How Successful Is China's Currency Manipulation?

The US Treasury has been reluctant to name China as a currency manipulator. It fears that official use of these words would be seen as the start of a trade war. In the plain-English sense, however, China certainly does manipulate its currency, doing so by frequent intervention in foreign exchange markets. Heated rhetoric aside, the real question is, how successful has the manipulation been in maintaining the competitiveness of Chinese exports?

To answer that question, we need to look not just at nominal exchange rates, but at real rates. In nominal terms, the yuan has strengthened about 2.5% since China's June 19 decision to ease its currency policy. That works out to an annualized rate of nominal appreciation of almost 8%. The simplest way to calculate real appreciation is to add on the difference between China's inflation rate (3.5%, according to August data) and US inflation (about 1%, or even less if the dip in the September figures holds up). Doing so gives us an annual rate of real appreciation of more than 10%. Two or three years of that would pretty well eliminate the 20 to 40% undervaluation that critics are talking about. True, three years is longer than the time horizon of your average politician, but it's not exactly a glacial pace of change, either.

But wait, you might say, we can't be sure that China will continue to allow an 8% rate of nominal appreciation. The latest hints from inside the PBoC suggest that 3% nominal appreciation could well be the maximum. Wouldn't that mean it would take a lot longer to correct the existing undervaluation?

No, not necessarily. In order to slow the rate of nominal appreciation, the PBoC would have to step up its currency intervention. Chinese inflation is already accelerating month after month. Slowing nominal appreciation from its recent 8% pace would increase inflationary pressure even more, both by keeping import prices from falling, and via the newly minted yuan that intervention pumps into China's domestic money supply. With inflation accelerating further, the rate of real appreciation might not slow by much, if at all.

The bottom line: Yes, China is a currency manipulator, but not a completely successful one. Condemning as trivial the 2.5% appreciation of the yuan since June sounds good in the halls of Congress, but that number far understates the rate at which the yuan is really losing its competitive edge against the dollar.





Flash footnote (published on Treasury web site shortly after the above post)

"WASHINGTON – Secretary of the Treasury Timothy Geithner recognized China's actions since early September to accelerate the pace of currency appreciation, while noting it is important to sustain this course.

Since June 19, 2010, when China announced it would renew the reform of its exchange rate and allow the exchange rate to move higher in response to market forces, the Chinese currency has appreciated by roughly 3 percent [sic] against the U.S. dollar. Since September 2, 2010, the pace of appreciation has accelerated to a rate of more than 1 percent per month. If sustained over time, this would help correct what the IMF has concluded is a significantly undervalued currency. "



Follow this link to download a free set of classroom-ready slides discussing China's currency policy and the real exchange rate. An earlier version of this post appeared on SeekingAlpha.com

Chocolate Lovers Keep Nervous Watch on Volatile Cocoa Prices

World cocoa prices have been on a long upward trend, with a lot of volatility along the way. Prices have fallen a bit in the last few months, but chocolate lovers are watching nervously. What is going on? Will chocolate soon become a luxury good?

One of the factors driving chocolate prices has been strong income elasticity of demand. In the United States, a 10% increase in income has been estimated to increase per capita chocolate consumption by 9.2%. Income elasticity is a little less or a little more in other countries, but everywhere chocolate is a normal good. Global income growth thus explains much of the long-term price trend.

As for volatility within the trend, supply conditions play the bigger role. Cocoa supply, like that of any farm product, is subject to fast-developing changes in growing conditions. For example, earlier this year market-watchers were worried about a virus called stunted shoot disease that threatened the crop in the Ivory Coast, the world's biggest producer. Later the virus threat proved to be overstated. Good weather, especially in neighboring Ghana, the second biggest producer, boosted supply and prices fell.

Volatility of prices is increase by the fact that chocolate demand is very inelastic. In the US, short-term elasticity of demand has been estimated at about -0.2, and is even lower in some big European consumer countries. When demand is inelastic, even a small shift in the supply curve can produce a big change in the market price.

An interesting episode earlier this year illustrates how volatile cocoa prices can be. In July, Armajaro, a London-based commodity trader and hedge fund, took an exceptionally large physical delivery of cocoa when July futures contracts expired. The price spiked in response to fears of an attempted squeeze on the market, and competitors cried foul. Armajaro vigorously denied any wrongdoing. It insisted that it was not trying to hold the delivered cocoa off the market, but needed it only to meet contractual commitments of its own. If Armajaro really had been holding the cocoa off the market, it would have lost big, since prices have fallen sharply since July.

The bottom line? You may have to get ready to pay more for your chocolate--or you may not. But look at the bright side--if the thought of rising chocolate prices depresses you, just remember that chocolate itself is a reliable cure for depression!

Click here to view or download a free set of classroom-ready slides that use the concepts of supply, demand, and elasticity to tell the story of chocolate prices. The slide show includes questions that can be used for an in-class quiz or discussion of supply and demand theory.

The Continuing Resolution: Fiscal Alchemy in Action?

Once again, on October 1, 2010, the federal government's fiscal year started without completion of the budget process. Instead, Congress passed a continuing resolution allowing most branches of government to keep on spending at the same rate as last year until early December. The budget process has been completed on time, without continuing resolutions, only three times in the past 35 years.

