The alarming drop in Chinese nominal GDP will force the PBoC to devalue again

I am in the US on a speaking tour at the moment so I have not had a lot of time for blogging, but I thought that I just wanted to share one alarming macroeconomic number with my readers – the sharp drop in Chinese nominal GDP growth.


Yesterday we got the the Q3 numbers and as the graph shows the sharp slowdown in Chinese NGDP, which started in early 2013 continues. A similar trend by the way is visible in Chinese money supply data.

This is of course very clearly shows just how much Chinese monetary conditions have tightened over the past 2 years and this is of course also the main reason for the sell-off global commodity prices and in the Emerging Markets in the same period.

One thing in the number, which is interesting is that Chinese real GDP growth is now outpacing nominal GDP growth. As a consequence the Chinese GDP deflator has turned negative. Said in another way – China has deflation and in fact the pace of deflation is accelerating.

PBoC – it is time to let the Renminbi float

Even though the People’s Bank of China (PBoC) has devalued the Renminbi slightly against the dollar the PBoC still manages the Chinese currency tightly against the US dollar. As a consequence the PBoC continues to import the tightening of monetary condition from the US on the back of the sharp appreciation of the dollar over the past year or so.

However, China does not need monetary tightening. The sharp decline NGDP growth rather shows that China need monetary easing!

So unless Fed Chair Janet Yellen changes her mind and ease US monetary policy the PBoC will have to devalue the Renminbi again and potentially completely decouple from the dollar and letting the Renminbi float freely.

To me it is only a matter of time before we get another Chinese devaluation and that very well could spell the end to the ‘dollar bloc’ as we know and that certainly should be welcome. On the other hand if the PBoC does not realize the need to de-couple the Renminbi from the dollar then it is very likely that Chinese growth will slump further and it will then only be an question of time before Chinese goes into recession.

This topic will be central to my lecture at the Dallas Fed on Thursday. See here.

PS My US trip so far has been very inspiring and I hope in the coming weeks to share some of my impressions.


If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: or

China: It just got worse – more bad news and more policy mistakes

It is becoming increasingly clear that the Chinese authorities are mismanaging the economic and financial situation and the risk that the authorities will to cause something to blow increases day by day.

First we had the ill-advised attempts to prop up the falling Chinese stock market by the Chinese authorities essentially buying stocks and by to some extent banning the selling of stocks.

Now the Chinese authorities are trying something even more stupid – shooting the messenger:

Chinese authorities have arrested nearly 200 people for alleged online rumor-mongering about China’s stock market turmoil and a recent, deadly chemical factory explosion in Tianjin.

Among the arrested is Wang Xiaolu, a journalist for financial publication Caijing Magazine, “who has been placed under ‘criminal compulsory measures’ for suspected violations of colluding with others and fabricating and spreading fake information on securities and futures market,” according to Chinese state media.

This smells of desperation and signals to global investors that the Chinese authorities really are clueless about what is going on in the economy and in the markets.

Obviously the Chinese stock markets are not falling because of “rumours”, but this is the well-known behavior of many governments around the world – when the markets are going up it is because of the great policies of the government, but when they are going down it is because of the evil actions of “speculators”.

Meanwhile the Chinese authorities are continuing to claim that everything is fine and that real GDP is growing above 7%. However, looking at all other indicators of Chinese growth it is clear that the Chinese economy is slowing fast and is growing much less than 7%.

Just take two sets of data published today. First of all, the final Caixin/Markit manufacturing purchasing managers’ index (PMI) dropped to 47.3 in August – the lowest reading since March 2009 and down from 47.8 in July.

Second and equally telling South Korean exports dropped as much as 14.7% y/y in August – much more than the consensus expectation of a 5.9% y/y drop. China of course is a key market for South Korean exports and South Korean export normally is a very good indicator of Chinese manufactoring activity.

Given the kind of drop in the Chinese stock markets we have seen in August and what the commodity markets are telling us and given the macroeconomic data coming out it is pretty hard to avoid the conclusion that China was hit by a “sudden stop” in August as we saw a serious escalation of the currency and capital outflows.

This is of course also what we have been seeing in the currency markets, where the Chinese authorities have been forced to allow the renminbi to weaken. The forward markets are telling us that more devaluations should be expected.

To make things worse we today got yet another policy failure when the People’s Bank of China (PBoC) in yet another attempt to make the problems go away announced that it will try to limit capital outflows by imposing a reserve requirement on financial institutions trading in foreign-exchange forwards for clients. This is essentially a form of currency controls.

This is of course just another attempt of trying to shoot the messenger. The markets are telling us that more devaluations are coming. How do you manage that problem? Shot down the market. Again this smells of panic and the likely consequence is to further escalate the outflows rather than the opposite.

