The Right Call on China
May 11, 2006
Stephen Roach (New York)
The US Treasury made the right call on China in its bi-annual “Report to Congress on International Economic and Foreign Exchange Rate Policies.” It would have been easy to succumb to the increasingly intense bi-partisan political pressures on Capitol Hill and label China a currency “manipulator.” But Treasury took a principled stand to the contrary — unleashing a predictable political backlash. This underscores the dangerous protectionist wildcard that continues to haunt the global economy and world financial markets.
The Treasury report is required under the “Omnibus Trade and Competitiveness Act of 1988” (OTCA). This was the 32nd report issued since passage of OTCA. Over the 17 1/2-year time span since the first report in October 1988, only three countries have been charged with actually manipulating their currencies relative to the dollar — South Korea (1988-89), Taiwan (1988-89, and 1992), and China (1992-94). It has now been nearly a dozen years since a country (China) was last labeled a manipulator. There has been a host of other instances when additional countries have been singled out for special attention in this report — either examined as potential currency manipulators or formally put on notice to consider policy changes in the context of their international adjustment responsibilities. In the past, these included Singapore (1988, 1996-97, and 1999), Hong Kong (1988), Malaysia (1999, 2000-01, and 2005), Japan (2003-04), and Russia (2001). The May 2006 report singled out China for special attention, with Treasury underscoring “the central conclusion that far too little progress has been made in introducing exchange rate flexibility for the renminbi.” Ongoing discussions with Singapore and Malaysia over foreign exchange matters were also cited in the latest report. Like most laws, there is a certain amount of ambiguity to the interpretation of OTCA. The key concept, as far as I am concerned, is the context in which currency manipulation is described. The Act is less concerned with movements in foreign exchange rates per se, but more with a country’s willingness to use its currency for the “purpose of preventing effective balance of payments adjustments.” In this vein, the currency can be seen as the means toward an end. This important distinction allowed Treasury to look beyond the relatively limited movement in the cross rate between the dollar and the renminbi in the second half of 2005 — the period covered in the latest report — and focus, instead, on China’s role in resolving mounting global imbalances. From that perspective, it is really not that difficult to make the case that China is now making serious progress in complying with the goals of the Act insofar as its balance-of-payments adjustment is concerned. Key in that regard is the case for Chinese rebalancing — a conclusion that I have also been stressing (see, for example, my 24 April Special Economic Study, “China’s Rebalancing Challenge”). Upfront in Treasury’s latest report is clear recognition of China’s increasingly important efforts to shift toward more of a consumer-led growth dynamic — a dramatic departure from the export- and investment-led impetus of the past 27 years. As I have also argued, the Treasury report concludes that a successful execution of this strategy will entail a reduction in Chinese surplus saving that would facilitate a narrowing of its current-account surplus with important implications for the bilateral imbalance with the US. No one — Treasury, I, or the Chinese — under-estimates the daunting challenge China faces in attempting to boost household consumption. If anything, this has been the biggest shortcoming of the modern Asian development experience. But the Treasury report gives China credit for trying — very much at odds with the alternative interpretation of a nation that is using its currency deliberately to circumvent the adjustment process. Treasury also defends its position on China for several other reasons: First, the decade-old peg was abandoned on 21 July 2005. Second, while the Chinese currency has appreciated only slightly on a bi-lateral basis against the US dollar — moving up a little over 3% during the past nine months — its multi-lateral move has been considerably greater. The RMB rose by more than 9% against a broad basket of China’s trading partners in 2005. Third, China continues to make progress in introducing other financial sector reforms — especially in the area of adding greater liquidity to its foreign exchange market. Fourth, China’s senior leadership has gone on public record in maintaining the nation’s commitment to ongoing currency reforms. While these are all significant developments on the road to currency reform, they do not guarantee a balance