Friday, February 6, 2009

The yuan peg and the inevitable US deflation

Whether deflation or deflationary spiral will happen in the US is a big topic I've been pondering for months. I'm always inclined to agree with the deflationists because of the underlying picture I see in the economy. But some insights inspired by ndk's post have led me to the conviction that deflation is not only what MUST happen, but that this deflation will have to be deep. The price competitiveness of Chinese product and labor has given rise to massive US trade deficit with China. The peg has ensure that this cannot be corrected by currency moves. This massive trade deficit cannot be made even more massive because then too much claims on US wealth would be surrendered to China. Therefore a US unilateral inflation policy is not feasible. In fact as you will see in the elaboration below, only a deep US deflation would correct this imbalance and this is exactly what we will see.

What dawns on me is that US cannot stop its trade deficit with China because its economy over the years has become too uncompetitive against China. Blame the bloated health care system, the outdated transportation infrastructure, the corrupt and wasteful US federal government that continues to squander over 10% of the US GDP annually, and the crowding out of the useful indsutrial capital stock by years of overinvestments in housing capital or financial alchemy. For example, the wage gap between a US auto-workers and a Chinese auto-workers are just too staggering, while their productivity gap are surely not that. The only way out is for the US economy to deflate significantly against China (call it 20-30%). You can achieve that "real deflation" by either devaluing the currency against yuan or have a price level deflation. Problem is you can't devalue the USD against yuan without China's consent. That leaves you only with price level deflation as a choice. Also don't forget Chinese output productivity is improving rather rapidly by the year, which makes everything a moving target. Unfortunately the target is moving further and further away from US. There is a long way to go before China's competitiveness improvement gets tapped out. With every 10% increase in scale of China's manufacturing base, they gain in network effect and economy of scale. They also continue to invest their savings into infrastructure such as roads, rails, telecom and ports, etc, which further enhances their cost competitiveness versus other developing nations. Yes the supply of cheap migrant workers for coastal factories was almost exhausted in 2007, (the trend is reversing due to massive layoffs in coastal areas) there are still 800 million farmers in China. If more industrial bases can be built inland, one can argue that the labor in China is practically inexhaustible. A casual China observer from outside might dispute this point. Although I have my own good reasons to believe that it is true. (Maybe for another post?) Anyway, whether this is true or not shouldn't even affect the conclusion of this posting. 

Absent a stop of the massive US-China trade deficit. which ran at $256BN in 2007 and is essentially the same in 2008, China will own too much US assets in the not too distant future. The exponential rise of China's USD reserves has been scary and I wager that will continue, albeit not as exponentially.  Because China holds mostly debt instruments in the reserve portfolio and it will most likely continue to do so, it is better for US if US deflate the economy before China owns too much of US assets. Inflation won't solve the problem because it will only makes this problem worse by making Chinese goods priced even more competitively versus US's.

As ndk articulated, which I agreed, China has enough firepower left to reign in inflation, both by hiking reserve ratio requirement again or sterilization. While the Chinese government is currently trying to ease credit to warm up the growth engine again, it doesn't imply that they would tolerate high inflation, should it resurface in the horizon again. If China doesn't let inflation happen, US cannot by itself engineered high inflation without worsening the trade deficit with China and hence jumpstarting the death spiral of liquidating the wealth of the nation. In fact, not only high inflation is impossible, even a meagre 2% US inflation is unsustainable. The chasm of relative competitiveness between US and China together with the RMB peg dictates that US has to deflate. This is perhaps the new impossible trinity. If a large economy pegs its currency against another large economy, the relative price competitiveness of labor and products cannot differ too much without one country handing over substantial wealth to the more competitive one over the long term. The gap here is staggering as well. This in history is without precedents and hence one cannot and should not be able to draw from empirical experience. We are in uncharted territory, yet again. (Remember in early 20th century, the competitiveness gap between US and Europe were nowhere as staggering, due to the lack of a massive US population)

However, one thing that ndk didn't mention is the possibility of a moderate RMB appreciation against USD. Yes the PBOC might not like to have 15% revaluation as this will make their balance sheet look insolvent. But they can easily manage a 5-10% annual revaluation against the USD, as they have done in the past. There are interest incomes from their fixed income portfolio apart from the cushion provided by Chinese government deposits. Central banks can't bankrupt as long as central government's fiscal power can backstop the losses incurred. In the US, the US Treasury put in a $400BN Supplmental Financing to the Fed's balance sheet, which can be forgiven if these AIG CDOs, Bear Stearns Maiden Lane and ABS papers turns out to be worthless. So we should not underestimate the magnitude of an RMB appreciation that PBOC can manage simply because it is bankrolled by the Chinese government's taxation power. 

In summary, my conclusion is CURRENTLY that US price deflation is inevitable, unless Chinese agree to tolerate high inflation or to revalue RMB massively against USD. The possibility of Chinese government tolerating high inflation is nil. The chance of some moderate RMB appreciation exists. Although China will not have the obligation or the incentives to do so. That is not a good position US is in. 

Another interesting thought experiment is as follows. If US tries to unilaterally devalue their currency by whatever means, whether it be helicopter or other crazy approaches (which are indeed feasible if the US government raise debt to fill the hole in the Fed's balance sheet), what would the USD be devalued against? It can't devalue against RMB unless China agrees. It can devalue against Euro, but then so would the RMB. Then the same problem occurs to Europe. Europe would run too unsustainable a trade deficit with China that too much European wealth will be owned by China. SAFE will have too much euros flowing in every year that it will also have to decide whether to cross them to USD or not. If they do, which they will, it will just move the USD back up against euro. Europe collectively will also want to intervene anyway to prevent euro from appreciating too much against USD and RMB. If you think it through, there isn't any way USD can be devalued against the world's major currencies. The only option is deep deflation.

No comments:

Post a Comment