"The principal counterpart to the overvalued dollar is the undervaluation of the Chinese renminbi, which would have needed to appreciate about 21 percent on a weighted average basis and about 40 percent against the dollar to achieve equilibrium," according to the Peterson Institute study by economists William Cline and John Williamson.

Between 1995 and 2004, China maintained  a 8.28 renminbi/yuan (renminbi: Mandarin for "people's currency"; yuan (Mandarin for "unit") peg to the dollar, which helped restore price stability. In July 2005, in response to pressure from Washington to raise the value of the Chinese currency as politicians in the US Congress were threatening sanctions to reduce the ballooning US trade deficit, the renminbi was linked to a basket of currencies and the People's Bank of China kept the value within a tight range.

By July 2008, China had accumulated about $2 trillion in official exchange reserves and the value of the currency had risen 20 per cent against the dollar.

The FT's John Authers said Federal Reserve figures show that over the past three months, the Treasury debt it holds on behalf of foreign official accounts has risen by $174bn, which implies that China has bought more bonds.

FT Video June 29, 2009

Dr. Peter Morici of the University of Maryland says that in 2008, Chinese monetary authorities purchased more than $400bn in US and other foreign currencies - about 10 per cent of China's GDP and 25 per cent of its exports.

Dr. Peter Morici: China and the Great Recession - - Recalibrating US-China

About half of China's exports are made by foreign-owned firms or joint ventures.

US researchers say trade statistics can mislead as much as inform. For every $300 iPod sold in the US, the politically volatile US trade deficit with China increases by about $150 (the factory cost). Yet, the value added to the product through assembly in China is probably a few dollars at most.

In 2007, a teardown analysis of the 451 parts, which made up the 30-gigabyte video iPod, was used to track the value-added from the US, across Asia and back to the US.

Markus Jaeger of Deutsche Bank Research says the risk of an emerging markets (EMs) crisis seems to be receding fast. He says it is remarkable, though not really surprising, how resilient the EMs have proven in the face of the most severe financial crisis since the Great Depression. EMs with large liquid liabilities relative to liquid assets have proven especially vulnerable. Policy-makers will conclude that the marginal benefits of reserve accumulation continue to outweigh its cost.

Jaeger says the risk of an emerging markets (EMs) crisis has been receding, even in Eastern Europe, if market risk indicators are to be believed (see chart). Risk appetite has been gradually returning and there are tentative signs that capital flows to EMs may have bottomed out. The provision of large official financing packages, combined with a sense that the risk of a financial-sector meltdown in the developed markets has faded, has helped lift demand for riskier assets, including EM assets. He says the full fall-out from the real economy “crash” has not been yet experienced , but an economic downturn - - even one as severe as this - - should be more manageable than a global financial-sector meltdown. The EM asset price rally has also been fuelled by the expectation that in many (but not all!) EMs the economic downturn will be sharp but short-lived, in contrast to the developed markets, where a sustained rebound will remain elusive.

The Deutsche Bank Research economist says the Volcker shock of the late 1970s drove many major EMs into default. Although the world economy quickly recovered from the shock, for many EMs the 1980s turned out to be a “lost decade” characterised by economic stagnation and repeated crises. This time, no major EM has defaulted and most major EMs have managed to maintain relatively sound fundamentals, measured in terms of external liquidity, public-sector solvency and banking-sector stability. Many EM economies - - especially outside Central and Eastern Europe (CEE) - - should therefore recover relatively quickly, even if a return to pre-crisis, US-consumer-fuelled growth rates is unlikely as long as the developed markets continue to de-leverage.

Jaeger says it is remarkable, though not really surprising, how resilient the EMs have proven in the face of the most severe global financial and economic crisis since the Great Depression. Key pre-crisis credit metrics predicted fairly accurately which countries were going to encounter significant difficulties and which countries would manage to “weather the storm” more easily. Countries with large liquid external liabilities relative to liquid external assets, especially if characterised by large non-FDI-financed current account deficits, proved vulnerable and many of them were forced to turn to the IMF. The majority of countries that received official bail-outs are located in CEE (see chart). This is not surprising. Many EMs in Asia and Latin America had switched – more or less deliberately and with varying degrees of intensity – to a policy geared towards FX reserve accumulation following severe capital account crises in the 1990s and early 2000s. By contrast, many EMs in CEE failed to build up a comparable external buffer.