Continuing resolutions, with their short time horizons and failure even to attempt optimization of policy, are an example of what Eric Leeper has called "fiscal alchemy." (Monetary Science, Fiscal Alchemy, presented at the Kansas City Fed's 2010 Jackson Hole conference.) "Monetary policy choices," writes Leeper, "tend to be based on systematic analysis of alternative policy choices and their associated macroeconomic impacts: this is science. Fiscal policy choices, in contrast, spring from unsystematic speculation, grounded more in politics than economics: this is alchemy."

Leeper sees another sign of fiscal alchemy in the long-term debt projections issued by the Congressional Budget Office. These project debt within limits marked by a "baseline scenario" that assumes no changes in law, and an "alternative scenario" that shows an exploding debt that cannot possibly be achieved. The gap between these two projections, neither of which can rationally be expected to occur, is not only large--it is growing larger every year. (He would like to see the CBO issue more realistic, model-based projections that would narrow, although not eliminate, the range of uncertainty.)

Although no one claims monetary policy is perfect, there is a great contrast between fiscal policy by continuing resolution, with no attempt at all to provide a stable framework for expectations, and the carefully worded policy statements issued by the Fed, which explicitly recognize the importance of anchoring expectations about the future course of policy.

In a rare comment on fiscal policy, Fed Chairman Ben Bernanke has recently noted that countries that continually spend beyond their means suffer slower growth in living standards. The only real question, Bernanke says, is whether the needed adjustments to fiscal policy will take place through a careful and deliberative process that weighs priorities and gives time to adjust to new policies, or whether it will be the kind of rapid and painful response to crisis that we have recently witnessed in Greece and elsewhere.

Follow this link to download a free set of classroom-ready slides that discuss continuing resolutions and fiscal alchemy.

Poverty and the Recession: Is The Worst Still Ahead?

Reports released over the last few days provide final dating for the 2007-2009 recession and data on U.S. poverty and income for 2009. How are they related? How did the recession affect poverty? Now that the recession is officially over, can we expect that the worse is behind us in terms of poverty and income?

The Census Bureau report showed the poverty rate rising from 13.2 percent in 2008 to 14.3 percent in 2009, the highest rate since the early 1980s. The figure that grabbed the headlines, however, was not the overall rate but that for working-age Americans, which climbed to 12.9 percent, its highest level since the Census Bureau's continuous data series began 35 years ago. The remarkable increase in working-age poverty is undoubtedly linked to the extreme rate of long-term unemployment, which has risen far above its levels of any previous recession. The economic distress of the working-age population is further indicated by the record numbers of people without heath insurance, also a subject of the Census Bureau report.

Is the worst behind us? Unfortunately, there is little reason to hope that it is. In recessions of the 1960s and 1970s, the peak rate of unemployment tended to coincide with the year in which the recession ended, but starting with the dual recessions of 1980-82, the picture changed. Since then, peak poverty has begun to lag farther and farther behind each recession.

The bottom line: We can expect even worse poverty data in 2010 and probably in 2011 as well.

Follow this link to download a free set of classroom-ready slides with charts and analysis based on the 2009 poverty report.

US Inflation: What is the Trimmed Mean CPI and What Does It Tell Us?

On September 17, 2010, news headlines reported that the US Consumer Price Index for August had increased by 0.3 percent. Is this a good or bad number? Unfortunately, monthly CPI changes don't tell us much. What steps can we take to make inflation data more useful for interpreting and formulating economic policy?

The first step is to convert monthly data to annual rates.  If the July-to-August monthly change (which was 0.254 percent, before rounding) were to continue for a full year, the annual rate of inflation would be about 3.1 percent. Annual rates are almost universally used in discussions of economic theory and policy.

Month-to-month changes are highly volatile. To reveal the underlying inflation trend, the next step is to look at changes in the CPI from the same month a year ago rather than changes from a month ago. Since inflation was lower for most of the previous year than it was in August, the year-to-year figure that month was just 1.1 percent, much lower than the annualized monthly figure of 3.1 percent.

The next step takes into account the fact that some prices, like those for food and energy, lie largely beyond the influence of domestic monetary and fiscal policy. Those prices are set in world markets and are subject to influences ranging from world politics to weather to oil spills. To show inflation trends with volatile food and energy prices removed, the Labor Department publishes a core CPI series. The core CPI increased at just a 0.9 percent annual rate in August.

Finally, we might ask, why adjust only for food and energy prices? Why not exclude any prices that show unusual changes in a given month? The Cleveland Fed publishes just such a series, called the trimmed mean CPI. It excludes the most extreme 16% of price movements each month. Many economists see it as the clearest indicator of underlying inflation trends, an improvement over the core CPI. The trimmed-mean CPI and core CPI numbers were about the same for August, 2010, but the trimmed mean series shows a more pronounced trend toward lower inflation over the previous two years.

The bottom line: Monthly inflation figures can sometimes signal a turning point in inflation, but those turning points are just as often masked by random noise. At present, the core CPI and trimmed mean CPI show that US inflation is still on a downward trend. Expect the Fed to stick to its easy-money policy until the trend shows a clear upward turn.

