Do markets determine the value of the RMB?

Last Tuesday the PBoC surprised the markets with a partial deregulation of the currency regime, order prompting a great deal of discussion and debate about the value of the RMB. Part of the discussion was informed by a consensus developing in one part of the market that the RMB is no longer undervalued but is in fact overvalued. Why? Because if left to the “market”, that is if the PBoC stopped intervening, the excess of dollar demand over supply would force the RMB to fall.

This argument is based on a pretty confused understanding of how markets work and why investors do what they do. I thought it might be useful if I were to try to lay out the issue a little more clearly, and along the way address related issues. Because it isn’t necessarily easy to tie all of the topics together in an essay, I thought it might be better if I put it in the form of a series of questions.

There are two conclusions, or at least two points I would argue:

  1. “Market” forces, that is the balance of supply and demand, do not always indicate the relative valuation of an asset. This is partly because there are several ways to define market forces, but mostly because we usually think of valuation in terms of economic fundamentals. An overvalued currency is one in which market fundamentals, by which I mean the valuation of assets on the basis of expected cashflows discounted at an interest rate that is not distorted, drive supply and demand.
  1. Supply and demand for an asset can also be driven by what traders often call “technical” factors. These are generally changes in supply in demand caused by other than fundamental factors. When China first approved the QFII program that permitted foreign investors to buy stocks, for example, or had China’s stock markets been included in the MSCI global benchmark in June, as was expected, there was or would have been an immediate increase in demand for Chinese stocks that would have caused prices to rise for reasons that had nothing to do with an improved economic outlook.

When I was a student, I was taught that if prices did rise, they would do so by an imperceptible amount because they had been trading at a level consistent with a fundamental balance between demand and supply, and as soon as foreign purchasing caused prices to increase, Chinese investors would take advantage of “excessively high” prices to sell out. Of course this is almost the opposite of what happened. Prices rose precisely because of expected buying, and then fell in the case where the buying materialized.

There was no fundamental valuation to anchor prices. Once I became a trader this was one of the many things I had to unlearn, but rather than reject altogether the idea that fundamental valuation plays any role, which too often is the reaction traders have when they first learn that markets are not always driven by value, I thought it would be more useful to identify the conditions under which market prices do or do not respond to fundamentals.

  1. The RMB almost certainly would decline in value today without PBoC intervention, but this does not indicate at all that the RMB is overvalued. In fact the best argument is that the market is driven largely by technical, and that if we try to extract information from fundamental markets, we almost certainly would arrive at a very different conclusion. The RMB, it turns out, remains undervalued, although I suspect not by very much.

How did the PBoC change its currency regime?

The PBoC’s statement on August 11 that it was changing the country’s currency regime set off an explosion of analysis, accusation, praise and questioning that hasn’t yet subsided much. Along with devaluing the currency by 1.86%, the most since 1994, the PBoC announced that it would modify the way it set the reference rate, known as “central parity”, that determines the RMB’s trading band, and it would so so “for the purpose of enhancing the market-orientation and benchmark status of central parity”.

It has, in effect, partially deregulated the exchange rate mechanism by relaxing intervention procedures, although it is still able to intervene as much as ever. Effective August 11, the PBoC said, the central parity would be set on a daily basis equal to “the closing rate of the inter-bank foreign exchange market on the previous day.” Probably to indicate that this did not mean the end of PBoC intervention, it added that the rate would be set “in conjunction with demand and supply condition in the foreign exchange market and exchange rate movement of the major currencies.”

Until that day the PBoC set central parity every day at whatever rate it thought appropriate. In principle this is supposed to mean that the value of the currency is a function of the PBoC’s best estimate of the exchange rate that maximizes China’s long-term productivity. In the best of cases, however, the sheer complexity of any economy, let alone the global economy within which it operates, would make this impossibly difficult to determine even if there were objective ways of valuing the choice between a short-term cost or benefit and a long-term cost or benefit, or of choosing how costs or benefits will be distributed among different economic sectors or social groups.

This is why there is a grudging consensus, although certainly not unanimous (nor is all the consensus grudging), that the most effective and efficient way to determine the exchange rate is to let the market decide. If all potential buyers and all sellers of RMB, whatever their reasons, collectively decide on a price at which all transactions can clear, that price is presumably the best estimate of the exchange rate that maximizes China’s long-term productivity.

Why did they do it?

There are three different reasons that might explain the PBoC’s move Tuesday.

  • Improve trade. While China’s current account surplus has been very high, this is mainly because imports have done worse than exports. Both have fared poorly. The numbers were especially bad in July, when imports were down 8.1% year on year while exports were down 8.3%. Because of its peg to the appreciating dollar, the renminbi has been very strong on a trade-weighted basis. The new currency regime may be aimed at reversing this.
  • Qualify for SDR. There may have been concern that the large and persistent gap between the fix and actual trading in both the onshore and the offshore markets would prevent the RMB from qualifying for inclusion in the SDR basket. What is more, by including a RMB pegged to the dollar, the already overly dominant weight of the dollar in the SDR would be substantially increased, something the IMF clearly does not want. Beijing may be eager for the RMB to become part of the SDR basket because it believes this will result in significant foreign inflows that will help reverse China’s very large and potentially destabilizing capital account deficit. Its strategy may be working. On Wednesday the IMF described the new pricing mechanism as “a welcome step as it should allow market forces to have a greater role in determining the exchange rate”. It followed by noting, a little obviously, that the “exact impact will depend on how the new mechanism is implemented in practice”.
  • Monetary freedom. The well-known “impossible trinity” makes it impossible for a central bank to control both domestic interest rates and the exchange rate if its capital account is open. Although technically not open, China’s capital account is porous enough for all practical purposes. This means that as long as the PBoC intervenes in the currency, it cannot provide debt relief to struggling borrowers, and to the economy overall, by lowering interest rates without setting off potentially destabilizing capital outflows. This constraint would be even tighter if the Fed began to raise interest rates. Reform of the exchange rate mechanism restores interest rate flexibility.

There is no way to say for sure which of these drove the PBoC decision because the PBoC, like most central banks, has preferred to be a little vague about its reasoning, but I suspect that it changed the currency regime primarily either to gain monetary freedom or, more likely, to qualify for inclusion in the SDR. I doubt that the desire to turbocharge exports played much of a role, but I worry that if the PBoC was hoping to reverse the huge deficit on its capital account, the success of its plan will hinge on whether it was able to distinguish between fundamental demand and technical demand.

What determines the PBoC’s best estimate of the appropriate exchange rate?

The exchange rate has several functions in any economy, and what the PBoC decides is the most appropriate exchange rate depends on what it is trying to accomplish. These include:

  • By transferring wealth from one sector to another, the exchange rate can be used to subsidize favored sectors at the expense of others. High exchange rates benefit household consumers, the services sector, and urban residents, among others. Low exchange rates benefit the tradable goods sector and commodity producers, among others.
  • This process of transferring wealth also means that a higher exchange will speed up the rebalancing process, in this case by transferring wealth from the PBoC and the tradable goods sector to households.
  • The interest rate and the exchange rate are two of the most important prices in an economy, or put differently, they are two of the most important pieces of information economic entities, including businesses, use to make investment and operating decisions. When the RMB trades at its fundamental value, economic agents within China are most likely to make the decisions that optimize overall value today and preserve the sustainability of economic behavior. Anything that pushes it away from fundamental valuations will distort the investment and operational behavior of all economic entities.

How does the market provide information?

We can usefully think of the “market” as a machine that processes a vast amount of information quickly and smoothly. Any agent who possesses superior information about a product or service that will cause a change in its supply or its demand will buy or sell based on the information. His buying or selling becomes the way in which the information is absorbed by the market and presented, in the form of a price, to all other agents.

This isn’t necessarily the most accurate of ways in which to determine a price but it seems to be more accurate than any other method we have been able to come up with. Put differently, it seems to be the most accurate way to drive the allocation of goods and services in a way that maximizes social wealth (which is, after all, what a market is supposed to do). We shouldn’t assume, however, that with the market all of the tough questions have been adequately answered.

The market implicitly does determine the answer to these questions, like the trade-off between the present and the future, or the different values it places on the needs of different social groups. We know that the market does these things because that is what it means for the market to clear, but the answers it provides will vary according to the institutions, including moral values, that form part of the system within which it operates.

One of the most important advantages, or efficiencies, of “letting the market decide”, however, is that it doesn’t seem like the answers the market gives us are in fact affected by our institutional setup. The market’s “decisions” are given a veneer of neutrality that everyone accepts, even though the decision is not neutral at all. This seeming neutrality reduces the political maneuvering that might otherwise occur.

Does PBoC intervention to support the RMB mean that it is overvalued?

One of the main questions being batted around is whether, under the new system, the value of the RMB is finally going to be determined by the market. If it is, it almost certainly means that the value of the RMB will decline.

Why? Because the balance of payments, which is the sum of the current account surplus and the capital account deficit, is in deficit if we exclude PBoC interventions. At current prices there is more RMB selling than there is buying, and the PBoC has to sell reserves and buy RMB in order to keep the currency from depreciating.

This, many people argue, proves that the RMB is overvalued. The “market”, they claim, has spoken, and it has told us that the RMB is overvalued.

They are wrong. The “market” is not telling us that the RMB is overvalued. It is telling us only that there is more supply of RMB than there is demand for RMB at the current exchange rate. Because “overvaluation” and “undervaluation” usually refer to the fundamental value of a currency, this excess of supply over demand would only imply an overvaluation of the RMB if supply and demand were driven primarily by economic fundamentals.

What drives supply and demand for the RMB?

Excluding central bank intervention, which is mainly a residual contributed automatically by the PBoC to balance supply and demand for foreign currency, all purchases or sales of foreign currency in China can be divided into current account activity, which mostly consists of the trade account, along with other transactions including tourism, royalty payments, interest payments, etc., and capital account activity, which consists of direct investment, portfolio investment, and official flows.

Imbalances in both the current account and the capital account can be driven by economic fundamentals, in which case it might make sense to say that the RMB’s “correct” exchange rate is broadly equal to the clearing price at which supply is equal to demand. In this case if the central bank were to purchase RMB, reserves would decline and it would be reasonable to assume that PBoC intervention would cause the RMB to become overvalued, while PBoC sales of RMB would cause reserves to increase and the RMB to become undervalued.

But neither the current account nor the capital account is necessarily driven only by economic fundamentals. As an aside, most people, including unfortunately most economists, typically assume that the current account is independent and the capital account, if they think of it at all, simply adjusts to maintain the balance, but this is an extremely confused way to think about the balance of payments.

During the past thirty years especially, reserve accumulation and private capital flows have overwhelmed trade flows, to the extent that small changes in gross capital flows have often forced large changes in trade and current flows. Even in the 1950s and 1960s, when international capital flows were much smaller, and did not drive trade flows to nearly the same extent, capital flows very often constrained trade flows – most famously the “dollar shortage”, which was only relieved by the Marshall Plan.

What might push the current account balance away from fundamentals?

If the domestic and foreign tradable goods sectors are not subsidized or penalized, the market for tradable goods can be seen as operating largely on the basis of fundamentals. In that case imbalances in the supply and demand for foreign currency may indicate under- or over-valuation of the currency. But the trade account can depart from fundamentals under these or similar conditions:

  • If Beijing were to impose significant tariffs, prohibitions on imports, or otherwise intervene directly in trade, it could distort the current account in ways that do not reflect economic fundamentals.
  • Regulations that discriminate against or in favor of imports – for example Japan in the 1970s and 1980s imposed safety inspections for foreign cars, whose very slow pace prevented imported automobiles from being competitive except at the very high end of the market – can distort fundamentals.
  • Without central bank intervention the capital account must balance the current account, so that if there were significant net inflows or outflows on the capital account, these net flows would force the RMB up or down in order that the current account surplus or deficit balances the capital account.

What might push the capital account balance away from fundamentals?

If capital enters or leaves China in order to earn higher expected returns on investment in business or manufacturing capacity, or to purchase undervalued assets, we can broadly assume that capital flows are driven by fundamentals. Otherwise they are not. Non-fundamental capital flows into or out of China might include:

  • Wealth or portfolio diversification,
  • Speculative inflows driven by asset bubbles, or “carry trades” driven by arbitrage opportunities based on capital-flow restrictions,
  • Flight capital driven by fear of political instability, financial instability, or the anti-corruption drive,
  • Official flows driven by political considerations,
  • Investment outflows that are not sensitive to economic fundamentals, for example those driven by government directives to acquire commodity-producing businesses and land, or to acquire technology or management skills

Can the market decide on an appropriate value for the RMB?

Whether or not we believe that the market should determine the value of the RMB is one of those questions – like whether or not we support of free trade, supply side economics, fiscal deficit limits, debt, etc. – that tends to be framed as a question of principle when in fact it isn’t. These work well to enhance productivity and wealth under certain conditions and fail under others, so that it is much more useful to specify the conditions under which they work – for example, what are the conditions in which China would generally be better off if the markets decided the value of the RMB?

To answer we need first to decide what our objective is. If we have political goals, for example wealth redistribution, or the protection of certain types of industries until they are sufficiently competitive, we would probably want to start with an idea of the economically optimal exchange rate on a fundamental basis and then move it in one direction or the other.

In China’s case, I would argue that the goal is to eliminate some of the distortions in the Chinese economy that weaken domestic demand and systematically misprice economic inputs, most notoriously capital. These have left China with a dangerous dependence on debt, excess capacity and inventory, and a state sector in which incentives to innovate and create value are overwhelmed by political incentives (that include capturing explicit or implicit subsidies).

One consequence has been so much wasted investment that I am convinced that many years from now we will look back at China in the 2000s, rather than Japan of the 1980s, as the classic example of capital misallocation. If eliminating these distortions is indeed the goal, I would argue that the correct exchange rate would probably be one that is determined by the country’s economic fundamentals, i.e. one that matches supply and demand for dollars in the real economy – or perhaps a little stronger than that in order to help the rebalancing process.

If on the other hand the goal is to ensure that China has sufficient reserves, I would argue that the correct exchange rate would probably be one that is determined by the country’s overall balance of payments. In the past a country’s money supply was often a function of its gold or silver reserves, and economic performance could be severely impaired by a shortfall of specie reserves. Today there are countries running persistent deficits, or in which domestic investment is severely constrained by insufficient savings. In these two cases it might make sense to focus on the overall balance of payments and the information it might give us about an appropriate exchange rate for the RMB, but China is obviously not one of these countries.

What happens if the exchange rate is set at a “wrong” price?

An important characteristic of a market is its systemic ability to adjust, whether quickly or not. If there is a distortion in the price of any good or service, the price of other goods and services automatically adjust to return the market to what is assumed to be an optimal stage.

This is why economists who argue that the value of currencies like the RMB should be fixed – usually in terms of other major currencies, such as the dollar, or in exchange for commodities, the longest serving of which has been cowries, followed by gold – can also argue that markets should determine all prices without being inconsistent. If the central bank pegs the value of its currency to another currency, as the PBoC pegs the value of the RMB to the USD, all other relevant variables, most importantly the interest rate, will automatically adjust so that the economy will presumably get the full benefit of the market’s superior ability to process information.

How do prices adjust to distortions?

Every transaction or policy moves a system away from equilibrium, just like every price distortion. If there are reasons to prevent a quick return to equilibrium, the system becomes increasingly unbalanced. This is why Albert Hirschman argued that all growth tends to be unbalanced growth, and in economies with very large state sectors, these imbalances can persist.

In the idealized “Smithian” world of innumerable economic agents none of which is big enough to distort the adjustment process, the economy must quickly adjust so that the system is never far from equilibrium. In this world the only thing that can cause a crisis, which is a nothing more than a very rapid, disruptive adjustment of a major imbalance, is some kind of major external shock, which is soon followed by a crisis.

In a world, however, in which there are institutions or institutional players large and powerful enough to block the adjustment process, the imbalances can build for a very long time. As they do, they put increasing pressure on the institutions that prevent adjustment, and so the adjustment itself becomes increasingly disruptive (often causing policymakers to react by preventing adjustment even more aggressively, thus locking the country into a potentially self-reinforcing process of growing imbalances). Eventually the adjustment must occur, either rapidly in the form of a crisis (and it takes an increasingly small external “shock” to trigger the crisis), or slowly in the form of a long and usually difficult period of rebalancing.

This is not the place in which to enter into a long discussion of how economic systems work, but it should be clear that we live in a world in which there are many large institutions, most obviously governments, as well as legal and regulatory constraints, perhaps most importantly within the financial system, that prevent automatic adjustments from occurring immediately.

There are however at least two important points worth reminding anyone thinking about how currencies are pegged:

  1. Volatility is transformed, not eliminated. All economies are volatile, and while the impact of volatility on any economic entity can be exacerbated or minimized by the structure of its balance sheet, this only happens as volatility is assigned to agents less able or more able to absorb it. Pegging the RMB to the USD, for example, does not eliminate the volatility associated with expected changes in the USD value of the RMB. Instead the volatility shows up as higher volatility in China’s money supply, higher volatility between USD and non-USD currencies, greater trade imbalances, and so.
  1. Interventions are effectively forms of wealth transfer. Pegging the RMB to the dollar at a low rate, for example, transfers wealth from importers to manufacturers in the tradable goods sector in a process well understood by most economists. But while it reduces currency volatility, it increases volatility in the money supply. What is more, as the PBoC attempts to control the interest-rate component of this volatility by fixing interest rates (which until recently also transferred wealth from savers to borrowers directly), there is even more volatility in China’s money supply, both in the present, in the form of inflows and outflows, and in the future, as it is “stored” in the form of rising bad debt.

Because regulators can never choose how much volatility they will permit, at best they can choose the form of volatility they least prefer and try to control it by transferring it elsewhere. This is usually a political choice and not an economic one, and is about deciding which economic group will bear the cost of volatility.

Even when it is an economic choice aimed at resolving a particular problem, once that problem is resolved and the transfers begin to undermine productivity, the beneficiaries are often powerful enough to prevent reform. Government interventions in the currency usually aim at creating wealth transfers to subsidize favored sectors or at suppressing volatility that penalizes favored sectors, or both. The analysis of their impacts is never complete until we have also worked out the impact on those sectors from whom wealth has been transferred or to whom volatility has been transferred.

The “impossible trinity” adjustment

The best-known of these adjustment processes, and the one most relevant to the RMB, is the impossible trinity, which is simply a restatement of the way money supply must automatically adjust. In an open system (free capital flows being one of the three legs of the trinity) the PBoC can choose to peg the USD value of the RMB, in which case the money supply adjusts as money is created or destroyed in order to match supply and demand in the market in which RMB and USD are exchanged. Or it can chose to determine the size of the money supply (which it attempts to measure by looking at interest rates), in which case the exchange value of the RMB will rise or fall in order, once again, to match supply and demand in the market in which RMB and USD are exchanged.

This in fact may be one of the main reasons (which I listed above as the goal of regaining monetary freedom) the PBoC changed its currency regime. For the past two years Chinese interest rates have been too low relative to the value of the currency for supply and demand in the capital markets to balance, and we know this because China has a large capital account deficit. It experienced massive net outflows on the capital account.

Because these net outflows put destabilizing pressure on a banking system used to net inflows, there were two ways the PBoC could manage the process. It could raise interest rates high enough to satisfy investors, or it could cause them to reduce their required yields.

But it is important to understand that there is no particular reason in principle for supply and demand in the capital markets to balance. Before 2014 China ran large surpluses on both its current account and its capital account, and because the balance of payments must balance, by definition, it had elsewhere to run a massive deficit equal to the sum of the two, and it did in the form of a central bank deficit – another name for rising foreign exchange reserves.