But it not only smells of panic – it also is doing a lot of harm to the Chinese economy. Maybe paradoxically the small stepwise devaluations of the renminbi have signaled to the markets that more devaluations are coming and as a result this has escalated currency and capital outflows.

As a result the PBoC has had to do even more intervention in the currency markets to prop up the renminbi. This of course is essentially monetary tightening and the consequence will be a further slowdown of the Chinese economy and likely also more financial distress.

Let the RMB float!

This is also an important lessons to other “peggers”. There is no such thing as a small devaluation. Either you maintain your peg or you let you currency float.

So to me there is really only one way out of this problem for the Chinese authorities – stop the shenanigans and let the renminbi float freely!

This likely would lead to a major drop in the Chinese currency in the near-term, but the alternative is that the outflows continues and if the PBoC continues to intervene and continues to introduce draconian anti-market measures (such as jailing journalists and banding FX and equity selling) and then the crisis will just deepen.

The developments in the past few weeks have reminded us all that China really still very much is an Emerging Markets and that the Chinese authorities are much less in control of events than many people believed.

The Chinese authorities had it easy as long as the structural tailwinds kept the capital flows coming in and the US kept monetary policy easy. However, now we are seeing a sharp structural slowdown in the Chinese economy, currency outflows and an effective tightening of US monetary conditions. As a consequence it is becoming more and more evident that the Chinese authorities are not the supermen that they sometimes have been made up to be.

As I argued in my previous blog post this is essentially the ‘dollar bloc’, which is falling apart. If the Chinese authorities continues to try to fight the inevitable – a fairly large renminbi depreciation – then a lot more harm will be done to the Chinese economy and the risk of full-scale financial crisis increases dramatically.

We have it all here – monetary strangulation through a badly constructed monetary regime, political mismanagement and when the story of this crisis will be written I don’t doubt there will be lots of talk of moral hazard and cronyism as well. In fact when I watch the actions of the Chinese authorities I am reminded of the way the Suharto regime in Indonesia (mis)handled the crisis in 1997-98.

It was the same finger-pointing at “evil speculators” and the introduction of draconian and ill-advised methods to prop up the currency. In the end it all failed – the central bank was forced to allow a major devaluation, but only after an ill-fated attempt to prop up the currency more or less had blown up the financial system and caused a major contraction in the economy. And it was of course also an end of the Suharto regime (probably the most positive effect of the crisis).

The Chinese Communist party today should remember how and why Suharto’s regime fell apart. China can still avoid a Indonesian style crisis, but then the Chinese authorities should stop copying Suharto’s policies.

The ‘dollar bloc’ was never an optimal currency area and now it is falling apart

Global stock markets are in a 2008ish kind of crash today and I really don’t have much time to write this, but I just want to share my take on it.

To me this is fundamentally about the in-optimal currency union between the US and China. From 1995 until 2005 the Chinese renminbi was more or less completely pegged to the US dollar and then from 2005 until recently the People’s Bank of China implemented a gradual managed appreciation of the RMB against the dollar.

This was going well as long as supply side factors – the opening of the Chinese economy and the catching up process – helped Chinese growth.

Hence, China went through one long continues positive supply shock that lasted from the mid-1990s and until 2006 when Chinese trend growth started to slow. With a pegged exchange rate a positive supply causes a real appreciation of the currency. However, as RMB has been (quasi)pegged to the dollar this appreciation had to happen through domestic monetary easing and higher inflation and higher nominal GDP growth. This process was accelerated when China joined WTO in 2001.

As a consequence of the dollar peg and the long, gradual positive supply shock Chinese nominal GDP growth accelerated dramatically from 2000 until 2008.

However, underlying something was happening – Chinese trend growth was slowing due to negative supply side headwinds primarily less catch-up potential and the beginning impact of negative labour force growth and the financial markets have long ago realized that Chinese potential growth is going to slow rather dramatically in the coming decades.

As a consequence the potential for real appreciation of the renminbi is much smaller. In fact there might be good arguments for real depreciation as Chinese growth is fast falling below trend growth, while trend itself is slowing.

With an quasi-pegged exchange rate like the renminbi real depreciation will have to happen through lower inflation – hence through monetary tightening. And this I believe is part of what we have been seeing in the last 2-3 years.

The US and China is not an optimal currency area and therefore the renminbi should of course not be pegged to the dollar. That was a problem when monetary conditions became excessively easy in China ahead of 2008 (and that is a big part of the commodity boom in that period), but it is an even bigger problem now when China is facing structural headwinds.

Yellen was the trigger

Hence, the underlying cause of the sell-off we have seen recently in the Chinese and global stock markets really is a result of the fact that the US and China is not an optimal currency area and as Chinese trend growth is slowing monetary conditions is automatically tightened in China due to the quasi-peg against the dollar.

