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Himalayan Crossings: Explaining the Rise of China and India

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Archive for January, 2011

The Muddle over China's Currency, Trade Imbalances, and Inflation

Monday, January 31st, 2011

Paul Krugman’s recent Op-Ed in the New York Times further amplified his past arguments about how China’s (too low) currency peg is preventing job creation in other countries. He adds to his previous arguments on the Chinese currency near-pegging, this time arguing that, “the root cause of China’s (monetary and inflation) muddle is its weak-currency policy, which is feeding an artificially large trade surplus.”

Even if the peg is causing some of China’s current inflation surge, it surely is not all of it, and probably not even most of it. The macroeconomic details of this argument could be fairly well tested (and hopefully will be in several years).

Many commentators, some who don’t normally like Krugman, applauded. This latest chapter of analyses and editorializing on the causes and consequences of China’s near-peg of its currency continues the decade-long misdirected emphasis on the current account issues by American experts and policy makers. The most prominent misguided argument in the past has, of course, been that the peg boosts Chinese exports (unfairly). Perhaps so, but only at the margin, and it surely is not the epic evil against which the likes of US Senator Charles Schumer inveigh.  Recently Mark Wu and Minzie Chinn provide useful correctives against the claims that an RMB revaluation is the road to greater American employment.

Simply put, what these researchers have found is that not much would change for the US if  there were a revaluation of the Yuan in the amounts that would be probable in any likely scenario.  Chinese exports that compete with existing US exports and facilitated by the cheap Yuan don’t compete in third markets with US exports anyway.  No new jobs there.  And, regarding Chinese imports to the US, if Chinese exporters can tolerate a higher Yuan (as Chinn suggests based on analysis of exchange rate pass through), China will keep selling Americans the goods that they won’t make for themselves, and the US will keep buying from China even if the RMB rises against the US Dollar.

Americans and Europeans are not interested in making the things that China exports. Most of those exports are not even largely manufactured in China. Recent research confirms what most Political Economists of East Asia already knew; China assembles things and adds only little value to manufactured goods whose production and major value addition happens elsewhere. In any case these things assembled in China are not things that the US is making or would wish to make. The job-loss argument is a red herring.

According to Krugman and his supporters the Yuan peg is supposed to drive current account surpluses which over a longer period of time are said to cause inflation.

A quick look at these two graphs would at least introduce some skepticism about this.

China’s Current Account Balances(%GDP)

U.S Vs China Inflation rates

Huang Yiping chart using CEIC data on CA surpluses.

The last major Chinese inflation cycle from 1992 and 1996 corresponded with one of the smallest current account surpluses (and even a current account deficit) in many years.

So what is causing Chinese inflation?

Finance is the cause; in particular directed (and misdirected) credit. Victor Shih has been explaining this for some time and wrote against the Krugman peg-causes-Chinese-inflation hypothesis last week.

Here is what he wrote:

China’s currency peg certainly is a cause (of inflation in that country), but perhaps not the root cause. The root cause is the soft budget constraint that underlies the entire economic system, especially for state firms. When China did not run current account surpluses, over-lending and inflation also occurred repeatedly. Basically, when banks did not have enough capital to finance new loans for SOEs, the PBOC printed money to give to banks. Now, net inflows and fixed exchange rate give the PBOC an automatic mechanism to print money. The PBOC wouldn’t need to print so much money if large amount of loans didn’t need to be rolled over year after year. This underlying logic still has not changed today.

Why the Chinese Leadership is Happy to Have Outsiders Focus on Trade Imbalances and Inflation Cycles:  The Deeper Reasons for Chinese Currency Control

As readers of HimalayanCrossings already know, our argument is that China’s currency policy political. That policy is driven by the need to protect the Chinese capital account so that the government and party can continue a system of financial repression and limit the dispersion of ownership of core industrial assets. This provides the leadership — via the huge pool of high captive national savings — with the ability to guide industrial policy (witness the cleantech revolution in China), and helps prevent the growth of concentrated business interests that might rival the party.

Thus, these misguided emphases — in the past on Chinese trade manipulation, and now on Chinese self-inflicted inflation — are music to the ears of China’s leadership. If foreign critics are focused on these sideshows, they miss the main event; the ownership- and industrial-policy-driven capital control regime.

The Future of Indian Infrastructure: Rail Freight in India and the Limits of Fancy Consultant's Analysis

Tuesday, January 25th, 2011

McKinsey’s report on Indian Infrastructure has been receiving a lot of attention since it was published. To read the  complete report please click here.

While it focuses on forecasting, it does little to explain a key point; the political economy of current and future rail freight use in India.What is the political economy of limited freight rail use?  Why can’t more freight travel on the existing network?  Will the same obstacles that are now limiting use of the existing track also limit the growth of rail freight use after new track McKinsey is forecasting is built?

These are the pitfalls of smart consultants doing good technical work, but failing to analyze the political environment and political risk that will shape the outcomes they are forecasting.