn't do it for me. Like many of you, I lean towards flexible exchange rates. I hope that someday China's economy is healthy enough to float more-or-less freely with the dollar. The Chinese are simply more patient about how to get there than many of us are.

Apropos of my last post on China, macroblog quotes from these two Wall Street Journal articles. His parentheticals along with a couple of quotes...

More competition (and opportunity) looms...

China is opening its vast retail-banking market to foreign institutions at the end of the year, under its World Trade Organization obligations. Foreign investors will then have a shot at China's $1.7 trillion in savings.

... sort of:

But foreign banks' true access to that money is limited by their tiny branch networks. HSBC has the biggest presence of any foreign bank in China, with its 20 banking outlets, compared with some 20,000 for ICBC, the country's biggest bank.

And there is this (also on page C1):

Chinese regulators are planning a policy change that could trip up foreign banks in China just when they are being granted fresh rights to expand.

Within the next few months, the China Banking Regulatory Commission plans to ask foreign banks to change the way they are incorporated, as well as to make accounting and management changes, to roughly conform to the way Chinese banks are structured, according to a senior official at the watchdog agency...

The most far-reaching measure is a request that foreign banks put China operations into a stand-alone entity that is locally incorporated, according to the official and a senior officer of a foreign bank who has been briefed on the plans. The steps are necessary to enhance regulation and control risk, the regulator said.

Under the new rules, foreign banks would face requests to pony up more capital and possibly higher taxes than they now pay, the official said.

It seems likely that they are worried about foreign banks repatriating their profits. Locally incorporated stand-alone entities would be easier to regulate. More twists and turns in this process are turning up all the time.

This Wall St. Journal (subscription req'd) article alerts us to a potentially troublesome situation. To those who watch these events closely, it's just another drip from the faucet. It's not going to go away any time soon either.

Last week, U.S. Trade Representative Rob Portman announced a task force to take up complaints about unfair Chinese trade practices. U.S. politicians allege that China deliberately keeps its currency weak to make its exports cheaper in dollar terms and U.S. imports more expensive.

Now, the U.S. Treasury, which has so far sought to avoid confrontation with Beijing over the currency issue, is preparing the ground for a possible decision to label China a "currency manipulator," in a regular review scheduled for April, although the semiannual report often is issued well after the scheduled release date. The Treasury has been sounding out Wall Street investors about such a move, which would require the U.S. to open formal talks with China on the issue.

I have trouble understanding how they get "currency manipulator" from a fixed exchange rate whose only move in the last decade has been (albeit slightly) in our favor. I understand that it is a political label. The effect of the label is to force talks between the two countries. Ok, fine.

But this business about a 27.5% tariff on imports from China is ludicrous. All that would accomplish is to turn the clock back on our economic relations with China. It's not going to force them to speed up the financial modernization process as much as Congress might like to think it would. Even if it did, a revaluation is not going to solve all our problems. It may not even shrink the overall trade deficit that much at all.

What is odd is the way that Secretary Snow is turning around 180 degrees on this issue so suddenly. Why it seems like only a few short months ago, I posted a link to this story from the New York Times.

BEIJING, Oct. 17 - For two years, Treasury Secretary John W. Snow has pushed and prodded China to let its currency float more freely. On Monday, he declared his satisfaction and changed the subject.

After a week of meetings from Shanghai to Beijing, Mr. Snow buried his specific demands for the yuan beneath a broader call for China to overhaul its system of banking and investment.

The stance sounded bolder and more ambitious, a demand for China to clean up its banks, build a sophisticated market for trading currencies and let Wall Street firms become full-fledged players in the stock market.

But the new call was also a retreat. By closely linking the narrow issue of the currency to long-term goals of "financial modernization," Mr. Snow implicitly gave Chinese leaders years to adopt anything close to a floating exchange rate.

"We are here to encourage the progress, to support the progress," he said on Monday. "Moving toward a truly flexible exchange rate regime requires quite a large number of steps," he added. "We recognize that will take some time."

And you thought I'd forgotten!