of payments adjustment for a Chinese economy that has a current account surplus that hit 7% of its GDP in 2005. As noted above, the rebalancing toward a consumer-led growth dynamic stands out as potentially the most important development in this regard. This conclusion stands in sharp contrast to the politically-inspired fixation on a small move in its bi-lateral exchange rate with the US dollar. What matters most is multi-lateral progress, and on that count, China has made good progress in addressing many of its broader international adjustment problems. While this judgment is well supported on its merits, a large bi-partisan coalition of US politicians continues to argue very much to the contrary. This underscores the biggest flaw of OTCA and its bi-annual accountability report — it has become a political football. With the US Congress in no mood to accept responsibility for its fair share of the problem -- namely, policies that are pushing America’s national saving rate to record lows — the debate focuses more on finding someone else to blame for this unfortunate state of affairs. With China accounting for fully 26% of last year’s record $780 billion US deficit in tradable goods, the blame game usually stops right there. Never mind, the “water balloon” imagery — that if a saving-short US were to close down trade with China, the bi-lateral US-China trade deficit would simply flow to another trading partner. Democrats and Republicans, alike, are united in their willingness to opt for the anti-China gambit to “solve” America’s outsize trade and current-account deficit problems. Sadly, those are the policy blunders that almost always end in tears. The good news is there is a possibility that the US Treasury may have just issued the last of an increasingly antiquated generation of reports under OTCA. The existing framework was adopted in a very different context — in the pre-globalization era of the late 1980s, when a worrisome US deficit in tradable goods peaked out at around $160 billion. With today’s deficits now five times those prevailing when OTCA was conceived, a new framework is certainly in order — and long overdue. Legislation has been proposed by Senators Grassley (R-Iowa) and Baucus (D-Montana), the Chairman and ranking minority member of the all-powerful Senate Finance Committee, that would radically transform the currency report and its role in the trade adjustment process. Under the provisions of the “United States Trade Enhancement Act of 2006” (USTEA), the IMF research staff would play an important role in crafting the FX report. In effect, this would replace a staff of three the Treasury currently uses to produce this effort with a staff of nearly 2,700 IMF researchers. Moreover, the Grassley-Baucus legislation would substitute the concept of currency manipulation with the word “mis-alignment.” This not only alters the connotation of non-compliance, but it also turns the analytics of the report-writing effort into more of a shared responsibility within the broader global community. This is quite consistent with the recent proposals for IMF reform — namely, the April 21 announcement of multi-lateral surveillance and consultation — that establish a new process for dealing with the adverse implications of global imbalances and the challenging imperatives of global rebalancing. Under USTEA, the Treasury’s currency report would be depoliticized to some extent — reducing its role as a foil in the trade protectionist debate. Personally, I think there is a good chance this bill could become law before the mid-term elections this coming November. But it will require a big push by the forces of political sanity in the US — not always feasible in an election year. The US Treasury was in a lose-lose position insofar as the current groundswell for protectionist actions is concerned. Had China been judged guilty of manipulation, the Treasury report would have fueled the bandwagon of protectionism. But now that Treasury has failed to render such a verdict, the politicians are arguing that the Administration has once again let China off the hook. The currency report has, in effect, become a lightning rod for the debate over US trade policy. That could well be the biggest risk of all. With Washington expending excess political energy on China bashing, it runs the real risk of failing at the most important task of rebalancing — addressing America’s unprecedented saving deficiency. In my view, the Treasury report was a solid effort in presenting a balanced case on the so-called China problem — defending the adjustments the Chinese have made while putting considerable pressure on them to do more. Unfortunately, it probably does not defuse the protectionist time-bomb that is still ticking in Washington. That remains the biggest worry of all.