This of course is being made a lot worse by the fact that the Fed for some time has become increasingly hawkish, which as caused an strong appreciation of the dollar – and due to the quasi-peg also of the renminbi. And worse still – in July Fed chair Janet Yellen signaled that the Fed would likely hike the Fed funds rate in September. This to me was the trigger of the latest round of turmoil, but the origin of the problem is a structural slowdown in China and the fact China is not an optimal currency area.

China should de-peg and Yellen should postpone rate hikes

Obviously the Chinese authorities would love the Fed to postpone rate hikes or even ease monetary policy. This would clearly ease the pressures on the Chinese economy and markets, but it is also clear that the Fed of course should not conduct monetary policy for China.

So in the same way that it is a problem the Germany and Greece are in a monetary union together it is a problem that China and the US are in a quasi-currency union. Therefore, the Chinese should of course give up the dollar peg and let the renminbi float freely and my guess is that will be the outcome in the end. The only question is whether the Chinese authorities will blow up something on the way or not.

Finally, it is now also very clear that this is a global negative demand shock and this is having negative ramifications for US demand growth – this is clearly visible in today’s stock market crash, massively lower inflation expectations and the collapse of commodity prices. The Fed should ease rather than tighten monetary policy and the same goes for the ECB by the way. If the ECB and Fed fail to realize this then the risk of a 2008 style event increases dramatically.

We should remember today as the day where the ‘dollar bloc’ fell apart.

PS I have earlier argued that China might NEVER become biggest economy in the world. Recent events are a pretty good indication that that view is correct and I was equally right that you shouldn’t bet on a real appreciation of the renminbi.


If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: or

Malaysia has a freely floating Renggit – and thank god for that!

The Chinese surprise devaluation yesterday and has put currencies across Asia further under pressure. This is only a natural and the most stupid thing local Asian central bankers could do would be to fight it. Rather as China moves closer to a freely floating exchange rate it should inspire other Asian countries to do the same thing and I am therefore happy to see that the Vietnamese central bank this morning has widened the fluctuation band for the Dong and in that sense moved a bit closer to a freely floating Dong. Even though the hand has been forced somewhat by the PBoC’s devaluation yesterday it is nonetheless positive that we are seeing a move towards more freely floating exchange rates in Asia.

In that since it is not a “currency war”, but rather a liberation war, which in the end hopefully will secure monetary sovereignty to Asian nations such as Vietnam.

The floating Renggit is a blessing – also when it drops

This morning we are also seeing big moves in the Malaysian Renggit and the Renggit has already been under some pressure recently on the back of a worsening of Malaysia’s terms-of-trade and increased political uncertainty.

The sell-off in the Renggit has sparked some local concerns and the demands for the central bank to “do something” to prop up the Renggit are surely on the rise. However, it is extremely important to remember that the problem for Malaysia is not that the Renggit is weakening. Rarther the Renggit-weakness is a symptom of the shocks that have hit the Malaysian economy – lower commodity prices (Malaysia is a commodity exporter), increased political uncertainty and Chinese growth concerns.

None of this is good news for the Malaysian economy, but the fact that this is reflected in the Renggit is not a problem. Rather it would be a massive problem if Malaysia today had had a fixed exchange rate regime has was the case during the Asian crisis in 1997.

So the Malaysian central bank (BNM) should be saluted for sticking to the floating exchange rate policy, which has served Malaysia very well for nearly exactly a decade.

In fact BNM should move even closer to a purely free float and waste no opportunity to stress again and again that the value of the Renggit is determined by market forces and that the BNM’s sole purpose of monetary policy is to ensure nominal stability. The BNM should of course observe exchange rate developments in the sense it gives useful information about the monetary stance, but never again should the BNM try to peg or quasi-peg the Renggit to a foreign currency. That would be the recipe for disaster. As would such stupid ideas as currency and capital controls.

My friend Hishamh over at the Economics Malaysia blog has an extremely good post on his take on the Renggit situation. You should really read all of it. The post not only tells you why the freely floating Renggit is the right thing for Malaysia, but it is also extremely good in terms of making you understand why every (ok most…) countries in Asia should move in the direction of the kind of currency regime that they have in Malaysia.

Here is a bit of Hishamh’s excellent comments:

Another week, another multi-year low for the Ringgit. Since BNM appears to have stopped intervening, the Ringgit has continued to weaken against the USD, to what appears to be everyone’s consternation. There is this feeling that BNM should do something, anything, to halt the slide – cue: rumours over another Ringgit peg and capital controls.

To me, this is all a bit silly. Why should BNM lift a finger? Both economic theory and the empirical evidence is very clear – in the wake of a terms of trade shock, the real exchange rate should depreciate, even if it overshoots. NOT doing so would create a situation where the currency would be fundamentally overvalued, and we would therefore be risking another 1997-98 style crisis. Note the direction of causality here – it isn’t the weakening of the exchange rate that gave rise to the crisis, but rather the avoidance of the adjustment.

