China: A tale of three swan songs

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This post is a guest contribution by Dian Chu, market analyst, trader and author of the Economic Forecasts and Opinions blog.

The United States, the European Union and others have long been critical of China’s renminbi / yuan regime. Many U.S. lawmakers complain China’s currency is undervalued by as much as 40% and undercutting the competitiveness of U.S. products.

Internationally, China is under growing pressure − especially from the United States − to appreciate the value of the yuan. Chinese leaders contend that the yuan’s role in trade balance is limited, and have asked nations to loosen the restriction on the import of products instead.

Two diverging Swan diagrams

This yuan-induced heated debate prompted two prominent economists to reference the age-old Swan diagram. However, each came up with a different position for China. The Swan diagram is generally used to represent the situation of a country with a currency peg. The concept was developed by Trevor Swan in 1955.

The two diverging swan images are also reflective of the clashing views regarding currency between China and the U.S. In this case, beauty is really in the eye of the beholder. While both economists agree that China’s currency is undervalued, they differ on the approach of the issue.

Krugman (The U.S.) – Bow or tariff!

Paul Krugman’s NY Time blog, dated March 11th, made a case for China being “clearly in the lower zone: a trade surplus at levels that are raising international tension, plus inflation.” (Diagram 1)

Krugman and the U.S. government believe China to be in the lower quadrant, and that all balance will be restored through price and a yuan adjustment by the Chinese. This also implies China’s domestic consumption is close to equilibrium; whereas according to the IMF estimates, China will not qualify for an OECD membership till 2010 when its average per capita national income catches up to $20,000.

Part of Krugman’s recommendation is for the United States to declare China a currency manipulator, and impose a 25% countervailing duty on Chinese exports unless China bows to the demand of appreciating the renminbi / yuan.

In addition, Krugman is under the notion that the surging deficit of the U.S. is, in effect, being “domestically financed”. He then challenges China to unload its U.S. debt holdings as it would be “an expansionary policy for the United States”. (Note: An “expansionary policy” typically leads to currency devaluation and consumer inflation.)

Frankel (China) – Two policy instruments

However, in a January, 2010 presentation Jeffrey Frankel, Harpel Professor, Harvard University − also Krugman’s MIT schoolmate − suggested China was actually in the upper quadrant, stating “China is now in the overheating and surplus quadrant of the Swan Diagram”. (Diagram 2)

Frankel believes between 2002 and 2007 China crossed from the deflationary (left) side of internal balance (ES: excess supply, recession, unemployment) to the inflationary (upper) side (ED: excess demand, overheating), and again in 2009, and has now moved upward in the Swan diagram. (Diagram 2)

Frankel’s “China 2002” point is probably representative of where China sees itself. That is, there could be some currency undervaluation, but the balance of payments surplus would be primarily the result of insufficient domestic demand.

This is also partly supported by China’s trade surplus having increased even while the yuan was appreciating by 20% from 2005 to 2008. This position thus entails longer-term strategic policy measures to expand along the X / horizontal axis to achieve the equilibrium.

Frankel believes it is in China’s own interest to let the yuan appreciate to cool off the overheated economy, trim excess reserves and avoid future crashes. Thus he recommends using two policy instruments: real exchange rate and spending. This, he concludes, would lead to a gradual yuan appreciation together with an expansion of China’s domestic demand, and the development of neglected sectors such as health, education, housing and finance.

Swan diagram says bilateral

Right now, various data points suggest China is either in the left or upper quadrant of the Swan diagram, as Frankel proposes. Nonetheless, the diagram also illustrates a key point that is often overlooked. In general, exchange rate adjustment (Y / vertical axis) is necessary, but not sufficient, to address external imbalances while maintaining internal balance.

A satisfactory resolution of global imbalances will require a combination of exchange rate adjustment (Y axis), expansion of domestic demand / investment (X / horizontal axis) in surplus economies (e.g. China), and increase in saving relative to investment in deficit economies (e.g. the U.S.).

External and internal balance can only be simultaneously achieved at centre point where the two lines intersect.

Krugman rebuffed by mentor

So, based on the Swan diagram and economic statistics, Krugman’s assumption on China seems flawed and has overlooked the important inter-relationship between the real domestic demand and exchange, and is most likely not in the best interest of either country.

While Krugman is all too eager to wage an all-out trade war against China, his views are also being widely rebuffed by experts from different disciplines, including JP Morgan Asia Chairman Steven Roach, and Jagdish Bhagwati − Krugman’s professor at MIT − who admittedly is “no fan of China”.

The coming black swan – yuan devaluation

The debates among the economists echo verbal clashes between the American and Chinese government leaders. Interestingly, by positioning China in the upper quadrant of the Swan diagram, Frankel seems to suggest a coming yuan devaluation, which is part of “the next black swan scenario” warned by Société Générale strategist Albert Edwards last November.

According to Edwards “China will aggressively devalue the yuan following a deep 2010 downturn coupled with escalating trade wars. . . . China will be heading into trade deficit throughout 2010.”

Edward’s black swan call is partly based on serious concerns about the sustainability of a global recovery.

Expect more trade deficit from China

Now, part of Edwards’ prediction is already beginning to emerge. On Sunday, Commerce Minister Chen Deming said China is likely to see a trade deficit in March. Last year, the yuan was steady, but customs data indicate China’s trade surplus contracted 50.4% from a year earlier in the first two months this year to $21.76 billion.

China’s stated policy is to try to share the earnings from its economic boom with its people, especially in rural areas. As discussed earlier, this seems a logical step for China to take as it is moving to increase consumer demand − the horizontal axis − on the Swan diagram.

More trade deficits resulting from increasing imports could be expected as China pushes through its wealth redistribution at home.

Great Recession to the Greatest Depression?

Meanwhile, under election-year pressure, U.S. senators from both sides of the political aisle unveiled legislation this week that would impose tough new penalties on China if it failed to revalue its currency. It is also widely speculated that the U.S. Treasury Department is likely to label China as a currency manipulator in a report due in mid-April.

So, ironically, Krugman, who sings a different swan song from Frankel, also places us right into part of Edwards’ vision − escalating trade wars − via his trade barrier recommendation.

The continuing mixed signals from various economic data points suggest the world is not quite out of the woods of a double-dip recession, which indicates part two of Edwards’ scenario of “a deep 2010 downturn” could materialize.

It would appear that stars are alighing so that Edwards’ entire prediction could come to pass, ending with China aggressively devaluing the yuan. This would no doubt wreak havoc in the commodities, currency as well as stock markets, plunging the Great Recession into the Greatest Depression.

It’s just as the old saying goes, “Be careful what you wish for, you may get it.”

Quote Du Jour:

“Sadly, my remarkable MIT student Paul Krugman has joined the ranks of the … Democrats and the labor unions … which will embrace any argument that advances their anti-trade agenda.” ~  Jagdish Bhagwati

“We should take out the baseball bat on Paul Krugman … We’re lashing out at China rather than tending to our own business, which is raising U.S. savings.”  ~ Steven Roach

Source: Dian Chu, Economic Forecasts and Opinions, March 23, 2010.

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1 comment to China: A tale of three swan songs

  • Doug Anthony

    Prieur du Plessis examined the China PMI report earlier this month – here is the question: based on that data, what would a China trade deficit look like – that is, what would the March PMI have to look like to represent that fast a change in the trade balance? Is it plausible (trade deficit) or is the data of all types just manufactured?

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