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Andy Xie: China should hike interest rate rather than revaluate its currency

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From Century Weekly, Xie’s views on interest rates and exchange rate. Insightful as usual.

But acting on the currency first, especially in small steps, would further inflate China’s property bubble and inflation, potentially leading to a major economic crisis in two years. A small increase in the yuan’s value would fail to resolve two pressing problems: inflationary pressure at home, and political pressure from the United States. Moreover, a small appreciation would attract hot money, stoking inflationary pressure.

This was exactly what happened in 2005, making the bet on RMB revaluation a sure win and attracting more hot money inflows. Despite capital control, lots of hot money still manage to get in, as the system is rather porous. A major receptor for these speculative inflows is the Chinese property market.

By all measures (stock value to GDP ratios, inventory value to GDP ratios, new property sales to GDP ratios, price to income ratios, rental yields, and vacancy rates) China’s property market is one of the biggest bubbles ever. It’s probably much bigger than the U.S. property bubble relative to GDP.

Xie doesn’t have much kind words for those who tout currency appreciation as “good for China” in the sense it helps contain inflation.

Why is this policy option so popular among interest groups? Because it would fuel the hot money inflow, which in turn would support and expand the property bubble. Of course, inflating the property bubble will only worsen inflation. And the odds are that a small currency appreciation would only make the property bubble bigger and inflation worse.

In a standard economy, currency appreciation cools inflation by decreasing import prices. China’s imports are mainly raw materials, equipment and components. A small currency appreciation would have virtually no effect toward cooling inflation. So while a small appreciation might be justified politically, it should not be used to fight inflation.

On the other hand, a major appreciation or revaluation could cool inflation by removing further currency appreciation expectations. It would trigger a hot money exit from China, creating a liquidity crunch that would almost certainly burst the property bubble. I doubt anyone would support such a policy move.

For China to achieve a soft landing from the current property bubble – if this is at all possible – interest rates must steadily increase by 2 percentage points in 2010, another 3 points in 2011, and further in 2012. Such a trajectory for interest rates would not burst the bubble, but it would prevent real estate interest rates from further declining in an atmosphere of rising inflation.

And insight on the real cause of Chinese trade surplus: that of suppressed consumption.

I am surprised that China is still running a trade surplus. …The surplus, I think, can be attributed more to distortions in domestic pricing than the currency’s cheapness.

First, high property prices are a major deterrent to middle class consumption…. But first-time buyers, such as newlyweds, have to save more to purchase property. Indeed, since prices are so high, parents have to save to help them…

Second, prices for middle class goods and services are very high. Autos stand out: Prices in China for cars, even those built domestically, are the highest in the world. …

Third, China’s taxes on the middle class are too high. The top marginal income tax rate of 45 percent applies at quite low income levels by international standards. The 17 percent VAT is also among the highest in the world. Because China tends to invest its tax proceeds, high taxes suppress consumption.

So to balance trade and boost consumption, structural changes in the economy is needed rather than tweaking the exchange rate. Yes, this will take a decade to bear serious fruit and won’t help those facing elections in November. Well, too bad. Life sucks.


Written by Cindy Luk

April 13, 2010 at 3:01 am

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