Development Bank Research Bulletin

What are in the Chinese currency basket?

Officially Chinese Yuan is not pegging USD, but a basket of currencies that include mainly USD, Euro, Japanese Yen, Korean Won, and various other secondary currencies. The precise weight of each currency in the basket is however confidential. As a matter of fact, it is actually not clear whether the basket actually exists, or whether USD actually makes up 100% of the basket.

Many private sector analysts have been doing some reverse-engineering to back out the weights by regressing USD/Yuan rate on movement of other major currencies.

T-A-C Financial Research, for example, reports that USD’s weight in the basket is estimated to be 33%, while weights for other currencies are 11% for Euro, 30% for Japanese Yen, 16% for Korean Won. Morgan Stanley’s estimate of USD’s weight is much higher at 43%.

According to a report by T-A-C (pdf file), the predicted weights fit the actual movement of USD-Yuan rate very well in 2005, with a R-Squared of over 90%. Using this weighting scheme, Based on consensus forecast of USD exchange rates with other major trading partners, T-A-C forecasted in September 2005 that  USD/Yuan rate will on average reaches 7.99 in August 2006. In the most optimistic situation, Yuan may appreciate to 7.91.

Certainly, all of these forecasts of Yuan movement are conditional on China’s actually using a weighting scheme (as opposed to human discretion) to set the exchange rate  and the scheme will remain unchanged.

Yuan needs revaluation, not flexibility (volatility)

Should Chinese currency Yuan’s exchange rate be made flexible? Or should we be happy with just a large revaluation (and then fix it there)?  At least currently these two goals are consistent, as everyone expects Yuan to revaluate once flexibility is allowed. But in the longer term, Yuan can move in both directions, and we need to evaluate the pros and cons of it.

A new research (done by professors Philippe Aghion, Philippe Bacchetta, Romain Rancière and Kenneth Rogoff ) suggests that it may not be advisable to introduce flexibility (volatility) too early into Yuan when China is still a financially underdeveloped country. Their theory and empirical evidence shows that, for countries with relatively low levels of financial development, exchange rate volatility generally reduces growth.

Then I think an unidirectional revaluation of Yuan upward would suit the needs of both Chinese and Americans, since no one is actually demanding flexibility (I guess the Congress will explode if China were to devaluate Yuan, although it is also a “flexibility” intepreted literally)

Now that we establish that what everyone wants is just a revaluation, then one proposal could be: Using government (not market) force to gradually lower the Yuan-Dollar rate to 7 or even 6 (to appease some American politicians), and fix it there after 2008 U.S. election (after which I think the need to use China as a scapegoat will be gone),  until there is need in the Chinese’s side to further adjust the exchange rate.

Exchange Rate Volatility and Productivity Growth: The Role of Financial Development (PDF file)
Abstract: This paper offers empirical evidence that real exchange rate volatility can have a significant impact on long-term rate of productivity growth, but the effect depends critically on a country's level of financial development. For countries with relatively low levels of financial development, exchange rate volatility generally reduces growth, whereas for financially advanced countries, there is no significant effect. Our empirical analysis is based on an 83 country data set spanning the years 1960-2000; our results appear robust to time window, alternative measures of financial development and exchange rate volatility, and outliers. We also offer a simple monetary growth model in which real exchange rate uncertainty exacerbates the negative investment effects of domestic credit market constraints. Our approach delivers results that are in striking contrast to the vast existing empirical exchange rate literature, which largely finds the effects of exchange rate volatility on real activity to be relatively small and insignificant.

Why I think Peter Morici is wrong in Chinese currency revaluation issues?

Dr. Peter Morici (University of Maryland) is a dedicated China-basher on Yuan revaluation issues. His articles on Yuan revaluation issues appear in numerous national and international  newspapers. I agree that China should allow more flexibility in Yuan exchange rates and it is in China’s own interests to let Yuan appreciate. But the reasoning based on which Dr. Morici reach his conclusion is problematic.

