SMU Political-Economic Exchange

AN SMU ECONOMICS INTELLIGENCE CLUB PRODUCTION - Why Calls for Rapid RMB Appreciation Are Ill-founded - Future of the Eurozone - Capital Outflows from U.S Quantitative Easing The Fortnight In Brief (17th July to 30th July) US: A thorn in the side for President Obama US economic growth slowed to 1.5% in the second quarter as consumption spending remained feeble. However, the housing market grew 9.7%, showing signs that this sector of the economy may finally be strengthening. The slow pace of growth and poor employment figures is not doing any favours for President Obamas re-election campaign with 100 days left to the US presidential elections. Asia Pacific ex-Japan: Please, More Stimulus; Its Exhausting. Chinas economy is expected to resume its usual 8% growth by the end of 2012. Changsha city has announced that it will be dispensing investment projects totaling $130 billion. Several other Chinese cities are pumping in money to prop up the housing and construction industries. In addition, to entice more foreign investors to continue fueling the economy, the Chinese government is generously cutting corporate taxes by up to 50%. In South Korea, economic growth slid to a disturbing 2.4% - lowest since the 2009 financial crisis; the main culprits being her weak Eurozone importers and weakening domestic consumption. With South Koreas consumer confidence index experiencing a downward spiral, fiscal stimulus seems to be increasingly pertinent. EU: Talking tough to save the Euro Higher borrowing costs for Spain and Italy threatened to intensify the Eurozone debt crisis as investors remain unconvinced by efforts taken by the EU to rescue the economy. In response, the European Central Bank president, Mario Draghi, told a London conference on Thursday that the ECB will do anything necessary to save the Euro. While this affirmation reversed the surge in borrowing costs for peripheral states, investors are looking for more drastic actions from Eurozone governments and the ECB. PROUDLY SUPPORTED BY ISSUE 21 30 JULY 2012

IN COLLABORATION WITH

Why Calls for Rapid RMB Appreciation Are Illfounded

By Kenneth Ho, Singapore Management University
With Permission from the Project Firefly Team a global platform for inquisitive and thinking students and recent graduates and author SMU student Kenneth Ho, the winning entry for the Monthly Competition in the Current Affairs section has been reproduced here, for the benefit of all SPEX readers. 1 Introduction Since the early 2000s, there have been repeated calls for a currency realignment between the Renminbi (RMB) and the United States Dollar (USD) to correct the macroeconomic imbalance between the China and the United States. Specifically, since the United States is running a huge current account deficit with China and China has a current account surplus with the United States, the RMB should appreciate against the USD. The economic logic is that the United States would import less from China as imports become more expensive in USD terms. Also, China should begin to import more from the United States since imports from the US will be cheaper in RMB terms. Overall, the United States current account deficit with China should shrink and Chinas current account surplus with the United States should gradually disappear. To further urge the Chinese to comply, the United States have repeated pointed to scholarly studies based on Purchasing Power Parity that suggest the RMB is undervalued by about 37.5% (Lipman, 2011). The Chinese have in fact responded to these calls and since June 2010, the RMB has appreciated by about 5.3% against the USD. However, they continue to monitor the exchange rate via a Managed Floating Exchange Rate regime and the United States has renewed calls for more significant appreciation of the RMB against the USD. Without denying the need for the RMB to appreciate against the USD, I argue that the current approach of gradual appreciation of the RMB is preferable to rapid revaluation. There are two main themes to my argument. Firstly, rapid revaluation of the RMB might not help to correct the U.S. current account deficit with China. To show this, I will draw upon empirical evidence from the United States trade data with China and Japan when there were previous currency realignments between these nations. Secondly, there are some benefits if China continues with its current strategy of allowing the RMB to appreciate gradually. 2 RMB Appreciation Might Not Correct U.S. Current Account Deficit The most widely cited argument for a RMB revaluation is that it can help to correct the U.S. current account deficit with China. Specifically, since the Yuan is undervalued with regards to the U.S. dollar, this manipulation has created excessive demand for imported Chinese goods resulting in a current account deficit for the U.S. A revaluation, it is argued, will raise U.S. exports to China and decrease Chinese imports to the U.S. thereby helping to correct the current account deficit. However, the empirical evidence does not seem to support this claim.