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Bad News Bears
May 11, 2006
Serhan Cevik (London)
An increase in the volatility of inflation is normal in low-inflation environment. In the past four years, Turkey has experienced remarkable disinflation — from an average of 77.5% in the 1990s to single-digit rates — as well as a marked decline in the volatility of inflation (see GARCHing Ahead, February 21, 2005). In our view, the normalisation of the country’s macroeconomic landscape is a secular phenomenon supported by prudent policies and structural changes. Therefore, the journey towards price stability, albeit becoming more challenging with exogenous shocks like higher commodity prices, is highly unlikely to come to an untimely end. Of course, an increase in inflation volatility is normal in today’s low-inflation environment and especially when exogenous factors create frictions in inflation dynamics. And this is exactly what has happened in the last couple of months when the consumer prices index recorded ‘unexpected’ fluctuations. Coupled with the sharp increase in energy and commodity prices, seasonal variations in food and clothing prices led to an increase in headline inflation. Nevertheless, underlying inflation presents no immediate threat and, contrary to hypochondriac arguments, economic fundamentals still support the secular disinflation process. Consumer price inflation increased from 7.7% at the end of last year to 8.8% last month. The CPI posted a month-on-month increase of 1.3% in April, well above our forecast of 0.9% and the consensus estimate of 0.5%. Consequently, the annual inflation rate rose from 7.7% at the end of last year and 8.2% in March to 8.8% last month. There are several factors contributing to this worse-than-expected figure, but the notable one was the 9.2% increase in clothing prices that contributed 80 basis points to the 1.3% jump in the headline figure. Indeed, the CPI excluding seasonal products posted a month-on-month increase of 0.8%, only marginally higher than 0.6% recorded in April 2005. Though this is in line with seasonal adjustments in the clothing sector, the surprising development was that the VAT reduction from 18% to 8% on clothing had no effect on final prices. Even so, the sector still experiences deflation, not inflation, as clothing prices declined by 8.8% on a cumulative basis in the first four months and posted a year-on-year drop of 1.8% in April. In addition to seasonal adjustments in the clothing sector, the rise in food prices due to adverse weather conditions earlier this year, administrative adjustments in alcohol and tobacco prices and, of course, the continuing inertia in non-tradables (like rental prices) pushed inflation — temporarily — higher. Higher energy and commodity prices are the most important factor slowing disinflation. Although the lira’s strength has helped cushion the impact of soaring energy quotes, the rise in oil and natural gas prices still contributed approximately 150 basis points to headline inflation (see More Turm(oil), April 26, 2006). Unfortunately, core measures of inflation do not have full immunity from exogenous developments (like surging gold prices) and seasonal fluctuations (like in clothing prices) that may distort the analytical value of such indices, at least, in the short-term. For example, gold has a 1.4% weight in the Turkish CPI basket and the shocking increase in international gold prices caused a 6.3% jump in the miscellaneous category in the first four months of this year. Nonetheless, despite the threat of higher commodity prices, goods price inflation excluding oil and gold has already moved to around 3% and seasonal variations will soon turn favourable for the future direction of inflation. Structural changes have lowered the non-accelerating inflation rate of unemployment. The rise in commodity prices has a direct inflationary effect, but inflation dynamics ultimately depend on the second-round impact and that is determined largely by the state of the labour market and the set of macroeconomic policies. Even though the ‘crowding-in effect’ of fiscal consolidation boosts growth, fiscal and monetary policies remain restrictive enough to help containing the pass-through from energy prices to the rest of the economy. In spite of an above-trend output expansion in the last 16 quarters, Turkey’s labour market, with a jobless rate of 11.8%, is still far from full employment. Indeed, if we include the large pool of ‘discouraged’ workers, the slack is even greater. Furthermore, structural changes have lowered the non-accelerating inflation rate of unemployment (NAIRU) and reined real wage growth in the economy. Thus, going forward, the state of the labour market — and demographic potential to increase labour force participation — will continue dampening inflationary pressures, as long as the government does not make politically-motivated arbitrary wage adjustments. Productivity growth is lasting longer than most economists thought possible. Following a 32% increase in the past four years, productivity figures show no sign of deceleration on the horizon. As a matter of fact, the growth rate of output per hour-worked accelerated from 4.7% in the first half of 2005 to 6.1% in the third quarter and 8.4% in the last quarter of the year. On the other hand, real wages have constantly grown drastically slower than productivity, resulting in an unprecedented drop in unit labour costs. Real wages in the manufacturing sector, for example, increased by 2.9% in the post-crisis period, compared to 32% increase in output per hour-worked. In our opinion, the lower elasticity of real wages to productivity is exactly what the Turkish economy needs at this stage to maintain disinflation and to boost employment growth. And given the strength of the investment cycle, we see no reason for an adverse shift in productivity trend. For instance, the 196.7% real increase in business investment spending on machinery and equipment will no doubt keep paying off in efficiency gains at the level of production. The potential growth rate of the Turkish economy is on an upward trend. The surge in capital spending and productivity growth reflects the power of macroeconomic normalisation and increased openness that force companies to focus on improving balance sheets and growing the bottom line. In our view, these structural changes have also raised the potential growth rate and allowed the economy to grow at an above-trend pace without experiencing an episode of overheating. In other words, despite robust output growth, the Turkish economy is still operating with an unemployment rate that is almost twice as much as the NAIRU and an output gap that makes the effect of higher energy prices manageable. In addition, we need to take into account the global output gap and competitive pressures that effectively lower the rate of price increases. On the whole, since investment growth, compared to consumer spending, has made more contribution to the increase in total domestic demand, we believe that the recent pick-up in inflation is not, as some argue, a result of a sudden emergence of demand-driven inflationary pressures, but reflect higher energy prices and seasonal fluctuations. Rising oil prices have complicated the central bank’s efforts to ease the policy stance. Despite exogenous challenges, we expect inflation to decline noticeably in the coming months and reach 5.5% by the end of this year and 4% in 2007. Nevertheless, we have argued in favour of keeping interest rates unchanged until June when inflation is likely to start declining once again. Of course, monetary policy decisions should be based on, at least, a 12-month horizon and, given the transmission lag, maintaining the same policy stance may indeed lead to inflation below the target range next year. However, in today’s volatile conditions, signalling properties of policy decisions, especially after the disappointing process of appointing the new central bank management, are far more important in shaping inflation expectations. That said, the Turkish economy remains on a non-inflationary growth path and will enjoy, thanks to fiscal consolidation and structural reforms, lower risk premium and credit rating upgrades. This is why we still believe that the Central Bank of Turkey will have an opportunity to lower the policy rate by 125 basis points in the reminder of this year.
