Thursday 25 March 2010

Growing out of Poverty

The role that economic growth has had on poverty reduction in China should not be underestimated. It surpasses any effect from government policy.

This recent paper is a useful addition to the literature.

Growing out of Poverty: Trends and Patterns of Urban Poverty in China 1988–2002

Simon Appletona, Lina Songa and Qingjie Xiab

a University of Nottingham, Nottingham, UK

b Peking University, Beijing, China
Accepted 6 November 2009.
Available online 17 December 2009.


This paper estimates trends in absolute poverty in urban China using the Chinese Household Income Project surveys. Poverty incidence curves are plotted, showing lower poverty in 2002 than in 1988 irrespective of the poverty line chosen. Incomes of the poorest fell during 1988–95, contributing to a rise in inequality. However, inequality has been fairly constant thereafter. Models of the determination of income and poverty reveal widening differentials by education, sex, and Communist Party membership. Income from government anti-poverty programs has little impact on poverty, which has fallen almost entirely due to overall economic growth rather than redistribution.

Key words: poverty; inequality; economic growth; welfare; Asia; China

This DVD provides a real life backdrop to this academic article.

Sacrificing her education to earn money for her family, and suffering drudgery, loneliness and displacement, Li Jieli must leave her rural Chinese home to work in a far-away factory where she is only a number. Li's story gives us a look behind the factory gates. Will her job provide her a basis for growth and personal fulfillment? She has only been back home once in the last three years. In the depressed Iron Range of Minnesota, Wayne Peterson and David Olson are also forced to make difficult choices to survive in a job market impacted by global trade. The local iron mine had shut down due to high labor costs but has recently reopened because of demand for iron from China. Pensions and benefits from the previous owners are gone. Questions of corporate responsibility in both countries come into play as Wayne and David must decide about where their security lies in a shifting global economy.


Thursday 18 March 2010

China calls in the multinational army to defend against aggressive US

The war of words over China's exchange rate relative to the US is getting hotter.

Following Paul Krugman's recent intervention (see previous post) China is fighting back. Multinationals know which side of the bread is buttered.

Robert Pozen at least speaks some sense.

China asks US groups to back it on currency [FT]

China called on US multinationals on Tuesday to lobby the Obama administration against taking protectionist measures over the Chinese currency, just as attitudes towards China appear to be hardening in the US ­Congress.

Yao Jian, a spokesman at the Chinese commerce ministry, said that some companies had already been lobbying against recent restrictions on Chinese imports to the US and he hoped this would increase.

“We hope that US companies in China will express their demands and point of views in the US, in order to promote the development of global trade and jointly oppose trade protectionism,” he said.

The comments came as the political heat surrounding China’s currency policy intensified in Washington. Led by Chuck Schumer, the New York Democrat, and Lindsey Graham, the South Carolina Republican, a group of senators said China’s refusal to let its currency appreciate was damaging the US economic recovery and hurting American competitiveness.

“China’s currency manipulation would be unacceptable even in good economic times. At a time of 10 per cent unemployment, we will simply not stand for it,” Mr Schumer said.

The senators have proposed a bill that would require the Treasury to identify countries with “fundamentally misaligned currencies” as well as those that need to be tackled with “priority action”.

Those countries would have nearly a year to adjust the value of their currency before the US administration was required to bring a case against them at the World Trade Organisation, according to the proposal. The Treasury would also have to “consult” the Federal Reserve and other central banks about “remedial intervention in currency markets”.

Expecting an appreciation, some measures could be taken earlier, including forbidding Chinese companies from participating in US government contracts, requesting an International Monetary Fund consultation with China, and including currency undervaluation as part of dumping calculations. Mr Schumer and Mr Graham have been leading the charge in Congress against China’s currency policy for several years, and have periodically presented similar proposals.

But their efforts may have gained fresh impetus on the back of a recent flare-up in tensions between Beijing and Washington on issues including currency.

On Sunday, Wen Jiabao, Chinese premier, warned other countries that pressing China on currency policy amounted to protectionism and insisted the renminbi was not undervalued.

“That was the last straw,” said Mr Schumer, who complained that the US had been “lectured”. “We are fed up, and we are not going to take it any more.”

On April 15, the Treasury will release its latest semi-annual currency report, and pressure is building on the administration to describe China formally as a “manipulator” – a move that it has resisted until now even though President Barack Obama was sharply critical of its currency regime during the 2008 election campaign.

Tim Geithner, the Treasury secretary, said in an interview with Fox Business News on Tuesday: “I think ultimately [China] is going to decide over time it’s in their interest to move to a more flexible exchange rate.” He said the Schumer bill was “an illustration of how strong people feel about this, and it’s understandable and it’s true in countries round the world”.