The increase in central bank reserves was a residual, and not a decision by the PBoC. When it decides to peg the value of the currency, it has no choice but to accumulate or lose reserves, as the impossible trinity ensures that money supply rises or falls to match supply and demand in the market in which RMB and USD are exchanged.

The structure of the investor base matters

The fact that the capital account deficit has grown to overwhelm the current account surplus does not tell us whether or not the net imbalance is driven by fundamentals. What matters is whether or not the capital account is driven by fundamentals.

There are, very broadly, two reasons to bring money into China and two reasons to take it out, and we can define these as fundamental and speculative. As I explain in my book, Avoiding the Fall, as well as in a November 2013 blog entry, there are three different types of investment strategies that explain most investment decisions, and depending on the mix of investment strategies in any given market, the behavior of that market, including what it decides is information, determines whether that market will react to fundamental or technical information how it will interpret that information.

A fundamental investor brings money into China in order to invest in a project that will deliver value over the long term. A speculator brings money into China in order to purchase an asset, usually stocks or real estate, which he can quickly sell at a profit. Investors who borrow USD or HKD to buy short-term RMB-denominated government bonds or other debt in order to earn the interest rate spread, as well as profit from any increase in the value of the RMB, are technically relative value investors, but for our purposes are speculators because they provide net inflows into China if is seen separately from the offshore markets.

More importantly, they process and interpret information in the same was as speculators and rather than act to stabilize prices (by buying for value when prices decline), they tend to enhance volatility by reinforcing appreciation and depreciation expectations. Technically the second and third of the three are illegal and violate capital restrictions, but these involve domestic investors, businesses or SOEs who are able to take advantage of corruption or weak regulation to circumvent these restrictions.

Similarly a fundamental investor takes money out of China in order to invest in foreign projects that will deliver value, including diversification benefits, over the long term. Investors who take money out of China in order to hide it, however, or because they are frightened by perceived financial or political risk, should for our purposes be classified as speculators, not because they seek speculative profits but because they have the same systematic impact as speculators.

Finally there are investors who take money out of China in order to achieve political objectives. For example they may seek to reduce China’s dependence on foreign-owned agricultural or non-agricultural commodities.

The purpose of this classification is not to identify the good guys and the bad guys but rather to understand market dynamics. I spent most of my career on Wall Street trading floors, and like most traders and institutional investors I think of markets differently than do most economists and policymakers. In order to understand how markets will perform I try to work out the structure of the investor base, understand market “technicals”, i.e. potential changes in supply and demand, along with their triggers, and look for convexities or implied options. A market dominated by speculators must react in a profoundly but predictably different way than one dominated by fundamental investors.

How do speculators interpret information differently from fundamental investors?

One of the reasons the PBoC may have permitted RMB depreciation is to regain control of monetary policy. The “impossible trinity” prevents a central bank from controlling both domestic interest rates and the exchange rate if its capital account is open. Although technically not open, China’s capital account is porous enough for it to be “open” for all practical purposes.

It turns out that interest rates in China are higher than they are elsewhere in part because of the constraints imposed by the impossible trinity. Even with higher interest rates on its government bonds, in which the risk of default is widely perceived to be close to zero, there is nonetheless a large net outflow on China’s capital account. Why don’t more investors take advantage of higher Chinese interest rates and equally low credit risk by bringing money into the country?

The most obvious reason is that they are worried about depreciation risk. Because most wealthy Chinese seem to think about RMB in terms of USD or Hong Kong dollars, it is the fear that any depreciation of the RMB against those two currencies (the Hong Kong dollar is pegged to the USD through a modified currency board) greater than the couple of percentage points interest rate differential would yield less than equivalent USD or Hong Kong dollar bonds.

This means that as long as the PBoC intervenes in the currency, it cannot provide debt relief to struggling borrowers, and to the economy overall, by lowering interest rates without setting off potentially destabilizing capital outflows as the interest rate differential narrows. This constraint would be even tighter if the Fed began to raise interest rates, which would also cause the interest rate differential to narrow.

So how do we reconcile the PBoC’s desire to reduce interest rates with the higher interest rates investors need to compensate for the greater risk of devaluation? The answer, it turns out, is fairly straightforward. The interest rate investors require to buy bonds must decline until it is equal to the PBoC’s target interest rate. Because the interest rate investors require is a function of their perception of the devaluation risk, this means that the currency must decline until the perception of devaluation risk is low enough to meet the PBoC targeted interest rate.

In that case it would be a fairly easy matter to reduce the value of the RMB to the point at which investors believe the currency to be correctly valued. Once it reaches that level, there is no longer a bias to currency volatility and the RMB is as likely to rise as it is to decline. The currency would then be fairly priced, the expected volatility very low and unbiased, and investors would require nothing more than the risk-free cost of capital (assuming, of course, that expected inflation is positive).

But is the capital account buying dollars for fundamental reasons – that is, because foreign assets are cheaper that Chinese assets or foreign growth expectations higher than Chinese growth expectations?  Probably not. Three things seem to drive the outflow, which was a net inflow two years ago and has only recently surged to such astonishingly levels.

  • Government-directed purchases of commodity producing assets or of strategic technologies, which are not sensitive to issues of fundamental valuation.
  • Flight capital, driven probably by rising political or financial uncertainty, which is not sensitive to issues of fundamental valuation.
  • Speculative capital worried about currency depreciation.

The capital account does not seem to be driven by fundamentals, in other words, and is instead driven mainly by outflows that are not sensitive to valuation issues. But in a highly speculative market, price movements are usually self-reinforcing, so that a falling RMB may actually increase the desire or need to sell. This might be because there are leveraged investors, including investors in derivatives, whose borrowing costs are inversely indexed to the exchange rate. More likely, it may also be because speculators interpret a dramatically falling RMB as signaling a change in PBoC policy and higher risk, so that the more the RMB depreciates, the higher the required premium. Finally, in a speculative market, if investors believe that they are collectively big enough to set off a self-reinforcing selling process, they may self-consciously decide to interpret a declining RMB as a sell signal. This last, especially, is well understood by traders, even when non-traders ssometimes find it too “irrational” to be credible.

In theory this means the value of the RMB could fall infinitely, but in practice it can only fall until it is low enough to bring out enough fundamental investors to convert the market from a speculative market to a fundamental one. Their buying then stabilizes the market and can actually set off a self-reinforcing price reversal. Alternatively the decline might be halted by very sophisticated interventions by the PBoC that convince speculators that the currency is more likely to rise, and so have the same impact.

So is the RMB overvalued or not?

Capital is leaving China for reasons that have little to do with economic fundamentals and that do not imply that the RMB is overvalued, and the capital account deficit is large enough to overwhelm the current account surplus. This suggests that the balance of payments is unbalanced, before PBoC intervention is factored in, but this imbalance tells us little about the fundamental value of the RMB.

On the other hand the fact that the trade account is in such large surplus seems to tell us that the RMB is undervalued. Why? Because if China is growing much faster than its trading partners, and if it has much lower unemployment than its trading partners, and if it is leveraging up while its trading partners are deleveraging, standard trade theory tells us very clearly that absent intervention and distortions, China would run a trade deficit, probably even a large one, and its partners the corresponding surplus.

But China is, instead, running a trade surplus. This “surprising” trade position should be a very clear indication that either the currency is undervalued, or that there is some other equivalent trade distortion. In itself, it seems fairly clear, at least to me, that the current account surplus indicates that the RMB is undervalued on a fundamental basis, and that the balance of payments deficit is caused primarily by speculative outflows, or other kinds of outflows that are not sensitive to economic valuation issues.

How does the RMB affect inflation?

One final point concerns the impact of China’s devaluation on global deflation. As of this writing the RMB has depreciated by too small an amount to matter much, but assuming that it had depreciated by a lot more, would this add to global deflationary pressures?

Most analysts say that it would. A depreciating RMB causes the price of Chinese goods to fall, and so lower prices add to deflationary pressures. While I think it would indeed add to deflation, this is not because it reduces the price of Chinese goods. Ultimately deflation requires that aggregate supply for goods and services rise relative to aggregate demand, or that aggregate demand fall relative to aggregate supply.

If Chinese prices drop, how does it affect supply and demand abroad? By reducing the price of Chinese imports, it represses the tradable goods sector, which may respond by firing workers. It also raises the real value of disposable household income and in so doing may increase household consumption. The net impact depends on whether or not the consequent increase in the household income share of GDP is overwhelmed by the increase in unemployment.

How does it affect supply and demand in China? By increasing the price of foreign imports, it subsidizes the tradable goods sector, which because unemployment in China is low, may respond by bidding up wages. It also reduces the real value of disposable household income, which can reduce the consumption share of GDP. The net impact depends on whether or not the consequent increase in the household income share of GDP is overwhelmed by the increase in unemployment.

By itself a depreciating RMB is not deflationary for the world. It is only deflationary if it causes a relative increase in supply over demand, and this is most likely to occur because of the impact of consequent wealth transfers.

 

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  1. Mr. Pettis,

    Thank you for the insight. I thoroughly enjoy reading your work as you constantly lead me to consider “that which is unseen.”

    My question regards the end concerning inflation. you wrote,
    “If Chinese prices drop, how does it affect supply and demand abroad? By reducing the price of Chinese imports, it represses the tradable goods sector, which may respond by firing workers. It also raises the real value of disposable household income and in so doing may increase household consumption. The net impact depends on whether or not the consequent increase in the household income share of GDP is overwhelmed by the increase in unemployment.”

    But my big worry with this is that central banks in competing countries will REFUSE to accept repression of their tradable goods sector and higher unemployment. What if, instead, they respond through further competitive devaluations of their own currencies?

    We have already seen many EM currencies depreciate since the devaluation, and the ECB, Riksbank, BoJ, RBA are all running extremely accommodative monetary policies and driving their currencies further down. So households are not benefiting from the transfer of wealth and export sectors continue to be propped up.

    Given these dynamics, I would argue that a RMB which depreciates significantly will drive further global deflation. Would you disagree?

    -Geoffrey Bostany

    • “But my big worry with this is that central banks in competing countries will REFUSE to accept repression of their tradable goods sector and higher unemployment”

      Why is that a “worry”? The USA should respond as you suggest. China has a trade surplus [due to overvalued currency] while the USA has a trade deficit, it is the USA that has the most to gain. Same for the UK.

      “We have already seen many EM currencies depreciate since the devaluation,…,

      Given these dynamics, I would argue that a RMB which depreciates significantly will drive further global deflation. Would you disagree?”

      What is the difference between this and what he wrote? The depreciation is against the USD and thus it will be US households who will be harmed the most at first, but considering that they are the net consumers in the global economy it will go back eventually to the trade-surplus countries. And then… etc.

    • ^^G.B. WROTE: “Given these dynamics, I would argue that a RMB which depreciates significantly will drive further global deflation. Would you disagree?”
      —————————-

      To paraphrase Milton Friedman, deflation is everywhere and at all times a monetary phenomenon.

      Nominal GDP growth-rate = Real GDP growth-rate + Price-level growth-rate
      Nominal GDP growth-rate = Money Supply growth-rate + Velocity growth-rate (neglecting higher order effects)
      Therefore, from (I) & (II), we get:
      Price-level growth-rate = (Money Supply growth-rate – Real GDP growth-rate) + Velocity growth-rate

      A general & sustained decrease in price-levels (i.e. deflation) can ONLY come from TWO sources:
      (1) A reduction in the relative money supply (i.e. money supply growth-rate – real GDP growth-rate is negative), and/or,
      (2) A reduction in the velocity of circulation of money (i.e. negative velocity growth-rate)

      In light of this, it remains for you to explain how RMB depreciation would “drive further global deflation”. Would it, in your opinion, cause:
      (1) A reduction in global relative money supply?
      (2) A reduction in the global velocity of money? And if so, how?

      Please let me know your thoughts.

      • if import prices go up, we call it imported inflation (I mean, that’s in literally every beginner textbook ever printed). if import prices go down (oil and other commodities as we speak) of course deflation can be imported as well. you could usefully post the answer to your own question tho 🙂

        • I have vaguely heard of terms like “Cost-push inflation”, “Demand-pull inflation” et cetera. Ideally, you would ask the Original Maestro, the Guru of Greenspan, Milton Friedman himself, to explain these things that are in “literally every beginner textbook ever printed”. But since Friedman is not around anymore, you could try looking at the velocity of money & relative money supply during the 1970s oil price-rise period to see if you can find any patterns of interest.

          In any case, here are the data from FRED for the velocity of liquid money in the US:
          https://research.stlouisfed.org/fred2/series/MZMV

          Note carefully that the velocity of money has been falling in a secular fashion since 1980, ever since Friedman’s Monetarist ideology triumphed over Old Keynesianism with the ascension of Reagan.

          As I have been saying (see comments section of Michael’s previous post), with Japanese-style deflation on the horizon, Friedmanism has now reached a dead-end. We need a revolution of new ideas in America. Somebody needs carry out an ideological coup and purge the Friedmanites from the Federal Reserve. Without this, I am sorry to say, America is doomed.

          POSTSCRIPT:
          (A) Here is a comparison between the 1970s inflation and the velocity of liquid money during that period–
          https://research.stlouisfed.org/fred2/graph/?g=1FKN
          (B) We note that ‘velocity of money’ is not merely a theoretical residual of some equation identity; it actually has a specific physical meaning and can be observed qualitatively, even though it cannot be measured quantitatively–
          http://goo.gl/hq0oMc

      • “Nominal GDP growth-rate = Money Supply growth-rate + Velocity growth-rate ” ; should be M X V?

        • Nominal GDP growth-rate = Real GDP growth-rate + Price-level growth-rate (NEGLECTING HIGHER ORDER EFFECTS)
          Nominal GDP growth-rate = Money Supply growth-rate + Velocity growth-rate (NEGLECTING HIGHER ORDER EFFECTS)

          Y = A X B
          (1+y) = (1+a) X (1+b), where y, a, b are growth rates of Y, A, B
          (1+y) = 1 + a + b + ab
          y = a + b + ab
          y = a + b (neglecting ab as a higher order effect for small a,b)

          Example:
          (1+x) = (1+0.04) X (1+0.03)
          1 + x = 1 + 0.04 + 0.03 + 0.0012
          x = 0.04 + 0.03 + 0.0012 = 0.0712 = 7.12 % (with no approximation)
          –OR–
          x = 0.04 + 0.03 = 0.07 = 7% (with approximation neglecting higher order effects)

          Approximation ERROR= 0.12/7.0 = 1.7%

    • Mr. Pettis writes, “By itself a depreciating RMB is not deflationary for the world. It is only deflationary if it causes a relative increase in supply over demand.”

      My argument is that if the RMB depreciates enough to prop up China’s export sector, then Chinese firms that contribute to global supply would be subsidized and the imbalance of global supply over demand would persist. Furthermore, if currencies around the world continue to depreciate, we can apply this logic to the rest of the world.

      Therefore, if global currency depreciation continues to prop up export sectors of countries around the world, this would continue to exacerbate the global imbalance of supply over demand and deflation would persist.

      To john’s point about the depreciation being against the USD, this is noted. I am not sure how to measure U.S. demand/supply as a fraction of total global demand/supply. But the only way that global supply and demand would come back in balance is if the U.S. demand (fueled by USD appreciation) is large enough to bring supply and demand back into balance.

      In other words, USD strength suppresses U.S. supply of tradable goods and fuels higher U.S. demand. but the question is this – is the U.S. contribution towards rebalancing strong enough to offset the global supply that will be propped up via global currency depreciation? I don’t know. I would need to measure the U.S. demand/supply as a fraction of global demand/supply which I am not sure how to do.

      But it seems that if the U.S. contribution is not large enough, then deflation will persist via continual imbalance of global supply over global demand.

      • 1) Assume that the whole world devalues against the USD (i.e. the Dollar strengthens universally)
        2) US current account deficit rises as US aggregate demand leaks out to assist the rest of the world
        (a) Exports drop due to price-competition, causing layoff pressure in export sectors (loss of market share)
        (b) Imports rise due to price-competition, causing layoff pressure in domestic sectors (substitution)
        3) As unemployment pressure rises in US, the US government responds with large budgetary deficit
        (a) The rise in the US current account deficit must be equal to the rise in its capital account surplus
        (b) The rise in capital account surplus is merely foreign central banks pushing in reserves to suppress their currencies.
        (c) It is this rise in capital account surplus that the USG must borrow & spend to prevent rise in unemployment
        4) This added Keynesian demand keep US unemployment from rising and sustains the larger current account deficit
        5) Therefore, the US government (or households or taxpayers) must go deeper & deeper into debt to save the world.

        What if the USG (or households or taxpayers) refuses to borrow & spend? Then the rising unemployment in the US will have the same effect as a counter-acting USD devaluation against the currencies of rest of the world. US wages will be cut and prices will drop (deflation) such that US once again regains competitiveness (e.g. Spain in Euro).

        Let me know your views.

      • The US (~ 22% of world GDP) will not be big enough to accommodate virtually the entire rest of the world, including two large economic zones in current account surplus that are the Eurozone and now China (together ~ 30% of world GDP), trying to devalue simultaneously to provide debt relief to their domestic economy. Especially as the US has identical debt constraints.

        Is the impossibility of everybody trying to simultaneously devalue against everybody else to relieve its own excess debt finally sinking in after several years of magical thinking? In the best case, that could finally prompt the search for more promising solutions to the dysfunctional world trade and monetary system. That is if there is time because the immediate danger now is that 6.5 years of cumulative global asset inflation vs. 6.5 years of cumulative global income deflation is fast being reconciled and money created out of nothing is quickly returning to nothingness. It is therefore likely that policymakers, confused and under emergency pressure, will once again resort to expedients aimed at relieving short term pain at the cost of increasing systemic fragility.

        • DvD

          Your point to remedies being sought in present circumstances to longer term systemic problems is most poignant. This has been the steady point I have been making. And frankly, it is likely the time. Then we can all get back to ground zero, and vast slews of worthless dialogues can be divested from these very serious concerns as reality rather than preference comes to the fore.

        • ^^DvD WROTE: “Is the impossibility of everybody trying to simultaneously devalue against everybody else to relieve its own excess debt finally sinking in after several years of magical thinking?”
          ————————————-

          This is what the next International Conference of Central Banks is going to look like……
          http://goo.gl/jB3AiN

      • Geofrey

        It is this logic, that you use, which I often refer to, when I say, that the global system will necessarily alter of recent dynamics (occurrences since GFC, and the 1998 to 2008 period in which the global economy doubled.)

        That is, more countries need to stand beside the US as a global demand driver. Of course, all will act parochially, and the switch should have been made far before this; which of course is why the mantra of the rise of the global middle class came to the fore over the period of heightened growth, and in the immediate aftermath of the GFC, as popular pundits tried to reinvigorate the early 2000’s, Asia decoupling thesis.

        So your point is poignant, but has more than the likelyhood of deflation, which was attempted to be staved off by all the post crisis movements, but really just switched from using a manual to a battery driven screwdriver for the coffin.

        While many market ponderers consider this, or that, some to argue some cause or factor here or there, some bogeyman, etc….the entire trajectory of global development has been thrown off its kilter, and of course excesses have driven skewed development trajectories globally.

        This is unfortunate.

        Another interesting point, is Michael’s, all we have done is brought demand forward.
        Over the long term a smoothing effect with natural rates of growth. Spikes for a period will revert to a mean.

  2. No, markets do not determine the RMB value…apparently brilliant economists do. The RMB maybe undervalued on a fundamental standpoint, but often the marketplace leaves currencies undervalued for many years at a time- or overvalued. The flow of money out of China clearly makes the RMB much weaker in the near term,( irrespective of fundamental economist valuation); markets would drive it much lower if the PBoC did not intervene and jawbone.

