RMB Appreciation: the Specter of a “Lost Decade”

Maybe as a contribution to reported efforts by Japanese premier Naoto Kan and Chinese chief state councillor Wen Jiabao to mend bilateral ties, Takatoshi Ito, a Japanese economist and University of Tokyo professor, has some words of advice for the guardians of China’s currency, especially those who disapprove of a rise in the Yuan RMB’s exchange rate. On October 7, Ito wrote in an article for the Handelsblatt that

A specter haunts China’s exchange-rate system: the long-standing dispute between the US and Japan during the 1980s and early 90s about the Japanese Yen’s value. The dispute only ended when Japan’s economy entered its “lost decade”. The Chinese are determined not to repeat this experience. Obviously, history – and the history of finance in particular – never repeats itself to the letter. But the arguments one can hear concerning the Yuan these days do generate a strong sense of déjà-vu among the Japanese.

From JR's foreign currency reserves

Just as back then, US Congress – preparing retaliatory action – is the center of American anger, reacting to pressure within the US, writes Ito, citing the September 1985 Plaza Agreement as China’s main argument against RMB appreciation. After America, Britain, France, Japan and West Germany had agreed to common efforts to depreciate the US dollar, the Yen’s exchange rate rushed from 240 to 178 Yen per USD by March 1986. Japan intervened into the opposite direction: lowering interest rates, selling Yen and buying Dollars. Low interest rates discouraged capital inflow and pushed inflation of assets.

Ito:

The bubble of Japanese property and share prices didn’t build and burst because Japan had given in to US pressure to revaluate the Yen, but because it resisted [appreciation]. If China wants to draw the right conclusions from Japan’s experience, it needs to know what really happened in Japan back then.

China should look carefully if there are indications of overheating within the domestic economy, and if prices for shares are rising sharply. To allow for a rise in the Yuan’s value would be a good approach to avoid both.

Michael Pettis believes that the rise of the RMB’s value will be inexorable, and adds a warning:

This is the problem China faces.  It must raise the value of the renminbi as part of its rebalancing towards greater domestic consumption, but if it does so too quickly, the rebalancing will occur not as an increase in consumption relative to rising production, but rather as a drop in production relative to declining consumption.

This may seem like a confusing point, but it is worth understanding.  China can rebalance with high unemployment as well as with low unemployment, and the difference has to do with the speed of the rebalancing.  If China adjusts too quickly, consumption will actually decline, and production will decline even faster.  In that case China rebalances (consumption rises as a share of GDP), but under conditions of rising unemployment.

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Related
“Full of Expectations”, October 5, 2010
Geithner/Soros/Summers: “Growth Now”, June 23, 2010
Laobaixing against RMB appreciation, April 26, 2010