China: Exchange rates, productivity and inflation

Pettis writes today:

China is faced with a difficult policy choice. It can maintain an undervalued exchange rate, it can run the risk of inflation, or it can increase the domestic costs of financial repression. How Beijing balances these separate forces will determine the pace and form of its necessary rebalancing.

Which is much along the lines of what I wrote a couple of weeks ago. As always, I highly recommend reading all of Pettis' blog, which is very informative. What I found most interesting this time around was his discussion in inflation. In a closed economy, a rise in productivity increases the amount of goods provided, leading to price decreases as the number of good rises and the amount of money stays the same. In this scenario productivity increases and money supply growth can coexist and maintain price levels stable, even if a small amount of money is being printed.



What is happening in China is different. In an export-driven economy, an increase in productivity leads to higher current-account inflows, and an increasing demand for the exporter's currency, causing it to appreciate, which increases the price of the exported goods for other countries and slows down the inflows. If that can't happen, as is the case in an economy with a pegged currency and a central bank that won't change it, the extra currency inflows should cause inflation. This is because the Chinese workers are on the wrong side of the productivity gains here. Because they don't consume the goods they are creating with increasing efficiency, they aren't benefiting from the increased efficiency. Instead, the added currency inflows create an over supply of money for the level of goods in the economy, resulting in price-level increases. Why, then, has inflation in China over the last couple of years been in control, then?

Pettis brings up a great point by Robert Aliber, explaining:

if the nominal exchange rate is not allowed to rise, policymakers can still contain inflation by what economists call financial repression ... In the Chinese context, financial repression exists because the vast bulk of Chinese savings is in the form of bank deposits, and the deposit rate is set at extremely low levels.

This has the effect of transferring large amounts of income away from net savers, which for the most part consists of Chinese households, and in favor of net users of capital ... Net savers are forced into subsidizing net users, in other words ... The consequence is that monetary growth is channeled not into household demand but rather into the production of more goods, and the inflationary impact of monetary expansion is muted.

Ain't that something? This is one of the reasons increasing domestic consumption and letting the Renminbi appreciate is important. Increasing domestic consumption would allow the Chinese to take part in the lower prices resulting from their productivity increases, through reduced inflation, increase in the purchasing-power of the Renminbi and positive (or at least less-negative) real interest rates. This is not an argument about blaming the Chinese for lost jobs manufacturing plastic trinkets (which weren't even made here anymore) or instigating the trade deficit, it's about mal-investment.