    It is a farce if the IMF buys into the idea that the new -4% RMB rate is a more market-driven valuation. The strong-arm intervention of the state in the chinese equity market is hardly suggestive of the Xi letting the price discovery mechanism take root in china. Instead, Xi is exercising his power and control since China got snubbed by the IMF, and excluded from the MSCI index. Without any accomodation by the western hedgemony, Xi acted in his short term interests.

    China’s short-term interest in stemming the outflow the FX reserves – it ran a negative $500 billion in last 6 months, even with a huge trade surplus. The govt balance sheet has $3.5 trillion in FX reserves, but is perilously weak compared to $15 trillion in chinese savings which are desperate to get out of China- A 4% devaluation closes the carry trade for ordinary chinese citizens, and is likely a first order target for the PBoC, releasing some pressure on the RMB. But even closing the carry trade is not enough to stem the tide.

    But more generally, while the FX market are not efficient at setting the “true fundamental” value of currencies, they are the best and last bastion of free markets- largely uncorrupted by central bankers. The FED and ECB control the bond market and increasingly the stock market in the developed world – being buyers in times of turmoil. While a market discovery rate for FX may be way off from a currencies fundamental value (REER) for a considerable length of time, it is far superior to a bureaucrat (or worse an economist) setting the values based on some equation. The “impossible trinity” for China is more simply the impossible task of bureaurcrats determining the flow of capital in a complex economy. The Soviets clearly demonstrated the failure of central planning for a relatively small and closed economic system. The Chinese do not have a small and insulated economic system, instead they have a massive global enterprise. There is no way the PBoC or MP is up to the task of efficiently allocating capital, interest rates or FX better than a free and dynamic marketplace.

    I see the sudden devaluation of RMB more as evidence that the Xi will not make the hard choices to let the Chinese economy rebalance under market forces and evolve, but instead a desperate move to relieve short-term cashflows. My hopeful scenario that China will/can rebalance without a huge disruption or hiccup is seriously challenged by the RMB devaluation and stock market intervention.

  3. So what happens if the U.S. imposes tariffs on Chinese exports forcing the trade surplus to diminish or reverse?

    • China will contest the tariffs in the WTO (World Trade Org) and if these tariffs are found to be unfair, then the U.S. would withdraw the tariffs.

      But if the tariffs get approved, then China imposes tariffs of their own. Tit for Tat.

  4. Thank you for;
    Writing so i can understand.
    For giving something back to a small investor like me.
    I will keep up my study of your writings.
    i have benefited mentally and financially.
    Oddly your writings often sound like my fathers words.
    He taught me to trade.
    Sincerely
    Steve Becker

  5. Michael,
    China lends RMB to developing countries on condition that they spend the money on Chinese companies for infrastructure. Doesn’t this undermine your argument that China’s trade surplus implies an undervalued currency, since the current account is credited regardless of currency value?

  6. Incisive as usual. When the carry trades and other leveraged instruments rise ferociously in a global trading markets skewed towards speculation, the red flags of an imbalanced capital account that PBOC has to tackle had alerted some traders to exit.

    Looks like PBOC has come of age to use the pegged exchange rate to first douse the fuel of leveraged speculation in order to regain the flexibility of setting domestic interest rate to pace the imbalances of the economy. Of course, there are trade-offs and spillovers into the global economy. The trade-offs have been calculated including the cost to be borne by the household sector with Savings at low interest rate for some time until the more crucial instability is muted. Spillovers are essentially not the priorities in the “here and now” for PBOC who has to place China’s economic interest first.

    Over and Under Valuation are tired cliches in the present speculative markets where traders wrestle with Central Banks who are the Main Players with their Regulatory arsenals and their Printing Presses.

    The market dynamics may not deliver to PBOC’s Script but is less consequential to a PBOC that “gets it” and through inevitable misses grows even more formidable to engage the trading crowd. Kudos to their currency regime change if not in form at least in mindset.

    Looking at China through the “as is” lens of Economic Fundamentals is a Gem. It clears so much Smog and Spin. A gem that you can even revisit/enhance your Algos as you engage the markets.

  7. I have not finished reading but just as a matter of exposition I think the discussion would be much more clearer if you started by explaining what the difference between the “price” and the “value” of an asset are. When the two don’t match (I am not sure but markets with one dominating player on either side can obviously have prices that don’t reflect value because that single player can fix the price at a cost to itself).

  8. To expand on my previous comment, the idea being that basically you need a “good” market for price to match value. Now the mainstream view is that if PBoC stops intervening you have a “good” market and so the resulting decline in prices is indicative of the fact that RMB is currently overvalued. You seem to argue that without PBoC intervention the market is still “bad” and hence price changes do not yet reflect value.

    • The market is far from what it would be if anyone, anywhere could buy and sell RMB the same way they can USD and Euros. To mention a couple of big-ticket differences, think of all the ‘captured’ revenue that foreign companies are holding (in RMB) within China that they would repatriate if they could; and all the exchanges that would occur if everyone in China who wants to get their money out were able to freely exchange RMB for foreign currencies. Those two seem like the biggest pressures to me. But if Dr. Pettis is right and the RMB really wants to go up in value, I presume there are some big-ticket ‘buy’ pressures lurking out there somewhere. (Or maybe I just don’t understand the thing very well haha.)

    • ^Hesam WROTE: “You seem to argue that without PBoC intervention the market is still “bad” and hence price changes do not yet reflect value.”
      —————————————————

      Here is Michael’s ex-China colleague Patrick Khovanetz explaining why even if PBOC stops all intervention in the forex market from now on, the market will still be “bad”…….
      http://foreignpolicy.com/2015/08/11/china-currency-devaluation-global-race-to-the-bottom/

      EXCERPTED QUOTE: “The Chinese will try to argue they are just letting the market have its way. This is misleading: For years, the Chinese prevented the RMB from rising in value by buying nearly $4 trillion in foreign currency. The current market “equilibrium” is predicated on that massive distortion. The only way to get to a truly market-based RMB is to first unwind China’s past intervention by supporting the RMB and drawing down China’s foreign currency reserves.”

    • Several years ago I postulated on this blog that with the rise of debt that the RMB might switch toward being overvalued.

      Similarly, in 2011, with the Arab Spring (even prior to collapse in oil prices) that the Gulf Arabs, with increased spending to placate their coddled populations with ridiculous government salaries, and profligate spending programs, and rising fiscal spending, and ever-increasing pension costs, and spending requirements, would eventually have to devalue, to make their oil revenues stretch in local currency terms. Spiking prices, and igniting inflation. IMF now stressing need to introduce taxes to diversify government revenues, ovely dependent upon the dynamics of the collapsed commodity supercycle, otherwise known as, China spending too much on its industrialization, while proceeding to due it in a shortened timeframe, pushing up those costs, as it deprived others, forced others to increase their own development costs, known as the world economy doubling over 10 years, or like Michael, bringing demand forward, time to pay the piper.

      And while all this is true.
      With porous borders, the RMB weakening, in the best of cases might have been just to see the impact on hotflows, and weakening further, with subsequent market actions, and sectoral data since then, will likely see a very big movement of capital out of China.

      But rather than merely seeing this a depreciation to gain export advantage, true beforee, when dollar is weak, it may just be to increase the value of dollar income in RMB terms for th domestic market, insofar as servicing the ever continuously rolled over debt and interest obligations.

      • CSteven WROTE: “Several years ago I postulated on this blog that with the rise of debt that the RMB might switch toward being overvalued.”
        ———————————————–

        So is the RMB overvalued or undervalued w.r.t. the US Dollar? In the special case of China, one thumb rule to determine this is as follows:

        A) Calculate the total amount of USD debt-claims held BY China on the rest of the world. Generally, this is taken to mean the reserves held by the central bank, BUT it could be lower or higher depending on what the central bank is holding and how the commercial banks operate globally.
        B) Calculate the total amount of USD debt-claims held by the rest of the world ON China. Generally, this is taken to mean the total external debt reported by the central bank, BUT it could be lower or higher depending on how detailed the central bank reporting is and how Chinese companies operate globally.

        If (A)>(B), then the RMB is undervalued w.r.t. the USD & (A)-(B) is the magnitude of suppression.
        If (A)<(B), then the RMB is overvalued w.r.t. the USD & (B)-(A) is the magnitude of support.
        If (A)=(B), then the RMB is Goldilocks w.r.t. the USD & there is no suppression or support.

        http://goo.gl/UtpM7o
        http://goo.gl/P5AjMY
        http://goo.gl/DS9fVF

        All things considered, it does appear that the RMB is UNDERVALUED w.r.t. the USD, but it difficult to say by how much since (A) & (B) are difficult to precisely determine in China.

        But then why is it coming under downward pressure? The answer is that capital flight has little to do with whether the RMB is fundamentally overvalued or undervalued. Capital came into China chasing higher returns (fast growth) and currency appreciation (whether through the inflation-differential or through the exchange rate). Therefore, capital flight is connected to expectation of future growth rates in China and expectation of the direction of future monetary policy. Since the consensus is that growth in China will keep slowing, the first tendency is for capital to flee. In addition, when we consider that producer-price deflation is occurring in China, we can see that currency appreciation, whether via a higher inflation-differential or via the exchange rate, is now practically impossible in the near future. With the currency appreciation motive also lost, the tendency of capital is again to flee.

        To summarize, capital is fleeing China, despite the undervalued nature of the RMB, because of the future expectation of slowing real growth and persistent deflation. To reduce capital flight, China must find ways to boost real growth and fight deflation. One way for China to do that (even though at some cost to the rest of the world) is to hold its reserves nearly constant and let the RMB go further down. The falling RMB would allow China to steal some growth from the rest of the world and also allow it to export some of its deflation to the rest of the world.

        Just some thoughts. Let me know your views.

  9. Could you clarify what a “high” exchange rate is in the following statement? “High exchange rates benefit household consumers, the services sector, and urban residents, among others.” Does “high exchange rates” mean “a weak currency,” or does it mean “a strong currency”?

    Many thanks for your informative post.

  10. – If the yuan was to be included in the SDR then that would mean pegging the yuan to the USD. And that’s precisely what the China doesn’t want to. See their recent devaluation.

  11. “This ‘surprising’ trade position should be a very clear indication that either the currency is undervalued, or that there is some other equivalent trade distortion.”

    Could this trade distortion be economic subsidies? As you mention, there is extreme mal-investment and overcapacity in many industries. Many exports seem priced at or near marginal cost.

  12. I think what you said is that your best guess is that China is making its currency more flexible so they can support the domestic Chinese economy or at least domestic economic agents with easier monetary policy?

    How is that not unambiguously good? for China and the world (assuming that the domestic economy does need easier monetary policy.)

    • This issue seems so complicated I doubt there is any unambiguous outcomes. But more Chinese demand does sounds like a good thing.

      Unless of course they use the looser monetary policy to exacerbate / maintain the imbalances that Prof. Pettis has identified, rather than boosting household consumption.

      • Which of course, lowering interest rates, and other movements, move against rebalancing.

        Michael, a status, in light of present occurrences, of the rebalancing dynamics might be useful. It seems that they have reversed course over the last couple. Where, if my memory serves me correctly, you were thinking progress was being made.

        It is pretty obvious at this point, they are trying to hold a steady-state; and such is becoming unglued.

  13. The International Monetary Fund signaled that China’s yuan won’t be added to the IMF’s influential basket of reserve currencies for at least a year

    The fund’s executive board approved an extension of the current basket of reserve currencies included in its special drawing rights, or SDRs, to Sept. 30, 2016. The action confirms an earlier proposal for a delay in the five-year reshuffling of the basket, which doesn’t include the yuan. The board said a decision on the future basket is expected by the end of the year.

    http://www.wsj.com/articles/imf-signals-yuan-wont-be-considered-a-reserve-unit-for-at-least-a-year-1440000935

  14. Michel,

    You stated:

    Beijing may be eager for the RMB to become part of the SDR basket because it believes this will result in significant foreign inflows that will help reverse China’s very large and potentially destabilizing capital account deficit.

    But these capital account outflows have taken over the role of PBoC foreign exchange purchases in financing China’s current account surpluses. As such, they are clearly a stimulating a weakening economy by sustaining exports.

    Without these capital outflows, the authorities will have to choose between a smaller trade surplus and overt exchange-rate manipulation with all the attendant risks of trade conflict.

    While one could imagine the authorities would like a more orderly outflow of capital, aren’t the authorities lucky (by comparison to the alternatives) that these capital outflows are occurring?

    • ^Ken Today WROTE: “But these capital account outflows have taken over the role of PBoC foreign exchange purchases in financing China’s current account surpluses. As such, they are clearly a stimulating a weakening economy by sustaining exports.”
      —————————-

      This is true AS LONG AS the net capital account outflows do not exceed the current account surplus. Once they exceed that point, as they have done currently, this is no longer true.

      CASE I) Capital Account Balance = +40, Current Account Balance = +60, therefore Reserves rise by 100
      CASE II) Capital Account Balance = -40, Current Account Balance = +60, therefore Reserves rise by 20
      CASE III) Capital Account Balance = -60, Current Account Balance = +60, therefore Reserves are constant
      CASE IV) Capital Account Balance = -100, Current Account Balance = +60, therefore Reserves FALL by 40

      Note that in all these hypothetical cases, the current account balance is the SAME.
      In CASES (I) & (II), China would be accused of active currency manipulation (i.e. “suppressing” its currency by piling up reserves).
      In CASE (III), there is no such accusation as the reserves are constant and no intervention occurs.
      In CASE (IV), however, China would actually be “defending” its currency by drawing down on its reserves. In fact, this is probably why they have devalued the Yuan. They may be hoping to either increase the current account surplus (by making yuan products cheaper for foreigners) or decrease the capital account deficit (by making yuan assets cheaper for foreigners) so as to prevent further depletion of their reserves.

      The danger of falling reserves due to the large-scale flight of speculative money is that asset prices in China tend to come under pressure. This is especially so if the speculators sell real estate in China and move their money out en masse. The negative effect of falling real estate prices on both the banking system (via fall in collateral value & defaults) as well as household consumption (via fear of loss of multi-generational lifetime savings) would have a devastating effect on the economy.

      Do you disagree? Please let me know your views.

      • Vinezi,

        The identities of the balance of payments means that the current account surplus = net outflow of savings = (private capital outflows + reserve purchases). Remember in your examples, negative capital account balances and reserve purchases are outflows and finance a current account surplus.
        So in all four of your cases the current account equals 60 and the net outflow of savings also equals 60.

        These outflows will have similar effects on Chinese interest rates and asset prices.

        Having said that, you make a good point about the effect of these savings outflows on domestic asset prices. But the PBoC has accepted those costs when buying dollars in the past. What may have changed is that China is more concerned by the reactions of trading partners than in the past.

        • ^Ken Today WROTE: “These outflows will have similar effects on Chinese interest rates and asset prices.”
          ————————————————————-

          You are correct in repeating Michael’s Holy Mantra that once change in reserves are included in the Capital Account Balance (CAB1), then the CAB1 must be equal to the Current Account Balance (CAB2). That is the definition Michael uses, although it must be noted that most Central Banks do not use this definition in their reporting. Most Central Banks use the definition CAB1-CAB2= Change in Reserves. In other words, most Central Banks do NOT include change in reserves as part of their CAB1, but rather account for it as a separate residual. In fact, this is why Michael’s statements have seemed confusing to so many visitors here in the past. I would strongly recommend that Michael change his definitions, but that is his decision.

          Returning to the issue of effects:

          In CASE (I), the consolidated balance sheet of the entire Chinese Banking System (CBS) expands by 100 due to the external account.
          In CASE (II), the consolidated balance sheet of the entire CBS expands by 40 due to the external account.
          In CASE (III), the consolidated balance sheet of the entire CBS does not change due to the external account.
          In CASE (IV), the consolidated balance sheet of the entire CBS SHRINKS by 40 due to the external account.

          This is why in Case (I) & Case (II), we get upward pressure on asset prices, while it switches to downward pressure in Case (IV). In other words, the increase in reserves in the first two cases tends to be inflationary (whether in asset prices or producer prices), whilst the decrease in reserves in Case (IV) tends to be deflationary. Since deflation, whether in asset prices or producer prices, is something China fears at the moment, it cannot afford to draw down on its reserves. This is why large scale net capital account outflows (see definition: NOT including change in reserves)– BEYOND that needed to ‘finance the current account balance’ — are destabilizing.

          Do you disagree? Let me know your thoughts.

          • Hi Vinezi,

            First, a point about whether reserve flows should be included in the capital account. I think that they should be mentioned as completely separate line items by the statistical authorities, because private capital flows and public purchases of reserves behave differently and are controlled by different actors. Reserve flows are public policy and capital flows are autonomous private behavior (except maybe in China). Thus, a lot of information is lost by over aggregation of data. But that is an issue of data presentation, not outcomes.

            You are quite correct, that reserve changes can affect base money. In fact, depending on the money market multipliers, an increase of 100 in your Case I can have a much larger effect on the other monetary aggregates — providing that the central bank is not sterilizing its reserve purchases.

            It’s my understanding that the PBoC does generally sterilize, I believe by issuing securities to the banking system to absorb the additional base money created by reserve purchases. When it sells reserves, I assume that it reverses the whole process and repurchase the securities. This would minimize the effects on the money supply and asset prices.

          • ^KT WROTE: “….providing that the central bank is not sterilizing its reserve purchases. It’s my understanding that the PBoC does generally sterilize……”
            ——————————————–

            Complete sterilization, implying no change in liquidity (i.e. FULL control over monetary policy), is an impossible concept.

            CASE (I) China does not pile up reserves: No change in liquidity. This is the reference case.
            CASE (II) NO STERILIZATION: China piles up reserves by selling ‘freshly-printed’ yuan to buy up incoming Dollars. This implies a MASSIVE increase in liquidity compared to CASE (I).
            CASE (III) STERILIZATION: China piles up reserves by first selling ‘freshly-printed’ yuan to buy up incoming Dollars, but then issues (quasi) sovereign bonds to remove the ‘freshly-printed’ yuan from the market. Yes, this implies a reduction of liquidity compared to CASE (II), BUT it still results in an increase in liquidity compared to CASE (I). After all, while the (quasi) sovereign bonds may not be as liquid as yuan, they still have non-zero liquidity.

            This is why, no matter what China does, the very act of piling up reserves tends to increase overall liquidity, and is, hence, inflationary (whether in asset prices or producer prices).

            Let me know your views.

          • Vinezi,

            “Complete sterilization, implying no change in liquidity (i.e. FULL control over monetary policy), is an impossible concept.”

            I agree. The question is, how ineffective is sterilization? Just because it’s not perfect, does not mean it is totally ineffective or that it’s not 99 percent effective. It’s not binary.

            Besides, Central Banks do lots of things intended to increase liquidity. That does not mean that in every case, serious price inflation will result. The inflationary effects will be weaker if aggregate demand is weak. P Krugman has had lots of fun at the expense of hard core monetarists’ predictions of rampant inflation as a result of quantitative easing. Right now, the PBoC is taking its own extreme measures to add liquidity and support asset prices because aggregate demand is weak and the Chinese economy harplus capacity.

            On the other hand, the monetary policy dilemmas for the reserve-issuing country are far worse. Reserve purchases increase asset demand while simultaneously reducing the demand for the domestic goods of the reserve issuer. If the reserver issuer’s CB tries to restore aggregated demand for goods, it will increase liquidity and the demand for assets. So just to maintain the same level of aggregate demand for goods, the demand for assets has been increased twice. This process clearly risks cleating an asset bubble. So the reserve issuers’ CB has a choice, accept a weaker economy now as a result of the foreign demand for reserve assets or risk an asset bubble and a worse recession later. Not hard to think of a good example of that.

