Wednesday, January 12, 2011

Real Appreication of Chinese Inflation

The Times' Keith Bradsher reports on inflation in China:
In China, consumer prices were 5.1 percent higher in November than a year earlier, according to official government data. And many economists say the official figures actually understate the rate of inflation, which might in reality be twice as high.

“Four percent, China can bear it — beyond 5 percent, people will complain a lot,” said Huo Jianguo, president of the Chinese Academy of International Trade and Economic Cooperation here.

Higher global commodity prices, as well as rising wages in China, play roles in the increasing cost of Chinese goods. But economists say the main reason for the inflation now is China’s foreign exchange reserves, which surged by a record amount in the fourth quarter.

The central bank has been pumping out currency at an ever-accelerating pace over the past decade to limit the renminbi’s appreciation against the dollar. That strategy has helped preserve a competitive advantage of Chinese exporters by keeping their prices relatively low on global markets — while also protecting the jobs of tens of millions of Chinese workers in export factories.

Now, though, that cheap currency policy seems to be reaching its limits. The extra renminbi are feeding inflation. That is starting to undermine exporters’ price competitiveness — just as a stronger renminbi would do if Beijing was not intervening to begin with. 
That is, there are two ways for a real exchange rate to appreciate: through changes in (i) nominal exchange rates and (ii) relative prices (i.e., inflation).  The real exchange rate is defined as the nominal exchange rate, e, (e.g., the dollar price of renminbi) times the ratio of the two countries' price levels:
real exchange rate = e x P(China) / P(US)
While China intervenes heavily by selling renminbi for dollars to keep e from rising (and piles up massive "reserves" of dollars in the process), faster inflation in China - the increase in P(China)/P(US) - means that Americans must give up more stuff to get a unit of Chinese stuff.  That is, the relative price of Chinese goods is rising.

China is intervening as hard as ever in the foreign exchange market, according to Bradsher's article:
China’s foreign reserves leaped by $199 billion in the fourth quarter. The increase was much larger than economists had expected, and they suggested that China had roughly doubled its intervention in currency markets to around $2 billion a day. 
But the policy only works to the extent that China can offset the inflationary effects of the extra renminbi - for example by raising bank reserve requirements - and it appears they're no longer effectively able to do so.

The real increase in the price of Chinese goods will show up in US prices, but only modestly due to limited "exchange rate pass through".  In part, this is because consumer prices we pay reflect not only the price of the Chinese goods, but also the local retail and distribution costs, which are often a large portion of the retail price and not affected by the real exchange rate.  Of course, that means to effectively shift demand away from Chinese goods, the movements in the real exchange rate need to be even larger (somebody wrote a dissertation about this...).

A more important margin of adjustment may be substitution away from Chinese goods to those produced in other developing countries (i.e., this is great news for Mexico).  This Financial Times article by James Mackintosh discusses the problems created by the efforts other countries feel obligated to make in order to hold their own currencies down because of China.  Secretary Geithner raised this issue in a speech:
The undervaluation of the Chinese currency, the renminbi, and restrictions on capital flows in and out of China gave Chinese companies “a competitive advantage” and “impose substantial costs on other emerging economies that run more flexible exchange rates,” Mr. Geithner said.

“This is not a tenable policy for China or for the world economy,” he added. 
Politically, its sensible strategy for the US to try to frame China's currency policy as one that mainly hurts other developing countries rather than the US - it lets them be the bully, not us (as The Onion reported, China's closing the gap here, too). But the real appreciation also helps in terms of easing the pressure on the other countries that compete with China in export markets.

As David Leonhardt writes in his Times column:
Without taking inflation into account, the renminbi has risen 3 percent against the dollar since last summer, when China began letting it rise. Once inflation is accounted for, the real increase has been about 5 percent. At that pace, the renminbi could erase its artificial undervaluation — as some economists estimate it — in less than two years. 
Will this ease tension between the US and China?  Perhaps, but Leonhardt argues that there are bigger things to argue about:
For the United States, the No. 1 problem with China’s economy is probably intellectual property theft. Technology companies, for example, continue to notice Chinese government agencies downloading software updates for programs they have never bought, at least not legally.

No wonder China has become the world’s second-largest market for computer hardware sales — but is only the eighth-largest for software sales.

Next on the list, say people who work in China or do business there, is the myriad protectionist barriers China has put up. These barriers make this country’s recent efforts at “buy American” protectionism look minor league. In some cases, Beijing has insisted that products sold in China must not only be made there but be conceived and designed there.

There has been more interesting stuff written recently on the issue of "rebalancing" the current account relationship between the US and China - see Martin Feldstein, David Altig, Paul Krugman and Free Exchange.

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