Pegging the currency under these circumstances would be spectacularly stupid. I’ll have more to say about this in my next post.


In the present circumstances, it’s not even clear why BNM should in fact intervene. You can make the argument that the Ringgit is fundamentally undervalued, and the FX market has overshot; but I have no idea why this is considered “bad”. If you want to live in a world of free capital flows, FX volatility is the price you pay.

… Malaysia’s latest numbers puts reserve cover at 7.6 months retained imports, and 1.1 times short term external debt, versus the international benchmark of 3 months and 1 times. Malaysia is at about par for the rest of the region, apart from outliers like Singapore and Japan.

Australia and France on the other hand, have just two months import cover, while the US, Canada and Germany keep just one month. You might argue that since these are advanced economies, there’s little concern over their international reserves. I would argue that that viewpoint is totally bogus. Debt defaults and currency crises were just as common in advanced economies under the Bretton Woods system. The lesson here is more about commitment to floating rather than the level of reserves. One can’t help but see the double standards involved here.

…All in all, this alarmism betrays a lack of general economic knowledge in Malaysia, even among people who should know better. Or maybe I’m being too harsh – it’s really a lack of knowledge of international macro and monetary economics.

…The Bank of Canada, the Reserve Bank of Australia, and the Reserve Bank of New Zealand, have all aggressively cut interest rates and talked down their own currencies – it’s the right thing to do in the face of a commodity price crash. BNM on the other hand has to walk and talk softly, softly, because Malaysians seem to think the Ringgit ought to defy economic laws.

Bravo! Please follow Hishamh! His blog posts are always good and insightful.


If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: or

Another look at the Chinese M1 gap – still a bit more room for easing

This morning the People’s Bank of China (PBoC) cut its key policy rate by 25bp to 5.1% – undoubtedly reacting to worries about slowing growth. The question is whether such a cut is warranted or not?

I have long argued that over the long run 15% M1 growth has been consistent with nominal stability in China. Hence, from around 2000 to 2008 Chinese M1 stayed on a pretty narrow path around 15% yearly growth. In the PBoC reacted to the global shock and the expected negative shock to Chinese money-velocity by expanding money supply growth significantly pushing M1 way above the 15% trend – probably overdoing it quite a bit (and luckily so for the global economy)

However, since mid-2010 actual M1 has started to re-approach the old 15% trend and in 2014 actual M1 dropped below the 15% trend – indicating a tightening of monetary conditions. The graph below illustrates that.

China M1 gap May 2015


Obviously one could easily argue that 15% M1 growth might be too excessive today as Chinese real GDP trend growth has slowed in recent years and will slow further in the coming years.

I would certainly agree with such argument. Therefore, I have tried to look at an alternative M1 trend where I assume the M1 growth should slow in line with a slowdown in potential real GDP growth from 10% (around 2010) to 6% in 2020. This basically means that I assume a gradual slowdown in “trend” M1 growth from 15% in 2010 to 11% in 2020.

The graph above also shows that (the green line). This trend (“Slowing trend growth”) is also still above the actual M1 level, but not by much. So in that sense today’s rate cut can be justified, but on the other hand based on such simple measures of the ‘money gap’ it is hard to argue for major monetary easing.

So what did I miss? Well, money-velocity. The calculations above assumes a stable trend in M1-velocity over time. That is probably wrong to do – particularly because the Chinese authorities are planing further financial sector liberalisation. But I will have to write about that at another time – now it is time to take the kids to the playground…

Tighter monetary conditions – not lower oil prices – are pushing down inflation expectations

Oil prices are tumbling and so are inflation expectations so it is only natural to conclude that the drop in inflation expectations is caused by a positive supply shock – lower oil prices. However, that is not necessarily the case. In fact I believe it is wrong.

Let me explain. If for example 2-year/2-year euro zone inflation expectations drop now because of lower oil prices then it cannot be because of lower oil prices now, but rather because of expectations for lower oil prices in the future.

2y2y BEI euro zone

But the market is not expecting lower oil prices (or lower commodity prices in general) in the future. In fact the oil futures market expects oil prices to rise going forward.

Just take a look at the so-called 1-year forward premium for brent oil. This is the expected increase in oil prices over the next year as priced by the forward market.

brent 1-year foreard

Oil prices have now dropped so much that market participants now actually expect rising oil prices over the going year.

Hence, we cannot justify lower inflation expectations by pointing to expectations for lower oil prices – because the market actual expects higher oil prices – more than 2.5% higher oil prices over the coming year.

So it is not primarily a positive supply shock we are seeing playing out right now. Rather it is primarily a negative demand shock – tighter monetary conditions.

Who is tightening? Well, everybody -The Fed has signalled rate hikes next year, the ECB is continuing to failing to deliver on QE, the BoJ is allowing the strengthening of the yen to continue and the PBoC is allowing nominal demand growth to continue to slow.