A Treasury official said: “A more market-oriented Chinese exchange rate will make an essential contribution to a stronger, more balanced global economy.”

US multinationals operating in China have long been opposed to Washington taking action over the perceived undervaluation.

“A 10-15 per cent appreciation of the renminbi would have a very modest effect on the margins of the US current account deficit,” Robert Pozen, chairman of MFS Investment Management and a senior lecturer at the Harvard Business School, told the Financial Times. “The US needs to stay quiet. Hopefully, it won’t name China a currency manipulator.”


Paul Krugman kicks China in the RMBs

Paul Krugman (Nobel prize winner) has weighed into the Chinese currency argument.

The Americans are now getting seriously ****** off with China's exchange rate manipulation. Krugman makes some good points. Of course China is manipulating it's currency. This is not controversial. The issue is how much China's policy really is a drag on the world economies.

It was not China that caused the financial crisis. It was not China who lent millions to people without jobs, homes or prospects....need I go on.

Remember that Krugman is influential and he is not a rabid neo-con - far from it.

The arguments that the Chinese government regularly employ will become harder to make. I have covered the main arguments before.

The bottom line is that there is very little the US can do - at least the US economists acknowledge that a trade war would be far more devastating.

It will be very interesting to watch developments. The question of who has who over a barrel is interesting. I prefer the "two drunks" analogy. One moves and they both fall over.

Most importantly, I recommend that Krugman and anyone concerned by this article to read the previous post on this blog from Michael Pettis on what China's large surplus really means.

US citizens may also not react too kindly to a 20% increase in the price of virtually everything - is that supposed to boost the economy?

Taking On China [New York Times]

Tensions are rising over Chinese economic policy, and rightly so: China’s policy of keeping its currency, the renminbi, undervalued has become a significant drag on global economic recovery. Something must be done.

To give you a sense of the problem: Widespread complaints that China was manipulating its currency — selling renminbi and buying foreign currencies, so as to keep the renminbi weak and China’s exports artificially competitive — began around 2003. At that point China was adding about $10 billion a month to its reserves, and in 2003 it ran an overall surplus on its current account — a broad measure of the trade balance — of $46 billion.

Today, China is adding more than $30 billion a month to its $2.4 trillion hoard of reserves. The International Monetary Fund expects China to have a 2010 current surplus of more than $450 billion — 10 times the 2003 figure. This is the most distortionary exchange rate policy any major nation has ever followed.

And it’s a policy that seriously damages the rest of the world. Most of the world’s large economies are stuck in a liquidity trap — deeply depressed, but unable to generate a recovery by cutting interest rates because the relevant rates are already near zero. China, by engineering an unwarranted trade surplus, is in effect imposing an anti-stimulus on these economies, which they can’t offset.

So how should we respond? First of all, the U.S. Treasury Department must stop fudging and obfuscating.

Twice a year, by law, Treasury must issue a report identifying nations that “manipulate the rate of exchange between their currency and the United States dollar for purposes of preventing effective balance of payments adjustments or gaining unfair competitive advantage in international trade.” The law’s intent is clear: the report should be a factual determination, not a policy statement. In practice, however, Treasury has been both unwilling to take action on the renminbi and unwilling to do what the law requires, namely explain to Congress why it isn’t taking action. Instead, it has spent the past six or seven years pretending not to see the obvious.

Will the next report, due April 15, continue this tradition? Stay tuned.

If Treasury does find Chinese currency manipulation, then what? Here, we have to get past a common misunderstanding: the view that the Chinese have us over a barrel, because we don’t dare provoke China into dumping its dollar assets.

What you have to ask is, What would happen if China tried to sell a large share of its U.S. assets? Would interest rates soar? Short-term U.S. interest rates wouldn’t change: they’re being kept near zero by the Fed, which won’t raise rates until the unemployment rate comes down. Long-term rates might rise slightly, but they’re mainly determined by market expectations of future short-term rates. Also, the Fed could offset any interest-rate impact of a Chinese pullback by expanding its own purchases of long-term bonds.

It’s true that if China dumped its U.S. assets the value of the dollar would fall against other major currencies, such as the euro. But that would be a good thing for the United States, since it would make our goods more competitive and reduce our trade deficit. On the other hand, it would be a bad thing for China, which would suffer large losses on its dollar holdings. In short, right now America has China over a barrel, not the other way around.

So we have no reason to fear China. But what should we do?