He says the lesson policy-makers are likely to draw from the crisis is that the marginal benefits of reserve accumulation (economic and financial stability) continue to outweigh its potential costs (foregone economic growth, fiscal costs). Even countries with what looked like solid external positions by pre-crisis standards experienced quite disruptive capital account shocks. The shock could have been buffered somewhat more, had governments benefitted from greater policy flexibility on account of larger FX reserve holdings. At the very least, this is the conclusion many EM policy-makers will come to. The narrowing of the US current account deficit will make competition for FX reserves more intense, and this will tempt many EMs to keep their exchange rate undervalued, or at least to keep their currency from appreciating (substantially) once their balance of payments moves into surplus. A large output gap will sharply limit inflationary pressures, further enhancing the attractiveness of such a strategy. Neither the prospect of EMU membership in CEE nor the IMF’s Flexible Credit Line, only readily accessible for “well-managed” countries, will dissuade the majority of EMs from going down this path.

Markus Jaeger  concludes that equally important, many of the countries that had accumulated large FX holdings prior to the crisis will maintain policies geared towards reserve accumulation, whether or not this is desirable from a domestic growth and global adjustment point of view. Politically, it will be difficult to fundamentally change a policy that has “worked” in terms of maintaining stability. Some change at the margin is possible, but a fundamental policy change is unlikely. He says opposition to EM FX accumulation should be limited in the near term; even with respect to China, which will continue to account for the bulk of global reserve accumulation. A combination of narrowing US current account deficit, widening US fiscal deficit and increasing US reliance on Chinese purchases of US government debt seems to have led Washington to adopt a softer stance on China’s exchange rate and FX accumulation policies. The policy debate seems to be shifting from FX intervention policies and global imbalances to fiscal policy and economic growth. This should make it easier for both sides to find common ground. It also means that Beijing – and other EM countries – is likely to encounter much less resistance than pre-crisis to an exchange rate policy that is, intentionally or unintentionally, geared towards reserve accumulation.

An article by the authors of the Petersen Institute study was first published on VoxEU.org last month: 

William R. Cline and John Williamson

Large external imbalances persist and remain a significant concern. This column estimates a set of medium-run “fundamental equilibrium exchange rates” compatible with moderating external imbalances that might guide international policy efforts. It says that the US dollar is overvalued and the Chinese renminbi is undervalued.

Most writing about exchange rates forecasts how exchange rates are about to change. Most of these writings are not worth the paper they are written on – short-run exchange rate movements are, to a good approximation, a random walk (Meese and Rogoff 1983). We believe it to be socially more valuable to attempt to evaluate what exchange rates could help to support a viable medium-run equilibrium position for the real economy. That is the purpose of the estimates of “fundamental equilibrium exchange rates” we prepare (of which the latest are in Cline and Williamson 2009).

Assumptions

In undertaking such an exercise, one needs to make assumptions both about the course that external balances would take if policy did not attempt to address these disequilibria, and assumptions about the objectives that should be sought by policy (as well as assumptions built into the model deployed). In our most recent work we have employed as a frame of reference most of the assumptions reflected in the IMF’s latest World Economic Outlook for 2012. Unfortunately we think the IMF is too complacent in forecasting that at the exchange rates of last March the US current account deficit would basically stabilise at 3% of GDP (the forecast for this year) rather than suffer a new deterioration, and that the oil price would stabilise next year at a real level of $62.50. We therefore modified the 2012 current account forecasts of the IMF model in two respects – by adding to the IMF forecast for each country other than the US a sum equal to their proportionate share of the increased US deficit that would materialise under Cline’s forecast, and the impact of the higher oil price. After adjustment to secure international consistency, this gave us forecasts of actual current imbalances.

The key assumption regarding objectives is what current account target should be pursued by each country. We employed two rules to determine these, based on the philosophy that countries should be left alone except where their decisions either impinge on the rights of others or jeopardise their own stability. In general we argued that countries should strive to keep imbalances (surpluses and deficits) under 3% of GDP. Reflecting the philosophy, countries with smaller forecast adjusted imbalances were assumed to be within the target range and require no adjustment. However, we recognised that countries with large inherited stocks of foreign assets or liabilities might have difficulty in achieving this aim, so countries with a forecast imbalance in excess of an absolute 3% of GDP were treated as also within the target range provided that the a larger imbalance did not threaten to further increase the absolute ratio of net foreign assets to GDP. This gave figures for presumed desired current imbalances (see Table A at the end of this column). The gap between each country’s forecast current account balance and the target limit (either 3% of GDP or net foreign assets-based) constituted the desired change in current account balance to be accomplished.