As I have pointed out here and here more recently, steps have been taken moving China in the right direction. So what gives? It's not unambiguously clear that the President himself would favor the tariff option (been there, done that). Does this have to do with the Congressional election cycle? Perhaps. Is it just cheap talk? Will Sec. Snow do another turnaround in a few months? Are they positioning themselves to claim victory if there is another small revaluation this year?

I think you know how I would answer those questions at this point. This is something we definitely want to keep an eye on.

From the WSJ (subscription required):

BEIJING -- China will allow the yuan to be traded over the counter for interbank spot forex trading starting Wednesday, the country's central bank said Tuesday.

China will publish yuan benchmark rates each trading day versus the U.S. dollar, euro, Japanese yen, and Hong Kong dollar, the People's Bank of China said in a statement on its Web site.

The new trading system is another step toward giving market forces a larger role in determining the value of the yuan, and making the market for the currency more flexible.

See here for my last post on the yuan.

China Daily sums up the developments for 2005 and looks forward to the new year. A slow, steady path to revaluation and more open exchange is definitely in the works. True, it's still pretty much a dollar peg, but these moves are significant as a signal. When it comes to their currency, China seems to be doing everything right at the moment. One can't help but expect another small revaluation to happen sometime soon. This summer, announcements of changes in the operation of the market were quickly followed by the small revaluation. We've had two pretty significant stories in the last few days. If there is another revaluation soon, it will be small. This is a story that will play out over years, but the next headline could always come at any time.

From the beginning I've argued that China will at some point have to adopt a meaningful currency reform but that they should do it on their own timetable. It should also be pretty clear that a number of things will have to happen in a certain order. This isn't the sort of thing that you just go out and do haphazardly. For example, I posted this just a few short days before the small revaluation that happened back in July.

So what next? The answer came today via this WSJ article (subscription required).

SHANGHAI -- In another step toward more currency flexibility, China's foreign-exchange regulator approved the first batch of foreign and local banks to act as yuan market makers, bankers familiar with the matter said.

Here's what China Daily had to say:

Expectations for further appreciation of renminbi remain in the marketplace, as trading partners continued to push for a stronger yuan and complained about narrower-than-expected price fluctuations.

The introduction of market makers in transactions between renminbi and foreign currencies will likely broaden the fluctuations, but "it will only be seen after the system has worked for some time," the trader said.

China's four State-owned commercial banks, such as the Hong Kong-listed China Construction Bank, are still the biggest traders of yuan in the market after the People's Bank of China (PBOC), the central bank.

But foreign banks will play a bigger role in the future. "It will enable us to fully participate in the development of the foreign exchange market, while providing more flexibility for our clients," Richard Stanley, Citigroup's China chief executive officer, said in a statement. "We believe this is another important step for the advancement of China's currency market."

The introduction of more market makers, which are expected to provide liquidity by quoting both selling and buying prices, will also help reduce the burden on the central bank to absorb excess dollars in the market.

The PBOC enforces the trading band of renminbi by buying the excess dollars in the market with local currency. Its purchases of dollars are added to a growing stockpile of foreign exchange reserves, while the local money it uses injects new liquidity into the banking system.

With China's foreign trade continuing to see huge surpluses and expectations for a renminbi appreciation remaining strong, heavy inflows of dollars have fuelled the growth of local money supply to unhelpfully fast rates.

There will probably be a year in the not so distant future when the economic story of the year is currency reform in China. I don't think 2006 will be that year. Maybe 2007, but even that might be pushing it (of course, the Olympics are in 2008). Until then, expect a story like this every few months confirming that progress is being made.

Alan Bjerga reports:

BEIJING -- "Excuse me for my frankness," said Andy Wei, pouring another cup of tea in his top-level Beijing office, "but American media report little about China."

"Whenever someone comes to visit from the U.S. or Europe, they always see things that are different from what the media tells them, if they're told anything at all. People will ask me if Deng Xiaoping is president. They don't know Hu Jintao. They know about bird flu, SARS. They don't know China."

Andy Wei knows China. He heads the Beijing office of Goodrich, a supplier for Boeing and other companies that has something on nearly every airplane made today. Wei's been at Goodrich and predecessor, pre-merger companies since shortly after he left the Chinese Air Force for 18 years in 1991. He started in the Air Force as a translator, and he still translates -- China to his bosses in America, America to his employees in China.