As a result the world is once again becoming increasingly deflationary and that might also be the real reason why we are seeing lower commodity prices right now.

Furthermore, if we were indeed primarily seeing a positive supply shock – rather than tighter global monetary conditions – then global stock prices would have been up and not down.

I can understand the confusion. It is hard to differentiate between supply and demand shocks, but we should never reason from a price change and Scott Sumner is therefore totally correct when he is saying that we need a NGDP futures market as such a market would give us a direct and very good indicator of whether monetary/demand conditions are tightening or not.

Unfortunately we do not have such a market and there is therefore the risk that central banks around the world will claim that the drop in inflation expectations is driven by supply factors and that they therefore don’t have to react to it, while in fact global monetary conditions once again are tightening.

We have seen it over and over again in the past six years – monetary policy failure happens when central bankers fail to differentiate properly between supply and demand shocks. Hopefully this time they will realized the mistake before things get too bad.

PS I am not arguing that the drop in actual inflation right now is not caused by lower oil prices. I am claiming that lower inflation expectations are not caused by an expectation of lower oil prices in the future.

PPS This post was greatly inspired by clever young colleague Jens Pedersen.

Don’t bet on a real appreciation of the renminbi

It rarely happens, but Scott Sumner and I do sometimes disagree on something.

Not surprisingly this time it is on a (mostly) non-monetary matter – the long-term outlook for the Chinese economy.

In my recent post I argued that China might NEVER become the largest economy in the world. Scott – a self-proclaimed Sinophile – strongly disagree with my claim. Here is Scott:

I have several problems with this argument.  First, if Lars really feels PPP is wrong, and that we should use nominal figures, then he should not be talking about China having recently grown at 7 to 7.5% per year.  In PPP terms China may have been growing at 7.5% vs. 2% in the US, but in nominal terms the gap is far wider, due to the Balassa-Samuelson effect.  China’s real exchange rate has appreciated strongly over the past decade.  So if Lars is right that nominal exchange rates are the right test, then China’s been catching up to the US at a rate far faster than either Lars or I assume. And in that case China’s nominal growth could slow dramatically and yet still be growing far faster than the US (where trend NGDP growth is now about 3%, in my view.)  Lars avoids this problem by assuming the Balassa-Samuelson effect will suddenly come to a screeching halt, whereas I think the yuan is headed to 4 to the dollar.  He also assumes a 3% RGDP growth rate for the US, whereas I believe it will be closer to 1.2%, growing over time to perhaps 2% in a few decades.

Other than it is a bit paradoxical that Scott aka Mr. NGDP is so eager to dismiss using nominal terms rather than real terms when it comes to comparing the absolute size of an economy the real disagreement comes down to whether there is a Balassa-Samuelson effect or not. According to the the BS effect relatively poorer countries – such as China – will see its exchange rate appreciate in real terms relative to richer countries such as the US.

In my China-post I assumed that there was no BS effect – and that the relative exchange rate between China and the US in the future would be determined by the Purchasing Power Parity (PPP). This assumption of course means that there is no difference whether we use real or nominal growth rates in GDP when comparing the relative size of the Chinese and the US economy (both measured in US dollars).

I acknowledged in my post that my no-BS effect assumption was a bit brave and I would happily agree that there is nothing theoretically wrong with the Balassa-Samuelson effect. However, I would also say that having worked professionally with forecasting Emerging Markets currencies for nearly 15 years I would be extremely skeptical about its importance of it from an empirical perspective. I will return to that below.

Scott often argues that the markets is the best thing we have to predict the future. I strongly agree with that. Despite of that Scott makes a bold prediction on the outlook for the Chinese renminbi.

Hence, Scott not only predicts a real appreciation of the renminbi, but he also argues “I think the yuan is headed to 4 to the dollar” – hence significant nominal appreciation.

That is an extremely bold prediction given USD/CNY today is trading around 6.15. Said in another way Scott is basically predicting a 50% appreciation of the renminbi! This is in direct contrast to what the markets are predicting. If we for example are looking at a 1-year forward for USD/CHY the market is now predicting around 2% depreciation of the renminbi. So we should ask Scott – do you believe markets are efficient or not?

A look at South Korea and Taiwan tells us we should not expect Chinese real appreciation

There is also another way to think about whether or not we will see a real Chinese appreciation or not in the coming decades and that is by looking at the experience of similar countries. China’s transition and its catching-up process is often compared to South Korea and Taiwan. Therefore, I have looked that the historical development in in the South Korean won and Taiwan dollar.

I have chosen 1990 as my “reference year”. The reason is that at that time South Korea’s and Taiwan’s GDP/capita relative to the US were more or less where Chinese GDP/capita is today compared to the US.

Lets first have a look at South Korea.

