Monday, November 08, 2004

Whither the Renminbi Peg?

This is something I posted on Brad DeLong's Econ blog about dollar-renminbi issues. Everyone should keep in mind that currency markets, although vast and deep, are subject to manipulation by central banks...

The PRC runs a big trade surplus with us, so they have a lot of dollars. It is in their interests to keep the RMB cheap (to keep exports competitive) and stable (to encourage further foreign direct investment).

The policy is definitely mercantilist in nature. Multinationals have concluded that China is the only scalable manufacturing base in the world: close to a huge pool of inexpensive but skilled labor and also close to fast growing markets (in China and the rest of Asia). The PRC government does not want to do anything to alter these beliefs, which led to $60B in FDI last year. Perhaps more important than the dollar investment figure, there is a huge transfer of technological and business knowledge in progress.

Once it is too late for Western companies to turn back, and domestic demand has grown enough that the economy is not wholly dependent on exports, they will definitely let the currency float.

This is essentially what happened with Japan: export driven growth on the back of a cheap currency, followed by eventual appreciation of the currency. It is hard for us to remember that the Yen used to be cheap in the 60's and 70's.

Another related point: the size of the PRC economy is very different when measured by nominal FX rates vs. PPP. It is clear that this differential will eventually go away as the country becomes fully integrated with the world economy. (Perhaps one could define "integrated" as no large discrepancy between PPP and FX rates, since the same bundle of goods should cost roughly the same in China as in the US, if trade is working properly. Recall the "no arbitrage" condition in efficient markets.) This will only happen if the RMB goes up substantially in value, just as the Yen did.

Note Added: Although the bilateral US-China trade deficit is large, China's balance of trade with the entire world is fairly even. They run big deficits with Japan, S. Korea and Taiwan. In some sense, the flow resembles: components imported to China from these countries, assembled there (modest value add), sold to consumers in US. Dollars flow back to China and to more advanced Asian economies.

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