Some still argue that we must reason gently with China, not confront it. But we’ve been reasoning with China for years, as its surplus ballooned, and gotten nowhere: on Sunday Wen Jiabao, the Chinese prime minister, declared — absurdly — that his nation’s currency is not undervalued. (The Peterson Institute for International Economics estimates that the renminbi is undervalued by between 20 and 40 percent.) And Mr. Wen accused other nations of doing what China actually does, seeking to weaken their currencies “just for the purposes of increasing their own exports.”

But if sweet reason won’t work, what’s the alternative? In 1971 the United States dealt with a similar but much less severe problem of foreign undervaluation by imposing a temporary 10 percent surcharge on imports, which was removed a few months later after Germany, Japan and other nations raised the dollar value of their currencies. At this point, it’s hard to see China changing its policies unless faced with the threat of similar action — except that this time the surcharge would have to be much larger, say 25 percent.

I don’t propose this turn to policy hardball lightly. But Chinese currency policy is adding materially to the world’s economic problems at a time when those problems are already very severe. It’s time to take a stand.


The Chinese manufacturing myth

Helen Wang writes about what is happening on the ground in China regarding the manufacturing sector. She touches on the problem of graduate unemployment which is something I covered in my last post.

The unemployment of graduates has important implications for UK and world Universities. Will the shortage of graduate jobs translate into a fall in the supply of students willing to invest large sums of money for a graduate education? Helen suggests this is the case with more vocational courses coming on stream.

Helen raises some interesting points about the production process and the role of innovation. China lags behind of course but is catching up quickly. Japan and Korea followed a similar development path and are now leading the world in terms on innovation and hightech production. China will catch up quickly and is reinforced by the new 5 year plan.

Myth of China’s Manufacturing Prowess [HelenWang]

In a meeting in Silicon Valley with high-tech and business professionals, I asked how many of them thought China was the world’s largest manufacturer. Almost 90 percent raised their hands.

The latest data shows, however, that the United States is still the largest manufacturer in the world. In 2008, U.S. manufacturing output was $1.8 trillion, compared to $1.4 trillion in China (UN data. China’s data do not separate manufacturing from mining and utilities. So the actual Chinese manufacturing number should be much smaller).

Contrary to the conventional view, manufacturing in the U. S. has been growing in the past two decades despite the decline in manufacturing jobs.

It is true that China’s manufacturing is growing faster than that of the United States. However, there is a key misconception about China’s manufacturing prowess.

In the United States and Europe, the manufacturing industry was created due to technology innovation. In China, the manufacturing industry is being created in response to global demand. Chinese manufacturers take orders from Western companies that have designed products for their home markets. They have no involvement with product development, innovation, market research, and even packaging.

Unlike the manufacturing industry in the West that gave birth to a middle class of both white-collar and blue-collar workers, manufacturers in China mostly absorb surplus labor from rural areas with few skills. Those rural migrant workers live in dormitories, earn about $100 to $200 a month, and hardly fit into the category of the middle class. (To be clear, there is a burgeoning middle class in China. Most of them are in urban private businesses, state-owned enterprises, and multinationals).

James Fallows, national correspondent for the Atlantic, visited many factories in China. He saw people working on the assembly lines and was convinced those tasks would only be performed by machines in the United States.

While people in the West fear China as a global manufacturing powerhouse, the Chinese consider their manufacturers to be the sweatshops for the world and see themselves as being in a disadvantageous position.

Yes, China is making efforts to drive its economy up the value chain. The 11th Five-year Plan (2006 – 2010) called for “scientific development.” A key initiative is an increase in the R&D-to-GDP ratio from about 1.3 percent in 2005 to 2.5 percent by 2020. However, how much of the funding is actually used for research and development and how well the research is being transferred into manufacturing are both highly questionable.

Given the unpredictability of the regulatory environment, many Chinese manufacturers tend to focus on short term gain. They compete on volume and price, and only enjoy wafer-thin profit margins. This has kept Chinese manufacturers from investing in research and development or training employees.

Recently, Chinese manufacturers experienced a shortage of low-waged workers. On the other hand, millions of college graduates have been unable to find jobs. With college tuition sky high, more and more young people are turning to vocational schools, which may offer better prospects of employment at lower cost. This means a majority of Chinese workers may be trapped in low-skilled jobs, making China’s move up the value chain even more challenging.

While the rest of the world fears China’s manufacturing power, China is trying to move away from its “sweatshop” manufacturing and become a service-oriented economy. However, China may find itself locked into place, at least for now, due to the hundreds of millions of rural migrants that need jobs.

In this regard, China is doing the world a service, producing affordable goods for Western consumers, which improves living standards and keeps inflation low in Western economies.