Real won.jpg

The first thing we see it that PPP seems to have been a pretty good “predictor” of the long-term development in the won over the long-term. I have calculated PPP based on the relative development in the GDP deflators in South Korea and the US.

But lets return to the question of real appreciation. Has there been a real appreciation of the won (against the dollar) since 1990? The answer is NO. In fact there has been a slight depreciation of the won in real terms.

But of course South Korea went through a major crisis in 1997 so it might be special. So lets instead look at Taiwan.

real TWD

Guess what? Since 1990 the Taiwan dollar has actually depreciated significantly in real terms against the US dollar. Maybe exactly because it has appreciated in the years ahead of 1990.

No matter the reason both the Taiwanese and the South Korean experience tell us that real currency appreciation is no given or automatic part of the catching up process for economies like South Korea, Taiwan or China.

A closer look at the renminbi’s recent real appreciation

In his comment Scott makes the following comment China’s recent appreciation of the renminbi:

“China’s real exchange rate has appreciated strongly over the past decade”

The graph below shows that Scott’s claim is correct.

Real CNY

But the graph also shows that the renminbi was more or less flat against the dollar in real terms from the early 1990s until 2005-6. Hence, we had at least 15 years of economic catch-up without any real appreciation of the CNY at all. Hence, again it is fair to argue that real appreciation does not automatically follow from economic catch-up. The period from 1990 to 2006 shows that quite clearly.

Furthermore, we want to ask ourself whether the real appreciation over the past decade really is a result of economic transition and catching up or something else. Hence, it is quite clear that over this period the People’s Bank of China have tried to curb inflationary pressures by undertaking a managed strengthening of the renminbi against the dollar – both in nominal and real terms. That process might now be coming to an end as the Chinese economy has slowed rather dramatically and inflationary pressures clearly have eased as well – particularly since 2011-12.

Finally let us again return to the examples of South Korea and Taiwan. The graph below shows the real exchanges of South Korea, Taiwan and China (against the US dollar). ‘Year zero’ is 1990 for South Korea and Taiwan, while ‘year zero’ is 2014 for China. Hence, the graph is “calibrated” so all three countries are at a similar income level versus the US in ‘year zero’.



I think the graph is quite telling – the appreciation of the renminbi over the past decade has been fairly similar in size to the appreciation in the in won and the Taiwanese dollar in the decade ahead of 1990. However, as also illustrated above that real appreciation didn’t continue. In fact a decade later both KRW and TWD had depreciated more than 10% in real terms against the US dollar.

This of course is not a prediction for what will happen – it is just an illustration that based on the experience of Taiwan and South Korea there is no reason to expect continued real appreciation of the renminbi.

So my message to Scott is – don’t bet on a real appreciation of the renminbi!

PS Scott uses the term yuan and I here have used the term renminbi. Renminbi is the official name for the Chinese currency and yuan is the main unit of currency.

The risk of Chinese monetary policy failure

Back in October 2012 I wrote a blog post on what I called “My favourite Chinese monetary graph. In this post I am returning to this topic as I think the monetary developments in China has become increasing worrying.

My focus was on the development in M1:

Imagine a 4% inflation target – this year’s Chinese inflation target – trend real GDP growth 10-11% and money-velocity growth between -1% and 0% then the money supply (M1) should grow by 15-16% to ensure the inflation target  in the medium term. This is more or less a description of Chinese monetary policy over the past decade.

Over the past decade People’s Bank of China has been targeting M1 (and M2) growth exactly around 15-16% (give and take a bit…). Overall the PBoC has managed to hit its money supply target(s) and that has more or less ensured nominal stability in in China over the past decade.

I find it useful to track the growth of M1 versus two idealized targets path of 15% and 16% going back to 2000. This is my favourite graph for the Chinese economy.

This is how the updated M1 graph looks today:

M1 China Feb 2014

Back in October 2012 the actual level of M1 had just broken below the 16% trend line and since then M1 has kept inching downward compared to both the 16% and 15% trend lines and recently we have broken 15% tend line. This is obviously a very crude measure of monetary conditions in China, but I nonetheless think that the indication is pretty clear – monetary conditions are clearly getting tighter in China and I think it is fair to say that monetary conditions are disinflationary rather than inflationary.

Since my October 2012-post distress has clearly increased in the Chinese money markets and growth worries have certainly increased. Furthermore, given it is hard to ignore the connection between the continued tightening of monetary conditions in China and the turmoil we have seen in Emerging Markets over the past 6-12 months – after all China is a global monetary superpower.

It is time to ease Chinese monetary conditions 

I think that is totally appropriate that the People’s Bank of China (PBoC) initiated monetary tightening in early 2010 and overall the tightening has been warranted – even though it has had negative market implications for particularly some Emerging Markets. However, it is obviously not the task of the PBoC to conduct monetary policy for Brazil or Turkey for that matter. However, I think it is now pretty clear that Chinese monetary conditions has become too tight for China.

