Despite the noises continuously made by the US congressmen, the Chinese RMB will not be up there on international investors' worry list of global risks. The main risks lie in the United States, the risks that the former Fed chairman, Alan Greenspan, repeatedly warned the public about: the property market bubble and the unsustainable current account deficit.
The property market bubble in the United States began at about the same time as the "New Economy" and grew with the Internet bubble. Housing prices continue to climb upward in the aftermath of the stock market crash in 2001, thanks to the Fed's aggressive interest rate cuts in an effort to keep American consumers spending and to boost the US economy. The subsequent hikes of the Federal Funds rate since June 2004, to Mr Greenspan's dismay, have failed to push the long-term interest rates up. If anything, the 30-year bond rate has been getting lower in this round of monetary tightening, to the effect that the yield curve turned inverted towards the end of 2005. With the average 30-year mortgage rate staying below 6.5 per cent, the property market simply marches on.
According to the US Census Bureau press release on February 14, housing construction reached a seasonally adjusted annual pace of 2.28 million homes in January, the highest rate in 33 years. Despite the signs of slowdown in sales volume of existing homes, the price could resume its upward movement when mortgage interest rate stays low.
As to the unsustainability of the US current account deficit, we should remember that in June 1977, Treasury Secretary W. Michael Blumenthal made comments on the issue when it was only 1 per cent of GDP, thereby establishing his reputation for "talking down" the dollar. Nowadays, the US current account deficit is more than 6 per cent of GDP and the US net investment position is negative with a magnitude over 20 per cent of GDP. Could international investors turn a blind eye to the obvious imbalance, or should they seriously worry about the ultimate crash of the US dollar and the resulting global meltdown as the investors unload their dollar assets?
A solution to resolving these two issues is needed. And no finger should point at the RMB exchange rate policy. After all, 10 years after the 1985 Plaza Accord and with 100 per cent appreciation of the yen from 200 yen/Dollar to 100 yen/Dollar as well as 72 per cent appreciation of the Deutsche Mark from 2.46 DM/Dollar to 1.43 DM/Dollar, the US current account deficit to GDP barely improved by 1 percentage point. How can anyone think that RMB appreciation would magically shrink the US current account deficit?
In fact, if substantial RMB appreciation forces bankruptcy in low-profit-margin Chinese firms that have been absorbing the layoffs by State-owned enterprises over the years, the resulting social unrest could destabilize China, which will lead to lower demand for US exports and greater US current account deficit. By improving the flexibility of RMB exchange rate system in a gradual manner and thereby maintaining China's social stability, China contributes the most to global economic stability. This is exactly how an important country such as China should behave as a responsible member of the global economic community.
The solution is with the United States and not, as pointed out by Governor Ben Bernanke in March 2005, with global savers. The problem is not the global savings glut, it is the lack of savings in the United States on the part of the government no doubt, but also on the part of the individual households. Believe it or not, the extremely low household savings in the United States can be partly attributed to the rising housing price. Think about it: Who needs to save if his house is gaining value astronomically? By the time of retirement, all he needs to do is to cash in on the house or get an annuity through reverse mortgage to pay for all the bills for the rest of his life (increase in rental cost consistently falls short of the increases in housing price). Saving little is indeed rational if the housing price continues to rise at its current pace indefinitely, if down payment and mortgage cost remains low, and if the dollar does not collapse in the foreign exchange market. Unfortunately, these are big "ifs."
International investors would like to see more responsible behaviour and better targeted policies from the United States. They do not mind that the US property market cools off, as long as it does not melt down. They can cope with the US dollar easing off, but not crashing.
Yes, the Fed is pushing up the short-term interest rate in order to control the speculative favour in the property market. Yes, Greenspan repeatedly issued public warnings of the property market bubble and the unsustainability of current account deficit. Yes, the US Treasury has abandoned the gibberish that a strong dollar is in line with the US national interest. But when conventional medicines do not work, one needs to look for alternatives.
"Something unusual is clearly at play here," as Greenspan said. The long rate had stayed stubbornly low and failed to respond to the hikes of the Federal Funds rate. The reason, alas, is that the long rate stayed low precisely because the Fed has been doing such a terrific job so that the long-term inflation expectation is low. The hawks in the Fed have had the upper hand for too long. It is time to welcome the Fed doves. If Bernanke, the new Fed chairman, has his heart where his mind was when he was an academic, we may have some hope. We will see his true colour in the upcoming FOMC meetings. Remember, unusual circumstances require unusual thinking.
What the Fed should do is to follow "inflation targeting," a framework that Bernanke favoured before he took the helm at the Fed. Furthermore, the medium- to long-term core CPI inflation target could be in the range between 2.25 and 3.25 per cent, namely with an upper bound higher than the average core CPI inflation rate during the past 10 years but nevertheless at a level that will not cause much concern for business planning.
Bernanke could announce his intention by putting on hold the rise of the Federal Funds rate. This will surprise the Wall Street, but no matter. The expectation of long-term inflation will be revised up and the yield curve will be tilted upward. Given the slightly higher long-term inflation, the dollar will gradually weaken, which in turn feeds back to the international investors demand for higher long-term yield in US government bonds.
We need the Fed doves to help remove the lid on the long rates and break the wishful thinking that cheap financing is always around for property purchase, for fiscal budget deficit, and for current account deficit. The property market will cool off. With well-targeted CPI inflation rate eating into the value of the house and with dollar depreciating against all major currencies, the property market bubble will shrink over time. The US households will finally begin to realize that they need to save for their retirement nest egg, or else, be prepared to face the reality that the equity they build into and the capital gains on their house won't be enough to keep them happy for the rest of their retirement life.
The risk of allowing for inflation to resurface is that it may go out of control. But we trust that the Fed has had more experience in putting the inflation rate within the desired range. Will the moderate increase in long-term inflation rate have a negative impact on long-term health of the economy? There is no evidence suggesting this will be the case. A core CPI inflation rate between 2.25 and 3.25 per cent will not put a dent in long-term productivity growth.
The author is a professor of economics and Senior Wei Lun Fellow at Hong Kong University of Science and Technology.
(China Daily 03/28/2006 page4)