Tuesday 9 March 2010

New York Times: "Educated and Fearing the Future in China"

One reason this blog was started was to give advice to Chinese students on where to study in the UK (for economics and finance). See right hand column and scroll down.

One big issue is the real value of education. Education is seen as very important in China and families will save for 20 years to send their only child to take a postgraduate education for 1 year in the UK.

Does this make sense? Are the returns high enough? The New York Times investigates.

A number of opinions are sought. This article makes a number of important points.

Bottom line - the number of high skilled jobs is not matching supply - result - unemployment of highly educated (and expensively educated) workers.

There is a lot of economics that needs to be considered. (1) too few graduates going into self employment, (2) too much concentration in the coastal cities forcing up wages and house prices, (2), education system and what it really teaches, (4), brain drain.

Educated and Fearing the Future in China [NYT]

As China’s economy recovers, employers are competing to hire low-skilled workers, but many of China’s best and brightest, its college graduates, are facing a long stretch of unemployment.

In 1999, the government began a push to expand college education — once considered a golden ticket — to produce more professionals to meet the demands of globalization. This year, more than 6.3 million graduates will enter the job market, up from one million in 1999. But the number of high-skilled, high-paying jobs has not kept pace.

What might be done to correct the mismatch between expectations and reality? How is this problem altering Chinese attitudes about upward mobility? If college graduates are not reaping economic rewards, how will the next generation view the value of education?

* C. Cindy Fan, associate dean of social sciences, U.C.L.A.
* Yasheng Huang, professor of political economy, M.I.T.
* Daniel A. Bell, professor of political philosophy, Tsinghua University
* Albert Park, economist, University of Oxford
* Loren Brandt, economist, University of Toronto

To read more on each persons perspective you need to visit the website directly.

Materialism and Social Unrest
Cindy Fan

C. Cindy Fan is associate dean of social sciences and professor of geography at the University of California, Los Angeles. She is the author of “China on the Move” and numerous articles.

Like prostitution, stocks, private cars, beauty pageants, and McDonald’s, “unemployment,” thanks to collectivization, was practically absent from Chinese life for the three decades after 1949.

The Chinese economy, no longer centrally planned, has not put enough people back to work.

Deng Xiaoping’s economic reforms paved the way for the collapse of inefficient state-owned enterprises, shattering the “iron rice bowl” of millions of workers and creating the first wave of unemployment in post-Mao China.

Unemployment among college graduates is a hot-button issue in China. A large number of young people have little other than materialism and consumerism to believe in — a general description of Chinese society today since socialist ideology lost its grip. Not having a job is a perfect recipe for social unrest.

Today, China’s official unemployment rate is about 4.3 percent, but it is a gross underestimate because of underemployment among both rural and urban Chinese — they may have a job but their skills are underutilized and they are underpaid.

What explains this situation? No doubt, the global economic crisis has contributed to job loss, but China is considered one of the first economies to recover from the recession.

Another explanation widely cited in the media is the government-directed increase in university enrollment since the late 1990s. But even with that expansion, less than 8 percent of the Chinese population are college-educated compared with more than one in four in the U.S. That suggests there is much room for growth in higher education, especially if the country is to live up to the expectation of “China’s century.”

Instead, three explanations may account for the relatively high unemployment among college graduates. First, geography matters. Young people from smaller places and rural areas, upon obtaining a university degree, are likely eager to go to or stay in big cities. This effect is crowding the labor market in cities like Beijing and Shanghai and hurting the economy of small cities and towns.

Second, globalization matters. By rough estimates, one quarter of the Chinese who have studied overseas have returned. Nicknamed “sea turtles” (haigui), these returnees are highly competitive and can easily push the domestic college graduates down the job hierarchy.

Finally, China’s economy continues to be dominated by the industrial sector, which accounts for about 49 percent of the gross domestic product. While services — the most likely sector for college graduates — account for about 40 percent of the G.D.P., high-skilled, professional jobs are still relatively few compared with low-end service jobs like those in sales.

Creating high-end jobs and increasing the incentives for young people to live in smaller cities are obvious ways to reduce their unemployment. But this is easier said than done. The Chinese economy is no longer centrally planned, and as we have observed on this side of the Pacific, relying on the market alone — even with stimulus packages — has not yet put enough people back to work.

A Terrible Education System
Yasheng Huang

Yasheng Huang is professor of political economy and international management at Sloan School of Management, Massachusetts Institute of Technology. He is the author of “Capitalism with Chinese Characteristics” and will soon begin a large-scale survey of college graduates in China.

In 2007, the job openings for new graduates fell by some 22 percent compared with 2006, according China’s National Development and Reform Commission.