          • ^^K.T. WROTE: “Reserve flows are public policy and capital flows are autonomous private behavior (except maybe in China).”
            ———————————————-

            Reserve Flows are MONETARY policy in that they involve changes to the balance sheet of the Central Bank. This is why when countries set a fixed peg and keep their capital account open, they lose control of monetary policy.

            Capital Flows, whether private or public, whether autonomous or command, are NOT MONETARY policy as they do not involve changes to the balance sheet of the Central Bank.

            This is why there is a HUGE difference between Reserve flows and Capital flows, and Michael makes matters confusing by lumping them together in his definition of capital account balance. In fact, it is exactly this HUGE difference that is being missed when you say (quote), “In all four of your cases the current account equals 60 and the net outflow of savings also equals 60. So these outflows will have similar effects on Chinese interest rates and asset prices”. This is clearly not correct. Interest rates (price of money) and asset prices are affected by monetary policy and hence by Reserve Flows. Even if net outflow of savings is the same in all four cases, if the reserve flow in each case is different, then the effect on prices (price of money, price of assets, prices of products) will be different in each of the four cases.

          • Let us look at it another way. Let us SIMPLIFY by assuming that the current account is balanced and that there is no other activity on the capital account except for the transactions mentioned below:
            1) Assume that foreign speculators chasing returns come in with Dollars to purchase Chinese real estate.
            2) The Central Bank takes their Dollars and pushes them out (reserve accumulation) to buy & hold ultra-safe low-yield USG bonds.
            3) The Central Bank then issues safe sterilization bonds to borrow savings of risk-averse Chinese savers who do not want to speculate.
            4) The Yuan received from these risk-averse Chinese savers is then handed over to the foreign speculators.
            5) The foreign speculators then rush to add to the demand for real estate and bid up Yuan prices even further.

            Now note the balance: The foreign savings that came into China via capital inflow exactly equals the local savings that was pushed out of China via reserve outflow. Clearly, no more Yuan have been created; what has happened is merely a re-assignment of existing Yuan. So why should it make a difference to asset prices in China?

            The answer lies in the fact that the foreign savings that came in was “hot” money that was chasing return (GREED), whilst the equivalent Chinese savings that was pushed out as reserves was “cool” money that was desirous of safety (FEAR). So even though the quantity of Yuan does not change in this example, the “quality” or “nature” of the overall Yuan pool in China clearly changes. The replacement of “cool” money with “hot” money increases the total “temperature” of the overall Yuan pool. China, as a whole, becomes more greedy and less fearful, and this is precisely what causes inflationary pressure on asset prices (e.g. real estate).

            Conversely, if the process reverses and the “hot” money flows out again, whilst the corresponding reserve draw-down implies the flowing back in of “cool” money, asset prices will then come under deflationary pressure– even though the quantity of Yuan still remains the same.

            Just some thoughts. Comments welcome.

          • ^^KT WROTE: “Besides, Central Banks do lots of things intended to increase liquidity. That does not mean that in every case, serious price inflation will result. The inflationary effects will be weaker if aggregate demand is weak. P Krugman has had lots of fun at the expense of hard core monetarists’ predictions of rampant inflation as a result of quantitative easing. Right now, the PBoC is taking its own extreme measures to add liquidity and support asset prices because aggregate demand is weak and the Chinese economy harplus capacity.”
            ————————————————————

            (A) Paul Krugman was right to make fun of those who say that merely increasing the quantity of money will lead to rampant inflation in the US, but that is because of the way inflation is conventionally defined. Inflation is defined by either CPI or GDP-deflator, neither of which include the prices of assets. This is why, if you look at my comments above, I always made it a point to add the specific caveat “whether in producer prices or in asset prices” whenever I mention the word “inflation”. While he was making fun of others, I wonder if Herr Krugman was even a little bit concerned about the fact that the US stock market, despite gloomy global conditions, is in the stratosphere, even as house prices in the US are back to their historical bubble-peak of 2007.
            https://research.stlouisfed.org/fred2/graph/?g=1Ggy

            (B) You are correct that if aggregate demand is weak compared to potential aggregate supply (i.e. overcapacity), as it has been continuously in China for a long time, then increasing liquidity will not necessarily lead to rising prices of goods & services. However, note the following points:
            1) Given China’s massive and widespread overcapacity, we should have seen falling producer prices across the board (i.e. deflation) over the last 10 years. However, this did not happen (until recently). This is because the inflationary effect of expanding balance sheets was cancelling the deflationary effect of overcapacity and maintaining reasonably steady producer prices.
            2) The reason that the expanding balance sheets in China did not cause EVEN higher inflation in producer prices is because the excess supply of liquidity was being channeled into inflation of the prices of real estate (due to lack of investment alternatives) in China.

            (C) As a general principle, if the demand for liquidity is less than its supply, then increasing liquidity causes inflation (NOTE: whether in producer prices or asset prices). Conversely, if the demand for liquidity is more than its supply, then increasing liquidity prevents deflation (NOTE: whether in producer prices or asset prices). Either way, NOTE CAREFULLY, that increasing liquidity is **ALWAYS** inflationary, whether it actually causes inflation or merely prevents deflation, whether in producer prices or asset prices.

            (D) You are correct when you say that (quote) “right now, the PBoC is taking its own extreme measures to add liquidity and support asset prices because aggregate demand is weak and the Chinese economy has surplus capacity”. This is PRECISELY why China cannot afford to let its reserves fall, as that would cause the consolidated balance sheet of the entire Chinese banking to shrink and hence REDUCE liquidity in the economy. In fact, this may be the reason for the devaluation– they are desperate to prevent their reserves from falling sharply.

            (E) On the issue of sterilization, you are correct that sterilization bonds ensure that the M0 money supply does not increase. However, given that China issues such bonds (or their equivalent) to the commercial banking system itself, it automatically means that:
            (a) The balance sheet of the commercial banking system also expands to accommodate reserve accumulation, AND, as a consequence,
            (b) The M1/M2/M3/MZM money supply DOES increase, even though sterilization may have negated the rise in M0 money supply.

            Let me know your thoughts.

          • Here is a question: If increasing liquidity is ALWAYS inflationary, why has Japan been unable to shake-off deflation, in BOTH producer prices & asset prices, after all these years of pumping in more and more liquidity?

            The obvious answer is that the increasing liquidity is merely preventing further deflation. In other words, without the massive increase in liquidity in Japan, their deflation problem in BOTH producer prices & asset prices would have been much worse. This answer, while true, is unsatisfactory, because it does not tell us much; rather, it looks more like an escape hatch that allows the holding of a debate position.

            The more useful answer is that even after massive liquidity creation, the demand for liquidity is still more than its supply in Japan. In fact, it is the rising liquidity itself that is creating additional demand for it. In other words, Japan has a psychological problem or a crisis of confidence. Everybody now believes that deflation, in both producer-prices and asset-prices, lies ahead. Nobody believes that house prices or stock prices will sustainably rise in a secular fashion. In a deflation-expectation environment, nobody want to borrow to do anything long-term. The preferred asset to hold on to is now money. Therefore, even as the consolidated balance sheet of the entire banking system in Japan inexorably expands, all the Japanese people want to do is sit still on the right side of it and do absolutely nothing. Since the left side HAS to be occupied by SOMEONE, as a matter of little choice, it is occupied by the Japanese government.
            http://goo.gl/RQafkv

            Will China suffer the same fate? I don’t know.

      • An articulate way of explaining the interchanging of reserves, current account flows and capital account flows with good observations.

        Thanks Vinezi

        • Vinezi; your question is a important one; i went round and round with DvD on this and got nowhere – I’ll try again. The error lies in assuming liquidity has increased in japan and the US. I argue it has not. Massive increases held within the banking system does not translate into increased liquidity; massive savings held by corporations does not translate into liquidity. Nothing new here: Keynes described this as pushing on a string. Velocity in the US has been falling for years. Various versions of “helicopter money” would increase liquidity. So far China has followed the Japanese model fairly closely; I see no reason why something similar can’t happen in China; liquidity evaporates quickly at high temperatures.

          • ^Dan Berg WROTE: “Massive increases held within the banking system does not translate into increased liquidity; massive savings held by corporations does not translate into liquidity.”
            ———————————————–

            Yes, they do. The liquidity in the system has certainly increased. The problem today is not the lack of liquidity, but the lack of confidence. The problem is that the WILL of market participants (whether commercial banks & corporations, as in your example, or someone else) to DO something with that increased liquidity in the physical economy is weak. This is a falling velocity problem related to market confidence & price expectations and has little to do with the quantity of money (or current level of liquidity).

            1) In the US, some of the increased liquidity is bypassing the physical economy and being directed into the financial economy (“decoupling”), thereby fueling asset-price inflation. This is because US market participants STILL have confidence in the financial economy, but not much confidence in the real economy– whatever that might mean. Therefore, until confidence in the prospects of the real economy returns, further increases in liquidity in the US will only exacerbate the current bubbles in real estate and stock.

            2) In Japan, the increased liquidity has lost its multiplier effect, because after the initial government spending in the physical economy to prop up aggregate demand & prevent contraction, the liquidity just bypasses both the physical economy AND the financial economy and moves into a state of ‘compulsive hoarding’. This is because Japanese market participants do not have much confidence in either the financial economy or the real economy. This is why it is very difficult to get inflation in either producer prices or asset-prices in Japan despite massive increases in liquidity. In other words, the increase in liquidity in Japan is merely being accumulated by market-participants as the most desirable asset by far (i.e. market-participants are merely sitting still on the RHS of the consolidated balance sheet of the entire Japanese banking system). This implies that the “price of money” (reflecting how desirable it is to people) is rising w.r.t everything else in Japan (i.e. deflation).

            Does this help converge the dialectic between you & DvD? Let me know your counter-thoughts.

  15. Thanks for a thought-provoking piece!
    Well, we know the inclusion of the Yuan in the IMF’s SDRs is held back until next year.
    Manipulation in the market can come from private investors as well the central banks and the government. As long as there is a group of people (like a cartel) agreeing on a policy direction the market can manipulate to whatever direction they want to take.
    An example of that is when George Soros + Co. tries to short the HK Dollar believing HK will abandon the peg, but were subsequently rumbled as HK authorities step in to ban short-selling and defended its currency with their reserves.

    Sometimes intervention will not comply with the general directive, as in the case with China markets, whereby state institutions have bought over 1 trillion RMB of stocks, but the market won’t go up.

    But on the subject of Yuan devaluation and the appropriate exchange rate, I think there is meaningful to track the weakness and strength of a currency.
    That is to look at the number of Yuan in money supply (M2) to hold one unit of FX reserve. In the early 2000s, China requires 70 to 85 Yuan to keep one unit of FX reserve, while pegged at 8.28 to 1 USD. As China’s reserves grew, and it is accumulating FX reserves, the number of Yuan to hold, one unit dropped to the 40s. At that point, China needs to appreciate its currency, but still its reserves kept rising until it fell to a low of 28 Yuan by 2008.
    However, things change, and China’s money supply grew much faster than its FX and the number of Yuan begins to rise until it accelerated starting from late 2014.
    Now the number of Yuan to hold one unit of FX reserves stands at 37, as the currency response to its first devaluation.
    Given the changing dynamics of China growing money supply and falling reserves, that number is likely to increase to put pressure on the Yuan to devalue further.
    So, Michael is there any real correlation between the numbers of local currency from its money supply to hold one unit per FX reserve?
    Thanks again for the interesting article.

    • There is no such firm relation of a number of this to hold a number of that, but you are onto the logic that I used a few years back to say that China’s debt trajectory would likely lead to debt dynamics. That is if there was pressure to revalue, that the growth of debt would change those dynamics, now, while this will lead to tensions with some advanced countries, this causes China’s developing world peers to do the same, to do the very undervaluation that China had, and to further devalue as China devalues, as China’s undervaluation hypercharged its growth at the cost of its developing world peers. China devalue, others devalue more, well we are overvalued now, only because you built out so much capacity that you collapsing everyones prices, and now you want to say you are overvalued and want to compete with us on currency value, when you were building out all that capacity and debt, while the USD was weaker against our currenies, and now you say its too expensive and you have to devalue. everyone will beggar their nieghbor right out of the global system that saw developing countries rise.

      It’s over, the old frames and beliefs die. Such a shame that so many countries wasted their time pretending they were victims on the back of continental philosophy, post-modern beliefs and an over-grasping sociology.

  16. I am a bit confused by the following statements in this post: “Beijing may be eager for the RMB to become part of the SDR basket because it believes this will result in significant foreign inflows that will help reverse China’s very large and potentially destabilizing capital account deficit.” “…. as long as the PBoC intervenes in the currency, it cannot provide debt relief to struggling borrowers, and to the economy overall, by lowering interest rates without setting off potentially destabilizing capital outflows.”
    I recall that MP has previously stated that the capital account is the reverse of the current account, (money coming in via the current account necessarily goes back out via the capital account). Similarily Investopedia states: “The sum of the current account and capital account as reflected in the balance of payments will always be zero; any surplus or deficit in the current account is matched and cancelled out by an equal surplus or deficit in the capital account.”

    I understand that a persistent current account surplus over a long period of time can result in a destabilizing buildup of debt in the deficit countries (e.g. Spain, Greece) but the statements in the current MP blog post seem to be talking about something completely different. Is the first quote saying Beijing is hoping that inclusion of RMB in the SDR will result in a smaller current account surplus and therefore smaller (equal and opposite) current account deficit? Can anyone explain this?

    • need to correct the last sentence to: Is the first quote saying Beijing is hoping that inclusion of RMB in the SDR will result in a smaller current account surplus and therefore smaller (equal and opposite) capital account deficit? Can anyone explain this?

    • Because of capital flight.

      So more foreign investment rather than OBChinese, and others, domestic players who got money offshore and repatriated through a channel, and want the safety of offshore, so hundreds of billions have left over the past year. This upcoming quarter we will see a movement of capital offshore, in just a quarter that is a very large fraction of the last year due to what the government has been doing.

      It’s intersting but the government has just done what Michael had suggested, the transference of capital via government action, but this has likely been transferred not to the middle classes so they can consume, but to the wealthy and politically connected. I suspect we see very big capital flows this quarter.

      Start looking at spikes in London and anything one can find on BVI.

      The government looks this way, they look inept, the markets not doing what it wants. What if it just used state assets, to transfer more wealth to system beneficiaries.

  17. Here is the comparative graph from FRED that shows why China may have had little choice but to devalue:
    https://goo.gl/UjG4Nv

    As seen in that graph, virtually every major currency (except GBP) has been weakening against the USD recently. Given China’s peg to the USD, this was causing the Yuan to strengthen against every major currency. This naturally made Australian & Canadian real estate cheaper for Chinese investors, even as it made Chinese products more expensive for Australian, Canadian & Japanese consumers. The USD peg was turning out to be a millstone around China’s neck and hence the recent talk of moving away from it.

    • Devaluation of a currency does not increase deflation on a GLOBAL basis. All it does is that it exports deflation from the economy of the devaluing country to the rest of the world. As a result, it merely re-distributes the global deflation burden by reducing internal deflation, while increasing deflation in all other countries by the same amount.

      In other words: Devaluation of a currency does not increase overcapacity on a GLOBAL basis. All it does is that it exports some of the overcapacity from the economy of the devaluing country to the rest of the world. As a result, it merely re-distributes the global overcapacity burden by reducing internal overcapacity, while increasing overcapacity in all other countries by the same amount.

      In other words: Devaluation of a currency does not decrease aggregate demand on a GLOBAL basis. All it does is that it imports some of the aggregate demand from the rest of the world into the economy of the devaluing country. As a result, it merely re-distributes the global availability of aggregate demand burden by increasing aggregate demand available to the economy of the devaluing country, while decreasing the aggregate demand available to all other countries by the same amount.

      In other words: Devaluation of a currency does not increase unemployment on a GLOBAL basis. All it does is that it exports some of the unemployment from the economy of the devaluing country to the rest of the world. As a result, it merely re-distributes the global unemployment burden by reducing internal unemployment, while increasing unemployment in all other countries by the same amount.

      Hence the frequent references of late to the term ‘currency wars’.

      PS: Note that if the devaluation has nothing to do with deflation, overcapacity, inadequate demand or unemployment, but is triggered (or forced) by a BOP crisis (e.g. India 1991, Russia 1998, Brazil 1999), then the above statements are NOT true.

      Just some thoughts. Comments welcome.

  18. Yes, China devaluation is small. A little butterfly flapping its wings … It will spread deflation globally precisely because highly speculative global markets (in the sense you give to this expression) have “interpreted” it that way.

    Yes, only markets, and no group of civil servants however clever and well intentioned, possess the sheer computing power to constantly set zillions of prices in such a complex system as the economy. It seems appropriate to remind everybody that this is also true for asset prices.

    The IMF should have been vocal before China joining the WTO, not 15 years later. Especially if it is to utter such oddity as welcoming the devaluation of a country with a high current account surplus. The IMF simply confirms it is part of “the long list of much-hyped initiatives aimed at transforming the global trading system but that now languish in obscurity, known primarily for absorbing university graduates from very prestigious schools who have failed their other job interviews”. Kill it and return the money to the various taxpayers, that will easily be the best IMF contribution ever to public debts sustainability.

    • ^^DvD WROTE: “Yes, China devaluation is small. A little butterfly flapping its wings …”
      ————————————————

      This is just the beginning. As long as its reserves keep falling (i.e. net capital outflows are greater than current account balance), China will devalue again & again to apply a brake to this process. Falling reserves will make China’s deflation (producer prices & asset prices) worse, while helping the rest of the world. This is something China will not accept. So the pressure to devalue will only cease if & when the reserves stabilize.

      At each devaluation step they will say this is the “last one”. The irony is that since nobody will believe them, this step-by-step devaluation will only increase capital flight (‘get out now before the next devaluation’ syndrome) and make their headache worse. It would have been better for China to devalue by a large amount at one stroke and then convincingly say that they were done.

      What do you think? Is China done with devaluation? Has China lost control? Is there panic in Zhongnanhai?

      • It seems to me that, so far, Chinese policymakers are traveling along a remarkably similar road than Japan with a 25 years lag. They are now where Japan was in 1990 with their real estate and equity bubbles imploding after a spectacular credit expansion over the preceding 5 years, triggering a drop in interest rates and an effort to depreciate the RMB. The maximum pressure to appreciate the RMB was in 2010, precisely 25 years after the Yen was revalued upward at the 1985 Plaza Accord.

        After having repeated all the exact same mistakes as Japan previously (the urge to always repeat the same mistakes again and again despite clear-cut evidence of their detrimental effects has something totally fascinating, don’t you think?), it is now highly likely that China will face its own “balance sheet recession”. How they choose to deal with it remains to be seen. It is obvious that the path followed by Japan leads to a dangerous impasse but it is already visible that maximum pressure will apply to Chinese policymakers to follow precisely that path. It seems almost inevitable.

        The fact that, in different countries, at different times and with different policymakers in charge, the workings of the international trade and monetary system leads inexorably to a tremendous debt build-up in both the deficit and the surplus countries by replication of the exact same mechanisms has to be seen as remarkable and as an inherent flaw of the system. It should urgently open the eyes stubbornly wide shuts of present and future policymakers and their advisors before the whole world sit on 400% debt-to-GDP with no equity left in the system, ie. before the prolonged adherence to wrong economic doctrines leads everybody to bankruptcy with the not always pleasant consequences attached.

        • I think one factor that will make chinese bubble pop even worse than japan in 1990 was that when japan’s bubble popped, china’s economy was beginning a period of explosive growth, and increasing trade between china and japan cushioned Japanese economy’s fall. There’s no such cushion for china today.

