Scott Sumner  

China: The real problem is nominal

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Here's a report on China in the Financial Times:

Before the release of Wednesday's second-quarter gross domestic product estimate, China's nominal GDP growth rate had plummeted from almost 20 per cent to 5.8 per cent since 2011, a much sharper decline than the inflation-adjusted figures that have trended downwards from 9.5 per cent to 7 per cent over the same period.

The difference between this year's first-quarter nominal and real growth figures implied that the so-called GDP deflator -- a broad measure of inflation that covers all types of goods and services -- was negative, at -1.2 per cent, for only the third time in nearly two decades. That transformed the government's 5.8 nominal growth figure into 7 per cent real growth -- bang on Beijing's growth target of "about 7 per cent" for the full year. But it also implied that China suffered from nearly unprecedented deflation in the first quarter.


A few comments:

1. China's GDP numbers are viewed with some suspicion, but the broad trends are considered fairly accurate, in a qualitative sense.

2. The current slowdown in NGDP growth is very similar to the late 1990s and early 2000s. In both cases RGDP growth slowed, and NGDP growth slowed even more sharply. That suggests a negative aggregate demand shock. In both cases the NGDP slowdown created a debt problem, or perhaps intensified a pre-existing debt problem. This is consistent with the market monetarist approach---sharp slowdowns in NGDP growth reduce RGDP growth and put stress on debtors. Of course China has many other problems, some more severe, but if you are trying to explain cyclical changes in China, then the real problem is nominal.

3. There is nothing wrong with 5.8% NGDP growth. If China kept growth at that pace for the next 20 years, their business cycle would become more stable. The problem now, and in the late 1990s, is the sharp deceleration in NGDP growth.

4. China is not at the zero bound, so there is no doubt that monetary policy explains the sharp slowdown in NGDP. "Debt deflation" is a misleading term, as monetary policy is the causal factor, and debt distress in the symptom. The same was true in the US in the 1930s, and in late 2008, in Argentina in 1998-2001, and in Europe over the past 7 years.

5. But why would the PBoC want to reduce growth in NGDP? There are two possibilities. One is that they wanted to pop the debt bubble, by tightening monetary policy. This would be an indirect method of trying to reform the economy, move it away from debt-fueled growth in possibly wasteful investment spending. But there is a simpler explanation, which applies equally to the episode of the late 1990s. Both then and today, the yuan was linked to a strongly appreciating US dollar. As other countries depreciated their currencies against the dollar, China held fast. The simplest explanation for the Chinese business cycle is to simply look at the strength of the dollar. When the dollar is weak, as in 2007, Chinese growth is really strong, and vice versa.

China should now ease monetary policy, which would mean letting the yuan depreciate against the U.S. dollar. The U.S. would loudly complain, but we are a paper tiger, which (fortunately) has no intention of becoming highly protectionist.


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COMMENTS (12 to date)
Michael writes:

Comment #3 surprised me -- that 5.8% percent for decades would not be a problem. China still has a lot of its population not yet organized into anything nearly as efficient as 20th century production processes, so 7% real growth through imitation does not seem to me out of the question. And if that happens, as it has for the last two decades, then 5.8% nominal growth means trend deflation.

The elders taught that a little inflation eases relative price adjustment, and even a little deflation does the opposite. Even under NGDP level targetting you're going to have some people not paying much attention to aggregates and policy stances, so some of the money illusion that enabled that benefit of positive inflation should remain.

Do market monetarists reject that claim? Why?

EB writes:

Scott, are you reasoning from a price change in the foreign exchange market?

TravisV writes:

Prof. Sumner,

Please consider two issues:

(a) Downward nominal wage rigidity.

(b) Slowing income growth relative to nominal debts.

In slow trend growth countries like the U.S. and Spain, issue (a) has had a far bigger impact on RGDP than issue (b), correct?

In China, is it the reverse? Has (b) had a far bigger impact on RGDP than (a)?

Is it correct to say that downward nominal wage rigidity only begins to have a significant impact as aggregate nominal wage growth approaches zero percent?

Scott Sumner writes:

Michael, Most market monetarists believe it is NGDP growth that matters, not inflation. In our view deflation is actually desirable when you have very fast productivity growth. Even with 5.8% NGDP growth China would have relatively fast nominal wage growth, so I don't see money illusion as much of a problem.

