Has a slowing Chinese economy eliminated domestic pressure for a renminbi revaluation?

Alan Greenspan told Senators Schumer and Graham that China would soon make its currency regime more flexible, and that they should hold off. They no doubt took "flexible" to mean "let its currency appreciate against the dollar."

Yu Yongding -- an academic who also sits on China's monetary policy committee -- now says that there now is "no need" for China to adjust its exchange rate peg. That is a bit of a change. Yu Yongding, after all, caused a bit of a stir at Davos by saying "now is the time to revalue."

UPDATE: Dr. Yu has indicated that he was misquoted by the Financial Times, and his actual comment was more to the effect that there was no need to adjust interest rates, not the exchange rate.

Yu's comment may reflect a policy decision that the central bank needs to back the peg 100% to deter speculative inflows betting on any move. The central bank governor certainly has tried hard not to even hint at any possible revaluation.

``The time is not ripe yet'' to scrap the fixed exchange rate of about 8.3 yuan to the dollar, Zhou said in an interview in Basel, where he is attending meetings of central bankers at the Bank for International Settlements. ``Premier Wen has already said enough on the subject. I don't have anything to add.''

But it also may reflect concerns that China's economy is slowing. A slowdown in China's domestic economy certainly would be consistent with the significant slowdown in the pace of China's import growth in 2005. Oil import volumes -- which grew at an insane pace in 2004 -- have been quite subdued in 2005. But there is clearly much confusion - since reported oil imports do not track well with other numbers coming out of China.

One set of data is clear. The pace of China's export growth has not slowed, so China's overall trade surplus continues to balloon. Even with rising oil prices, the FT reports that China's surplus looks set to exceed $90 billion, up from $32 billion in 2004. That would generate a current account surplus of $110-120 billion -- or 6% of China's GDP.

Several things are worth noting:

1: China's economy almost certainly expanded more rapidly than the official data indicate in 2003 and 2004. Reported real GDP growth lagged behind growth in almost every relevant variable. Real GDP probably grew are a pace of well above 105, maybe even close to 15%. Slowing growth is different from no growth. Even if investment growth is slowing, it is still -- at least in the most recent data -- growing faster than GDP, so investment is rising as a share of GDP. It just is not rising as fast as in 2003 and 2004.

2. China is not currently finding it difficult to sell domestic central bank bonds to prevent rising reserves from leading to an increase in the money supply. Sterilization has been pretty easy so far this year -- contrary to what Nouriel and I expected. On one hand, rising rates in the US mean that China is earning more on its shorter-term investments in US dollar assets. China, of course, doesn't just invest in short-term Treasuries though, so it is not obvious that rising short-term rates are having a huge impact on the overall return on China's portfolio. On the other hand, restrictions on lending growth have left China's banks with lots of spare cash -- cash that they are investing in the sterilization bills sold by the central bank. The interest rate on those bills remains well below the interest rate China earns on its reserves. On a cash flow basis, China is not losing money selling sterilization bonds to offset rising reserves. While the central banks currency risk keeps on growing, at the margin, it is not losing money selling sterilization bonds.

3. One common denominator links moderating credit growth, easier sterilization (because the banks have more spare cash) and a slowing economy: the administrative controls on bank lending that the central bank imposed in 2004 when China started to worry that rapid credit growth was leading to excessive investment and domestic overheating. The economy did not slow just on its own accord -- Chinese government policy had something to do with the slowdown. And Chinese banks are not buying the central banks sterilization bills at very low rates just because they want to. The government won't let them expand their lending, and they have to do something with all the deposits that are flowing into the banking system. The otherwise excellent Financial Times story did not mention this.

China seems to have made a policy decision to rely on strong export growth -- exports are still growing at 30% y/y -- to support growth even as administrative controls seem to be leading to significant slowdown in investment. Or at least, that has been the result -- perhaps not entirely intended -- of China's policy decisions. China clearly had other options. It could, for example, have taken steps to stimulate domestic consumption even as it tried to reduce the pace of investment growth. In that case, slowing investment would have been matched by reduced savings, keeping China's external surplus from rising.

What is the likely result of all this? I agree with Nicholas Lardy. We are "entering the classic conflict situation."

With a rising dollar leading the renminbi's value to rise against the euro (don't forget that China now exports a lot to Europe), China may worry that say a 10% revaluation against the dollar combined with the dollar's move against the euro will translate into a 20% revaluation against the euro. And Chinese policy makers may want to wait until the Chinese economy stops slowing (if it is slowing) until they move.

But that timeframe conflicts with the US political calendar. The US government pretty clearly expects a move before this fall.

It would be one thing if China had actually run trade and current account deficits at the peak of its boom. If that had been the case, a slowing economy would lead its current account to move from a deficit toward balance. It is quite another to be running large surpluses in the midst of an investment boom. That implies that when China's economy slows, it will move from a large current account surplus -- China ran a larger surplus than Japan in 2004 -- to an even larger current account surplus.

I don't think it is entirely surprising that such a result would generate a bit of external friction. The US -- or at least the bits of the US that produce tradable goods -- would much rather China offset a slowdown in domestic investment with a rise in consumption (and a fall in savings), not rising exports. The US real estate sector has rather different interests, but it is not clear that the (growing) US real estate sector realizes how much China is contributing to their current good fortune.

China is also taking a real risk if it does not move -- and continues to rely on exports rather than consumption to support its growth. Among other things, China is betting that domestic US politics will allow the US market to remain open to Chinese goods even as China's global trade surplus -- not to mention its bilateral trade surplus with the US -- soars. Perhaps as importantly, it also is making a bet that the US consumption growth won't falter. Exports to the US account for a growing share of Chinese GDP. Given the size of the US current account deficit, that strikes me as a long-term risk to China. Looking ahead, the US import market almost certainly cannot continue to grow at its current rate - at least not for much longer.