          • ^^Meofios WROTE: “I think one factor that will make chinese bubble pop even worse than japan in 1990 was that when japan’s bubble popped, china’s economy was beginning a period of explosive growth, and increasing trade between china and japan cushioned Japanese economy’s fall. There’s no such cushion for china today.”
            ————————————————

            (1) China had a period of SLOWING growth from 1992 to 2000, so I am not sure what you mean when you say “beginning a period of explosive growth”.
            http://goo.gl/02mFQ8

            (2) Japan’s bubble was one of overcapacity (i.e. low consumption/GDP & inadequate aggregate demand because of falling investment). Therefore, the only external factor that could have helped Japan make the transition (i.e. rebalance) from an imbalanced investment-driven economy to a balanced consumption-driven economy was the willingness and ability of the rest of the world to run a current account deficit.
            http://goo.gl/2HMfqd

            (3) China ran current account surpluses during the 1990s and was, therefore, of no help to Japan. The real assistance to Japan after its 1991 bust was the rising current account deficits run by the US during its golden 90s period. It was the US that provided the additional aggregate demand that Japan needed to ease their transition from a bubble-economy into a balanced economy.
            http://goo.gl/rNnlz6

            In summary, if China goes the Japanese way, then what China needs is a source of external aggregate demand to help it transition as it weans its economy away from excess investment and toward healthy consumption levels. The question now is this: who will run these large current account deficits to help China? The US seem fatigued by debt, Europe is determined to run surpluses, and the rest of the world is institutionally unable to run high deficits on a sustainable basis.

            So you are correct that China’s rebalancing will be harder than Japan’s was in 1990s, but the principle reason for this is that while the US had a large apetite for debt during the 1990s, it is suffering from debt-fatigue now.

            Do you disagree?

  19. Vinezi:
    “Devaluation of a currency does not increase deflation on a GLOBAL basis … while increasing deflation in all other countries by the same amount.” (?)

  20. Hi Michael
    Yo mentioned: “On the other hand the fact that the trade account is in such large surplus seems to tell us that the RMB is undervalued. Why? Because if China is growing much faster than its trading partners, and if it has much lower unemployment than its trading partners, and if it is leveraging up while its trading partners are deleveraging, standard trade theory tells us very clearly that absent intervention and distortions, China would run a trade deficit, probably even a large one, and its partners the corresponding surplus.”

    Can you explain a bit deeper why stardard trade theory would suggest that China should be running a trade deficit?
    Regards from Fuengirola, Spain

    • There are several reasons. The faster-growing country with low unemployment is likely to be closer to capacity limits than the slower-growing country with unemployment, while because there is likely to be stronger upward wage pressure in the former and downward in the latter, wage adjustments might affect differential pricing, as well increase relative demand in the former and reduce relative demand in the latter. What’s more, if capital flows on a net basis from the latter to the former seeking higher returns, it must be balanced by the current account in both countries. This can happen by forcing up the exchange rate or forcing down interest rates in the faster-growing country, or any of a number of other reasons.

  21. Professor Pettis,
    In The Volatility Machine you categorize financial crises into two groups: 1) long-term liquidity contractions and 2) short-term collapses in financing at the margin. In the past the long-term liquidity contractions occurred because of a reversal in liquidity in rich country financial centers (the source of excess savings) and the short term contractions seem to have historically originated in EM countries (i.e. the destination for global savings). However, the current lending boom is difficult for me to asses bc the liquidity expansion seems to have roots in EM countries themselves…the recycling of the major trade surpluses (esp from China and OPEC). So how should we think about the current situation (assuming you believe we are at the start of crises)?
    For a LT liquidity contraction both of these sources would need to reverse. While excess savings from cmty oriented trade surpluses are declining, the trade surpluses of countries like China are now growing but due to investment falling relative to savings. Does that still contribute to a global liquidity expansion? Or is it better to think about China’s capital account deficit + fx reserves on absolute basis? Would it be the change in the stock or the flow of this excess savings that drives liquidity?
    Basically, could you help clarify what you believe really drove the liquidity boom and if you think that is reversing? You are the man, thanks!

    • ^MJM123 WROTE: “….(1) Does that still contribute to a global liquidity expansion?
      (2) Or is it better to think about China’s capital account deficit + fx reserves on absolute basis?
      (3) Would it be the change in the stock or the flow of this excess savings that drives liquidity?
      (4) Basically, could you help clarify what you believe really drove the liquidity boom and if you think that is reversing?”
      —————————————————————-

      (1) External-account imbalances do not, by themselves, contribute to an expansion of global liquidity. It is the external-account imbalance related *DEBT* (i.e. reserve accumulation) that contributes to an expansion of global liquidity. For example, if the external-account deficits were financed by the central banks of external-account surplus countries purchasing apartment buildings, hotels, factories, agricultural land, mines et cetera from the external-account deficit countries, then there would be ZERO contribution to any expansion of global liquidity by the global surplus/deficit situation. However, when the deficits are financed by the central banks of surplus countries essentially purchasing *DEBT* from the deficit countries (i.e. piling up forex reserves or ‘buy now, pay later’), then there is a LARGE contribution to the expansion of global liquidity.

      The issue of OPEC or commodity surpluses declining is immaterial. What matters is whether the total global imbalance (i.e. the sum of all external-account surpluses) is growing, shrinking, or staying steady. Given that central banks are unlikely to purchase anything other than debt to adjust their reserves, the total imbalances will be reflected in the rising, falling or staying steady of the total global reserves?

      Note that for global reserves to fall, then at least one of the following two things must happen:
      (i) The reserve issuing countries must run external-account surpluses to “pay back” their debt, AND/OR,
      (ii) The reserve issuing countries must sell non-debt assets (buildings, hotels, factories, agricultural land, companies, mines) to “buy back” their debt.
      Either way, a reduction in global reserves will contribute to a reduction in global liquidity.

      (2) In China’s case, the capital or current account is not the key point. The key point is the level of reserves it holds. If the level of reserves falls, then it will contribute to a reduction of liquidity IN CHINA. Whether it contributes to a reduction of liquidity in the reserve issuing countries or not will depend on whether some other countries just increases its own reserve by that same amount or not. If Chinese reserves fall, but reserves rise elsewhere to the same extent, then there will be no reduction in global liquidity due to this. Yes, Chinese liquidity will see a negative contribution due to its falling reserves, but liquidity in those countries that increase their reserves by the same amount will see a positive contribution. In other words, for GLOBAL liquidity to come under downward pressure due to this mechanism, the GLOBAL level of reserves must reduce.

      (3) Change in stock. Why? This is because the driver of liquidity is NOT the current account flow or the capital account flow, but rather the flow of RESERVES. The flow of reserves are reflected in the change in stock of reserves. Therefore, it is the ‘change in stock’ that determines the effect on Chinese liquidity.

      Net current account inflow – Net capital account outflow = Change in RESERVES (= External account balance)
      (i) If Net current account inflow = Net capital account outflow, then there is no change in reserves. In this case, there is no contribution to change in liquidity in China.
      (ii) If net current account inflow is higher than net capital account outflow, then reserve stock will rise (i.e. reserve outflow or ‘piling up’ makes up the difference). In this case, there will be a positive contribution to rise in liquidity in China.
      (iii) If net current account inflow is lower than net capital account outflow, then reserve stock will fall (i.e. reserve inflow or ‘draw-down’ makes up the difference). In this case, there will be a negative contribution to rise in liquidity in China or a positive contribution to a fall in liquidity in China.

      (4) DEBT, DEBT, DEBT. The global rise in debt (reserve accumulation) due to the persistent and growing trade/capital account imbalances over the last 30 years is what has been driving the global liquidity boom. Had these imbalances in trade/capital account been financed by transfer of title to illiquid assets (Greenfield FDI, factories, agricultural land, buildings et cetera), then there would have been no global liquidity boom. It is debt that is the driver of the liquidity boom and, hence, it is debt that is the driver of global asset-price boom (“bubbles”).

      Is it reversing? Keep an eye on the global level of reserves. If it falls (real fall, excluding valuation effects) significantly and in a secular fashion, then we can be sure that the cycle is reversing itself.

      Do you disagree? Please let me know your views.

      • Here is a recent Bloomberg article that says very much what I have been saying, namely that:
        http://goo.gl/NAsTEu
        (1) The piling up of forex reserves by China increases liquidity and hence tends to boost asset prices there.
        (2) A fall in global foreign exchange reserves contributes to a contraction in liquidity globally.
        (3) By implication, a fall in Chinese reserves tends to reduce liquidity within China and hence tends to puts downward pressure on real estate or stock prices there.

        Therefore, a large reduction & rapid in China’s reserves may puncture the real-estate & stock bubbles and lead to DEVASTATING consequences for their economy.

      • Vinezi,
        First off, thank you for taking the time to address these questions. But I want to respectively challenge you on a few points. First of all, I disagree that central bank purchase of debt assets are the only way to create an expansion in liquidity. If reserves are used to buy real estate or stocks in another country, this would have the effect of inflating financial asset values in the destination country and this typically leads to an increase in consumption that can lead to an increase global liquidity. There are numerous examples currently and historically of just this scenario driving liquidity expansions.
        Another point you make that I am not sure I agree with is your characterization of central bank reserves. While I am familiar with this line of argument, I have always been skeptical of the reasoning. The way I see it, creation of reserves actually serve to decrease liquidity in the current account surplus country as they are sterilized by “borrowing” money from their private sector to “lend” it in foreign countries. The borrowing serves to soak up the domestic excess liquidity which was created from the current account surplus. The liquidity expansion then occurs as the reserves are used to buy financial assets in the foreign country (as opposed to the money being recycled through the current account) which creates a necessary increase in debt to fund the foreign countries current account deficit. Reserve accumulation just served as a high-powered way to recycle the trade surpluses. If, under the gold standard, the current account surplus countries took the resulting excess gold and lent it back to the current account deficit countries the liquidity expansion would immediately occur in the deficit country. Although, this resulting liquidity expansion can be expansionary for both countries if the current deficit country’s economy is large enough to have a major effect on the current account surplus country…as was the case bw Britain and the US in the 1830s and the US and China for much of the last decade.
        But I also strongly disagree that reserves are “special” in a way that they are uniquely capable of expanding global liquidity while private capital flows are not. Historically GLOBAL liquidity/lending bubbles have typically been driven by an increase in risk appetite (due to changes in bank regulations as one example) in the financial centers that caused an increase in PRIVATE capital outflows to foreign countries in search of higher returns.

        • Vinezi, you state that global reserves uniquely drive liquidity and that “If Net current account inflow = Net capital account outflow, then there is no change in reserves. In this case, there is no contribution to change in liquidity in China.” If those two statements are correct then it must also be true that a country like the US, where the capital account balance = current account balance (i.e. zero reserves), can never have a liquidity expansion. Also, your logic means that countries that run current account deficits can’t have liquidity expansions, which stands in stark contrast to the experiences of countries like Brazil in the 70s or the US in the 1880s.
          Based on my view, a country can have a liquidity expansion caused by:
          1) domestic circumstances: For example, increase in domestic credit creation or an innovation that increases the velocity of money
          2) An increase in the money supply due to foreign sources: This can either come from a surge in capital inflows or from an influx of money as a result of a growing trade surplus. But the important point is that it does not require the accumulation of reserves. The accumulation of reserves is only relevant in the fact that it allows for a country to accumulate foreign money simultaneously through its capital account and current account.
          I will admit, this is a very confusing issue, but I would love to get Professor Pettis’ take on this topic. Could even be a very interest topic for a blog post!

        • ^MJM WROTE: “Vinezi, you state that global reserves uniquely drive liquidity….”
          ————————————-

          No, I meant that global reserve accumulation uniquely drives ADDITIONAL liqudity, BEYOND that determined by independent local or internal policy. If that was unclear, I apologize.

          ————————————-
          ^MJM WROTE: “If those two statements are correct then it must also be true that a country like the US, where the capital account balance = current account balance (i.e. zero reserves), can never have a liquidity expansion.”
          ————————————-

          1) Firstly, in the US capital account balance is NOT necessarily equal to the current account balance (i.e. reserve change is NOT necessarily zero). Since the US is the provider of reserves, the IMPLIED change in reserves in the US is negative (i.e the US goes deeper into gross debt). This implies that either the US must run a current account deficit OR a capital account deficit OR both. The sum of the US current account deficit and the US capital account deficit is equal to the change in reserves, which is usually negative for the reserve provider.

          2) As the reserve PROVIDER, the negative change in reserves in the US (i.e. further accumulation by the rest of the world) necessitates ADDITIONAL liquidity creation in the US due to external account. This liquidity expansion is beyond that determined by local or internal US policy. For additional information, please see my other comment on this page entitled “Global Liquidity Mirroring”.

          ————————————-
          ^MJM WROTE: “Also, your logic means that countries that run current account deficits can’t have liquidity expansions, which stands in stark contrast to the experiences of countries like Brazil in the 70s or the US in the 1880s.”
          ————————————-

          1) Any country that increases its reserves see a corresponding liquidity expansion due to this mechanism. This has nothing to do with whether the country runs current account surpluses or deficits. So how do the countries that run persistent current account deficits (e.g. India) accumulate reserves? By ensuring that the capital account surplus is larger than the current account deficit– the difference is the increase in the reserves account (i.e. accumulation).

          Once again, total liquidity increase is determined by the liquidity increase forced by reserve accumulation PLUS liquidity increase due to local or internal monetary policy. So even if Brazil has constant reserves, or even no reserves, it can certainly have a liquidity expansion due to its internal policies.

          2) So the next question is this: If China is worried about the fall of liquidity due to the decrease in its reserve stock (i.e. capital account deficit has become higher than current account surplus), why does it not compensate for this decrease in liquidity due to external factors by further increasing liquidity using internal monetary policy?

          The answer is as follows: Yes, China can increase in liquidity to MATCH (and hence CANCEL) the decrease in liquidity caused by escalating capital flight. However, that will result in a further DETERIORATION of the QUALITY of the consolidated balance sheet of the entire banking system. It is this deterioration of quality that leads to further “destabilization”.

          ————————————
          ^MJM WROTE: “An increase in the money supply due to foreign sources: This can either come from a surge in capital inflows or from an influx of money as a result of a growing trade surplus. But the important point is that it does not require the accumulation of reserves.”
          ————————————

          Nothing in the world REQUIRES the accumulation of reserves. If reserves are held constant and central bank intervention ends then Capital account balance EQUALS the current account balance. If this occurs then there is no effect on monetary policy due to the external account and the monetary policy is said to be 100% independent.

          It is incorrect to say that a surge in capital flows or a growing trade (current account) surplus increases the money supply WITHOUT reference to the reserves. Here is why:
          1) IF reserves are held CONSTANT, a surge in net capital inflows drives up the EXCHANGE RATE (i.e. strengthens the local currency) in such a way so as to increase the current account deficit. The end result is that net capital account inflows MUST equal the net current account outflows, because there is no change in the reserves. If this happens, then the money that came in through the capital account leaves through the current account and there is NO CHANGE in the local money supply.
          2) IF reserves are held CONSTANT, a surge in the current account surplus again drives up the EXCHANGE RATE (i.e. strengthens the local currency) in such a way so as to increase the capital account deficit. The end result is that net current account inflows MUST equal the net capital account outflows, because there is no change in the reserves. If this happens, then the money that came in through the current account leaves through the capital account and there is NO CHANGE in the local money supply.
          3) The ONLY way to increase local money supply via the external account mechanism is by accumulating reserves (i.e. an increase in the reserve stock). Conversely, the ONLY way to decrease local money supply via the external account mechanism is by drawing down reserves (i.e. a decrease in the reserve stock).
          4) In (1) & (2), there is no effect on local monetary conditions. In (3), the act of accumulating or drawing-down reserves leads to a change in liquidity beyond what internal monetary policy intended. This is why central bank intervention (change in reserves) is said to come at the cost of a loss of control over internal monetary policy.

          Please let me know if this is still unclear.

        • Mjm123: The way I see it foreign exchange reserves are created when a Chinese firm sells goods to Walmart, who pay firm $$ which the firm deposits ultimately in PBoC in exchange for RMB. Now PBoC has a choice. These new rmb can increase liquidity or PBoC can require banks to “return” same rmb for domestic bonds; hence no increase in liquidity.

          • ^Dan Berg WROTE: “These new rmb can increase liquidity or PBoC can require banks to “return” same rmb for domestic bonds; hence no increase in liquidity.”
            ————————————–

            No, there will be an increase in liquidity either way. The difference between the two situations is merely in the AMOUNT by which liquidity increases.

            Remember that the Yuan (i.e. currency) is just as much sovereign debt as a Chinese government (or Central bank) bill, note or bond. The only difference is that the Yuan is considered MORE liquid than a Chinese government bill, note or bond. Here is the ranking of liquidity for sovereign debt from highest to lowest: Currency > 1-month bill > 6-month bill > 2Y note > 5Y note > 10Y bond > 30Y bond.

            Therefore, whether the central banks issues NEW currency or (effectively) NEW sovereign bonds, there is always an increase in liquidity. If it issues NEW currency then the rise in liquidity is higher than if it issues NEW bonds (on net basis, via sterilization). Either way, the increase in liquidity is a certainty.

            Let me know if you disagree.

  22. In the discussion (or comments) section of Michael’s old article entitled “China, Europe & Optimal Currency Zones” (Nov 7, 2014), I made the following statements on ZIRP, QE, debt-load et cetera:
    http://goo.gl/FYhJxA

    Interestingly enough, here is a recent (Aug 17, 2015) article from the Wall Street Journal that raises the SAME POINTS as I did last year:
    http://www.wsj.com/articles/u-s-lacks-ammo-for-next-economic-crisis-1439865442

    Fear is now starting to set in. On the Titanic without lifeboats. Nowhere to run, nowhere to hide.

    • Vinezi: I disagree. I think you are misusing the term “liquidity.” A person, firm or market can be either illiquid or insolvent; we talk about a liquidity trap. Your sliding-scale definition makes these ideas incoherent. One other problem. Somewhere above you state that “interest rate is the price of money.” The price or value of money =1/P where P = price level. Price level doubles, what happens to the value (price) of money – saying nothing about interest rates. Interest rate = price of credit. Not the same. But at that point in the discussion where someone says: ok, define your terms, I’m afraid we are in the realm of rapidly declining returns.

      • Dan Berg WROTE: “I think you are misusing the term “liquidity.” A person, firm or market can be either illiquid or insolvent; we talk about a liquidity trap. Your sliding-scale definition makes these ideas incoherent.”
        ————————————–

        Here is the sliding scale definition (from comments above):
        Currency (MOST LIQUID) > 1-month bill > 6-month bill > 2Y note > 5Y note > 10Y bond > 30Y bond (LEAST LIQUID)

        This is not my definition. This is the universal definition of the relative liquidity of government debt. It you think this represent “misuse” of the term “liquidity”, then you should write to the Federal Reserve admonishing them.

        For example, when the Federal Reserve sells short-term bills from the RHS of its balance sheet and buys longer-term notes to REPLACE them, they they say they are doing this to INCREASE liquidity. Conversely, when the Federal Reserve sells longer-term notes from the RHS of its balance sheet and buys shorter-term bills to REPLACE them, they say they are doing this to DECREASE liquidity.

        What is so incoherent about all this?

        ————————————–
        ^Dan Berg WROTE: “Somewhere above you state that “interest rate is the price of money.” The price or value of money = 1/P where P = price level. Price level doubles, what happens to the value (price) of money – saying nothing about interest rates.”
        ————————————–

        Actually, if you look at all my previous comments, you will see that I have used both definitions; this is because these two definitions track each other in a normal, functioning market. When the price-level rises (i.e. money loses value) above the inflation target, the Fed raises the interest-rate (i.e. makes money more expensive) to oppose the process. Conversely, when the price-level falls (i.e. money gains value) below the inflation target, the fed lowers the interest-rate (i.e. makes money cheaper) to oppose the process. In other words, the changes in price-levels and the changes in the interest rate track each other– this is how the Fed maintains the inflation target (or price stability) by adjusting supply & demand.

