Gathering clouds over Rmb
(http://www.caing.com/xieguozhong/index.html)
Andy Xie/Febuary 5, 2010
In his first state of the union address President Obama dramatically altered his policy direction, at least verbally. He indicated that he would focus 100% on creating jobs, partly through doubling exports in five years. If followed through, the US is on a collision course with China’s export expansion strategy. A crisis, possibly centered on China’s exchange rate policy, may occur before the US’s mid-term election in November.
The trigger for Obama’s turnaround was the defeat of the Democratic Party in the special election for Ted Kennedy’s senate seat in Massachusetts. Ted Kennedy, a liberal democrat, held this seat for 47 years until his recent death. The Democratic Party candidate was Martha Coakley, the attorney general and a well known democrat in the state. As Massachusetts is such a heavily democratic state, no serious candidate emerged on the Republican side. A little known state senator, Scott Brown, accepted the candidacy on the Republican side. And he won by a landslide.
The election result holds a special significance for the Democratic Party. It held sixty seats out of the 100 member senate. The sixty votes are needed to force a vote on any bill. Even though majority approval is enough for a senate approval, sixty votes are needed in reality to pass any bill. As the Republican Party doesn’t cooperate with President Obama at all, he needs sixty seats for the Democratic Party to pass any bill. After losing the supermajority, he won’t be able to pass anything substantive. The interesting question is why the Democratic Party didn’t pass all the bills they wanted when they had the supermajority. Now it is too late.
There is little doubt that the result was a protest vote against the Obama Administration. The voters wanted to send a message that they thought the country was on the wrong path, and the Obama administration had not been addressing their top concern-employment. The Obama Administration has been boiled down in its first year in bailing out the Wall Street and healthcare reform. The Wall Street bailout is deeply unpopular, and the healthcare reform is the right issue at the wrong time.
In addressing the financial crisis the Obama Administration continued the Bush Administration’s policy-protecting the existing the system. The Obama Administration, as a new government, didn’t have to do that. Of course, the government needed to keep the financial system alive to protect the economy. But, how? It could have let the system go down first and then nationalized it. It would have created a clean sheet for building a new system rid of the flaws that led to the bubble. By bailing out the existing system wholesale the Obama Administration has created an enemy to its financial reforms. How could one expect the same people who benefited from the flaws in the system to support their abolition?
In the previous financial crises the big shots in the bubbles were prosecuted and went to jail. American people expect heads on pikes after a financial crisis. It is just good politics. One may not think that jailing a few crooks is so important. It is actually extremely important for the system to start with a new psychology. After the junk bond bubble burst in the 1980s the king of junk bond, Michael Milken, together with the top executives at the bankrupt Savings & Loans institutions went to jail. After the IT bubble burst in 2000 the top guys at Enron, Tyco and even some analysts on Wall Street went to jail. This bubble is bigger than any before. Yet no big shot has gone to jail. Indeed, the president dines with them and begs them to support his financial reforms. American people see it correctly: it is a farce. If the Obama Administration is unwilling to make the change, they will vote for someone else who would.
Next to bailing out the financial system, the Obama Administration focused its remaining energy on healthcare reform. No doubt that healthcare is the biggest problem for the US economy. It accounts for 16% of its GDP, twice as much as the average for the OECD economies. The excess cost is comparable to the total profit of the US corporate sector. And it is still growing twice as fast as the rest of the economy. Unless the trend is checked it threatens to bankrupt the whole country. The sad part is that the high cost hasn’t brought about a good or fair system. Between 40-50 million Americans (or 13-16% of the population) have no healthcare insurance. It is the biggest social equality issue. The Obama Administration initially set out to address both the cost and coverage issue in its reform agenda. But, as the opposition to cost cutting initiatives rose, the government compromised. Overtime it has become entirely about expanding coverage and spending more money. The cost would be born through raising taxes on the middle class. The reform became bad for middle class and good for a minority underclass. Hence, it has become socially divisive and turned into a lightening rod for the middle class anger.
At the same time the biggest issue-rising unemployment has been pushed to the third on Obama’s priority list. He has been repeating the Wall Street’s mantra; reviving Wall Street would revive the economy that in turn revives employment. The Wall Street has come back from a government bailout to big bonus time in just one year, while the unemployment rate is at 10% and, plus the underemployed, is over 17%. The taxpayers’ money brought back the Wall Street party while they are still looking for jobs. How could they not be angry? The special senate election in Massachusetts was their first opportunity to express their anger.
