Finance- Economy vs Real exchange rate

The Chinese experience shows the costs of under-valuation are a lot less than the benefits in terms of jobs. In recent years, as China’s exports have grown rapidly, and the country is registering increasingly larger surpluses on the current account (an estimated $140 billion this year), it has faced a lot of pressure for a “more flexible” exchange rate regime. Instead of openly calling for an upvaluation of the currency, the politically correct euphemism is to use the term “more flexible exchange rate”.


After holding on to a steady yuan-dollar exchange rate for more than a decade, China has engineered a modest appreciation (5.4 per cent) over the last year and a half. China’s exchange rate policy is clearly rooted in the need to create manufacturing employment. China needs to create at least 25 million non-agricultural jobs a year, considering the number of new entrants in the job market, as also the vast immigration from rural to urban areas. Most of these would have to be in the manufacturing industry, and its global competitiveness is, therefore, of crucial importance. Hence, the undervalued yuan. Indeed, for many years, the yuan’s fall in real effective terms was even more than in nominal effective terms, because China has had lower inflation than the US for nine years! This is remarkable at a time of surpluses on current account and huge capital inflows (in theory, both generate inflation pressures), resulting into reserves accumulation of a trillion dollars. One advantage China has in sterilising the excess money supply is that domestic interest rates are lower than the dollar or euro interest rates: this means that there are financial gains to the central bank in sterilising the growth in money supply. China is not only keeping domestic inflation low but, as a low-cost manufacturer, is a major contributor to keeping global inflation low despite the very high commodity prices of recent years.
But there is also a major risk in the reserve accumulation. As argued earlier also earlier, given the huge deficit on current account in the US, the possibility of a sharp fall of the dollar can hardly be ruled out. Indeed, diversification of Chinese reserves into other currencies (as Russia, Switzerland, Italy and the UAE are already doing) could itself trigger such a fall: it is Chinese investments in the US treasury market that keep the dollar from falling and the yield curve flat to negative. On the other hand, should the yuan appreciate against the dollar, there would be huge paper losses for the central bank as dollar assets become worth less in yuan terms. Assuming that, currently, 70 per cent of the reserves are in dollar assets, even a 5 per cent yuan appreciation against the dollar would lead to a translation loss of something like 250 billion yuan! Clearly, the authorities are treading on delicate ground trying to balance the needs of the real economy with the possibility of large paper/financial losses if and when the yuan is forced to appreciate in dollar terms.
Arguably, the root cause of the large and increasing surpluses China is registering on the current account, is the savings-investment imbalance. Despite huge investments, the savings rate is so high, above 50 per cent of GDP, that the excess savings result into a surplus on the current account. Interestingly, the household sector savings in China as a percentage of GDP are actually less than in India — this, despite the fact that personal consumption in China per capita is only about 70 per cent higher than in India, while per capita incomes are 2.5 times as large. The real cause of excess savings is the corporate sector: the corporate sector’s savings amount to as much as 30 per cent of GDP, with retained earnings alone contributing two-thirds of that. One reason, it seems, is that Chinese companies do not distribute dividends. At the macro level, one way of reducing the excess savings and the politically sensitive surplus on current account, is to get the public sector companies to distribute dividends, and spend the money on needed social services like health care, higher old age pensions, and so on. Sooner or later, we should see some movement in this direction even as the yuan gradually appreciates. Incidentally, the non-deliverable forwards market is factoring a yuan rise of just about 3 per cent over the next 12 months.
One point on which we need to learn from China is the focus on the real, job-creating economy rather than philosophical arguments about market versus managed exchange rate, the cost of sterilisation, and so on. On the second issue, what we often seem to overlook is that the cost to the real economy of an appreciating currency (jobs uncreated or lost, business profitability, forgone GDP growth, and so on) can be far, far bigger than the financial cost of sterilisation. To be sure, these costs are not as easy to calculate as the cost of sterilisation — but are, nevertheless, as concrete and perhaps even more important.

Crisis of confidence

The old-fashioned financial system was like Old Maid, a parlour game once beloved of small children. The banks were like players, dealt hands from a pack of cards, which they swapped among each other. At the end, one player was left holding a lonely queen—a bad debt, if you will—and lost. Over the past few decades the game has changed. Securitisation has snipped the old maid into pieces; new faces, such as hedge funds, have joined the party, enabling the banks to distribute those pieces among a larger number of players. When the game is over, lots of players are left holding small losses instead of one player holding a big one.
During two exceedingly prosperous decades, that theory seemed to work just fine. But the swings in almost all financial markets this month have made dispersed risk suddenly morph into dispersed mistrust. The uncertainty has been magnified .Meanwhile, collateralised-debt obligations (CDOs), made up of clumps of those securities and laced with leverage, have become almost impossible to trade. So none of the players really knows how much he has lost. While this uncertainty lasts, investors are taking it out on the banks that peddled the securities by dumping their shares; and the banks are taking it out on those they sold them to by demanding more collateral on their loans. The banks have even grown cagey about lending to each other.
The doubts burst into the open on August 9th when central banks were forced to inject liquidity into the overnight money markets because banks were charging punitive rates to lend to each other. At first, the problems appeared more serious among European banks. The pain in America was concentrated in the largest hedge funds, including those run by Wall Street’s biggest name, Goldman Sachs. Increasingly, however, analysts worry about the exposure of American, Canadian and Asian banks.
On Wednesday August 15th shares in Countrywide Financial, a large American mortgage lender, fell 13% after an analyst gave warning of possible funding difficulties. Despite liquidity injections by the Federal Reserve on August 15th, the S&P 500 index fell 1.4%. The heavy selling spread to Asian and European stocks on August 16th.
Every crisis begets finger-pointing, and the blame now is falling on the rating agencies that helped structure these exotic instruments. Currently, they are guided by a voluntary code that aims to tackle potential conflicts of interest. The biggest is that the agencies are paid by the firms they rate. Rating CDOs was a profitable business.
If these securities are now downgraded, banks could be forced to offload lots of illiquid instruments into a falling market—one of the fastest ways to lose money yet devised. But if there are no buyers, banks may have to sell something else to shore up their balance sheets.
Something like this indiscriminate selling has been affecting hedge funds over the past couple of weeks. Faced with more demanding standards from their banks and investors, some have been forced to unwind positions in order to realise cash. That has led to unusual movements in debt and equity markets, which have only got some funds deeper into trouble. Quantitative funds have been hardest hit, as investment models that had made money for ages briefly proved worse than useless.
Since banks lend to hedge funds, any problems there quickly become their concern. On top of this, both Bear Stearns and Goldman Sachs have found that when funds bearing their name get into trouble the desire to preserve their reputations soon leads to a rescue. Sometimes risk is not as far away from the banks as it seems.
At the end of Old Maid as banks used to play it, the loser would take a big write-off and then everyone could start playing again. In the new version, the use of leverage means the game is being played with hundreds of packs of cards and by thousands of different players. Working out who has won and who has lost in this round will take a long time.

Economist