Let me comment on them one by one. Let's start from: “It’s high time for John Snow to cite China for manipulating the Yuan” – in Finfacts, Ireland

“US Treasury Secretary John Snow will soon issue his semiannual report on the currency policies of major trading nations....Secretary John Snow should determine that China manipulates the yuan to obtain an unfair competitive advantage. Sadly, he will likely again deny sound economics and finesse the issue.”

“Should determine”? I shall “determine” that from now on the sun will rise from the west? Does the world work in such an egoistic way? And I feel particularly disturbed that he think whoever don’t think the same way as he does is not “sound economics”

“China to obtain an unfair competitive advantage”? Seems that most of China’s exporters are foreigner-owned. Is Dr. Morici saying that some hard-working American entrepreneurs are gaining an unfair advantage against some American vested interest (unions, etc)?

“International trade and investment flows best promote global prosperity and progress in developing countries when those reflect comparative advantages and national differences in market-determined rates of return for capital. Exchange rate adjustments are vital for ensuring that national trade and investment balances reflect these fundamentals and promote the efficient geographic dispersion of production.”

I think it is quite true. So why doesn’t Dr. Morici accept that fact that many manufacturing tasks are not American’s comparative advantage any more?

“For example, the 1997 Asian currency crisis was caused by overvalued currencies, such as the Korean won, engineered to allow manufacturers to buy western capital goods and technology on the cheap. These required borrowing dollars to support currency values and betting those loans could be repaid with future export earnings."

Doesn’t Dr Morici know that currency overvaluation is simply redistribution of profits from Korean net exporters to Korean net importers, and for those who import machines and then export final products, the effects are more likely to be canceled out?

Also, does this mean that Americans consumers are buying goods “on the cheap”. Then why the complaints? It’s redistribution of profits from some low-tech American manufacturers to American consumers. If you feel it is unfair, go legislate a law to tax American consumers and use the proceeds to compensate unemployed American workers. It is simply an American domestic issue.

“(In Korea....) When bad investment choices and corruption kept export enterprises from paying out as needed, dollar denominated loans could not be repaid and calamity followed. Speculators were tarred but it was the stupidity of finance ministers that precipitated the crisis.”

Who is to be blamed for the Great Depression then? Treasury secretary of the United States?

“In the 1980s and 1990s, Japan prosecuted a mercantilist assault on European and North American durable goods industries by purposely undervaluing the yen. When rising wages and other costs finally limited export-led development, Japan’s economy sputtered, and it has suffered a decade of stagnation.”

Don’t disseminate false information. Let me correct you. Japan fell into recessions because she yielded to the pressure of the United States and drastically appreciated Yen.

“Clearly, China’s currency practices create an unfair trade advantage and are one reason manufacturing is not enjoying the same scale of expansion as the rest of the U.S. economy.”

Why should manufacturing enjoy the same scale of expansion as the other sector at all? Manufacturing employment share has been declining for decades. (remind you: China was busy in Cultural Revolution at that time and wasn’t doing business with the U.S.  Who else do you want to blame then?) America prospers because she keeps moving away from low value-added manufacturing to higher valued-added services, research and development. It is an inevitable trend!

“Given China’s development status and trade surpluses, this pattern of official reserve purchases may be fairly characterized as currency manipulation. It may not be reasonably characterized as anything else.”

Remind me of: “Given that this person is Black or Hispanic, he may not be reasonably characterized as anything else other than a murder.”  What an interesting conclusion!

“Sooner or later, China will reach the limits of its ability to sell cheap goods in the United States. With its surplus of underemployed labor, rising wages won’t pose too much of a problem. However, Wal-Mart can only sell so many cheap gadgets, and if China steals too many U.S. jobs, stagnant wages will severely constrain U.S. demand for its products.”

Why do you think Chinese won’t move up the value chain? And based on what do you established that China “steals”?  Are theses jobs owned by the U.S., and not allowed to be occupied by poor people outside the U.S.? So whoever defeat you is stealing from you?

