14 December 2012

Understanding the International Macroeconomy (E368 AUT12) December 2012 Bloc Week

Nicolas Cheng, MIFFT2013 ncheng.mifft2013@london.edu

- Take-Home Assignment ESSAY 1: Should Governments Make Reductions of Public Debt and Fiscal Deficits their Immediate Priority?

The financial crisis and subsequent fiscal stimulus have exposed the scale of the public borrowing situation, at 100% GDP by 2011 across in OECD countries, UK and US. Such levels of public debt are not sustainable, and reduction of public debt and fiscal deficit sits high on governments agenda. The question becomes: How urgent is the situation? When should governments take action, and what are the macroeconomic implications of reducing fiscal deficits? In favour of fiscal stimuli, some argue that reducing public borrowing is not as urgent as fending off the crisis. No debt crisis has arisen from quantitative easing and fiscal stimulus efforts. Following the breakdown in the credit system, public borrowing is substituting for private borrowing, as long as governments can finance it thanks to low interest rates. Governments benefit from low interest rates, especially if they are able to issue debt denominated in their own currency instead of relying on foreign borrowing, and if they have access to a large pool of domestic, captive savings. There are many examples of countries living with high levels of public debt in the past. In order to be efficient, fiscal stimuli must be timely, temporary and targeted. Policies should encourage spending over saving, and investment over immediate consumption. The overall objective is to enhance the economys capacity to create employment and growth by making strategic investments and adjustments in non-priority investments.

However, this situation is not sustainable. First, never has public borrowing increased so quickly, doubling in the UK and US within a few years, and with such far-reaching implications in open and sophisticated capital markets. Moreover, the crisis is untimely for all developed economies, as public finance is forecast to go through an unprecedented rise in age-related spending. Given the global spread and scale of the crisis, countries are less likely to offset decline in their domestic demand through net exports. There might not be a boost in domestic demand, if households and businesses see through fiscal expansion, and save more as they anticipate a future rise in taxes. The effectiveness of the fiscal stimulus relies on multipliers. A fiscal stimulus may exceed the output gap, however low multipliers, for reasons mentioned above, may result in inflation instead of increased in output. The output gap may also be caused by real wages being too high. In those conditions, an increase in nominal aggregate demand does not necessarily translate into an increase in output or employment.

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Deteriorating debt ratios might lead to rising interest rates, leading to solvency issues in the mid to long term. The economic recovery should stabilise public borrowing and fiscal deficit, but may be limited in the absence of renewed economic growth. Structural deterioration of tax revenues following shocks to financial and housing sectors might further complicate a sluggish economic recovery. The current economic environment is very different now compared to the 1980s and 1990s, when access to consumer credit and the baby boomer demographics supported sustained growth. Until new growth engines are identified, there will be lower trend growth.

So, in this context, and How can governments get out of debt? The current high level of public borrowing results from the combination of discretionary fiscal measures to rescue banks and other parts of the economy, direct state intervention to regulate banks and avoid collapse of financial markets, and weakness of tax revenues during the recession. The IMF recommends steady increases and structural primary balances, in order to reduce debt to GDP ratio back to 60% by 2030. Several sources have to be combined to achieve prudent fiscal adjustment. Putting an end to fiscal stimulus packages will amount to 10-15% of the total adjustment required. A freeze on real-term spending per capita, excluding healthcare and pensions, could generate as much as 40%. This leaves a larger half of the adjustment to be founded elsewhere, from a change in retirement age, public sector pensions and benefits, middle class benefits, to raising overall participation in the workforce from older and female workers.

(664 words)

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ESSAY 3: Is the Chinese Renminbi Undervalued?

There is a widely accepted view in Western economies that the Chinese Renminbi (RMB) is undervalued, and that it is the root cause of Chinas enormous current account surplus and imbalance with the US, and other Western economies. To address this question, let us focus on the implications for policy makers: if the RMB is undervalued, should China switch to a more flexible exchange-rate regime, will this address current account imbalances between China and the West, and what are the risks involved?