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2.1 U.S. Current Account Deficit Grew When Yen Was Allowed to Appreciate An interesting historical parallel to consider is the case of Japan in the 1980s. Back then, the U.S. was running a trade deficit with Japan and a historic agreement, the Plaza Accord, was signed in 1985. The Plaza Accord stipulated that Japan would allow its currency to appreciate to help correct the U.S. current account deficit with Japan. Consequently, through the coordinated intervention of various Central Banks, the Yen almost doubled over the period from 1985 to 1987. However, the U.S. current account deficit remained inexorably high. In fact, it increased over the period from US$46.3 billion in 1985 to US$59.6 billion in 1987. Today, while the Yen is near a historical high, the U.S. current account deficit with the Japan stands at US$75.7billion. This suggests that a rapid revaluation of the RMB might not have the purported effect of correcting the U.S. current account deficit. 2.2 U.S. Current Account Deficit Grew When RMB Was Allowed to Appreciate Of course, it might not be directly comparable to look at Japans experience with the U.S. in deducing the likely outcome of a RMB revaluation. Chinas experience with the U.S. between 2005 and 2008, might be more instructive. During this period, China allowed its currency to appreciate by 17.6% relative to the U.S. Dollar but there was a minimal impact on the current account deficit. Contrary to the theory, U.S. imports from China rose steadily, from US$243.5 billion in 2005 to US$337.8 billion, a 38.7% increase over the period. Chinese imports from the U.S. also increased over the period, from US$41.8 billion in 2005 to US$71.5 billion in 2008. Although the percentage increase is larger at 71.1%, the current account deficit increased over this period while the RMB was allowed to appreciate. Accordingly, a subsequent round of appreciation might not have the purported effect of correcting the U.S. current account deficit. Additionally, the current account deficit might be due to other more structural factors such as excessive consumption in the United States. 2.3 Possibility of Import Substitution Furthermore, even if RMB appreciation reduces U.S. imports from China, some economists suggest that consumers might just end up purchasing more imports from other nations. In this scenario, while the current account deficit with China might shrink, the U.S. current account deficit with other countries is likely to rise and the overarching problem of global imbalances might remain. 3 Additional Benefits to Gradual Appreciation of RMB There are also benefits to the current strategy of gradual appreciation of the RMB as opposed to rapid revaluation. Countries that import heavily from China can avoid significant imported inflation. Also, the Chinese can retain enough control to engineer a soft landing for their booming economy instead of slamming the brakes on global growth immediately. 3.1 Trading Partners Can Avoid Significant Imported Inflation If China were to rapidly revalue the RMB to its fair value, this would result in significant imported inflation in many advanced economies like the U.S. who import heavily from China. If the RMB was to be revalued by 20%, then all Chinese exports would also become significantly more expensive. Some argue that there will be import substitution away from 3 Copyright 2012 SMU Economics Intelligence Club