...

Outsourcing is global reality everywhere, he said. "Singapore used to be strong in shipbuilding. Now that's shifted to South Korea and China. Singapore concentrates on IT and services. If they compete in shipbuilding, they fail. Americans and Europeans must also adapt to change."

But he said he wonders if they will -- if they're informed enough about economics to understand the basics of global development. And that brought him to his original point.

"I don't think Americans are informed about what's happening here, the good that's happening here. This country is underdeveloped, and it needs growth," he said. "This is fair competition, and you can't stop that."

Bjerga has been traveling China for the last month or so reporting on the aviation industry.

Writing for the Wichita Eagle, my old friend Alan is looking for someone to talk to about aviation.

The point is that connections matter everywhere -- maybe they matter more in China, but having four years of reporting experience in Washington, D.C., I think I understand the power of guanxi. And that's why I'm worried -- because I'm coldly aware that in China, I don't have any. Put yourself in the position of the Chinese for a minute. You're an aviation official. This American reporter wants to interview you, on-record, about topics that touch the core of a sensitive trans-Pacific relationship. You don't know this reporter, you've never heard of this reporter. You'll probably never talk to him again, and after he leaves, he could write something that could damage your career without giving it a second thought.

What would you say to the request? "I don't think I have time to schedule that interview." That's the position I'm in now.

American manufacturers won't be happy, but I think it's the right thing to do. I've been saying for a long time that we should back off on the revaluation talk.

Read the whole story from the NY Times:

BEIJING, Oct. 17 - For two years, Treasury Secretary John W. Snow has pushed and prodded China to let its currency float more freely. On Monday, he declared his satisfaction and changed the subject.

After a week of meetings from Shanghai to Beijing, Mr. Snow buried his specific demands for the yuan beneath a broader call for China to overhaul its system of banking and investment.

The stance sounded bolder and more ambitious, a demand for China to clean up its banks, build a sophisticated market for trading currencies and let Wall Street firms become full-fledged players in the stock market.

But the new call was also a retreat. By closely linking the narrow issue of the currency to long-term goals of "financial modernization," Mr. Snow implicitly gave Chinese leaders years to adopt anything close to a floating exchange rate.

"We are here to encourage the progress, to support the progress," he said on Monday. "Moving toward a truly flexible exchange rate regime requires quite a large number of steps," he added. "We recognize that will take some time."

Out of town and blogging sporadically, I should have known something like this would happen.

By now you've heard that China dedicded to revalue the yuan by about 2 percent. That is enough to get the market's attention, to be sure; but it's not as much as what some politicians wanted. Nor is it sufficient to really affect our economy right away. It won't fix the trade deficit.

In case you, like me, have been away from the news for the last 24 hours, you can catch up here and here, for starters. You can also check out the blogosphere-- macroblog, Economist's View, Max Speak, Dan Drezner, Brad Setser, and a Wall St. Journal Econoblog featuring Dave Altig and Nouriel Roubini just to name a few.

Kash at Angry Bear rightly realizes that this small move could actually prompt more speculation (Setser and Roubini note it as well). Remember various devaluations in history that prompted capital flight because the initial devaluation wasn't big enough? Well, this is the same prinicple working in reverse. One thing that can prevent it is for the Chinese central bank to do a good job of managing expectations. Keep a very close eye on this over the next few months.

King at SCSU Scholars as well as the Altig and Roubini Econoblog mention this post of mine. So let me tell you what was going through my mind when I wrote that.

I did mention the principle of macro/monetary theory that says that you can't have free trade in assets, fixed exchange rates, and independent monetary policy (you can have at most two of the three). I honestly did think about connecting the dots, but decided in the end to leave it to the reader (I have excellent readers who did notice the connection). I really didn't expect it to happen before the end of the week. (Who did?) But like many of the econobloggers out there, I figured something was definitely building. In that respect, the announcement on the lifting of capital controls earlier this week did seem to be almost a necessary step in a sequence of events--as a signal if nothing else. So while I didn't think it would be this week, I can't say I fell out of my chair with surprise. The combination of the relaxaton of capital controls (assuming it's more than just a token gesture) and today's announcement on the exchange rate are important steps in China's macroeconomic development. But it is just one more step--neither the first, nor the last.