EB, If I was drawing inferences about the US based on the strength of the dollar I would certainly be doing so. On the other hand I believe it is likely that a strong dollar would be contractionary for China regardless of whether it was due to tight money or strong US growth. But yes, there may be a little bit of reasoning from a price change, just no where near as bad as the cases I tend to criticize. I'm basically assuming the two country's equilibrium real exchange rates are somewhat uncorrelated.

Travis, Yes to your first question, but wage stickiness can be a problem even if the growth rate slows sharply, but remains positive.

Njnnja writes:

Is your recommendation for monetary easing primarily intended to increase domestic AD, or is it primarily to weaken the yuan and increase exports? Would the difference even matter?

TravisV writes:

Prof. Sumner,

Thank you very much. However, you didn't really say much about (b). I'm curious about the relative importance of (b) compared to (a) in cases like China's.

JP Koning writes:

" As other countries depreciated their currencies against the dollar, China held fast."

Good post. However, China 'holding fast' (as it did in 2008) could be construed as a form of monetary easing, since the default case over the last decade has been to appreciate the yuan against the dollar.

TravisV writes:

JP Koning just wrote an excellent analysis and cited a gem of an old Sumner post from September 2010:

http://jpkoning.blogspot.com/2015/08/freshwater-macro-chinas-silver-standard.html

Lorenzo from Oz writes:

"Debt deflation" is a misleading term, as monetary policy is the causal factor, and debt distress in the symptom.

Even more so if you are Richard Koo or Stephen Keen and you obsess about the debt part and miss the deflation part.

Scott Sumner writes:

Njnnja, It's all about AD, exports are far less important. Net exports don't necessarily rise with monetary easing. In China they are driven by high domestic saving rates (both public and private.)

Travis, I'd say it depends on the issue on which you are focusing. If the issue is the business cycle, then wage stickiness is the key. If the issue is financial system stability then nominal debt is the key.

So for RGDP in China, my answer is still sticky wages.

And thanks for the link.

JP, Good point, but I'd point to the fact that the previous trend rate of appreciation was very gradual, so when the dollar strengthened sharply and suddenly by double digits, the yuan was getting stronger even relative to trend.

Lorenzo, Good point.

Mark A. Sadowski writes:

Pardon me if I quote myself:

"A good place to start is by considering the relative weights of the currencies in TWEXBPA.

The three currencies with the greatest weights are the Chinese renminbi (21.3%), the euro (16.4%) and the Canadian dollar (12.7%). To estimate the real exchange rate (RER) of each of these currencies in terms of the US dollar I computed the ratio of the Bank for International Settlements (BIS) Real Broad Effective Exchange Rate for each currency area divided by the BIS Real Broad Effective Exchange Rate of the US. I term these ratios RERCHUS, REREUUS and RERCAUS.

The next thing I did was check to see if the US monetary base Granger causes the RER of these currencies in terms of the US dollar during the period from December 2008 through May 2015.

Not only does the US monetary base not Granger cause RERCHUS, the p-value for the non-causality test is an amazingly high 99.15%. Of course the IMF has classified the exchange rate arrangement of China as a “crawl-like arrangement” (page 6) with a “de facto exchange rate anchor to the US dollar” (see footnote) since 2007.

The Granger causality test result supports this classification, and in light of it, perhaps the exchange rate arrangement of China should really be termed a “crawl-like peg”.

In any case, to do further analysis of RERCNUS I would need to know China’s monetary base and overnight repo rate, and personally I find the website of the People’s Bank of China even less user friendly than the Bank of England’s web site used to be. So I’ll leave it until a later date, and for now, based on the near 100% value of the above p-value, I’ll assume that the outcome of my efforts will end up in grim defeat anyway."

https://thefaintofheart.wordpress.com/2015/07/14/the-monetary-base-and-the-exchange-rate-channel-of-monetary-transmission-in-the-age-of-zirp-part-2/

KirkC writes:

People in these comments have made some valid points. However the problem with China is complex, it is hard to determine anything when the data is unreliable. How can anyone provide thoughtful analysis of a country with data that is so unreliable?

This is of course withstanding the reality that all governments are somewhat unreliable in their data gathering techniques. China seems to have a bit wider margin of error in their data.

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