The debate about the RMB foreign exchange rate has intensified in light of Chinas growing trade and current account surplus, and Chinas active intervention in the foreign exchange market, buying up to from $15-20 billion to $45 billion a month to maintain a low RMB. With a low RMB, Chinas maintains its economy competitive relative to the US. As a result, Chinas foreign reserves increased from 15% GDP in 2001 to 40% GDP in 2006, tripling in 5 years.

First of all, the assumption often made is that the current account surplus driven by solely exchange rate, as an artificially low RMB results in higher exports and lower imports due to inflated prices of foreign goods. However, there are several other key drivers of the current account, including a gap between saving and investment, due to a lack of investment opportunities compared to the high local savings rate. The rapid growth in Chinas current account surplus can also be explained by industries relocations to China, which have effectively transferred some trade surplus from other East Asian economies to China. China gains higher employment and exports to Asian countries. As a result, Asian economies also maintain their currencies down, in order to remain competitive and not lose jobs and industries to China. The distortion of key factor markets in Chinas economy could also participate to its trade surplus. Labour costs may be distorted because of the segmentation between rural and urban markets, resulting from the household registration system, which limits mobility of labour, combined with an underdeveloped social welfare system. Capital is another key factor. Capital markets are distorted both internally due to government regulation of interest rates and state credit, and externally due to restriction of capital outflows over inflows. The gap between nominal GDP growth potential and long-term government yields suggests that Chinas capital is too cheap. Other key input factors include energy, oil, gas and electricity, which prices are also regulated and often lag and do not reflect actual prices in order to deter any shock to domestic production and consumption. Finally, environmental resources are another key factor, where costs are incurred due to a lack of environmental laws and limited enforcement. The exchange rate is only one factor amongst others; exchange rate alone may not resolve the current account imbalance. All of the above factors contribute to the international competitiveness of Chinese exports through lower input costs and higher production profits, and could be addressed by liberalizing the factor markets in order to address the current account imbalance. Specific measures could include the abolition of household registration systems, a better social welfare, market-based interest rates and liberalisation of energy markets.

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Furthermore, Chinas large current account surplus is also due to very low domestic consumption. The low RMB has depressed household income and consumption. A flexible exchange rate would transfer higher purchasing power to households, and could spur higher consumption or higher investment in the economy, reducing the current surplus. At a state level, reallocating resources from foreign exchange reserves, currently in excess of $1 trillion, to investments in the domestic economy would further reduce the current account surplus.

Some argue that greater flexibility in the RMB exchange rate may not lead to the expected adjustment in current account, on the grounds that the current account relates to the real exchange rate, not the nominal rate. Indeed, empirical research suggests that the real exchange rate is not always determined by how flexible a countrys nominal exchange rate is. Current accounts tend to revert to their long-run steady state, but there is no empirical evidence that interest rate flexibility impact how and when current accounts adjust. Therefore, even if China switched to a more flexible exchange-rate today, it is difficult to predict the impact on its real exchange rate. The RMB might even go lower, under difficult market conditions and concerns about Chinas unstable financial and banking sector, and present a risk on Chinas macro-economic stability. Alternative measures to boost Chinas domestic economy include monetary policy, which China could utilise further by widening the spread between lending and deposit rates, or raising the required reserve ratio. China could also extend its fiscal policy to include state-owned firms in the government budget, and require higher dividend payments.

In conclusion, most agree on the need for a more flexible exchange rate, as a key measure within a broader set of macroeconomic policy. As we prepare The de factor dollar peg may have served as a positive constraint and anchor for Chinas monetary policy. By switching to a more flexible exchangerate, China may lose that anchor and resort to an inflation targeting approach. However, Chinas Central Bank has a mixed track record for maintaining price stability and controlling inflation, especially in the 1990s. This may result in less stable domestic prices, adding to Chinas ongoing risks and challenges, including environmental degradation, food safety, and unemployment. The exchange rate is one variable within many others in Chinas macroeconomic policy, and cannot be considered as a standalone issue in policy discussions.

(944 words)