Raise interest rates first, not exchange rate

Andy Xie is a former Morgan Stanley analyst now living in China.

China Business, May 14, 2010:


China needs to exit the stimulus policy as soon as possible. Otherwise, inflation may reach double digits in the near future. The right way would be to raise interest rates first and move the exchange rate, if needed, second.

A small increase in the value of the RMB won’t solve two pressing problems: inflationary pressure at home and political pressure from the US. A small appreciation will further attract hot money, adding to inflationary pressure. Consumption is too small a share of imports for CPI to be affected by a small currency appreciation.

Financial markets are on the RMB appreciation watch again. The inflation pressure at home and the political pressure from the US have inflamed the expectation. The intensity and persistence of the RMB appreciation expectation is probably the most important reason for China’s vast property bubble. By all measures (e.g., stock value to GDP ratio, inventory value to GDP ratio, new property sales to GDP ratio, price to income ratio, rental yield, and vacancy rate) China’s property market is one of the biggest bubbles in financial history, probably much bigger than the US’ property bubble relative to GDP.

The appreciation expectations have caused hot money to flow into China, which in turn has caused excessive liquidity and speculation, fueling the property bubble and causing inflation to pick up rapidly. This is how Southeast Asian countries got into a crisis situation: they kept real interest rates too low and fueled speculation that eventually destroyed their banking system.

If the monetary stimulus is withdrawn, the property bubble will cool and may burst. This is why so many are arguing against increasing interest rates and instead support using currency appreciation to cool inflation. The reason this policy option is so popular among many interest groups is that it will further fuel the hot money inflow, supporting and expanding the property bubble.

In a normal economy currency appreciation cools inflation by decreasing import prices. However, China’s imports are mainly raw materials, equipment, and components, so a small currency appreciation would do virtually nothing. The odds are that a small appreciation would only make the property bubble bigger and inflation worse.

A big appreciation or revaluation can cool inflation by removing further currency appreciation expectations. It would cause the hot money to leave China. The resulting liquidity crunch would almost certainly burst the property bubble, but I doubt that anyone would support such a policy move.

For China to see a soft landing from the current property bubble, if that is even possible, interest rates should be increased steadily, by two percentage points in 2010, another three percentage points in 2011, and more rate hikes in 2012. Such a trajectory wouldn’t bring a positive real interest rate anytime soon – so would not burst the bubble. But it would prevent the real interest rate from further declining in the environment of rising inflation. At some point the real interest rate will start to inch up, slowly reining in speculation. Stopping real interest rates from declining further prevents inflation expectations from accelerating, which could stop inflation.

That the RMB must go up is the most widely held belief on Wall Street today. However, Wall Street has a poor record of getting its big calls right. Indeed, in the past two decades the Street has got its three biggest calls wrong: the East Asian Miracle, the IT Revolution, and the Financial Innovation, i.e., the derivative revolution. All three mega trends had considerable substance. The financial markets just got the market implications wrong.

Financial innovations in the form of derivatives and synthetic financial products promised to decrease risks and, hence, provide cheaper funding costs for all. The belief in their effectiveness led to rising demand and, hence, leverage. The rising leverage led to a credit bubble. For a few years the credit bubble kept the economy strong, which temporarily decreased bankruptcy rates. The observed declining risk strengthened the belief that the derivative products were indeed decreasing risk, which further inflated demand for them. We now know it was a bubble.
If Wall Street got its biggest calls wrong in the past two decades, could it get its RMB call wrong too? On the surface the assumption that the RMB is under appreciation pressure is self evident. Like any goods, the value for a currency depends on supply and demand. When the two are not matched, foreign exchange reserves rise or fall.

I am surprised that China is still running an overall trade surplus, even though it is a declining one. Considering how depressed the world economy is and how hot China’s is, a trade deficit would be more likely. The surplus, I think, can be attributed more to the distortions in the domestic price system rather than the cheapness of the currency.

First, high property prices are a major deterrent to middle class consumption. In mature economies, rising property prices boost consumption on positive wealth effect, because most middle class households already own property. In China, the positive wealth effect is limited because the credit system is not there for the middle class to monetize the capital gains. And those who are not yet in, such as newlyweds, must save more to purchase a property. Indeed, as prices are so high, their parents must also save to help them. Hence, China’s property bubble suppresses consumption and, therefore, boosts the trade surplus.

Second, the prices for middle class consumption of goods and services are very high. For example, even for locally-made automobiles, China’s prices are among the highest in the world. And prices for imported automobiles are 100% higher. As China’s middle class have income at only 20-30% of the OECD level, one would expect the consumption level to be lower than otherwise. Even though China’s automobile demand has been rising rapidly with the expanding middle class, it would rise even faster without the price distortion. Of course, imports would be much higher, reducing trade surplus. Third, China’s taxes on the middle class are too high. The top marginal income tax rate of 45% applies at quite a low income level by international standards. The 17% VAT is also among the highest in the world. Because China tends to invest its tax proceeds, high taxes suppress consumption.

If China’s property and consumption prices and tax rates decline to international levels, would China still have a trade surplus? If not, the right policy is to adjust the prices rather than the exchange rate.

When a country industrializes successfully, its currency value should appreciate. The appreciation could be in a rising exchange rate or inflation. What worries me is that inflation has already happened. Even though China’s reported inflation rate has been relatively low, the prices that one encounters in daily life appear to have risen enormously. Foreigners who visit China are often surprised that China’s prices are higher than in many developed countries.

I am not sure that the RMB appreciation pressure is entirely a bubble, but at least a big chunk of it is. Instead of looking at the appreciation pressure per se, it would be better to be rid of the hot money and domestic price distortion first. If the demand for the RMB still exceeds supply afterwards, the exchange rate should move.

Many analysts argue that raising interest rates would attract more hot money. This is the wrong view. Hot money comes to China for currency appreciation and asset bubbles, not interest rates. When the interest rate is raised, the expectation for property price appreciation wanes.

Increasing the RMB value will certainly trigger another round of frenzy. The resulting property boom may support the economy for the time being, but the long term consequences are very severe. Indeed, it could make a crisis inevitable.

The temptation for moving the exchange rate a bit is high. It seems like no cost. Many hope the US would be placated by it. Even though exporters may be hurt a bit, the domestic economy may benefit for the time being. It may seem a perfect short-term fix, but it is the wrong thing to do. There is no free lunch and when something seems like a free lunch, the long term payback is always bigger.

Originally published in China Business May 14, 2010:  Raise interest rates first, not exchange rate

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