        Question: Numerous economists today are pointing to the “dangers of cheap money”. What do they mean by that? Clearly, they are not talking of a rapid rise in the price-level, as the world is facing deflation (i.e. money is rising in value). So what do they mean by “cheap money” and why do they feel it is dangerous today? Let me know your thoughts on this matter.

        ————————————–
        ^Dan Berg WROTE: “Interest rate = price of credit. Not the same.”
        ————————————–

        Credit, Money, Debt.
        Patayto, Potaato.
        Tomayto, Tomaato.

        ————————————–
        ^Dan Berg WROTE: “But at that point in the discussion where someone says: ok, define your terms, I’m afraid we are in the realm of rapidly declining returns.”
        ————————————–

        There are no NEW definitions here. Nothing is being “re-defined” into order to buttress a specific argument. The definitions used here are widely used, even though they may be universally used. For example:

        A) Michael’s definition (commonly used by others as well):
        Capital account surplus = Current account deficit, where the Capital account include reserves flows.
        B) Definition used by most central banks of the world (and many others as well)
        Capital account surplus – Current account deficit = Increase in Reserves

        Both these definitions are correct and both are in current use. Definition (A) is shorter, simpler & “cleaner”, but definition (B) has the added advantage of increased resolution. The first definition is like saying that the average height of adult Americans is 5’10”, while the second definition is like saying that the average height of adult American men is 5’11’ and the average height of adult American women is 5’9″. They are both saying the same things, but the second is intuitively more informative than the first.

        • In the comment above: “For example, when the Federal Reserve sells short-term bills from the RHS of its balance sheet and buys longer-term notes to REPLACE them, they they say they are doing this to INCREASE liquidity. Conversely, when the Federal Reserve sells longer-term notes from the RHS of its balance sheet and buys shorter-term bills to REPLACE them, they say they are doing this to DECREASE liquidity.”
          —————————

          ERRATUM: The term ‘RHS’ in the above statement should be ‘LHS’.

          Government debt (bonds, notes, bills) are on the LHS of the balance sheet of the Federal Reserve.

      • Dan

        Vinezi is discussing sterilization of inflows.
        Michael has related elsewhere on the topic, I believe, that they do add to liquidity, but only slightly so because banks are forced to buy bonds that for all intents and purposes have no market; thus mostly illiquid, of state mandate, except insofar as they are bonds.

        Not sure if that helps you guys.

        My interest in this is with the even higher rate of money growth more broadly and the place of these bonds on bank balance sheets enabling asset bloat; thus enabling money creation by banks, and being supportive of liquidity in the system (if the gov bonds are illiquid and forced upon banks, they still sit on balance sheets.

        • ^CSteven WROTE: “…they do add to liquidity, but only slightly so because banks are forced to buy bonds that for all intents and purposes have no market; thus mostly illiquid, of state mandate, except insofar as they are bonds.”
          ——————————————-

          If the sterilization bonds (or they equivalent) are illiquid such that they HAVE to be forced onto to the commercial banks, then the size of the balance sheet of the commercial banks MUST increase to: (1) accommodate these bonds on the LHS and (2) accommodate the holders of the ‘freshly printed yuan’ on the RHS. This implies a rise in the M1/M2/M3/MZM money supply and results represents a rise in liquidity. For more details, please this previous comment on this very page:
          http://goo.gl/IAFFkM

          QUOTE: “(E) On the issue of sterilization, you are correct that sterilization bonds ensure that the M0 money supply does not increase. However, given that China issues such bonds (or their equivalent) to the commercial banking system itself, it automatically means that:
          (a) The balance sheet of the commercial banking system also expands to accommodate reserve accumulation, AND, as a consequence,
          (b) The M1/M2/M3/MZM money supply DOES increase, even though sterilization may have negated the rise in M0 money supply.”

    • Vinezi; After my 8/21 5:07 post your reply was: no. Had I said (last sentence): “. . .hence no effect on domestic prices.” Agree?

      • ^Dan Berg WROTE: “Vinezi; After my 8/27 5:07 post your reply was: no. Had I said (last sentence): “. . .hence no effect on domestic prices.” Agree?”
        ————————————–

        Unfortunately, no. The rise in liquidity in China increase due to reserve accumulation does have an inflationary effect of domestic prices, even though it might not actually cause run-away rise in inflation. This issue was addressed in the following comment on this very page:
        http://goo.gl/Zs9PW1

        QUOTE: “1) Given China’s massive and widespread overcapacity, we should have seen falling producer prices across the board (i.e. deflation) over the last 10 years. However, this did not happen (until recently). This is because the inflationary effect of expanding balance sheets was cancelling the deflationary effect of overcapacity and hence maintaining reasonably steady producer prices.
        2) The reason that the expanding balance sheets in China did not cause EVEN higher inflation in producer prices is because the some of the excess supply of liquidity was being channeled into inflation of the prices of real estate (due to lack of investment alternatives) in China.”

        In SUMMARY, no matter how we look at it, the act of increasing reserves– whether sterilized or not– increases liquidity in the system. This HAS to be true. If it were possible to increase reserves in a ‘sterilized fashion’ such that there would be no increase in liquidity, then the theory of the Impossible Trinity would be proven to be FALSE.
        https://en.wikipedia.org/wiki/Impossible_trinity

  23. Victor Shih – The Dangers of Capital Fleeing China
    ( Michael hope you can embed this video )

    • The fact China is dropping it’s RRRs shows the issues within the banking system are quickening. With bond issuance trending downward the reliance on repo’s, reverse repo’s regarding liquidity within the banking system are more than likely insufficient as the dropping of real interest rates pressures the banking system as more money looks to exit China.

      The last thing the PBoC wanted was lowering of interest rates. So this action in itself also shows how fragile the situation has become. You really must question the ” friendship ” between China and U.S.A at this critical juncture. With cyber wars already erupting between the two countries, one must question the timing of Federal Reserve interest rate hikes in this light. The rate hike becomes a weapon, a very powerful one as it would exasperate the liquidity crunch within the Chinese banking system & trigger more flight to quality ( hot money outflows ). So the longer term goals of China / Xi Jinping regarding dominance on a world stage and power must be considered as Washington does not agree with Xi’s longer term ambition’s. His consolidation of power and personal goals are understood within the halls of government and the derailing of this process may in fact drive the Federal Reserve toward rate increases. The geo-political issues would supersede what the markets ” expect ” as everyone thinks a rate increase is not happening with world markets on edge.

      All the countries / central banks that peg ( manipulate ) /w USD ( OPEC, China, Russia, Brazil, Vietnam etc ) are being crushed. The treasuries recycled by SWF, agencies, banks create bubbles on the mainland as these assets crash / deflation, very low interest barring notes created negative interest loans supporting by non-performing assets …… 🙁 , huge losses for the banks, thus the massive liquidity issues within the Chinese banking system. This is on top of NPL’s from past sin’s.

      So as the dollar continues it’s climb, the rate hike looming is not only priced in but future increases anticipated by forward looking markets. This will cause a massive flight to quality back into the U.S.A.

      It’s the reason the (PBoC) came out today and ” asked ” if the fed would hold off on a rate increase. Maybe should have thought of this before the cyber / attacks – espionage hand was played. Not very forward thinking when your under the control of the reserve currency – dollar denominated debt, currency manipulation recycling vortex. The tail does not wag the dog in the long run like many ” assume ” …..

    • This video is from 2011.

      • Indeed.

        Way ahead of it’s time. Still explains the massive issues facing China as the dollar denominated debt, NPL’s within the financial system, have only grown since then.

        Most believe 4 trillion in reserve is a massive buffer. As the outflows gather pace, yuan tumbles, rates drop this video helps describe the issues playing out in realtime.

  24. A huge misconception is the exporting of deflation from China.

    The world is facing deflation issues but as the PBoC deals with the yuan dropping, it sells dollar assets thus taking more liquidity out of the financial system ( banks, swf, shadow banks ) driving up interest rates. The swf, shadow banks issued high interest loans as deflation sweeps across the mainland in a negative feedback loop.

    All this taking place with a 28 trillion dollar debt overhang. The social mood within a deflationary environment throughout history sends most into saving or investing abroad as Chinese businesses have stopped investing in more capacity, now markets will bring pause as investment in real estate all slowing at once could cause a homegrown ” sudden stop “.

    • CV WROTE: “A huge misconception is the exporting of deflation from China.”
      ——————————————————–

      A) If China holds on to its reserves and lets the Yuan fall (i.e. stops “defending”), then China will export deflation.
      B) On the other hand, if China holds on to the Yuan and lets its reserves fall (i.e. keeps on “defending”), then China will import deflation.

      Given that China & much of the world is threatened by deflation, (A) is better for China, but bad for the rest of the world, while (B) is worse for China, but good for the rest of the world.

      Where is the misconception? Please explain.

      • Well the word on the street is China will export it’s deflation.

        China will continue burning up reserves defending the deflation engulfing it’s economy. But the thought China will export deflation IMO is false.

        The deflation was already running wild as soon as the securitization markets broke down in 2007-08. The balance sheet recession upon most is baked into the cake as all asset prices have been mis-priced since the early 90’s as financial innovation / 40-80 ~ 1 leverage produced bubbles and distorted consumption expectations.

        The way I look at it, deflation is now always and everywhere a monetary phenomenon like Milton Friedman’s famous meme’ ….

        • CV: China has been exporting wage and price deflation for 35 years.

        • ^^CV WROTE: “China will continue burning up reserves defending the deflation engulfing it’s economy.”
          ——————————

          You lost me here. How does the “burning up of reserves” by China “defend the deflation”? In addition, if “deflation is engulfing its economy”, why would China even try to “defend” that deflation?

          Please explain which of the following statements two you had in mind:
          A) China will continue burning up reserves defending the Yuan. This will make the problem of deflation, which is engulfing its economy, worse.
          B) China will defend against the deflation engulfing its economy by not burning up its reserves and letting the Yuan fall.

          In short, reducing reserves to prevent the Yuan from falling has a deflationary effect in China, while letting the Yuan fall to hold on to the reserves has an inflationary effect in China.

          Let me know your thoughts.

    • Indeed. The China “exporting of deflation” concept is confusing. China mostly produces and sells things the buyer economy (i.e., North America & Europe) does not want to “produce”. Although the invoices added up result in China being the largest trader… when adding up China’s “value add”… I doubt China is still the world leader. So… the exported deflation would only be on China’s “value add”. For example, most of the value of an iPhone is in the imported parts. The assembly of those parts done in China represents only a small portion of the value. If that small portion goes down by 10%… it would not effect the overall price of a phone. The cpu and “gorilla glass” inputs would remain the same price from the consumer countries perspective….

      And even when China produces a majority of the value add (i.e. domestic components) …. if a landed pair of pants into NA from China is $5.. but goes down in price to $4.50 because of “exported deflation”… the retail price at The Gap is $49.95 … really? The Gap is going to lower the price by 50 cents? They might take that price cut and spend it on advertising. I don’t see this being a strategic issue (yet).

      • ^Cjared WROTE: “iPhones, The Gap….”
        ———————————————————————–

        Let us say the US runs a current account deficit of X$
        Let us say that China runs a current account surplus of Y$
        Then the rest of the world (i.e. Non-US, Non-China) must be running a current account surplus of (X-Y)$

        Let us say that China’s devaluation causes China’s current account surplus to rise to Y+n$
        Let us further say that the US current account deficit STAYS THE SAME at X$ (because iPhone prices et cetera remain the same, as you say)
        Then the rest of the world must necessarily see their cumulative current account surpluses shrink by n$.

        This implies that, even though it might make no difference to the US itself, the rest of the world would face higher overcapacity. This is because, given current levels of global capacity, China’s stealing of n$ of existing aggregate demand from them would result in additional overcapacity elsewhere. This is deflationary for the rest of the world (i.e. non-US, non-China) in this example.

        This is why China’s devaluation (or letting the Yuan fall) exports deflation. It tends to ease deflationary pressure in China, while it increases deflationary pressure by the same amount in the rest of the world, EVEN IF we assume that the US will be unaffected by this.

        Do you disagree? Does this still conflict with your ideas about the prices of iPhones & the margins at The Gap?

        • Indeed, as you point out, the deflation issue is really one for developing countries. My comments were on “consuming” countries. I should have said North America. The general media has not been distinguishing between the two.

          I hope in pointing this out I don’t sound too insular in my thinking. I am not. The world economy has many players, and their circumstances are all different. My pushing back with a NA perspective is just meant to point that out.

      • ^Cjared WROTE: “…. if a landed pair of pants into NA from China is $5.. but goes down in price to $4.50 because of “exported deflation”… the retail price at The Gap is $49.95 … really? The Gap is going to lower the price by 50 cents?….”
        ——————————————————————

        Assume that the Chinese pant-industry and the Vietnamese pant-industry both have some overcapacity, as such industries usually do. At this time, assume that they are both selling pants to North America at 5$ each and the business is split between them.

        Now assume that China goes and devalues the Yuan, thereby reducing the dollar-price of Chinese pant-exports to 4.50$. Fifty cents may not seem like much to the customers at The Gap, however, in the highly price-sensitive global pant market, this is a huge discount for bulk buyers. This discount will lead those who were buying pants from the Vietnamese pant-industry to shift their business to Chinese pant-industry. Automatically, this means that:
        (1) The Vietnamese pant-industry will face increased overcapacity, while the Chinese pant-industry will reduce its level of overcapacity.
        (2) Vietnam will suffer from reduced overall aggregate demand, while China will enjoy increased overall aggregate demand.
        (3) Vietnam will face higher unemployment or under-employment with shorter-hours, while China will rise toward greater employment, with either reduced under-employment or longer-hours.
        (4) Vietnam will see its current account surplus fall, while China will see its current account surplus rise by the same amount (if buyers keep the total dollar purchase the same while increasing the number of pants).
        (5) As a result of (4), from this effect alone, China’s reserves will rise by the same amount that Vietnam’s reserves fall. This implies that liquidity in China will increase and liquidity in Vietnam will fall.
        (6) As a result of (5), China would have exported some of its deflation to Vietnam– even though all this makes little to no difference to the US.

        What can Vietnam do to stop this theft of aggregate demand by the Chinese? How will Vietnam respond?

        Vietnam can respond to this in two ways:
        (a) Devalue the Dong (by printing more money to increase liquidity via its internal monetary policy) to regain competitiveness.
        (b) Accept higher unemployment/under-employment for now and keep lowering wages AND prices (accept deflation) until competitiveness is regained.

        PS: We note that since Spain/Greece could NOT do (a) in EuroWorld, Spain/Greece had no choice but to do (b).

        Let me know your views.

        • In an earlier comment I made on this blog I tried to make the point that if North America does not reduce it’s demand for foreign goods, but increases that demand through this business cycle, there is no trade war.

          I think you are making the rebuttal to my comment, there is a trade war. But it’s not between the west and the developing world. It’s amongst the developing economies.

          Western economies are continuing to evolve their approach to including foreign inputs, including labour, into their economies. And quite successfully, we have grown considerably over the past several decades with little inflation, and dramatically higher consumption. Either in quality or quantity. With food it’s quality, with pants it’s quantity.

          In terms how Vietnam can respond. Well… what about trade deals? Improve their institutions such as courts, rule of law, property rights, streamline or reduce government regulation …. the list goes on…. but witness Singapore…

  25. Something for blog participants here to think about….

    A) Much has been written and even more said about how a “Tsunami of cheap money” flowed from the US (developed) to the emerging markets (developing) after the 2008 financial crash & ZIRP-QE.
    B) It is said that this “tide of cheap money” is now turning and flowing back into the US, because the Fed is about to raise interest rates and because the emerging markets are in trouble due to imbalances, excess debt and the commodity-price crash.
    C) A variety of grave consequences are predicted for emerging markets, including collapsing asset prices, debt defaults, currency crises, recessions, stagnation and so on.

    While all of (A), (B) & (C) are generally true, here is the question from the other end: What happens when this “tide of cheap money” flows back into the US? What do the blog participants here think it will do once it comes back into the US? Blog participants can choose from the following options—
    1) It will do what Yellen wants it to do and flow into the physical economy as real investment, thereby generating additional aggregate demand that will boost growth & lower unemployment.
    2) It will seek safety by taking refuge either in currency or USG bonds (with yields so low, there is little difference left), thereby doing nothing much at all.
    3) It will indulge in further risk-taking and flow into the financial economy as nominal investment, thereby pushing up the already-bubbly prices in stocks and real estate.
    4) Something else altogether.

    Which seems the most likely and which the most unlikely? Opinions, observations & comments would be welcome.

    • 50-60% into short term bonds, the rest into stocks chasing yield. If the bond market shows weakness then you could see even more enter the stock market. Maybe 20% goes into the physical economy.

      Over the last 50 years or so the business cycle has produced a recession every 7-8 years. So the question would be how will slowing global growth affect corporations dependent on foreign sales growth upon indexes. A wall of worry driving further gains on wall street or foreign buyers replacing domestic bringing forth the blow off top before a major correction following the rest of the world into another downturn …..

      Or the correction of the past few weeks turns into a cascade as deflation trumps all assumptions forcing the majority of the inflows into bonds as a rerun of the late 20’s -30’s plays out. With balance sheets still shaky across the globe the first sign of a global downturn will lock up investment as the nightmare is very fresh in society as debt still an issue for many including the global financial complex.

      • ^C.V. WROTE: “50-60% into short term bonds, the rest into stocks chasing yield. If the bond market shows weakness then you could see even more enter the stock market. Maybe 20% goes into the physical economy.”
        ————————————————————–

        Instead of going into something or staying in currency, what if the money coming back into the U.S. just “deleverages”? In other words, what if investors bringing Dollars (right side of bank balance sheet) back into the U.S. just pay down their debts (left side of bank balance sheet) and hence reduce the size of the consolidated balance sheet of the entire US Banking system?

        Is this possible? And if so, what would be its consequences?

        • Yes this is very much possible, the Irving Fisher effect.

          The deflation unfolding may crash global investment and take us all down much like the late 20’s -30’s. What unfolds after that ….. lets hope history does not repeat regarding world wars.

      • ^CV WROTE: ‘Maybe 20% goes into the physical economy.”
        —————————————————-

        Would you elaborate on why you think ANY money would go into the physical economy?

        All investments in the physical economy track future consumption. If investors feels that future consumption will be strong, then they will act so as to ensure that current investment in the physical economy will be strong.

        Therefore, if any of this money goes into the physical economy as additional (implying more than what is already happening) real investment, then it necessarily means that investors are seeing a strong rise in future consumption.

        But why would they see this? In fact, all the signs are in the other direction:
        (a) Real unemployment (headline unemployment plus non-participation) is very high. Therefore, with two-income families becoming one-income families, for example, the prospect of fast growth in consumption looks unlikely.
        (b) In addition, wage increases for those who are currently employed look unlikely in the face high non-participation, again putting downward pressure on future increases in household consumption.
        (c) Households are reluctant to borrow (and Banks reluctant to lend) against the ‘wealth effect’ to fund increases in consumption because of the 2008 experience.

        In light of all this, why would anyone increase real investment in the physical economy? Please explain.

        • If Donald Trump wins expect tariffs or taxes on imports.

          Or foreign capital might enter the USA as the rest of the world slows so manufacturing that has a good model in Europe or other countries may seek more market share by introducing a better mouse trap within an industry.

          Also, with nat gas prices in the USA well below world rates many chemical companies that use this already entering USA. Or manufacturing / trucking using nat gas / propane find our markets lucrative long-term.