Here's what I thought about the timetable to revaluation back in April.

A few years ago, it might have been 2002, I was asked when I thought China would begin to relax their exchange controls in a meaningful way and begin to float. At that time, I answered somewhere between 2008 and 2012, and that it would be gradual, perhaps taking that entire range of years to complete. Funny thing is that today I'm less sure. I don't think I have the confidence to give a range like that now. If pressed, my answer would probably be about the same, but with less confidence. There would be something to be said for beginning before the Olympics, but that's really going out on a limb.

How things change. More recently, I would have probably expected something by the end of the year, or more conservatively in 2006. I was still off by a bit.

I also said this at a moment when the game theory implications made me throw up my hands. So did China choose summer to make the move when Wall St. traders are vacationing in the Hamptons? Just a thought. I think the intention all along was to create an atmosphere where some movement would be expected, but no one would know the day. I'd say it worked.

The bond market took it as well as could be expected. The 10 year lost almost a point, but that's not bad all things considered. The yield curve looks a little more respectable, though I wouldn't take any extra undue joy from that. Besides, there is likely to be some further adjustment over the next few days as the market gets used to the new normal. Let's watch it for a few days. Certainly by the next FOMC meeting we might have some interesting things to say about it.

I agree with the consensus that this will not have a huge effect in and of itself. It is significant that China is no longer exclusively pegging to the dollar. But again, this isn't going to cure our trade deficit or lead to any other massive implications in the short term.

I do believe, however, that this is just one step in a long road. The pace may quicken or it may remain (dare I say) measured. I have said in the past that China will not make any moves until they feel it is time for them. I think that still applies to the endgame. You won't see complete convertibility or a true floating exchange rate for a long time. China has a lot of work to do before then. They also have to continue to build their monetary reputation. If they are able to maintain control over the rate within the band they have set out, it will go a long way towards building that reputation and moving the day of full convertibility closer. If today's move only turns up the speculative heat, then they may have moved too soon.

But for now, I'm optimistic that this very gradual change will be interpreted correctly. China is earning a reputation, and I don't think they will squander it. After one day, I'd say they should be very happy. Now comes day two...

What does this mean for the Fed and policymaking in general? Let's leave that for another day. So far, not much. 2% isn't going to throw a huge crimp in Greenspan's style. As time goes on, if there is further movement, you can be sure that I will have more to say.

And that's where we are. Everyone wants to say something, but what do you say that hasn't been said already? And there are some aspects on which comment is rightly reserved until we see how the market adjusts. We've been expecting it for a long time, but with little or no idea of when it would happen. Now realizing that the immediate impact will be little more than a ripple, we are left to ponder when and how the next move will take place and whether this will quell the speculation or encourage it. Despite the flurry of activity today, this story will play out over weeks and months.

But it sure is exciting, isn't it?

China's economic situation is truly fascinating. Seems like it would be a pretty easy task to collect a series of news articles to supplement an international macro text... just on China.

Case in point, from China Daily:

China plans to further loosen its strict capital controls to boost the competitiveness of its firms overseas, a move which would also relieve building speculative pressure on the yuan.

The State Administration of Foreign Exchange (SAFE) will deepen reforms by improving its management and creating a more supportive foreign exchange framework, Li Dongrong, deputy chief of SAFE, was quoted as saying by Financial News.

"Advancing and deepening the management of foreign exchange and structural reform is required ... so that domestic companies can go overseas and take part in international process of competition," said Li.

The reforms would grant domestic and multinationals in China greater strategic freedom by allowing them to buy more foreign currency as well as lend the money to overseas subsidiaries.

Chinese banks would also be allowed to lend foreign currency to Chinese companies operating in foreign countries directly, Li said.

...

Earlier this month China's central bank governor Zhou Xiaochuan was quoted as saying by local media that supporting Chinese companies to move into international markets was becoming a key strategy of the country's economic development.

The banking chief also said that China should lift certain foreign exchange controls in the near-term to create conditions for the full convertibility of the local currency, but did not say which ones.