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Further Tightening to Come, If Not Now
May 11, 2006
Sharon Lam (Hong Kong) and Andy Xie (Hong Kong)
The Bank of Korea decided to keep its policy rate unchanged at 4% in today’s meeting, amid concerns over won appreciation. The major surprise was the central bank expressing caution on the economy. Market expectation was divided on this month's rate decision, and we supported a rate hike. According to Dow Jones Newswires, six of the 13 economists surveyed expected a rate hike, while seven expected no change. Therefore, today’s decision was not a surprise to the majority. Yet, recent market opinions on Korea's policy direction and growth forecasts are quite divided, implying that Korea is entering a period of uncertainty. We have cautioned that the economy has lost some pace recently. We think the BoK's comment today that it may lower its 2006 GDP forecasts of 5% confirms our view. We are keeping our GDP forecast at 4.5%, with upside risk potential following the exceptionally strong 6.2% growth in 1Q. We expect to see slower growth in 2Q due to deteriorating external conditions and weakening sentiment. However, we expect growth momentum to improve sequentially in 3Q as the labor market continues to improve, yet the YoY growth rate is unlikely to exceed the 6.2% seen in 1Q. We believe the domestic demand recovery will reach its peak in the second half of this year. The Korean economy is indeed moving gradually towards the peak, but we believe the slowdown after that will be mild since there have been few excesses created in this cycle requiring sharp adjustment. We believe fundamentals are solid. Another major message from today is that the BoK expects inflation to be stable in the coming months. This differs from its statements earlier this year expressing concern over inflationary pressure. Won appreciation is the major driver behind low inflation. Coupled with its less positive stance towards the economy, the fading inflationary concerns mean the BoK has becomes less hawkish than before. Nevertheless, the BoK insists that the policy rate is below neutral. We agree. Korea's neutral rate should be at least 4.5%. With the strong liquidity within the economy, we urge the central bank to bring the rate back to the neutral level in order to avoid a possible asset bubble. Indeed, liquidity is driving the housing price increase in Korea, and even the government's tough administrative measures towards the housing market have been ineffective. We believe BoK is not done with this tightening cycle, with the goal being to move the rate to neutral. The key to timing is sentiment. When we see the consumer expectation index rebound, we believe the BoK will raise the rate. We expect sentiment to improve again soon, when the labor market improvement becomes more apparent. We look for a 50bp rate hike in 2H06. April’s seasonally adjusted unemployment remained at 3.5%, the same as in the previous two months. Korea’s unemployment rate has been hovering at around 3.5% after it peaked at 4% in September last year. The service sector is the driver behind job creation. Labor market growth usually lags the economy by about six months, we therefore expect more labor market improvement in 2H06. The Korean won has appreciated by 8.5% against the dollar since the beginning of this year, yet in the last month it has depreciated rapidly against the yen by 4%. The won/yen affects Korea's export competitiveness more than won/dollar, and we should not be worried about Korea's export growth this year. After all, Korea's export competitiveness has become more immune to currency movements than before, since Korean products are now not competing on price, but on brand image and technology. Meanwhile, we believe won gains against the dollar will see moderate reversal in the near term given Korea’s current account deficit, signs of peaking out and a temporary pause in rate hikes.
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