          JMO

        • It seems to me that much is reshoring…..I have noticed that more and more call centers are being relocated back to the US. More and more tech and service centers.
          So chemical industries, but supporting industries to the global reinvestment into Mexico taking place.

          There could, especiallly in the current environment be a call up for VER’s, as in the 1980’s under Reagan, Voluntary Export Restraints.

          The nature of the altering demographic picture will create lotsa space for certain types of products that serve the altering demographic picture, and Americans have always had their age specific toys, and also will likely see a rise in certain types of services (the first PhD in Geriatrics was only given about a decade and a half ago).

          There are a slew of infrastructure needs, which can be done cheaply in PPP’s (even those with Fed holding bonds of quasi-public org’s) at moderated interest rates; Sanders is onto something, but his numbers are too small, and his expectations for employment at said numbers too high. But long has this been discussed, I projected that this will be a 2016-18 issue several years ago. Done at a moderate pace, there are so many places in the world dependent upon commodities, it might be right more broadly, and globally supportive. They don’t have to build bullet trains, but so many places would benefit from light commuter rail. And so many other forms of hard and soft infrastructure for that matter.

      • ^^CV WROTE: “Over the last 50 years or so the business cycle has produced a recession every 7-8 years.”
        —————————————

        If you look up interest rates in all the previous recessions, you will see that they BEGIN to rise within 2-3 years of the end of recession.
        https://research.stlouisfed.org/fred2/graph/?g=1HaM

        As seen in the graph, the fed then KEEPS RAISING interest rates until the next recession hits (as you say, on average with 7-8 years), when it once again lowers the interest rates. This implies that, on average, the fed has 5 years (7-8 minus 2-3) to gradually take the interest rate from the stimulating-lows back up to normal levels (see the historical graph linked).

        Now here is the current problem: We are already 6 years into the recovery, but the fed is still at ZIRP. Therefore, even if the fed BEGINS to raise the interest rate in September, it may be 5 years before the interest rate can go up to levels considered ‘normal’. What if the next recession, that is statistically expected soon, hits much before the Fed has had time to raise interest rate to normalization level? What happens then? Will interest rates be reduced to negative (NIRP) to counteract the next recession? Will QEn follow? What would be the consequences of all these ultra-unorthodox actions?

        Please let me know your thoughts.

        • One thought… you are using the average in terms of frequency of contractionary periods. The longest expansion period ever recorded was 120 months, this was after the previous real estate bust combined with financial crises ( called the “savings & loan crisis”). Your chart shows the bust in 1988 and rates only starting to rise in 1994.

          The expansion period we are currently in began in 2009, after a huge real estate bust and financial crisis. History does not necessarily repeat, but markets always climb a wall of worry.

          Perhaps the slow rise in rates indicates we are going to break that 120 month record. In the early 90s labour markets were very slow to recover, just like today.

          In other words, the business cycle is certainly not dead. But perhaps this is a long slow recovery… just like the last record setter….

          • ^Cjared WROTE: “Your chart shows the bust in 1988 and rates only starting to rise in 1994…”
            ——————————————————-

            My comment referred to recessions, not ‘busts’ (presumably you mean stock market drops). The recessions in the linked federal reserve graph are clearly marked with grey bands. According to the graph, there was no recession in 1988. The recession began in 1990 and ended in 1991. Rates began to rise in 1994, almost exactly 3 years after the end of the recession. Please see the graph again and focus on the grey bands:
            https://research.stlouisfed.org/fred2/graph/?g=1HaM

          • ^Cjared WROTE: “Perhaps the slow rise in rates indicates we are going to break that 120 month record. In the early 90s labour markets were very slow to recover, just like today.”
            ——————————————————

            No, the labor situation today is UNIQUE. Nothing like this has been seen since the Great Depression. The labor market today is certainly nothing like it was the early 1990s.
            https://research.stlouisfed.org/fred2/series/EMRATIO

            1) In that graph, the parameter includes headline unemployment PLUS participation-rate changes, so that the statistical juggling effects are removed from the labor situation.
            2) Note that in the early 1990s, it took just two years after hitting post-recession bottom to get back to the previous peak.
            3) Now look at the current situation. Even after 6 long years of ZIRP, QEx and unprecedented rise in USG debt-load, the graph has barely budged.

            You are correct that it is certainly POSSIBLE that the current recession-to-recession period may break the previous record of 10 years. But there are two points to keep in mind:
            (1) Even if the current long “jobless slow expansion” period extends indefinitely, will the real employment situation substantially improve or will we just have rising ‘non-participation’ rates?
            (2) The current indicators point to severe trouble in emerging markets, while Europe is in deep debt trouble and Canada/Australia are being negatively impacted by the commodity downturn as well as their own stratospheric housing bubbles. In the face of all this, will the US be able to continue its slow expansion all by itself in magnificent isolation? Or will it go into recession along with the rest of the world due to the psychological effect? In other words, if the rest of the world goes into recession, will US households still be able to summon the courage to keep spending? Or will US households become even more wary by watching the pain all over the rest of the world and cut back on spending?

            Something to think about.

          • Regarding your chart. If you look at the rates through 1988 this was also boom in real estate. Peaking in 1988… the bust followed. There was another such boom peaking in 2006. The financial bust that followed the late 80s/early 90s real estate bust was the “S&L Crises”….

            The causality I was referring too was that during a real estate boom, the labour market naturally adjusts itself to that boom. Everybody and their brother drops engineering, teaching, to enter some component of the real estate market. When the bust happens, the subsequent adjustment can take years.

            I believe the Spanish labour market had a similar issue. But I’m not knowledgable on Spain or Europe. Better to let someone else comment.

          • Regarding Canada (perhaps also Australia)…. it is not a commodities based economy. Primary industry accounts for only about 6% of the economy. The rest of the economy was hurt by the high exchange rate. That has now over corrected, as exchange rates tend to do. I think Canada will do just fine.

          • It’s long been predicted that labor markets would get tight around 2018 due to baby boom retirement. Net out Fed jobs which tend to rise and fall with dominant demographics (baby bommer retirment) and we will likely start to see that smaller size of government that most Reaganites thought Ronnie gave us, when he actually helped to foment reform at the state and local level (privatization of gov services) but not nearly so at the Federal level, which tracks percentage of working age pop.

            So, the impact of baby boom retirement will see some tightening of labor markets regardless of recent jobless recovery.

            While it’s interesting to dance around the complexity of economic relations and these matters, do not fail to look further into the (business) environment for fundamental trends.

          • CSteven WROTE: “It’s long been predicted that labor markets would get tight around 2018 due to baby boom retirement.”
            ————————————

            This is true for Japan, but not true for the US.

            (A) In the US, EVEN IF ALL immigration is stopped, the number of young workers coming into the economy is STILL expected to be the SAME as the number of baby-boomer workers retiring. This is the result of a “column-like” population-pyramid (i.e. good demographics in the US).
            http://populationpyramid.net/united-states-of-america/2020/

            The reason that there will be more retirees per worker in the US due to the retirement of the baby-boomers is that the baby-boomers will be retiring at a faster rate than the current retirees are dying (i.e. rising life expectency).

            (B) In Japan, the number of their baby-boomer workers retiring from the workforce is expected to be the MORE than the number of young workers coming into the economy. This is the result of an “inverted” population-pyramid (i.e. bad demographics in the Japan).
            http://populationpyramid.net/japan/2020/

            In Japan, the problem of more retirees per worker due to the retirement of their baby-boomers will be MUCH WORSE than in the US. This is because not only will their baby-boomers will be retiring at a faster rate than the current retirees are dying (i.e. rising life expectancy), but also because the number of replacement workers coming into the workforce will be lower than those retiring (i.e. a shrinking workforce).

            CONCLUSION: Therefore, the only way to tighten labor-markets in the US is to CREATE more jobs. It would be futile to wait for the workforce to shrink because of baby-boomer retirement. By all predictions, once immigration (however slow) is included, the real workforce will keep rising as far as the eye can see. In other words, the population-pyramid in the US is not expected to invert any time this century:
            http://populationpyramid.net/united-states-of-america/2050/
            http://populationpyramid.net/united-states-of-america/2100/

            Let me know your counter-thoughts.

        • Regarding the job market. In the 90s, if you parse the market, the experienced bulk of the labour market got back to work. In particular, the baby boomers, of prime age and experience at that time. Again, with parsed data you will see severe under employment and unemployment of those younger than the boomers. Often referred to a generation X.

          But still, this employment issue with this recession have been greater when just looking at the chart you quote.

          But I go back to the demographic issue. Those same baby boomers are now retiring. This puts downward pressure on participation rate. Keep in mind the standard for participation in North America is high, not like Japan. A boomer cutting down their hours, or occasionally consulting would not be counted as participating.

          note.. in the 90s the demographic issue of “aging population” applied to NA. Since then, we have had a swell of immigration at the young end to counter the baby boomers… focused on families… with lot’s of kids not yet in the labour market. All this plays into the issues. And immigrants have more difficulty finder employment… but in the end they will be just fine…

        • Venezi,

          Thank you for finding the chart. The chart going back to the fifties shows the importance of the baby boomers coming into the workforce. That, along with women becoming more prominent in the workforce as well, resulted in a very high participation rate, as the boomers were much more populous than the generation before it. Remember, participation is the percentage of society eligible to work that do. A demographic bulge would “bulge” participation as well.

          The advent of more participation of women in the workforce is generally a fixture now. I suspect the participation rate among immigrant women is lower, although the participation rate among immigrant girls would with time match the general population.

          So, our expectation of a “normal” participation has to come down from the high in 2000… because of the importance boomers had, net the impact of increased gender equality in participation.

    • Increase the likelihood of a Tobin tax; especially with the way Republicans are being forced to deal with the China issue. And for all the constitutionalists the Fed’s have the right to regulate commerce, and tax it; so….

      Might even neatly fit into an overall tax reform more generally.

  26. GLOBAL LIQUIDITY MIRRORING: How does the rise in liquidity in the reserve providing countries cause a rise in liquidity in the reserve accumulating countries?
    ——————-

    The US provides the rest of the world (ROTW) with Dollars to hold as reserves. In order to do this without deflating or slowing its own economy, the US must increase Dollar liquidity by expanding the consolidated balance sheet of the entire US banking system.

    There are two ways in which the US can provide reserves: (A) Running a current account deficit, and/or, (B) Running a capital account deficit (note that the definition here excludes reserves).

    A) When the US runs a current account deficit to provide reserves, Americans (mostly consumers in reality) come on the left side of the US balance sheet and the central banks of the ROTW come on the right side of the expanded US balance sheet. Mirroring this is an expansion of the consolidated balance sheet of the entire banking system of the ROTW. In that balance sheet, the central banks of the ROTW come on left side and their local savers come on the right side.

    In effect, central banks of the ROTW are borrowing from their savers and lending to Americans (mostly consumers in reality) to finance the US current account deficit. In this case, the US goes deeper and deeper into debt to the ROTW.

    B) When the US runs a capital account deficit to provide reserves, American investors come on the left side of the US balance sheet and the central banks of the ROTW come on the right side of the expanded US balance sheet. Mirroring this is an expansion of the consolidated balance sheet of the entire banking system of the ROTW. In that balance sheet, the central banks of the ROTW come on left side and American investors come on the right side.

    In effect, central banks of the ROTW are merely swapping the savings of their local savers with the savings of Americans in order to balance-out the US capital account deficit. In this case, there is either no change in US debt to the ROTW on a NET basis, or, if Americans leave the right side of the balance sheet of the ROTW to purchase foreign real estate or equity (non-debt), then the increase in net US debt to the ROTW is balanced by a rise of US equity/RE claims on the ROTW.

    Does anyone disagree? Any flaws detected? Any alternative models or views? Comments welcome.

    • A corollary to (A) & (B) is the concept of providing reserves via “Central Bank Currency Swaps”.

      C) When the US does a currency swap to provide USD reserves, the US Federal Reserve comes on the left side and the central banks of the ROTW come on the right side of the expanded US balance sheet. Mirroring this is an expansion of the consolidated balance sheet of the entire banking system of the ROTW. In that balance sheet, the central banks of the ROTW come on left side and the Federal Reserve comes on the right side.

      In effect, central banks of the ROTW are merely swapping the increase in liquidity in their currencies with the increase in liquidity in the USD via the US Federal Reserve. In this case, there is no change in US debt to the ROTW on a net basis as all parties intend to keep their respective positions in all balance sheets until the time comes to reverse the swap. Once the swap is reversed, the added liquidity is removed from all the balance sheets of the world.

      EXAMPLE: Let us say the Federal Reserve does a currency swap with the Central Bank of Mexico.
      (i) In the consolidated balance sheet of the entire banking system of the US, the Federal Reserve comes on the left side, implying that the Federal Reserve considers the Dollars swapped to be a liability, and the Mexican Central Bank (MCB) comes on the right side, implying that the MCB considers the Dollars swapped to be an asset.
      (ii) Conversely, in the consolidated balance sheet of the entire banking system of Mexico, the Federal Reserve comes on the right side, implying that the Federal Reserve considers the Pesos swapped to be an asset, and the MCB comes on the left side, implying that the MCB considers the Pesos swapped to be a liability.

  27. Milton Friedman famously wrote, “inflation is always and everywhere a monetary phenomenon”. By equivalence, we can write, “deflation is always and everywhere a monetary phenomenon”.

    But there seems to be vehement opposition to this statement, even amongst researchers at the Federal Reserve, where, for all other purposes, Friedmanite ideology reigns supreme:
    http://www.dallasfed.org/assets/documents/research/eclett/2014/el1406.pdf

    QUESTION: So who is correct? Is Friedman right that inflation/deflation are ‘always and everywhere’ a monetary phenomenon? Or are his opponents, as in the linked paper for example, right that inflation/deflation are more a fiscal phenomenon than a monetary one? Or could there be many different sources of inflation/deflation? Or, most interestingly of all, could all these different views really be saying the SAME THING without realizing it?

    What are the various views amongst blog participants here? Can someone bring all these different views into a common theory that explains it all? Observations & insights would be appreciated.

    • Very poor paper from the Fed.

      The quantity theory of money states that Price x Quantity of purchases = Money Supply x Velocity of Money.

      It is immediately visible that one can not conclude from the lack of CPI inflation despite money supply expansion well above real output growth that inflation is not always a monetary phenomenon. For this assumes that velocity of money is constant.

      But who ever said that velocity of money should be constant? Why should it be? Has the Fed not noticed that velocity is not constant – it’s been collapsing for 18 years – despite being the agency in charge of this statistics? Is velocity a mere residual of the above accounting identity or does it have an existence of its own, and in that case what does it actually represent? What drives change in velocity? Is the change in velocity a monetary phenomenon or not, and if not what is it? What if money is used to purchase assets instead of purchasing consumer goods and services, is that not a monetary phenomenon, and if not what is it? Can the velocity of money in asset markets durably diverge from the velocity of money in product markets? Is the collapsing money velocity in the real economy a sign that Fed policies are effective or ineffective? Are changes in inflation due to changes in money supply or to changes in velocity or to both? Are the money supply and the velocity of money independent or interdependent variables? What causes the inflation dynamic to sometimes break completely out of range either on the downside (1930-1933 deflation) or on the upside (hyperinflation) in a cumulative and no longer auto-corrective manner?

      It is possible that inflation is not always and everywhere a monetary phenomenon. But this Fed paper is clearly not where you’ll find a convincing demonstration. To say that the introduction of the new Rentenmark in Germany in 1923 that ended the hyperinflation is a fiscal measure and not a monetary measure is just a sterile play on words (was is not because the new Rentenmark was issued in fixed quantity that it was successful in stopping hyperinflation?)

      The only thing this paper has convincingly demonstrated is that it is not always and everywhere good fiscal policy that taxpayer should fund such useless analysis devoid of any explicative power. If one wants to explain why observed inflation and inflation expectations consistently declined throughout 6 years of QE in complete contradiction to the Fed’s justification for QE, at least one should do it well.

      • ^DvD WROTE:
        (1) Has the Fed not noticed that velocity is not constant – it’s been collapsing for 18 years – despite being the agency in charge of this statistics?
        (2) Is velocity a mere residual of the above accounting identity or does it have an existence of its own, and in that case what does it actually represent? What drives change in velocity?
        (3) Is the change in velocity a monetary phenomenon or not, and if not what is it?
        (4) What if money is used to purchase assets instead of purchasing consumer goods and services, is that not a monetary phenomenon, and if not what is it?
        (5) Can the velocity of money in asset markets durably diverge from the velocity of money in product markets?
        (6) Is the collapsing money velocity in the real economy a sign that Fed policies are effective or ineffective?
        (7) Are changes in inflation due to changes in money supply or to changes in velocity or to both?
        (8) Are the money supply and the velocity of money independent or interdependent variables?
        (9) What causes the inflation dynamic to sometimes break completely out of range either on the downside (1930-1933 deflation) or on the upside (hyperinflation) in a cumulative and no longer auto-corrective manner?

        ————————————–

        (1) The “Fed” is an institution with a lot of people in it. Some may have noticed, whilst others may not have being paying attention. Even if the Fed has “noticed”, what does the Fed make of it? This question needs to be answered by the Fed as an institution. Incidentally, the best predictor for inflation-tracking is considered to be MZM money and MZM money velocity has been in secular decline since 1980:
        https://research.stlouisfed.org/fred2/series/MZMV

        (2) Velocity is not merely a residual of the accounting identity. It does it have an existence of its own, as it represents the willingness or unwillingness to hold on to money. Therefore, while the quantity of money (M) represents current monetary conditions, the velocity of money (V) represents the expectations of money-holders of FUTURE monetary conditions.
        (a) If people feel that money is going to lose value in the FUTURE (i.e. higher inflation is expected), then they will act to get rid of it TODAY. If this happens, activity on the right side of the bank balance sheet increases and the velocity of money rises.
        (b) On the other hand, if people feel that money is going to gain value in the FUTURE (i.e. deflation is expected), then they will hoard money TODAY. If this happens, activity on the right side of the bank balance sheet decreases and the velocity of money declines.

        Note of interest: (a) Represents the US from 1965-1980, while (b) represents Japan 1992-Present.

        (3) Yes, the change in velocity is a monetary phenomenon. Monetary policy can be divided into two parts: (a) managing current liquidity and (b) managing the expectation of future liquidity. The former is dependent on current interest rates, whilst the latter is dependent on the expectation of interest rates in the future. The former is the chief determinant of the change in the quantity of money, whilst the latter is the chief determinant of the change in velocity of money. This is why the velocity of money is HIGHLY dependent on the credibility of the central bank as it makes projections and is, hence, more difficult to control.

        (4) This question is ambiguous. Did you mean “if the money is used to purchase existing financial assets & recirculate them in isolation, instead of purchasing or creating physical assets (actual production assets) as well as the consumer goods & services that are produced by such physical assets”? If that is indeed what your question was, then the answer is that the purchase of existing financial assets & the recirculation of them in isolation is indeed a monetary phenomenon, albeit a useless one for all but those who work in the decoupled financial industry.

        (5) In my opinion, no. However, the markets can often stay irrational longer than naysayers can stay solvent.

        (6) In Japan, the collapsing velocity of money in the economy is DEFINITELY a sign that the Japanese central bank’s policies are ineffective. In effect, the Japanese central bank has lost all credibility in the eyes of Japanese market participants. This is because despite promising for 20 years to create higher inflation by rapidly escalating the quantity of money, they have failed. They failed because people do not believe them; the people have expectation of deflation and so they just hold on to money, thereby creating the very deflation they anticipated (i.e. self-fulfilling belief) by collapsing the velocity of money. See (2) for more details

        In the US, however, the decline in the velocity of money since 1980 has little to do with the effectiveness or ineffectiveness of the Fed’s policies. No one can even suggest that Americans have been holding tightly on to money since 1980. America is NOT Japan. So why has the velocity of money in the US been falling since 1980?

