API 120: Macroeconomic Policy Analysis Professor J. Frankel

API 120: Macroeconomic Policy Analysis Professor J. Frankel

Harvard Kennedy School Fall 2015

Problem Set 5
Due: Monday, November 9, 2015

NOTE: LATE PROBLEM SETS WILL NOT BE ACCEPTED

Please indicate under your name whether you did this problem set entirely on your own, or as part of a group.

There will be a grading bonus to those who do it on their own. Please write legibly.

Read the following editorial from the Financial Times. You are then to write a concise organized essay on the topic “What exchange rate policy should China choose?” Length should be about 600-800 words.

There is no single right answer. Include the pros and cons of increasing exchange rate flexibility for the longer run. Include also the pros and cons of appreciation versus depreciation and – especially – how this question relates to the first question at this point in time. Draw on what you have learned in class. It is suggested that you make an outline of your essay before you start to write.

FT View September 7, 2015

Beijing faces up to its monetary trilemma

If forced to choose, China should allow its currency to fall further

Given the past few months, waning Chinese enthusiasm for free market forces is not hard to understand. Beijing is used to holding the whip hand over the economy, permitting liberalisation only on its own terms, not those of the untrammelled market. If the gyrations of the Shanghai Composite index are any guide to unrestricted capitalism, better the tamer version long favoured by China’s leadership.

Equally clear is how dangerous it is to cling to such an illusion. As President Xi Jinping recognised when promising a “decisive role” for market forces, China cannot haul itself out of the middle-income bracket through bureaucratic genius alone. Resources must be free to flow where they are most in demand, even if this entails short-term distress to those sectors hitherto favoured by state interference.

Market liberalisation is markedly more difficult when the markets in question are macroeconomic. In this China has learnt how it is no more immune to the“trilemma” of monetary policythan any other country. Policymakers may desire free movement of capital, control over domestic interest rates and a stable currency, but they cannot have all three. Capital will always seek out the best return, driving either interest or exchange rates to wherever they are needed for balance.

For years, the floods of capital streaming towards China obscured the trilemma, as the People’s Bank of China absorbed the flow through the accumulation of ever more dollar reserves. But since mid 2014 the flows have inverted, causing reservesto fall by almost $300bn. This may have led to the PBoC’s decision to let the renminbi slide 2 per cent last month. Should funds continue to leave China, pressure on the currency will only build, adding a powerful extra reason for more speculative capital to join the rush.

The first recourse for governments facing a currency crisis is to hope that it goes away. It is possible that it might: China has other ways to stimulate its economy that would enable it to sustain the tight monetary stance needed to keep the currency strong. The PBoC still has more than $3.5trn of reserves, enough to absorb more than two years’ capital flight at the current rate. Some will be tempted to see the volatility of the past month as just a passing summer storm, proof of the markets’ irrationality, and likely to evaporate if confronted with sufficient determination.

But however unpalatable the other horns of the trilemma, historical precedent suggests that waiting out a crisis can be the riskiest course of all. The IMFrecently declaredthat the renminbi was no longer undervalued on a fundamental basis. Other developing countries have allowed their currencies to weaken against the dollar, so China’s has as a result grown relatively stronger against its trading partners. Its domestic economy is enduring a bout of sustained deflation, one that cries out for the medicine of an easier monetary stance. The longer that domestic needs are sacrificed to an external currency level, the less credible the promise to maintain it, and the more reserves are needed to stem the outflow of funds. Eventually, even $3.5trn might prove too little.

Such dynamics are all too familiar to historians of past currency crises, and lead to the same outcome with depressing regularity — depleted reserves, tighter money at home, and the currency still routed. Having squandered so much credibility on a doomed attempt to defy stock market gravity, China’s leadership should be wary about trying the same trick with foreign exchange. Should pressure build further on the renminbi, the right course would be to let it devalue again.

You may refer to the following graphs if you wish:

Sean Miner, “China’s Current Account in 2014 ” Feb. 8th, 2015, PIIE through Sept. 2015

through Q3 of 2015 through Sept. 2015