However, the PBoC has been extremely reluctant to step up monetary easing. In my view there are overall two reasons for this. First, PBoC obviously is worried that it could “reflate the bubble”. Second, the Chinese policy makers clearly seem to think that Chinese trend real GDP growth has declined and I would certainly agree that Chinese trend growth likely is closer to 7-8% y/y than to 10%.

So there likely has been good reason for a more cautious monetary policy approach in China, but if we indeed assume that Chinese trend growth has declined to for example 7-8% and money velocity on average decline 0-1% per year and the PBoC wants to hit 2-4%  inflation over the medium-term then M1 needs to growth by at least 9-13% (7+0+2 and 8+1+4).

Since October 2012 – when I put out my original post – Chinese M1 has actually averaged 9%, which is in the lower end of the range I think is necessary to avoid monetary policy to becoming excessively tight. Furthermore, it should be noted that the increased financial distress in China over the past year likely is pushing down both money velocity and the Chinese money multiplier, which in itself is disinflationary.

Concluding, I think there is little doubt that Chinese monetary conditions are becoming excessively tight – so far it is probably not catastrophic, but I can’t help thinking that the risk of nasty credit events increase significantly when economies go from a boom to a disinflationary weak growth scenario – said in another way I really fear is a “secondary deflation”.

PS A look at M2 growth would likely paint a slightly less scary picture.

PPS The growth rate of M1 in January 2014 was extremely weak (1.2% y/y). I am not certain what to make of the numbers, but it was what really got me to write this blog post.

The EM sell-off and China as a global monetary superpower

This is what I just told Ambrose Evans-Pritchard at the Telegraph:

“We have all these countries in trouble like Argentina, Ukraine and Thailand that are each local cases, but behind the whole emerging market story is Fed tapering and worries about slowing Chinese growth…China is now a global monetary superpower, co-leader with the US. When China tightens, that hits trade and commodities across the world.”

…and about the emergency monetary policy meeting of the Turkish central bank (coming up late Tuesday):

“Danske Bank said the Turkish authorities may have to raise rates by 200 to 300 basis points to placate the markets, a shock treatment that risks going badly wrong. “They are tightening to defend their currency, and in doing so killing the economy. In the end they will be forced to give up. There is the same risk in India,” said Mr Christensen.”

This is essentially the same message I also spelled out in my post yesterday – “Please don’t fight it – the risk of EM policy mistakes”

Sino-monetary transmission mechanism

I have talked and written about China as a global monetary superpower before and I think it is useful to repeat (part of) this story to help better understand what presently is going on in Emerging Markets.

David Beckworth has argued (see for example here) that the Federal Reserve is a monetary superpower as “it manages the world’s main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy gets exported to much of the emerging world. “

I believe that the People’s Bank of China to a large extent has the same role – maybe even a bigger role for some Emerging Markets particularly in Asia and among commodity exporters. Hence, the PBoC can under certain circumstances “dictate” monetary policy in other countries – if these countries decide to import monetary conditions from China.

Overall I see three channels through which PBoC influence monetary conditions in the rest of the world:

1) The export channel: For many countries in the world China is now the biggest or second biggest export market. So a monetary induced slowdown in the Chinese economy will have significant impact on many countries’ export performance. This is the channel most keynesian trained economists focus on.

2) Commodity price channel: As China is a major commodity consumer Chinese monetary policy has a direct impact on the demand for and the price of commodities. So tighter Chinese monetary policy is causing global commodity prices to drop. This obviously is having a direct impact on commodity exporters. See for example my discussion of Chinese monetary policy and the Brazilian economy here.

3) The financial flow channel: China has the largest currency reserves in the world . This means that China obviously is extremely important for demand for global financial assets. A contraction in Chinese monetary policy will reduce Chinese FX reserve accumulation and as a result impact demand for for example Emerging Markets bonds and equities.

For the keynesian-trained economist the story would end here. However, we cannot properly understand the impact of Chinese monetary policy on the rest of the world if we do not understand the importance of “local” monetary policy. Hence, in my view other countries of the world can decide to import monetary tightening from China, but they can certainly also decide not to import is monetary tightening. The PBoC might be a monetary superpower, but only because other central banks of the world allow it to be.

… China can act as a monetary superpower and determine monetary conditions in the rest of the world, but also that this is only because central banks in the rest of world … allow this to happen. Malaysia or Hong Kong do not have to import Chinese monetary conditions. Hence, the central bank can choose to offset any shock from Chinese monetary policy. This is basically a variation of the Sumner Critique. The central bank of Malaysia obviously is in full control of nominal GDP/aggregate demand in Malaysia. If the monetary contraction in China leads to a weakening of the ringgit monetary conditions in Malaysia will only tighten if the central bank of Malaysia tries to to fight it by tightening monetary conditions.