        ANSWER: In the US, the decline in the velocity of money since 1980 is related to the rapid and massive accumulation of reserves by foreign central banks and/or governments. In effect, as a result of rising reserve accumulation, foreign central banks have been rapidly increasing their presence on the right side of the consolidated balance sheet of the entire US banking system. Given that foreign banks do not intend to spend that money (i.e. they are by very nature holders or hoarders), they end up just sitting there on the right side of the US balance sheet and do NOTHING. This is the reason for the falling velocity of money in the US. Note, very carefully, that the behavior of foreign central banks on the right-side of the US balance sheet is very similar to the behavior of the Japanese people on the right side of the Japanese balance sheet. Unlike in the case of the Japanese people, however, the foreign central banks on the right side of the US balance sheet are not expecting future deflation; they are merely carrying out policy. Even so, their behavior still results in the same disinflationary pressure (from 1980 to 2009) or deflationary pressure (from 2009 to present) in the US as Japan has experienced since 1992.

        (7) It could be either or it could be both, but it CANNOT be neither. Therefore, in the sense that both quantity and velocity are monetary phenomenon, Friedman was right when he said, “inflation is always and everywhere a monetary phenomenon”.

        For example, excessively increasing money supply in an environment in which people expect further increases in money supply in the future, will lead to high inflation due to BOTH (a) a rise in the current money supply, as well as (b) a rise in the velocity of money. This is what happened in Weimar Germany and in the US between 1965-1980.

        However, even if the current increase in money supply is restrained such that it approximately matches real growth, if the expectation (or belief) of future inflation sets in, then current inflation will still rise via a rise in the velocity of money. Conversely, even if the current increase in money supply massively exceeds real growth, if the expectation (or belief) of future deflation sets in, then current inflation will still fall via a decrease in the velocity of money. The latter, of course, is the problem with Japan today.

        (8) They are independent. Money supply is a CURRENT concept and is easier to measure and control directly, while velocity of money is related to the FUTURE expectation of money supply and is difficult to measure or control directly. Regulating the velocity of money is a confidence game that the central banks must play with great agility and elan. In other words, money supply is like science, whereas the velocity of money is like religion. Therefore, all central banks are part scientific and part religious institutions. The Maestro was more than an economist, he was the High Priest in the Grand Temple of the Federal Reserve.

        (9) Belief. “We have nothing to fear, but fear itself”. Once a positive-belief in the system breaks down, the government and/or central bank must ACT rapidly and DECISIVELY to prevent the formation of a negative-belief. If the government is unable or unwilling to do this, then the negative-belief becomes set. Once this happens, then it is very difficult to reverse– as in Japan today (or Weimar Germany on the other extreme).

        Let me if you have any doubts, objections or counter-thoughts.

  28. Good study regarding the shadow banking system in China. Now standing at ( 2$ trillion USD )

    Helped power the stock market as the real estate / infrastructure market opportunities closed off. Talks about pool structures one safer / one riskier much like the leveraged tranche setup that powered the US mortgage leverage that powered housing prices going into the 2007 crash.

    http://danielaltman.com/data/AcharyaEtAl.pdf

    Shadow Banking Is Killing China’s Stock Markets

    The parallel banking system that funneled billions into stocks may be about to unravel.

    http://foreignpolicy.com/2015/08/26/shadow-banking-is-killing-chinas-stock-markets/?utm_content=buffer3c2f8&utm_medium=social&utm_source=twitter.com&utm_campaign=buffer

    • ^C.V. WROTE: “The parallel banking system that funneled billions into stocks may be about to unravel.”
      ————————————————-

      The term “consolidated balance sheet of the entire banking system” means a balance sheet whose left side includes ALL those assets that are liabilities for someone else (i.e. debt claims). Therefore, the term includes the assets of the conventional banking system, the central bank, the shadow banking system, the bond market, inter-corporate loans and any other system of accumulating assets that are the liabilities of others. What it does not include are assets that are not the liabilities of others, such as land, buildings, equity, machinery, gold, intellectual property et cetera.

      Therefore, the term “consolidated balance sheet of the entire banking system” in China includes its infamous shadow banking system. So if the shadow banking system unravels due to defaults, then it will bring down the whole “consolidated balance sheet of the entire banking system”. In other words, LARGE SCALE defaults in the shadow banking system (or in the bond market for that matter) will result in cascading default pressure in the conventional banking system as well.

      Do you disagree?

      • No.

        The only reason for bailing out stock market is preventing implosion of 2 Trillion USD shadow banking complex. The leverage and stock buyback scheme with this leveraged debt places all 500 + ” frozen company stocks ” at top of bubble in default today ……

        The PBoC has now pledged over 1 Trillion USD in rescue measures up until today. Not counting pension fund buy in plan under construction. ( this will take 6 months putting in place )

        They are very, very worried about the shadow banking nightmare that has developed as the major money center banks are the ones behind the off balance sheet leverage. The USA off-shored it’s risk in the mortgage crisis in 2007, China’s major issue today rest this crisis sits directly within the financial system. It could bring forth a massive crisis as leverage unwind …

  29. Professor Pettis, I’m trying to understand how China’s sale of US Treasuries will affect our economy and the dollar. What do you think of this article by Patrick Chovanec? http://foreignpolicy.com/2015/01/25/why-chinas-u-s-treasury-sell-off-is-good-news/

    • Patrick of course is right.

      • What happens if China buys yuan with the dollar earned from selling US treasury? By this doing China can (1) bring in more yuan to increase cash supply, (2) devalue dollar, (3) increase the value of yuan.

    • ^Tama WROTE: “I’m trying to understand how China…..”
      ———————————————-

      What if the Chinese Central Bank makes the following announcement:

      “We have decided to stop daily interventions in the exchange rate market and will no longer enforce a tight peg. From here on we will let the market decide the value of the Yuan. To prevent extreme changes over short periods, we have decided to set the band between 4 Yuan/USD to 8 Yuan/USD. The exact value of the Yuan within this wide band will be decided by market participants.”

      What do you think will happen?

      • VK: ref. reserves and liquidity; US only (trying to minimize the confusion). Look at total reserve balances in the US at FRED; huge spike. Then look at base money: currency + reserves. Then look at currency. The Fed bought Treasury bonds and agency mortgage backed assets. The proceeds of these purchases became excess reserves of banks, which were NOT loaned out. The Fed now pays 0.25% on these reserves. QE was designed neither to increase the money supply nor to increase bank lending, but to reduce to cost of long term capital.

        • ^Dan Berg WROTE: “VK: ref. reserves and liquidity; US only (trying to minimize the confusion). Look at total reserve balances in the US at FRED; huge spike. Then look at base money: currency + reserves. Then look at currency. The Fed bought Treasury bonds and agency mortgage backed assets. The proceeds of these purchases became excess reserves of banks, which were NOT loaned out. The Fed now pays 0.25% on these reserves. QE was designed neither to increase the money supply nor to increase bank lending, but to reduce to cost of long term capital.”
          ———————————————–

          1) The extensive discussion here was about the relationship between liquidity and FOREIGN EXCHANGE reserves held by central banks. You are now referring to the reserves that commercial banks hold at the central banks. These are two different concepts.

          2) Instead of saying ‘look at X, Y, Z at the Fred’, why not just provide a simple link to the SPECIFIC data to which you allude. Otherwise, different blog participants may wind up looking at different data and everyone will become confused. Once you provide the link, we can then discuss it.

          3) You are CORRECT that much of the “freshly printed money” from QEn is merely sitting in the reserve accounts of the commercial banks at the Fed. This is something I do not think anyone here has ever denied. However, note the following points:

          (A) The money supply HAS increased. Currency (i.e. right side of balance sheet at the fed) is only one part of the money supply. Therefore, even if the “freshly printed money” is “just sitting” in the reserve accounts of the commercial banks at the Fed as “excess reserves”, there has still been an INCREASE in the money supply. Here are the relevant data for the dramatic increase in money supply since we entered into the era of QE:
          https://research.stlouisfed.org/fred2/graph/?g=1IDN

          (B) There are THREE reasons why the Fed used QE to further suppress longer-term interest rates.
          (i) To encourage investors to get out of safe government debt and take RISKS, and,
          (ii) To make the servicing the CURRENT debt cheaper for the government & other borrowers, and,
          (iii) To encourage the taking-on of MORE debt by all borrowers.

          Note that (iii) implies increased lending.

          • Vinezi: good; I agree with everything in your 8/20: 5:10 reply; where we continue to differ is apparently the degree to which govt bonds IN CHINA add to liquidity or not; you say “a little”; I say no; CSteven helpfully says both. We can leave it at that and move on to something of more consequence.

  30. The market forces DO determine the value of the rmb until the Central Bank intervenes. That goes for all currencies. The USA has been the main manipulator of currency values for years now. Interest rates are set by the Central Bank, not market forces. If it were, interest rates today would be considerably higher. Governments worldwide are distorting markets by interventions and artificially low interest rates. The whole currency thing today has become a casino.

    • “The USA has been the main manipulator of currency values for years now.”
      It most certainly isn’t. Honestly I think this is the kind of silliness that stems from an inability to believe that other countries, or at least non-Western countries, have agency, or can create history on their own. The purpose of manipulating the currency is usually either to reduce unemployment by running favorable balances of trade or, for developing countries with low credibility, to reduce currency volatility. You would think that the “main manipulator” would run trade surpluses, in other words, and not the largest deficits in the world, and with deficits that surge especially when one particularly country has an overproduction problem, you have to wonder how it manages to do this while manipulating its currency. And while it is true that the Fed sets short term interest rates, so does nearly every other central bank. This is the main purpose of central banks.

      • A one hour conversation with Adam Tooze:

        • Thanks, Dan. The years between 1918 and 1939 form a fascinating and important period, for political and cultural history as well as economic history, and luckily for us it has inspired some of the best books ever written on economic history (Eichengreen’s “Golden Fetters:” is a real favorite of mine), but in the past three years I was blown away, first by Tooze’s “Wages of Destruction”, and then even more so by his “The Deluge”, whose nearly 500 pages I have read twice since it was published less than a year ago. He really is brilliant.

      • Here. Here. Well said. This is the sort of non-sense that muddles dialogues.

        Next we get to hear of the Builderburghers, the CFR (tell me Mr Kagan what really goes on at the CFR? Uhmmmm, a bunch of old fat guys sit around and talk.), and so much other non-sense, detracting from serious discussion, of globally important issues.

      • Disagree !!!!!

        Every country is a currency manipulator, even the US. The US knows very well how it can manipulate the USD and it has done so in the past as well. E.g., the US was jawboning the USD lower from say 2001 up to mid 2008. And by waging war in the Middle East it pushed the USD lower as well.

        • Willly what if I say that you are handsome and I am ugly, does that translate into you actually being handsome and me ugly?

      • Well, of course it was the US who, as WWII victorious power at Bretton Woods, insisted on having its national currency rather than a supranational unit of account used as international reserve instrument. What’s not to like when other countries actually do use it as reserve instrument? Are the US finally ready for an international monetary conference reforming the role of the $ as international reserve instrument? Not that this “currency manipulator” thing flying back and forth is not entertaining but may be we can just deal with it and move on.

    • BOB,
      Regarding U.S. currency manipulation, Michael is right. People should remember that the U.S. is still the world sole superpower, and therefore, set economic policies using its economic and military power.

      The Communist party, therefore, suited the American economic policies of moving its manufacturing base little by little, so the American owners can enjoy higher profits. And China enjoyed the inflow of U.S. capital to rebrand the country through infrastructure spending.
      That relationship has ended.

      In order for China to move up its economic ladder it needs to follow the path of Japan through innovation and invention, but that is not going to happen, as America knows China would need political reforms, in the form of free-thinking and creativity. This mean more freedom to the people, which will affect the vested interest of the ruling party.

      Though intuitively, I feel America wouldn’t allow China to climb the economic ladder any further because China will no longer serve U.S. corporate interest. Instead, they’re competing against U.S. corporate interest.

      Japan, is one example that gave the U.S. a run for its money, but it didn’t the resources, the population and size to become the world biggest economy.

      China, however, with its land size and population, along with its diaspora can compete against the U.S. and within 20 years or more would dethrone some of America’s well-known corporations.
      For example, B4 Apple entered the phone market we had SonyEcrisson, Blackberry, Nokia, Motorola, Alcatel, Samsung and so forth. As soon as the Iphone came out, Apple took away market share from the above competitors, with some going bankrupt, with others on their last legs. Samsung came out unscathed.

      Other reasons the U.S. wouldn’t allowed China to grow are:
      1. the threat to U.S. national security, as China developed sophisticated ‘National Champions’ they can apply these technologies in military applications.

      2. the world resources are depleted. My argument here is China will lift food prices up to levels that are unsustainable to continue the ‘capitalist’ model of consumption and investment. Also, India and other developing nations would want to follow China’s model putting pressure on the earth ecosystem.

      • Walter

        I do this
        I do that

        I have power
        Others expect i can do this, and do that
        And, that this and that happen.

        This is what all powerful parties can get a large population to believe, but they can’t make the world, the complex system that is the world beyond mere humans and their decisions to follow that; the complex adaptive system that is filled with humans and non-humans that have inter-relations and impacts, forces that are not the mechanical engineered operation that can be called forth by any party.

        To belief in the other is to believe in fairytales.

        As to India and others would want to follow the Asian Development model, yes, they do, and Nigeria, Kenya, Tanzania……Egypt….so many others. But China’s excess capacity, likley delimits their potential, this while a demand deficient world will eventually lead all roads back home.

        There will always be potential to source globally, but the 2000’s were an aberration built of China’s desperate attempt to get rich, before it got old.

        • ^Csteven WROTE: “…..follow the Asian Development model….”
          ——————————————–

          But is there even such a thing as an “Asian Development Model”?

          1) Japan, China & Malaysia have a policy of running persistent trade surpluses (i.e. they are followers of the cult of mercantilism).
          http://goo.gl/ryJzei
          http://goo.gl/z1jPS0
          http://goo.gl/jTka8r

          2) Korea & Thailand, on the other hand, used to run persistent trade DEFICITS until the traumatic experience of the 1998 Asian crisis pushed them into piling up reserves as a defensive strategy.
          http://goo.gl/lKuhsC
          http://goo.gl/13uYIC

          3) Philippines & Vietnam are typical developing-countries that run persistent trade-deficits.
          http://goo.gl/mccuz6

          In other words, some are mercantilist and others are not. Some practice financial-repression, while others do not. Therefore, to speak of an “Asian Model”, or to generalize with the wave of the hand about “all these Asian countries”, is not very meaningful.

          It would be better to speak of specifics, such as the practice of financial repression or a policy of running trade surpluses. So when you say that India might want to follow the “Asian Model”, exactly what did you have in mind? Are you expecting India to practice financial repression? Or are you expecting India to run a trade surplus? Or Both? Or something else altogether? Please explain.

  31. Dear Professor Pettis,

    Your rationale for markets-determined prices in the paragraph “How does the market provide information?” is very clear. It is the most accurate way to determine prices in a socially acceptable way. No group of civil servants, however clever and well intentioned, possess the sheer computing power to set prices in such a complex and dynamic system as the economy in a way that is politically and socially acceptable to everybody. Of course, this is equally true for the prices of assets since they are simply the capitalized values of incomes generated in the production process.

    Yet, you note that prices are not always and in fact not even primarily determined by fundamental balance between real supply and demand. Indeed, it seems clear that the market-determined prices of Chinese stocks in 2014, US residential real estate in 2005 or oil price in 2013 – to take some examples among countless – didn’t provide valid information about supply-demand dynamics to participants given the massive imbalances that developed in these markets and the trillions of $ of invested capital lost as a result.

    So, if market-determined prices are the best we’ve got and yet they swing so erratically and far on either side of fundamental value, this is not very much help at all. How can businesses, individuals and governments possibly allocate capital efficiently in such volatile circumstances?

    What conditions would in your mind make market-determined prices a better reflection of real supply and demand balances?

    Thank you

    • For a start we might learn to recognize when markets driven by economic fundamentals and when they are not. In the early 1990s, for example, the market for internet stocks seemed to be driven by a healthy sense of fundamental value. By the late 1990s, however, Warren Buffet complained, correctly I think, that it no longer were. If we can figure out why this shift takes place — perhaps because underlying liquidity seems to have changed and, with it, risk appetite, or perhaps because the political or financial system has changed incentives away from value maximization (creating a variation on the agency problem, maybe), or perhaps because of new kinds of money creation, new financial technology, technological uncertainty, political uncertainty, or a number of other reasons — it might help us decide to place greater or lesser faith in the market as a pricing machine. I have a whole lot more to say about this, perhaps even in my next book, but the main point I guess is that I have always found the debate about whether markets are rational or irrational fairly silly. if these concepts have any meaning, we should be able to specify the conditions under which a market will be rational and those under which it won’t.

  32. A study of the RMB versus the dollar by Robert Pretcher indicates that the market determines the value of the currency and that China pays just over the market. And now for some time, there will be a devaluation.

  33. China’s Renminbi has been accepted by IMF and thus yuan has become convertible into all the IMF currencies ( US dollar, euro etc …) . Today, with a now convertible yuan, what is the advantage for Mainland China and Chinese Hong Kong to maintain two different convertible currencies ? How long will the Hong Kong Dollar exist and if it survives, will it still be pegged to the US dollar in the future ?

    • Acceptance into the SDR basket does not make the RMB “convertible into all the IMF currencies”, mianne. The IMF has no right to decide on the convertibility of the RMB. That is done by the Standing Committee through the PBoC, and as far as I know, not only do they continue to restrict convertibility, but the restrictions today are greater than they were a year ago. Technically the only actual impact of the IMF announcement is that the Wikipedia guys are going to have to update their entry on the SDR.

      • Thank you for replying so fast . Poor Wikipedia guys ! You think that the FMI ‘s acceptance of the RMB into the SDR basket will have no impact on its convertibility into all the IMF currencies and that the Chinese Standing Committee , through the PBoC, will go on refusing the convertibility .
        If the restrictions to the convertibility of the RMB are greater than a year ago, the convertible HKD is very useful to China’s global trade and global financiary activities . However, as Hong Kong has been Chinese again since 1990, two different currencies for one country, China, could seem nonsensical . But China maintains the double currency for a very clever purpose : China uses Hong kong and the convertible HKD as a commercial and financiary interface with the rest of the world while sheltering China’s real currency, the non convertible RMB, against all the possible vile financiary foreign attacks . All over the world, in general, each country has just one currency . All the convertible currencies are attacked, one by one, by gangs of financiary villains whose interests are bullish at times, then just the opposite, indifferent to the consequences of their actions. Today the non convertible RMB is protected against such attacks while the Chinese trade and finance prosper thanks to the convertible Hong Kong Dollar. How clever if the double currency system lasts !
        As the US Dollar is particularly unstable, is it a good idea to go on pegging the Hong Kong Dollar to the USD instead of the yuan, or is it meant for China to make trading with the USA easier, whatever the US dollar is worth, even if the US economy and finance are nearly bankrupt one day ?
        Maybe I am too naive, but everything seems to have been carefully pondered and calculated by the Chinese authorities, who never seem hampered by the stupid prejudiced, conventional responses, that lead the European and American economies to their doom .

  34. Michael,
    You write ““Market” forces, that is the balance of supply and demand, do not always indicate the relative valuation of an asset. ”

    I don’t understand that whole paragraph. Could you get me started: what does “relative valuation” mean?

    I’m not sure whether I’m asking “What relative to what?” or “Is this like “comparative advantage,” a technical term which is going to bite the unwary because it looks tame but has important meanings that aren’t obvious?”

    TIA
    -dlj.

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