China keeps its currency effectively pegged at 8.28 yuan to the dollar, a level that many trade partners say is artificially low and gives the country an unfair boost in trade.

Doing away with curbs on outbound capital flows would also relieve pressure on the yuan and help the bank combat the billions of dollars in speculative money flowing into the country.

Fixed exchange rates, independent monetary policy, and free asset trade--an economy can have at most two of these, not all three. China has been pursuing the first two while capital controls have prevented truly free asset trade. The steps outlined in the article do not totally free up trade in capital, but they represent a step in the right direction if they follow through with it. Of course, the speculation on the possible revaluation of the yuan has stepped up lately. This announcement could be aimed at quelling some of that speculation. Time will tell.

Krugman says (NY Times):

But the negative effects of a change in Chinese currency policy will probably be immediate, while the positive effects may take years to materialize. And as far as I can tell, nobody in a position of power is thinking about how we'll deal with the consequences if China actually gives in to U.S. demands, and lets the yuan rise.

I've been saying that China will not revalue until it is the right thing for them to do for their domestic economy. I've never considered the yuan issue a critical policy matter for us (in the sense that a floating yuan would make life a lot better for us). Of course, anything that arouses so much passion in Congress is bound to get my (and your) attention. Everytime I ponder the yuan, I usually end up thinking about the fact that this is a much more important issue for the Chinese than it is for us and that we can't do much about it anyway. Inasmuch as we are one of China's major customers, they probably will not ignore any negative effects that it may have on us. Still, I'm inclined to agree with Krugman on this one. All of the blustering the U.S. has been doing has been puzzling me. Until recently it has just been a buzz in the background, but it's getting louder. Loud enough, in fact, that Greenspan is stepping into the ring. Greenspan says that revaluation will not matter that much for our trade deficit.

Yet Secretary Snow just appointed a special envoy to address the Chinese currency issue. And then you have this story that is just plain disturbing:

Snow said the dark mood on Capitol Hill represented "a dangerous situation" and he hoped China recognized and understood that was the case.

If you could see me now, you'd see that I'm just sitting here shaking my head.

UPDATE: The New York Times editorial page weighs in with similar sentiments.

From the NY Times editorial page:

At the heart of this debate is China's policy of linking the value of the yuan to the value of the dollar. That was called sound policy when the dollar was strong. But now that it is weak, Congressional critics call it manipulation because it makes already inexpensive Chinese goods even cheaper the world over. As proof that the yuan is undervalued, the tariff seekers point to the United States' ballooning trade deficit with China, which accounted for about one-fourth of the United States' gargantuan global trade imbalance of $617 billion in 2004.

The trade deficit and the loss of American manufacturing jobs are very serious problems. It would be nice to think that they would self-correct if China would only change its ways. Nice, but wrong. Most of the trade gap with China is caused by Americans' insatiable appetite for Chinese imports, for which there are few domestic substitutes. And even if the yuan's exchange rate is too low - a point on which economists differ - it is a minor contributor to the trade deficit. If China let the yuan appreciate by 20 percent, and most other Asian currencies followed suit, the deficit would probably decline by only about one-fifth over the next year or two. That's not nearly enough to bring the American trade imbalance into a range that is generally considered sustainable.

Tariff-mongering politicians don't necessarily want to believe this. "Many of us feel they're playing this country for a fool," Senator Charles Schumer of New York fumed at a recent hearing. Treasury Secretary John Snow, to his credit, explained at that hearing how a premature yuan revaluation might do more harm than good.

That's just a sample. Read the whole thing. It's right on target.

UPDATE: More on China in today's Times.

Nouriel Roubini agrees.

Now remember, I still lean to the "soft landing" side of things, though I acknowledge that our current position is not without risk. Raising the level of pressure on China to revalue the yuan increases the risk.

Remember also, that I have said that China will not do anything until it is their time to do so. So it may not surprise you that I think that the talk from Washington is just that. Talk. And talk, as Roubini also says, is cheap. This is the kind of talk that could weaken our credibility if people really sat down and realized that it will likely have no effect on China and, as far as I can tell, is only really intended for domestic consumption.