“China’s drain on oil and other global resources, and the inflation that creates, is about to preview that phenomenon”? Doesn’t the United States consume oil and global resources as well? So you don’t allow others to consumer too?

And an undervalued Yuan create inflation in the U.S. ? What kind of economics is this, Dr. Morici?

Skilled workers don’t fear losing jobs

In the new century, so long as you have skills that others don’t have, you will have a job, well-paid job. Skills don’t come to you randomly, people worked hard and sacrificed in leisure in the past in order to obtain skills, and certainly they should be treated differently from lazy people. No pain, no gains! Facing the same challenge, it is interesting why some people do not address it in a civilized way.

“A British consultancy and 150 former MG Rover engineers are aiming to start up production of Rover cars in China. Ricardo, the engineering group, is working on turning the intellectual rights into production and on creating a range of cars including a stretched version of the 75.” – Channel 4, U.K.

“In September 2004, for example, hundreds of Spaniards took to the streets to protest job losses to Chinese competition in the country's shoemaking industry. Demonstrators badly damaged two Chinese-owned warehouses and set fire to a truck owned by a Chinese businessman. Others unfurled banners that read Chinese Out.” – CNN Money

Latin America vs China: a more meaningful topic than India vs China

Many people are tired of the India vs. China debate. After all, India and China are more likely to be complementary than substitute for each other. One is better in hardware while the other is better in software, there is more opportunities for cooperation.

There absolute loser from China’s rise in world production is actually Latin America. Latin America has much higher wage level than China, Thailand, or Malaysia. The region however is much backward in production technology. This is not going to be sustainable. In a “flattened world”, no importers are willing to pay higher price for lower quality products.

Jeffery Sachs used to say: the problem of Argentina is not fiscal policy, but how it is possible that a country like Argentina, with per capita income as high as 10,000 USD, is still engaging in low knowledge-intensive productions.

It is not sustainable. You need to overhaul your education system and upgrade your production technology, in order to catch up with the rising East Asia.

The Inter-American Development Bank has just published a book on this very topic, titled  “The Emergence of China: Opportunities and Challenges for Latin America and the Caribbean”

The book is available for download (PDF file)

As food for thought, the book provides very detailed background information and insights. I am not happy with the answer of the book though, that the solution for Latin America is to serve China as a provider of energy, raw material, and commodities. You are turning Latin America into Africa (Nigeria, specifically)!

Brazil in the short term has reason to celebrate as it hits a jackpot as a result of China's hiking demand for iron ores, but don't forget that India is actually a bigger exporter of iron ores to China than Brazil currently is. If India can be an exporter of both raw material and high-tech services, why do you think Latin America should accept to be downgraded to a misery third-world exporters of commodity producer.

Hope this article can stimulate some discussions on how Latin America can cope with the rise of China and East Asia.

Richard Nixon used to advise then young Donald Rumsfeld : “Latin America does not matter.... no one gives one damn about Latin America!” Hope that’s not an accurate description of the reality.

Minimum wage, China vs India: is cheap labor the real answer for China’s success in manufacturing?

China has been said to be the World’s factory and cheap labor is said to be the reason why China attracts most of the manufacturing activities away from developed countries as well as from other developing countries.

Africa’s wage level is much lower than China, but they are never on the radar screen as threat to China’s position though. Nevertheless, let’s make a more relevant comparison between China and India.

India has a hard time in attracting manufacturing firms to move there. Many Indians attribute the “failure” to “that’s because we don’t have cheap labor; we focus on service industry with higher value-added”

Let’s compared the minimum wage of China and India to get a idea of who really has cheap labor.

Take China’s Guangdong province as an example. This province is where manufacturing activities agglomerate and where most immigrant workers from inland provinces are employed.

The hourly minimum wage in Guangdong province of China (Effectively July 2006- July 2007) :

Shenzhen (Special Economic Zone) and Guangzhou (two core cities, where manufacturing activities are moving out): 
4.66 Yuan/hour ( = 0.58 USD= 26.7 Rs.)