The Obama Administration is now taking a big turn in its policy direction. The healthcare reform is on the backburner. Creating jobs is everything. Indeed, unless the Obama Administration can make a significant impact on employment soon, the Democratic Party would go down big in the mid-term election in November. Like in 1994 the Democratic Party could lose its majority in the house. That would be an unmitigated disaster for Obama. Even if he hangs onto the Whitehouse for two terms, with a Republican majority in the House, he wouldn’t be able to accomplish much. This is why President Obama will make many policy decisions in the coming months in relation to employment.
His first decision is to offer $5,000 tax credit and to cap the benefit at $500,000 per employer. The total cost is estimated to be $33 billion. The amount is obviously small for a $15 trillion economy. While it’s good politics, it won’t be enough to change the fortune of the Democratic Party. He needs to make bigger and more substantive decisions soon.
Obama’s dilemma is that Washington’s political structure wouldn’t allow any substantial measure to be adopted. This is not a new situation. The senate voting system implies that the opposition must approve anything that the ruling party wants to do. As the opposition has not interest in making the ruling party successful, it is only willing to support anything that it champions. Hence, the ruling party can only adopt the opposition’s agenda to get anything done. The Clinton Administration passed a few measures that the Republican Party had championed. The Bush Administration did the same for the Democratic Party. The overall balance is that nothing radical could be done. When the economy is cruising well, this gridlock in Washington is quite good. When the economy is in big trouble like now, this system means that no meaningful solution is forthcoming.
As the government can’t do a lot, the Fed is called upon to shoulder most of the burdens for solving the economic problems. Its only tool is printing money. This is why the Fed leans towards loose monetary policy on average, i.e., the US economy has an inflation bias. For the past two decades, low commodity prices and global labor surplus kept inflation low. The inflation consequence of the Fed’s bias didn’t show up. Now, both factors have reversed. Inflation is coming soon, which would constrain what the Fed could do. The odds are that the Fed would be forced into raising interest rate soon. In 2012 the Fed funds rate could top 5% despite a sluggish US economy.
When the Fed’s hands are tied by inflation and the government is paralyzed by gridlock, the US’s only policy option is to pursue export expansion. The US’s trade deficit peaked in 2006 at $760 billion with exports one third less than imports. The deficit last year was probably half of the peak level. The contraction was due to import collapse rather than export expansion. It is a contractionary approach to solving the deficit problem and, hence, is not sustainable. If the US economy expands, the deficit will rise again, i.e., trade will subtract from rather than add to an US economic expansion. With no internal levers for sustaining demand growth, the US must change the external situation and make trade a positive element for its economic expansion. This is why Obama called for doubling the US’s exports in five years in his state-of-the union speech.
One option for expanding exports is to devalue the dollar. But, as the Fed goes into a tightening cycle, it’s not easy for the dollar to fall much. Indeed, as I wrote a few months ago, the dollar has bottomed. Its lowest point was in May 2008 when the dollar index (‘DXY’) reached 71. It peaked during the crisis at 90 when the safe haven trade pushed money into the dollar. It has been range bound between 75-80 for the past six month and will likely remain so for the whole 2010.
As devaluation isn’t a way out, the US will likely turn to trade policy for increasing exports. China is the most obvious target. The Rmb peg to the dollar is likely to be the focus again. During the crisis the peg was a stabilizing force. It prevented the dollar from a total collapse despite the Fed’s zero interest rate. Now the financial stability has been restored, and the Fed is ready to raise interest rate. The Rmb peg to the dollar isn’t important to the dollar stability anymore. It could make the dollar stronger than what the US wants. Breaking the Rmb-dollar peg is now in the US’s interest.
The US’s pressure over China’s exchange rate policy has begun with trade protectionist measures. It has recently introduced protectionist tariffs on steel pipes, tyres, poultry, electric blankets, etc. As unemployment has become a do-or-die issue for the Obama Administration, it must be seen as doing something about it. The protection measures against China so far cover billions of dollars, still small relative to the total imports from China, and wouldn’t create enough jobs to make a dent in the US unemployment rate. But, the publicity is good for the government. The Obama Administration will likely step up such protectionist measures for good publicity.