Chinese products to domestic products and cheaper imports from other countries. While this is true, Chinas share of world merchandise exports has risen significantly from 1.1% in 1982 to 10% in 2010. Chinese products are simply too important and it is likely that countries will still have to purchase some imports from China. In this scenario, rapid RMB revaluation is likely to result in some imported inflation in for countries that are heavily reliant on Chinas exports. This might create an additional set of problems for developed nations that are currently still struggling with their own growth and unemployment issues. 3.2 Flexibility to Engineer a Soft Landing for the Chinese Economy Currently, the Chinese government seems to be aiming for a precision strike with regards to its management of the tradeoff between growth and inflation. It has adopted a strategy of gradual increases in the interest rate, reserve ratio requirements and gradual RMB appreciation to manage its domestic inflation problem. The objective is to navigate a soft landing for the Chinese Economy such that growth is not compromised. Gradual appreciation might be the superior strategy as opposed to a rapid revaluation since there is a chance that policymakers might miss the mark and risk derailing the growth of the export oriented Chinese economy and by extension, the growth of the global economy. Also, given that there are significant lags between policy implementation and actual observable effects on the economy, a policy of gradual appreciation might be better suited to help China achieve its very specific goal of taming inflation while maintaining growth since it will be able to observe the results of its macroeconomic policies and adjust the approach accordingly. Empirically, Japans example provides further evidence that a gradual appreciation might be favorable to a rapid revaluation. As a result of the 1985 Plaza Accord, the Yen appreciated rapidly from its average of 239 per US$1 in 1985 to a peak of 128 in 1988, virtually doubling its value relative to the dollar. The Japanese government felt this overshot the mark and feared that the strengthened yen would have recessionary effects on the exportdependent Japanese economy. As a result, it began implementing expansionary monetary policy. However, the subsequent monetary expansion was also overdone and it led to the Japanese Asset Bubble that saw the Nikkei close at an all-time high of 38.915.87. Additionally, property prices soared to a dizzy US$93,000 psf. The subsequent bursting of the asset bubble led to Japans lost decade and brought about the pernicious problem of deflation. Japans example illustrates the exceedingly difficult task of coordinating effective macroeconomic policies when they are implemented too quickly. Accordingly, a gradual approach might better suit Chinas needs. 4 Conclusion In summary, I believe that a gradual appreciation of the RMB is favorable to a rapid revaluation because of two factors. Firstly, empirical evidence suggests that rapid revaluation of the RMB is unlikely to correct the U.S. Current Account Deficit. Secondly, there are added benefits of a gradual appreciation as opposed to a rapid revaluation. It will limit the imported inflation faced by trading partners and allow China to engineer a soft landing for its domestic economy while combating inflation.

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Future of the Eurozone

By Leslie Tay, University of York
This article looks at three broad issues that leaders of the eurozone should address to ensure the survivability of the single currency.

Euro: Flawed beginnings Less than 15 years from its birth, the Euro has imposed large economic costs. This comes as no surprise for economists who had foreseen the risks of imposing a common currency on a heterogeneous group of countries. These problems are compounded by the lack of a common fiscal union and political will amongst members to subvert national interests for the interests of Europe. Even though Eurozone trade has increased with the elimination of trading costs associated with having multiple currencies, this has been overshadowed by bigger problems such as unsustainable sovereign debts, fragile banking systems and persistent economic divergence within Europe. Too important to fail Despite these problems, the Euro is too important to fail. Talks of breakup of the Euro are nave and tend to overlook the economic costs involved in the process of returning to multiple currencies. The shear number of Euro members, the widespread use of Euro as a reserve currency and volume of trade within Europe will sustain the lifeline of Euro. To solve the Eurozone crisis, three issues should be addressed- tightening up fiscal discipline, improving banking regulations and promoting joint stability and growth at the European level. The golden key to solving these problems is a common European fiscal or federal union1 but this is unlikely in the next few decades due to a lack of a political will amongst European nations to surrender their fiscal sovereignty. Germanys strong opposition to a common Eurobond is testimony of this sentiment. In the meantime, other measures have to be implemented to ensure the sustainability of the union. Improving Fiscal Discipline The importance of fiscal discipline within the monetary union has long been recognized. The Stability and Growth Pact came into existence as early as 1997. It spelt out financial penalties for any country that has a budget deficit above 3% of its GDP or debt above 60% of its GDP. The No Bailout clause of the ECB meant that countries should be held responsible for its own fiscal policies. Unfortunately, even the custodians of the euro, France and Germany, failed to adhere to the fiscal rules by exceeding the set debt:GDP ratio (figure 1).

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Figure 1: Eurozone Debt as a percentage of GDP Source: European Commission Europe has since recognized its failures and taken measures to tighten fiscal discipline. Mario Draghi, ECB President, has emphasized on numerous counts that Europe should do more with respect to fiscal consolidation and that the ECB will not be a lender of last resort. Earlier this year, European leaders have signed a new fiscal compact treaty agreeing to keep their annual structural government deficit below 0.5% of nominal GDP. A notable change is also the use of reverse qualified majority voting2 in deciding whether to place a country in excessive deficit procedure or to impose sanctions. This is a vital step as the former voting system meant that sanctions were often avoided for fear of straining diplomatic relations. Despite these measures, European leaders should recognize that these treaties often contain threats that are not credible. In the medium and long run, the EMU should work towards designing a credible exit strategy. This concept is akin to banks writing living wills and allows an orderly exit of a weaker nation without compromising the entire Euro bloc. The exit strategy should include detailed timelines and clauses specifying how assets and liabilities will be denominated and how inflation and budget deficit will be kept in check. Separately, the EMU should also design incentives to reward countries that adhere strictly to the fiscal compact. One method of doing so is the blue bond proposal in which good debts are pooled together separately from debts that have flouted the fiscal compact rule. Blue bonds serve as the European counterpart to US T-Bills and would provide a steady flow of capital to EMU members with good behavior. This proposal essentially creates two separating equilibriums3 but runs the risk of cutting off capital to countries when it needs it the most. As such, it is not meant to be a complete solution, but it certainly reduces moral hazard and prevents a race to the bottom pooling equilibrium.