Shenzhen (outside SEZ), Foshan, Dongguan, Zhuhai, Huizhou, where most of the “sweat shops are actually located:
4.02 Yuan/Hour (=0.5 USD = 23.1 Rs.)

For India, I heard that the minimum wage is  between 7.5 -12.5 Rs./Hour.

(Please correct me if I am wrong; and if anyone can provide me with the minimum wage level, the actual enforcement, and the coverage of workforce,    in typical manufacturing-intensive regions in India, it would be most helpful for me to make a more representative  comparison)

So, minimum wage in China's manufacturing sector is between two to three times that of India!

You may argue that laws are never actually enforced in China. Well, indeed, complicated laws usually get circumvented in China. That’s why the most common violations of labor laws in China are, among others, paying normal wage for overtime work, insufficient safety and health work conditions, insufficient compensation for work-related injuries, no compensation for lay-offs...  These laws get circumvented because employers always managed to maneuver the vague language of the laws in favor of themselves. 

Minimum wage requirement however is in general complied by employers particularly in foreign-owned factories, because it is so easy for regulators to monitor and verify, particularly considering that most factories in the area are in the formal sector and not small workshops.

The most power force however is the market: today if you pay lower than the amount required by the minimum wage, I doubt you are able to recruit any skilled workers to work in Guangdong province, and most employers find it not worthwhile to go down the skill ladders. Labor cost after all constitutes only small fraction of the cost in typical factories producing electronic equipments and employers do not want risk having lower quality of disgruntled workers.  For details see my previous post in the Bulletin: “Unlimited labor supply in China? Not anymore! Wages are hiking!”

As a matter of fact, this is exactly why the minimum wage is set to the level where it is now, i.e. almost equal to market-clearing prices. The employers basically control the whole legislative process.

But still, the minimum wage level in Chinese “sweat shops” is much higher than in India where unions have bargaining power in the legislative process of labor laws.

Well, maybe the difference is not that high. First, living expenses in China is higher; second, Chinese workers in “sweat shops” typically have at least 9 years of education.

After all, it is the whole package: infrastructure, administrative efficiency, and education level of workers, flexibility of hiring and firing, etc. that are driving the location decisions of manufacturing firms

Update:

In a report by Deloitte and Touche "India and China: The Reality Beyond the Hype", it is cited that, according to IMF data, typical monthly wage for manufacturing workers in China is almost 4.7 times that in India. But I am not able to verify the number  it from the original source.  (Hat tip: PSD Blog)

How large is the economic benefit of merging Pakistan with India, Mexico with US....

Professor Enrico Spolaore and Romain Wacziarg published an interesting study on the economic effect of merging two countries on economic growth.  They conduct simulations for large number of potential mergers of geographic neighboring countries.  Some results are quite  interesting.

In general, small countries benefit from merging with larger countries, and poorer countries benefit from merging with their richer neighbors.

According to the simulation, were Bangladesh to merge with India, she would grow faster by 1-2 % per year, and in the long run, she may double her income. The merger of Argentina (or Bolivia, or Peru, or Paraguay, or Uruguay) with Brazil, or Mexico (or Canada) with the U.S. would create economic benefits of similar magnitude for these smaller neighbors as they get full access to larger markets.

Pakistan’s economic growth rate will increase by 1.2-1.5 % per year, and long-run income level will be double, if she were to merge with India. India on the other hand will not gain much. Indian growth rate would be raised by 0.1%, and in the long run become 10% richer. (This may explains why Indians in general are less interested in signing free trade arrangement with smaller countries such as Thailand.)

Certainly the merger of these two countries with different culture and religion will create social problems that certainly will outweigh the economic benefit. But on the other hand this also sadly highlights the huge economic costs of two countries hating each other for half a century.