The US’s trade policy will likely evolve from the current purpose for political publicity to a serious tool for economic expansion. With monetary and fiscal policies constrained, this is the only way forward for decreasing the US unemployment. The Obama Administration’s goal of doubling the US’s exports wouldn’t happen naturally. The US’s exports in the past five years rose by one third. The global economy won’t be as strong as in the past five as the US’s credit bubble has burst. Even if we assume that the US’s exports could rise by one third over the next five years, the shortfall from its goal would be over $600 billion. China would be the obvious target for making up the difference. It would require China to appreciate its currency dramatically and make a major switch from a production to consumption-oriented economy.
In the 1980s the US experienced economic difficulties similar to what it is experiencing now. It pushed Japan to double its currency value. In order to cope with the negative effect of doubling yen value, Japan’s central bank kept monetary policy loose, which led to the biggest property bubble in human history. Japan’s bubble economy did give some help to the US economy while it was restructuring. When Japan’s bubble burst, the US economy was restructured and ready for another growth cycle. That cycle ended in 2008 with the bursting of the US’s property bubble.
It is extremely likely that the US would push China to play the role that Japan did two decades ago. Its policy focus would be forcing China to double its currency value. As China’s export sector already has poor profitability, the pressure on China’s economy from doubling the currency value would be enormous. China’s monetary policy would do exactly what Japan did then. China is already experiencing a big property bubble. The overvaluation of China’s property stock may already exceed 100% of GDP, higher than the peak excess value during the US’ property bubble but is still much lower than the 300% of GDP overvaluation in Japan’s bubble. So it is possible for China’s bubble to triple.
When Japan lurched into its destructive property bubble, it was already a high income economy. China is still lower middle income and its per capita income is one tenth of Japan’s. If China makes such a large property bubble, when it bursts, China would stagnate just like Japan has in the past two decades but at low income level. China can’t afford to do what Japan did. It would trap China at a low income level permanently.
However, it would be unwise not to respond to the US’s pressure constructively. Without benefiting from China’s growth the US doesn’t have incentives to be the biggest export market for China. Indeed, to pressure China, I expect many more protectionist measures from the US this year. Before the November mid-term election, the US Congress could pass a bill to slap 30% tariff on all Chinese products unless China would appreciate its currency by the same amount.
China’s best policy is to be proactive now and undertake measures that would benefit the US and be good for China’s economy at the same time. First and foremost, as China’s competitive advantage has shifted from cheap labor to cheap capital, it could open its capital markets to US companies. It would decrease the bubble pressure at home and give the US economy a good lift when its financial system is in trouble. It would give Chinese investors more choices and the opportunities to benefit from multinational companies’ successes in China.
I believe that the international board proposed for Shanghai’s Stock Exchange should be set up as soon as possible. Among the first to be listed should be the US companies that have large businesses in China. Proctor and Gamble, Kimberly Clark, Coca-cola, Pepsi, Yum! Brands, Starbucks, General Motors, and Monsanto come to mind. The list could be much longer. China accounts for their biggest growth market and a big chunk of their profits already. It would be good for Chinese investors to invest in their China successes.
Second, China should lower tariffs on some imports that benefit the US economy. For example, China has the largest and fastest growing automobile market. China has been using the attraction of the market to lure international companies to produce in China. Indeed, overtime, they will find it in their interest to location production near to their customers. However, the tariff and tax structure is obviously an important element now that blocks foreign production from benefiting from China’s automobile market. The US labor union wouldn’t be interested in supporting the China trade without seeing large US auto exports to China. If China opens up its auto market, it would likely cause the US labor union to shift its position. It would dramatically decrease Obama Administration’s incentive for pressuring China to double its currency value.
Third, the US’s agriculture sector has a disproportionately influence over its political system. It would be wise for China to open the market for agricultural products. Of course, it may exert more pressure on China’s rural sector. The negative effect could be offset by more fiscal support. In the end, China’s rural problem is due to low labor/land ratio. The way out is urbanization. Through reforming the household registration system and granting land ownership to peasants, China is capable of much faster urbanization.
Clouds are gathering over China’s exchange rate policy. The US pressure this time would be much more serious than before. Unless China handles it well, a trade war is possible, with negative consequences for both. China should not just play defense this time. Taking constructive measures early could prevent the looming confrontation.