You see, Brad Setser's comment in this post (the Peoria comment) is right on. I think this probably is a case of a position being taken (on the exchange rate issue) to look like we're doing something to close the trade deficit. There would be a small upside to a revaluation, but the downside is much, much worse for both China and the U.S. if the revaluation is too much, too soon (see Roubini's quote about not biting the hand that feeds you).

And China isn't going to do anything that is not in it's best interest anyway.

A few years ago, it might have been 2002, I was asked when I thought China would begin to relax their exchange controls in a meaningful way and begin to float. At that time, I answered somewhere between 2008 and 2012, and that it would be gradual, perhaps taking that entire range of years to complete. Funny thing is that today I'm less sure. I don't think I have the confidence to give a range like that now. If pressed, my answer would probably be about the same, but with less confidence. There would be something to be said for beginning before the Olympics, but that's really going out on a limb.

Bottom line is that there are still plenty of reasons for China to go slowly, even though we all know where they (and we) want to be in the long run--when they are ready.

And most of the things that need to happen for China to be ready are beyond our control--certainly beyond what we can change with mere words. All other things equal, too much talk could come back to bite us later, regardless of whether China responds to it or not.

Alas, it continues, (Reuters)

BEIJING (Reuters) - U.S. pressure to free up the yuan will be counter-productive to China's planned currency reforms, despite a growing domestic sense of urgency for making such changes, the official China Daily said on Monday.

"Pressurizing China will be futile, if not even complicating the situation," the newspaper said in a commentary. "Worse, it will distract the United States from attending to the domestic causes of its problems."

UPDATE: Dan Drezner has an interesting take.

Read this:

BEIJING (Reuters) - China could spring a surprise on financial markets in deciding when and how it reforms the yuan, Premier Wen Jiabao said on Monday in comments seen as warning speculators trying to guess what the country might do.

"Our goal has been to let market supply and demand determine the exchange rate," Wen told a news briefing at the close of the annual session of parliament.

"We are carrying out such work now, and as for the timing and what measures will be adopted, this could be unexpected."

I like this part the best:

"The attitude by Beijing is they don't want to reward speculators," Claudio Piron, an Asian forex strategist with JP Morgan in Singapore, said of Wen's remarks.

"The only thing is, this statement itself is kind of going to bring speculators back into the market, so they've kind of contradicted themselves," Piron said.

The market moved a little...

Following Wen's remarks, the offshore non-deliverable yuan forwards market, used by speculators to bet on any change in the currency's value in the future, priced in a 4.8 percent appreciation in the yuan in one year, increasing from 4.6 percent priced in on Friday.

...but Andy Xie remains unimpressed.

Andy Xie, an economist with Morgan Stanley in Hong Kong, said China would not spring reforms any time soon, and that Wen's comments were no departure from Beijing's go-slow approach to currency changes.

"China's not in a position to move on the currency because the economy is not stable," Xie said. "The currency is the only anchor for the economy right now."

That would be my gut reaction too. (But maybe that's what they want us to think!)

Also, see this Bloomberg article, courtesy of Calculated Risk (a blog that I just came across recently but deserves your attention).

Are these stories connected? Stay tuned to find out!

From Reuters:

BEIJING (Reuters) - China will keep its currency in a relatively small range even when it implements a gradually more flexible exchange rate system, a state newspaper on Saturday quoted the top foreign exchange official as saying. The country had already made preparations to reform the exchange rate system, which currently keeps the yuan in a tiny range between 8.276 and 8.28 per dollar, the China Securities Journal quoted Guo Shuqing, head of the State Administration of Foreign Exchange, as saying.

"We will continue to maintain a managed floating system based on market supply and demand and will gradually increase exchange rate flexibility," Guo was quoted as saying.

"In fact, we have been constantly reforming the foreign exchange system and the exchange rate formation mechanism and have made a lot of preparations, including developing the forex market."

"As China is a developing country, the floaing range for the yuan exchange rate will definitely be relatively small," Guo said.

Sounds a little like opening a door just a little bit at a time when people are pounding on it trying to get in. It might just cause folks to pound harder. Good timing and effective management of expectations will be critical for success.