Greenspan on China Jude Wanniski April 21, 2005

The big swings on Wall Street yesterday and today are almost certainly related to China and the enormous pressure building on Capitol Hill in both parties to force China to revalue the yuan (renminbi) in order to stem the flood of manufactured goods -- especially textiles into the U.S. The sharp sell-off Wednesday afternoon began when the wires carried a report of increased support for such legislation in the House Ways&Means Committee. The bounce-back today can easily be explained by indications the administration is genuinely opposed to such legislation, but in his testimony this morning to Senate Budget, Fed Chairman Alan Greenspan tacked on another 50 points to the DJIA with his response to a question from Sen. Wayne Allard [R CO] about the dollar and the yuan.

For the first time, Greenspan said it was in China`s interest to revalue its currency. This is an excellent approach, as it will immediately cause Chinese officials to think in those terms, rather than being beaten up by the congressional bill to do it at gunpoint. With gold at $434 and China having a much less mature debt structure, it is in China`s interest to repeg at something closer to 7.5 yuan to the dollar, or to switch to a basket target. Bob Mundell argues vociferously against going off the peg, as China gets great benefits with the peg because it reduces uncertainties in trade contracts between China and the US, its biggest market. But at some point this benefit is overwhelmed by China importing inflation from the Fed. On the other hand, if there were a few positive measures forthcoming from Congress or the administration... to increase the demand for dollar liquidity... the dollar/gold price could fall on its own and China would not have the inflation burden it has now that Greenspan suggested when he said they should revalue. 

If there was a decision to give relief to textile manufacturers, which is always what this comes down to, a currency change in China will not help a bit. You cannot change the terms of trade by changing the unit of account. The only thing that would bring relief is a higher tariff on textiles. This would not be bad, especially in this climate where we are talking about raising taxes to produce revenues. Raising domestic taxes will make it harder for U.S. textile manufacturers to compete. A moderate increase in textile tariffs, even temporarily, would relieve the political pressure that could bring much worse "solutions." Here is the Greenspan position. Notice he does not say China should float the yuan, only that it should not have its current fix. 

GREENSPAN: Well, I think the first issue is that fixing the RMB to the dollar is beginning to significantly work to the detriment of the Chinese economy.   I think that it`s no question that two things are happening. One is, in order to sustain the value of the RMB relative to the dollar, they`ve been purchasing, as you know, very significant amounts of U.S. Treasury issues. 

In so doing, in order to prevent an inflationary money supply increase, they do what the central bank has called sterilize the purchase of foreign reserves, which are a reserve base for the expansion of the money supply. And they do that by selling bank issues, bank liabilities denominated in their currency. And so long as they do that, that tends to prevent purchases of foreign reserves from expanding the money supply.

However, because there are interest rate caps in China, they`re finding some difficulty in selling an adequate amount of domestic-currency-denominated debt to absorb the excess. And so that's creating imbalances, which suggests, sooner rather than later, that they`re going to have to, for stability`s purposes, move their currency.

Secondly, they`re also, by holding their exchange rate down, creating misallocation of resources in China, in the sense they are subsidizing the capital stock associated with very large numbers of workers. Meaning, because their concern is very clearly the stability that they`re worried about if there are large levels of unemployment, they are emphasizing the capital stock, which is of a lower technological state and therefore employs larger numbers of workers on average, because that keeps the employment at a maximum. But it also prevents standards of living from rising, because their intellectual technical capabilities are rising.

And if the exchange rate began to rise, they would start to move capital into more efficient types of uses, which essentially would mean that output per hour would rise, which is what you would expect when you get an increase in the amount of capital stock per worker. And holding their exchange rate where they are is preventing the growth in the terms that will be most valuable for China in the decades ahead. And so, as far as I`m concerned, it is very much in their interest to move.

And, as you can well imagine, we in the United States government have been in conversations with them to indicate that, in our judgment and in our experience, they should be moving sooner rather than later. And there is debate going on within China on this issue. I have no way of projecting when they will move. That they will move, I am reasonably certain.

ALLARD: And so your bottom line is that you think they`re headed for trouble with their current policies and they`ll pay the price in the future?

GREENSPAN: The sooner they move off this fix, the better off for China`s economy.