Follow this link to download a free set of classroom-ready slides discussing the trimmed mean CPI and other CPI variants. You may also want to steer your students to the Cleveland Fed's nifty interactive tool for generating inflation charts using all sorts of different inflation measures.

More on Financial Reform and Basel III: Regulating Bank Liquidity

As an earlier post explained, the Basel III agreement, now under negotiation, will set international capital adequacy regulations for banks. It will also set regulations for bank liquidity, which are the subject of this post.

Banks need liquidity because they cannot always control the timing of their needs for funds. For example, depositors may make unexpected withdrawals, sources of wholesale funding may not be rolled over in a crisis, line-of-credit agreements may create demands for liquid assets to fund loans, and off-balance sheet obligations provide further liquidity needs.

Bank runs are the classic form of liquidity crisis. Although deposit insurance mitigates runs on retail deposits in most advanced countries, insurance does not extend to large depositors or wholesale funding. As runs deplete a bank's liquid reserves, it can be forced to sell less liquid assets at "fire-sale" prices below book value. Doing so erodes its capital and may lead to insolvency.

During a crisis, a liquidity spiral may develop that spreads problems from weaker to stronger banks. Early in the crisis, a few weak banks are forced to dump assets to cover deposit losses, collateral calls, or other liquidity needs. Falling asset prices weaken the balance sheets of other banks, and force them, too, to sell assets are fire-sale prices. Soon even healthy banks are subject to stress. In the fall of 2008, just such a liquidity spiral helped spread the financial crisis throughout the globe from its origins in the U.S. subprime mortgage market.

Regulations to moderate liquidity risk can apply to both the asset and liability sides of bank balance sheets. Asset side regulations can require minimum cash reserves, including reserve deposits at central banks, and can also encourage holding of additional liquid assets like short-term government bonds. Liability-side regulations can limit banks' reliance on volatile wholesale funding while encouraging use of stable funding like capital and insured retail deposits.

The Basel III negotiations, now underway, include discussion of two major liquidity regulation initiatives. One is a proposal for a liquidity coverage ratio sufficient to guarantee that a bank could survive a 30-day stress period, hopefully long enough to permit recapitalization or orderly wind-up. Another proposal calls for a net stable funding ratio based on a ratio of available stable funding to required stable funding. The former is a weighted average of liabilities, with stable sources of funding like retail deposits and capital having high weights, and the latter is a weighted average of assets, with the most liquid assets having low weights.

The Basel III agreements are supposed to be completed by the end of 2010. They are the object of tough negotiations among national governments and fierce lobbying by banking interests. A preliminary meeting in July already resulted in some watering down of the initial proposals, including an agreement to postpone implementation of the net stable funding ratio during several years of observation. The final form of the Basel III agreements is certain to be a significant factor in shaping the timing and severity of the next banking crisis.

Follow this link to download a free set of classroom-ready slides explaining the need to regulate bank liquidity and discussing the Basel III proposals. These slides are best used together with those attached to my earlier post on Basel III and bank capital, which provides additional information on the Basel agreements in general.

Bernanke Confronts "Too Big to Fail"

In recent testimony before the Financial Crisis Inquiry Commission, Fed Chairman Ben Bernanke confronted the "too-big-to-fail" problem head on. "If the crisis has a single lesson," he said, "it is that the too-big-to-fail problem must be resolved."

How did the US banking system get into this position? It used to be known as a system of small banks, and there are still nearly 4,000 community banks with assets under $100 million. However, most of the growth of banking in recent years has come from large, multi-bank holding companies. According to FDIC data, the 105 banks with more than $100 billion in assets hold 78 percent of all bank assets. Even more striking, just four banks, each with $1 trillion or more in assets, control 58% of all bank assets.

A bank is too big to fail if its failure would threaten the function of the whole banking system via losses to uninsured depositors, losses to counterparties on complex transactions, and general fear of dealing with all banks when even the largest are seen as vulnerable. When banks become aware that they are protected from to failure, they become subject to the problem of moral hazard. Knowing they will be bailed out when they get in trouble, they take too many risks. Confident of bailouts, investors, in turn, supply capital to the biggest banks at favorable rates, so the big grow ever bigger.

What can be done? One solution would be to break up the biggest banks into smaller institutions. Such measures were discussed, but rejected, during recent discussions of financial reform. Instead, the 2010 Dodd-Frank Act took a different approach. It attempted to eliminate moral hazard by instituting a new resolution mechanism for complex banking organizations that would allow even the largest institutions to be wound up without bailouts of management, shareholders, or counterparties.

Will it work? It all depends on credibility. "Simple declarations that the government will not assist firms in the future . . . will not be credible on their own," Bernanke said in his recent remarks. Declarations of intent need to be backed up not just by Dodd-Frank type resolution mechanisms, but by other measures as well, such as the stronger capital requirements expected under the forthcoming Basel III agreements.

Ultimately, though, we will not know if the new measures will work until they are tested. We will find out only when the next crisis strikes.

Follow this link to download a free set of classroom-ready slides discussing the too-big-to-fail problem.