China’s impossible trinity

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This weekend’s meeting of the G20 group of countries sounded a relatively optimistic note on the global economy, in sharp contrast to the recent price falls in world asset markets.

So who is right: the markets or the ministers? The swing factor between a continuing stable but uninspiring global recovery and relapse into a global downturn is China.

The big question is: how steep is China’s economic slowdown? Those looking for an answer have pointed to China’s surprise decision to devalue its currency in early August.

Does this suggest that policy-makers are panicking and trying to boost exports?

The fundamental problem that China faces is that its economy is deeply unbalanced – both internally and externally – at a time that it is also slowing.

Economists tend to look at an economy for internal balance (a state of affairs in which neither employment nor inflation is too high or too low) and external balance (a situation in which a country’s current account (its borrowing or lending to the rest of the world) is neither too high nor too low.

China is currently struggling to achieve both kinds of balance.

Chinese policy-makers have a tricky task ahead but not unmanageable one.

It’s a challenge that could be made much easier by some global policy co-ordination and co-operation.

At the heart of China’s problem is the “impossible trinity” of international macroeconomics.

The impossible trinity – or trilemma – is the idea that it is impossible for a country to have three things at the same time: a stable currency, the free movement of capital (i.e. the absence of capital controls) and independent monetary policy.

A country can instead choose just two of the options from this policy suite.

The UK, in common with most developed economies, has free capital movement and an independent monetary policy – but not a controlled exchange rate.

The Bank of England sets interest rates at a level it thinks is right for the UK economy and – as capital can flow into and out of the UK at will – the exchange rate is determined by the market.

If, as in the late 1980s and early 1990s, the UK wanted to retain free movement of capital but have a stable exchange rate then it would cease to have an independent monetary policy.

Instead of being set as appropriate for UK domestic conditions, the interest rate would have to be set to maintain the value of sterling against other currencies – in effect monetary policy would be outsourced.

China’s policy mix has been to have an independent monetary policy and a controlled exchange rate, which has meant restrictions of the free movement of capital.

In reality the situation is a bit more complicated. China’s capital controls are porous, money does flow in and out of the country and the renmimbi has been semi-pegged to the dollar, rather than straight-forwardly stable.

But things are changing. China is currently pushing for the renmimbi to be formally included in the International Monetary Fund’s list of reverse currencies.

Part of that process involves dismantling its capital controls bit that exposes its own central bank, the People’s Bank of China (PBOC), to the trilemma.

The slowing domestic economy suggests an easier monetary stance is required and that an easier monetary stance, coupled with freer movement of capital, suggests that a weaker renmimbi lies ahead.

But as Karthik Sankaran of Eurasia Group has convincingly argued this wouldn’t be ideal either for China or for the global economy.

Domestically, a weaker currency would tighten financial conditions for any Chinese company that has borrowed in dollars at a time when the PBOC was trying to ease them. But the international spill-overs of a weaker Chinese currency matter more.

Before the financial crisis of 2008 China’s economy was far from externally balanced – indeed it was a major driver of global imbalance, with a current account surplus of 10% of GDP. That’s now down to around 2%, but a weaker currency could force it back up.

At a time when disinflationary factors, such as lower commodity prices, are at work and when Western inflation is stuck around 0%, then the last thing the world needs is a Chinese devaluation which would risk turning a still benign period of low inflation into a damaging spell of deflation.

China needs easier monetary policy and the world could do without a much weaker renmimbi.

Thankfully that is an achievable mix. But it requires Chinese capital controls to stay in place for longer than intended – giving China the ability to both have an independent monetary policy and a stable exchange rate.

The IMF was once regarded as fairly dogmatic on the need for countries to sign up to the free movement of capital.

But during the crisis that attitude shifted and the Fund recognised that there are times when capital controls might be appropriate. China right now feels like one of those times. If China can keep its capital controls while moving towards reserve currency status – even for a while – it may be better placed to seek balance.

It’s very easy to attack China’s economic policy missteps of the past few years.

Propping up an overvalued stock market and surprising the market with currency announcements are just the latest examples.

But the bigger criticism is usually over the nature of the post-2009 stimulus package – which kept Chinese growth high by going on a credit and investment binge driven by state owned enterprises, state owned banks and local government.

That’s left the Chinese economy with a serious mal-investment problem (the often mentioned empty ghost cities) and high level of debt.

But, for all the criticism, the counterfactual is rarely stated. What would global growth have looked like without it?

At a time when the world was desperately short of economic demand, China stepped up and provided some.

That stimulus package helped prop up global growth during the crisis but left China’s economy dangerously out of balance.

Helping China make the transition back towards balance needs to be a central aim for global policymakers.

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