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Better Banking System European banks have grown vulnerable as a result of the vicious cycle between banks and sovereigns. Prior to the crisis, banks tend to hold a significant amount of government bonds that were often regarded as safe assets (figure 2). They suffered a big blow when analysts began to question the ability of sovereigns to repay debts. Loose banking regulations also meant that banks overextended credit without scrutinizing the accompanying risk, resulting in real assets bubbles and risky speculative activities. When markets crashed, the balance sheet of banks became dangerously thin and banks experience difficulties in accessing the credit markets, making them susceptible to runs. These sentiments were fuelled by procyclical banking regulations. Without the ECB acting as a lender of last resort, national governments begin to bail out banks using their national budget, but this creates a vicious cycle as the credibility of their sovereign bonds, which ultimately sit in the books of bank assets, lowers. Correspondingly, banks cut down lending in the hope of meeting required capital ratios, diminishing the growth prospect of the troubled economy, thus completing the vicious cycle.

Figure 2: Banks holdings of Eurozone government securities Source: ECB Europe has taken action by relooking into financial regulations and considering the prospects of a banking union. The question however lies in the completeness of these solutions, as the EU has been known for stopping short of what is needed due to political reasons. In any case, banks regulations like Basel III and Deposit Insurance Scheme will go a long way in stabilizing the banking sector. The EU has also committed itself to adopting legislation for bank recovery and resolution. The EZ Banking Union, if implemented successfully, will allow better risk pooling as well as give the ECB greater power and autonomy in supervising banks in Europe, especially the macroprudential aspects, given that most banks have cross-borders operations. Promoting Stability and Growth The EU should take steps to facilitate economic convergence in the long run. Whilst economic divergence is not detrimental per se, persistent economic divergence is. Current and capital account imbalances should be a norm within Europe given the different states of economy (Figure 3). But these imbalances should be driven by investments and factor movements rather than by speculation in asset prices that results in unsustainable household and 7 Copyright 2012 SMU Economics Intelligence Club

corporate debts. European leaders should work towards sustainable growth and cooperate on measures that would improve their joint productivity and competitiveness. Surplus countries should take steps to boost domestic demand and continued productivity whilst deficit countries should work towards making their economies more competitive by restructuring their macroeconomic policies, labour markets, and goods markets. The Stability and Convergence programme and Europe 2020 strategy are signs of a good start.

Figure 3: Eurozone current account surplus and deficits Source: European Commission To salvage the Euro and EU, it is essential that leaders act on these three issues quickly. Ultimately, European leaders should recognize that in order to make the Eurozone sustainable, a complete union is needed- both in politics and economics. Rather than being forced by circumstances, it may be wise for leaders and citizens to acknowledge that this is the fate of Europe ever since they chose to adopt a common currency.
1

Federal Union: A political union in which members are bounded together by covenant with a governing representative head. Sovereignty is constitutionally divided between a central governing authority and individual states.
2

Reverse qualified majority voting: Under the reverse qualified majority voting (RQMV) procedure, a Commission recommendation is deemed to be adopted unless the Council decides by qualified majority to reject the recommendation within a given deadline that starts to run from the adoption of such a recommendation by the Commission.
3

Separating equilibriums: Separating equilibrium occurs when policies are priced fairly according to the risk types. In the insurance context, high-risk individuals are given full coverage at a higher premium rate whilst low risk individuals are given partial coverage. Similarly, in this context, red bonds are pooled separately from blue bonds with the former having a higher risk of default. Sources: European Commission, European Parliament, ECB

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Capital Outflows from U.S Quantitative Easing