Update 1: The Turkish central bank did not listen to me and instead hiked interest rates very aggressively – trying to stabilize the lira, but likely also killing growth. Recession can no longer be ruled out in Turkey. See my day-job comment on the Turkish ultra aggressive rate hike here.

Update 2: David Beckworth has an excellent comment on Ambrose and me. Read it! After it was David who came up with the term monetary superpower.

Helmut Reisen on the “China as monetary superpower” hypothesis

I have in a number of blog posts argued that China is a global or at least an Asian monetary superpower, which is exporting monetary tightening across Asia.

In a new very good blog post the former head of research at the OECD’s Development Centre Helmut Reisen discusses this hypothesis:

Usually, the current travails in emerging markets are blamed on expectations of slowing open market purchases by the US Federal Reserve System. Lars Christensen, head of emerging market research at Danske Bank, however, blames China´s monetary tightening as at least as important as the expected US Fed ´tapering´.  I have myself, with former colleagues, pointed to the growing impact that China´s growth has exerted since the last decade on GDP growth in middle- and low-income countries[1], pointing to the growing raw material, trade and production links of increasingly China centric emerging countries. So I shall have a lot of sympathy for Lars Christensen’s earlier proposition that China has also grown into a monetary superpower in a Sino monetary transmission mechanism with the rest of Asia. China´s monetary tightening, however, can hardly explain the current slump in Asian markets, on closer inspection.

So I nearly got Helmut convinced, but not quite. Here is Helmut again:

First, let us consider  the expected monetary stance in the US and in China. Graph 1 clearly shows that the market has formed expectations since May that the Fed would not continue open market purchases at the pace witnessed over the last years, partly fueled by Bernanke´s taper talk that month to US Congress. China´s monetary tightening, by contrast, occurred during late 2010 to early 2012 from when the Bank of China[2]. Since then, minimum reserve requirements were repeatedly reduced. Further, the PBC reduced its benchmark deposit and loan rates in June 2012. In addition, the PBC has also used a mix of monetary policy instruments to appropriately increase market liquidity. Even considering huge time lags, the current turmoil of Asia stock and bond markets cannot be blamed on China´s monetary tightening.

Hence, Helmut’s argument is that this is mostly caused by the Fed rather than by the People’s Bank of China. I do not disagree that the discussion of Fed tapering is having a negative impact on market sentiment in Asia. My view is just that that is not the whole story. China remains very important.

Furthermore, this is a good illustration of the Market Monetarist view of how to “measure” the monetary policy stance. While Helmut stresses that the PBoC has cut reserve requirements and interest rates recently Market Monetarists would instead focus on what markets are telling us about the monetary policy stance.

This discussion of course is similar to what happened in the euro zone and the US in 2008. Did the Fed ease or tighten monetary policy? Well, despite cutting nominal interest rates inflation expectations plummeted as did expectations for NGDP growth. That was indeed monetary tightening. And if we had good indicators for NGDP growth or inflation in China I would expect them to indicate a continued tightening of the Chinese monetary policy stance did the cut in official interest rates and reserve requirements.  The best market indicators for Chinese NGDP growth are probably copper and the Aussie dollar – and the Chinese stock market.

Hence, judging from for example the Chinese stock market monetary conditions have not become easier. Rather the opposite. And if the PBoC really had eased monetary conditions the Renminbi would have weakened significantly – it has not.

Furthermore, I would argue that communication about future changes in the money base is at least – in fact more – important than present changes to for example reserve requirements or interest rates. Hence, the communication from the Chinese authorities over the last couple of months has been decisively hawkish and if one wants to forecast the future path of the money base or the money supply in China one surely would have to conclude that the PBoC now plans a much slower rate of growth in the money supply than market participants had expected only a few months ago.

Furthermore, the PBoC’s rather clumsy handling of money market distress back in May-June left the impression that the Chinese authorities were quite happy about the impact it had on parts of the Chinese banking sector. In fact the turmoil gave reason to question that the PBoC really would act as lender-of-last-resort. That in my view was a very clear signal that the PBoC was quite happy with monetary conditions becoming tighter.

So yes, the PBoC has eased reserve requirements and cut official interest rates, but given the PBoC’s continued hawkish rhetoric market participants are not seeing the PBoC’s monetary policy stance becoming more accommodative – rather the opposite and judging from market pricing monetary contraction continues in China. That is having a clearly negative impact on the financial market sentiment across Asia.

That of course does not mean that Fed tapering is not important for what is going on in Asia at the moment. I think it is very important and it is for example clear that the sell-off in the Asian markets accelerated further this morning after the release yesterday of minutes from the latest FOMC meeting.

My point is just that the Fed is not the only monetary superpower in the world. The PBoC is also tremendously important. And on that I think Helmut and I are in total agreement.


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