Borders and Growth  (PDF file)
Abstract: This paper presents a framework to understand and measure the effects of political borders on economic growth and per capita income levels. We present a model that provides a theoretical foundation to estimate empirically the effects of political borders on growth. In our model, political integration between two countries results in a positive market size effect and a negative effect through reduced openness vis-à-vis the rest of the world. We estimate the growth effects that would result from the hypothetical removal of national borders between pairs of adjacent countries. We also identify zones of mutually beneficial political integration, and discuss the applicability of our framework to European political integration.

India loses out in free trade agreement with Thailand?

Ravi Krishnan in Indian newspaper Financial Express claims that India loses out in free trade agreement with Thailand.

His evidence is that:

During January-December 2005, Thailand's exports of items under the Early Harvest Scheme (EHS) of the Indo-Thai FTA stood at Rs 664.3 crore — an increase of 71% over calendar year 2004. In contrast, India's exports to Thailand actually declined 33.8% to Rs 195.6 crore.

His point is that: India receives less monetary revenue from trading with Thailand and thus loses out from the deal.

Ravi forgots that trade is exchange of goods for goods, goods for money, or money for goods. In any voluntary exchange/trade, when you give away goods or money, you will receive goods or money of equivalent value as compensation. 

Certainly in this deal Indians send more money to Thailand than Indians receive, but doesn’t it also indicate that Indians receive more goods from Thailand?

No one loses out from trade. As a matter of fact, both sides gain because with the same amount of money, you can get more stuff from Thailand than from inefficient domestic manufacturing sector back in India.

If you are a worker, do you think your boss always loses out when he hands you the paycheck. No, because he gets your labor of equivalent market value as exchange. Then why do you think India loses out from trade simply because Thailand exports more and receive more money from India?

Why Has There Been Less Financial Integration In Asia Than In Europe? Geography matters

Why Has There Been Less Financial Integration In Asia Than In Europe? Professor Barry Eichengreen has a geographic explanation.  His study shows that: distance between countries, whether they share a common language, and whether they share a land border, explain a good deal of the difference in financial integration between the two regions.

He also points out that recent surge of intra-regional trade in Asia is a good sign for further financial integration, because evidence that finance follows trade suggests that Asia is less financially integrated than Europe because it has done less to promote the growth of intra-regional trade.

You may also want to check out our previous commentary in the Bulletin: "A single Asian common currency?"

Why Has There Been Less Financial Integration In Asia Than In Europe? (PDF file)
Abstract: This paper asks why there is less financial integration in Asia than in Europe, taking as a case study the cross-border lending and investment activities of national banking systems. Our results suggest that different levels of economic development in Asia and Europe, along with other differences in regional circumstance that are largely predetermined from the point of view of policy (distance between countries, whether they share a common language, and whether they share a land border), explain a good deal of the difference in financial integration between the two regions. The rest of the gap is explained by policy variables. Evidence that finance follows trade suggests that Asia is less financially integrated than Europe because it has done less to promote the growth of intra-regional trade. Our results also suggest that controls on capital account transactions can have a lingering effect on the volume of cross-border claims and that their shadow is longest where those controls were maintained for the greatest number of years. The underdevelopment of financial markets and institutions in some potential lending countries also appears to be an impediment to financial integration in the region.

John Snow blames it on the rest of the world

Today John Snow, US Secretary of theTreasury, published an article in the Post that tries --again-- to blame the huge US twin deficits on the rest of the world.  The problem he implies, is not that the United States is the only economy in the history of the world to fight a war and reduce taxes at the same time; nor the unbeleivable fiscal profiglacy of this administration (remember the "bridge to nowhere"?).  Blame it on the Asians for their huge savings, low investment and government spending.  Yours truly saw him this morning walking on the street after a meeting part of the bi-annual IMF-WB spring meetings, where thousands of journalists, policymakers, and yes, bloggers, converge.  Being an innefectual secretary of the Treasury, with little understanding of economics, it was no surprise that he looked gloomy and weary.  What a difference with Rubin.