By Tong Kah Haw, Singapore Management University
Lately, there have been calls for the U.S Federal Reserve Bank (Fed) to implement more quantitative easing (QE3) amid the weakening U.S economy. Yet, there are many who remain unconvinced that QE3 will be happening anytime soon. The reason is that despite the apparent sluggish growth, the problem is not serious enough for the Federal Open Market Committee (FOMC) to implement such a loose monetary easing - the outright purchase of US Treasuries. The official unemployment rate of US fell unexpectedly to 8.2% from 9.7% back in 2010. The US continues to add an average of 75,000 jobs a month from the April to June quarter 2012, although its strongest showing was in March with about 220,000 jobs created. The Fed thus decided to opt for a less impactful stimulus measure known as the Operation Twist1 in June to bring long-term interest rate down in an effort to promote increased liquidity and lending. However, the Fed did hint that more aggressive monetary actions would be taken if the US continues to experience prolonged sluggish growth. Hence this has led to the speculation that QE3 is coming soon. However, QE is not without its fair share of criticisms. Besides being blamed for contributing to the weakening of the US dollar and causing inflationary pressure, a question remains - is QE fully effective in stimulating the internal US economy? Critics have argued that the excess reserves generated in the US financial institutions encouraged them to lend out to foreign private sector borrowers in emerging markets. As seen in Figure 1, borrowing has increased in emerging economies, particularly in Asia and the Pacific region, whereas it has slowed in the developed countries. Emerging countries are popular targets of excess capital due to its high investment yields and stronger balance sheets, which allows them to take on more leverage.

Figure 1 Source: Bank of International Settlement This article will thus briefly explore the overall private capital outflows that have arisen from past QE1 and QE2 policies and the impact of excess liquidity on Asian countries. 9 Copyright 2012 SMU Economics Intelligence Club

In a research conducted by the Asian Development Bank Institute (ADB), US overall capital outflows during three different periods (QE1, QE2 and the interim period without QE) were summarized and compared in Figure 2. The interim period without QE (Oct 09 Sep 10) were used as a base period to see if private outflows were significantly higher or lower during the periods with QE.

Figure 2: US Gross Private Capital Outflow Source: Asian Development Bank It must be noted that only the first two quarters of QE2 period were used for comparison so as to isolate the effect of the worsening effects of the Eurozone crisis, which sparked a major shift of market movements between April June 2011. From the results above, it was observed that there was a net outflow of 32.1 billion during QE1 and 73.5 billion during QE2 when compared to the base period. Overall, as much as 40% of the increase in US monetary base may have leaked out during QE1, and about 33.8% may have leaked out during the adjusted first two quarters of QE2. The next question to ask is how much of these US capital outflows ended up in Asian emerging countries? From the Figure 3 below, it was estimated that from January 2009 to March 2011, total private capital outflows averaged $220 billion per quarter, with about $60 billion to the Asia-Pacific and $22 billion to the emerging countries. However, these inflow figures were actually understated as leakages might have also occurred through offshore centers outside the region. One example will be Europe, which captured most of the inflows from the US and acted as a conduit for flows to the rest of the world.

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Figure 3: Gross Capital Outflows from US to Asia-Pacific Source: Asian Development Bank Such capital outflows have tremendous impacts on the economic activities, financial markets and inflation levels of the Asian Countries. Currencies Impact The Korean won have strengthened significantly from 2009 to 2012, spotting a 10% cumulative rise. Singapore dollar follows closely behind (3.3% cumulative rise) and the Indian Rupee (2.1% cumulative rise). It is important to note that the reasons for the rises are not solely due to the inflow of capital, as the weakening of US dollar (USD) and foreign exchange intervention such as sterilization2 policies played critical roles as well. Currencies inevitably affect a countrys balance of payment (BOP) and current account balances, as inflows can result in overvaluation of the regions currencies and tremendously damaging exports. Higher inflation Capital inflows can contribute to inflationary pressures in emerging countries, creating problems and causing governments to tighten monetary policies to control inflations. For example in 2011, China tightened monetary policies in view of the fact that its inflation hit an all time high of 4.4% in October 2010. Portfolio Diversification Woes During the QE periods which were post subprime crisis, an interesting trend emerged commodities market in emerging countries were moving in the same direction and becoming increasingly correlated with asset classes such as equities. This meant that buy-side players like mutual funds and pension funds managers had difficulty diversifying their portfolios through commodities. Threats of retaliatory measures With the printing of money in QE, the value of the US dollar depreciated and started to lose its exorbitant privilege as the worlds reserve currency. In an attempt to reduce its overdependence on the USD, countries were and still are increasingly trying to diversify its 11 Copyright 2012 SMU Economics Intelligence Club