The model employed to translate assumptions about the difference between forecasts and desirable outcomes into exchange-rate estimates was Cline’s work, notably his estimates of impact parameters (which measure the impact of a change in real exchange rates on current account outcomes) and his Symmetric Matrix Inversion Model (SMIM) (Cline 2005, 2008). The desirable changes in current account outcomes and the impact parameters gave desired changes in real effective exchange rates.¹ The purpose of the SMIM is to convert the set of desired changes in real effective exchange rates into a set of changes in dollar exchange rates.

Dollar overvaluation, renminbi undervaluation

The table shows the results of these exercises for the 29 countries for which we formed estimates.² The target changes in the real effective exchange rate are against the March 2009 base used in the IMF forecasts. Because the dollar has declined significantly since then (by about 5% on a trade-weighted basis), in some cases the extent of correction needed now is considerably smaller, and some currencies have even overshot.

The euro area and even the UK are still found to be marginally undervalued against the dollar, though both are slightly overvalued on a multilateral basis. The same is true for Japan and indeed a majority of the small currencies. Both of the immediate neighbours of the US, Canada and Mexico, are now estimated to be somewhat overvalued against the dollar, even though in March the Canadian dollar was undervalued. The only other currencies found to be more than marginally overvalued against the US dollar are the Australian dollar and the South African rand.

The main counterpart to the overvalued dollar is the undervaluation of the Chinese renminbi, along with a few of the smaller Asian currencies. We are somewhat nervous because our estimate (based on the figure of RMB 4.88 to the dollar) of Chinese undervaluation is even larger than it was a year ago (RMB 5.81 to the dollar), despite the fact that the RMB rode the dollar up by 14% in effective terms in the intervening year. It may be that our estimate is now too large because the IMF’s projection of the Chinese surplus seems not to have declined despite the RMB’s real appreciation, although the fall in commodity prices in the past year has presumably worked in China’s favour. But all the other potential biases, notably the way of formulating the Chinese current account target as a substantial surplus rather than the deficit suggested by the FDI inflow, are in the direction of minimising estimated undervaluation. Our analysis is one more piece of evidence that the major macroeconomic imbalance in the world today stems from China’s exchange-rate policy.

Moderating external imbalances

Whatever one thought about the importance of moderating external imbalances a year or two ago, one’s concern about the importance of reducing imbalances should be greater today. We are not among those who argue that the primary cause of the financial crisis was a savings glut in Asia – China’s surpluses did not force the quants to invent asset-backed securities, the rating agencies to overrate mortgage-backed securities, AIG to take a position on only one side of collateralised debt swaps, nor Lehman and others to leverage at 30 to 1.

But the system is far more fragile than we had thought two years ago. Large external imbalances can only aggravate, not moderate, fragility in the financial system. One sign of that fragility is Chinese nervousness about whether it should continue to build up US Treasury securities. Moreover, in a world economy fighting global recession, it is especially important to avoid the competitive devaluations that spurred increasing conflict and protection between the two world wars and led to the Bretton Woods system of fixed exchange rates. A meaningful pursuit of reduction in international imbalances and corrective movement in exchange rates has been on the international agenda for some time now, including in the IMF’s mandate to provide multilateral surveillance. It is in this context, then, that we prepared this second set of “fundamental equilibrium exchange rates” estimates, and we hope that they will provide a useful input into international policy efforts toward reducing imbalances.

References

Cline, William R. (2005). The United States as a Debtor Nation. Washington: Institute for International Economics.
Cline, William R. (2008). Estimating Consistent Fundamental Equilibrium Exchange Rates. Working Paper 08-6. Washington: Peterson Institute for International Economics.
Cline, William R., and John Williamson. (2009). 2009 Estimates of Fundamental Equilibrium Exchange Rates. PB09-10. Washington: Peterson Institute for International Economics.
Meese, R.A., and K. Rogoff (1983). “Empirical Exchange Rate Models of the Seventies: Do They Fit Out of Sample?” Journal of International Economics 14, 3-24.

1. The current account targets and the changes in real effective exchange rates relate to the period for which the IMF made forecasts, which was March of this year. But from this we calculated “fundamental equilibrium exchange rates”-consistent dollar exchange rates which (since this is not an age of high inflation) can be assumed to have remained constant, thus permitting the comparisons with recent market exchange rates in the final columns of the table.
2.  Four oil-exporting countries – Norway, Russia, Saudi Arabia, and Venezuela – are included in the analysis, but “fundamental equilibrium exchange rates” were not estimated since these depend critically upon savings strategies and the oil price and we have no credible forecasts of these variables. The rest of the world was forced to have zero change in its current balance, but there is no corresponding currency.

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