reserves to other currencies such as Yen and Renminbi (RMB). In addition, countries have introduced capital controls and trade barriers to safeguard its trade flows at the expense of others. Inconsequential Impact on Interest Rate and Bond Yields QE is meant to lower the bond yields of the US Treasuries through its massive purchase as part of the US Large-scale Asset Purchases (LSAP) programme3. Yet, research by the ADB has shown that bond yields in emerging countries did not change drastically except for the bonds of Indonesia, which registered a cumulative decline of 3.4%. It is hard to generalize this as the consequence of QE policies as Indonesia bonds are popular with foreign investors, hence explaining its higher price and consequently, lower yield. Conclusion The US QE is not fully effective in stimulating its internal market due to the outflow of capital to regions outside of US. About 40% of the increase in US monetary base leaked out during QE1 and 34% during first two quarters of QE2. A significant portion of these outflows can be traced to the capital inflows of the Asian emerging countries, which created unintended consequences such as the inflation rate target policies, currencies values and their financial markets. With such consequences, it is no wonder that public outcries against QE3 are prevalent. Yet, QE3 might just be coming around the corner. With the recent US economic growth slowing down to 1.5% in the second quarter of 2012 and with just 100 days before the US elections, Ben Bernake might just have some surprises in store for us during the next FOMC meeting.
Operation

Twist is a policy by which the Federal Reserve sells short-term government bonds and buys long dated Treasures, in an effort to push down long-term interest and therefore boost the economy.
2 Sterilization

is form of monetary action in which a central bank or federal reserve attempts to insulate itself from the foreign exchange market to counteract the effects of a changing monetary base. The sterilization process is used to manipulate the value of one domestic currency relative to another. Large-scale Asset Purchases (LSAP) programme refers to the purchase of US Treasuries, as well as agency securities and mortgage-back securities as part of the Feds strategy in credit easing.
3

Sources: Asian Development Bank, Fidelity Investments, BBC, Yahoo Finance, Financial Times

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The S&P 500 is a free-float capitalization-weighted index published since 1957 of the prices of 500 large- cap common stocks actively traded in the United States. It has been widely regarded as a gauge for the large cap US equities market The MSCI Asia ex Japan Index is a free float-adjusted market capitalization index consisting of 10 developed and emerging market country indices: China, Hong Kong, India, Indonesia, Korea, Malaysia, Philippines, Singapore, Taiwan, and Thailand. The STOXX Europe 600 Index is regarded as a benchmark for European equity markets. It represents large, mid and small capitalization companies across 18 countries of the European region: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the United Kingdom.

Correspondents Shane Ai Changxun (Vice President, Publication) changxun.ai.2010@smu.edu.sg Singapore Management University Singapore Herman Cheong (Vice President, Operations) Wq.cheong.2011@economics.smu.edu.sg Singapore Management University Singapore Fariha Imran (Marketing Director) Farihaimran.2010@economics.smu.edu.sg Singapore Management University Singapore Randy Lai (Editor) Tw.lai.2010@smu.edu.sg Singapore Management University Singapore Kenneth Ho kenneth.ho.2009@business.smu.edu.sg Singapore Management University Tong Kah Haw kahhaw.tong.2009@business.smu.edu.sg Singapore Management University Ben Lim (Vice President, Publication) ben.lim.2010@smu.edu.sg Singapore Management University Singapore Tan Jia Ming (Publications Director) jiaming.tan.2010@smu.edu.sg Singapore Management University Singapore Vera Soh (Liaison Officer) Vera.soh.2011@economics.smu.edu.sg Singapore Management University Singapore Seumas Yeo (Editor) Seumas.yeo.2010@smu.edu.sg Singapore Management University Singapore Leslie Tay lt571@york.ac.uk University of York

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