Although Chinese universities have pockets of excellence, they are churning out people with high expectations and low skills.

Some estimate that 30 percent of Chinese engineering students will not find jobs after graduation and that the average pay of the college graduates is now approaching that of rural migrant workers. At the same time, factories in Guangdong province cannot find enough labor. What is going on?

The idea that China is running out of unskilled labor is a myth. The news reports typically concentrate on Guangdong but this does not mean the country as a whole is short of unskilled labor. Development in rural areas in the past six years has meant that rural residents, previously denied economic opportunities close to home, now have a choice between going to Guangdong and staying in their hometowns. Many choose to stay. Any “labor shortage” in Guangdong is mostly evidence that the factories should not be located there in the first place.

But the job market is a problem for college graduates — with the opportunities created in the wrong places. Colleges educate students, but in China they also give a young person a formal right to move to an urban center.

You cannot tell a Chinese college graduate, “you’ve invested years and money in a college education, but your job prospects are in your home village.” So there is now a geographic mismatch between locations of jobs and locations of college graduates.

Secondly, there is a skills mismatch. In my conversations with Chinese managers and entrepreneurs, they constantly complain about a shortage of people with the right set of skills, capabilities and inclinations. China is so short of the right human capital, and books with titles like, “War for Talent,” are best sellers in China.

The Chinese educational system is terrible at producing workers with innovative skills for Chinese economy. It produces people who memorize existing facts rather than discovering new facts; who fish for existing solutions rather than coming up with new ones; who execute orders rather than inventing new ways of doing things. In other words they do not solve problems for their employers.

You multiply this skills mismatch by a sixfold increase in the college enrollments between 1997 and 2008, you get a sense of scale of the problem. Although Chinese universities are not without pockets of excellence, they are churning out people with high expectations and low skills. That combination cannot be good for any country, let alone a country with a low capita income.

Going Back to Mao?
Daniel Bell

Daniel A. Bell is professor of political philosophy at Tsinghua University and author of “China’s New Confucianism: Politics and Everyday Life in a Changing Society.”

“In education, there are no social classes,” Confucius said. The value of equal opportunity for education has deep roots in Chinese culture and may help to explain why most Chinese parents, regardless of social background, put so much pressure on their kids to do well in school.

Even at an elite university, students are lowering their aspirations or settling for government jobs.

It also helps to why explain the university entrance examination system — one of the least corrupt institutions in China — is designed at least partly to provide an equal opportunity for all students. Those who make the cut go on to university, regardless of social connections.

In response to societal demands for more educational opportunities, the government has boosted university enrollment by 30 percent annually over the past decade. Even in the context of a booming economy, the predictable consequence is that there are large numbers of unemployed college students. My own students — graduates of the elite Tsinghua University — are also feeling the pinch, though it usually means lowering their aspirations or changing their plans rather than coping with unemployment.

In the past, it wasn’t too difficult for graduates in the humanities to find highly paid jobs with foreign companies or Chinese financial institutions in Beijing or Shanghai. Many graduates are now considering working in smaller and less developed cities. Others are enrolling in graduate programs that delay the job search. Still others are considering jobs outside of their majors.

One of my graduate students has found a job as a Chinese teacher at a highly regarded secondary school and she says “with this job it will be impossible for me to make a great fortune but I’m quite sure I will be very happy.”

Increasing numbers of graduates are competing to take the civil service exams. Whatever their private misgivings about the government, a government job is increasingly seen as the best option in economically uncertain times.

In response to the job crunch, the government is cutting back on university enrollment growth to 5 percent annually. But the demand for university spots won’t stop growing and the government will find it increasingly difficult to maintain a “harmonious society.”’

The only long-term solution, in my view, is to change parental expectations. Not everyone is destined to be a successful professional or government official, and students will need to be filtered at an earlier age to vocational training, similar to the educational system in Germany.

But parents need to accept that working with hands can be just as socially valuable as working with the mind. A bit of Maoism, in that sense, might need to be reintroduced to China.

Waiting It Out
Albert Park

Albert Park is a reader in the economy of China at the University of Oxford. He has co-directed several surveys on China’s urban workers and is currently leading a World Bank-supported project on the impact of the global economic crisis on employment in China.

China has been confronting the challenge of employing college graduates for some years now. The number of graduates from regular institutions of higher education increased dramatically from 9.5 million in 2000 to 37.8 million in 2006.

The broader trends definitely suggest that the economy will be able to absorb more graduates.

Meanwhile, the urban unemployment rate for college graduates increased from 6.3 percent in 2000 to 11.9 percent in 2005, while declining for those with less education, according to calculations based on census data. It would be surprising if the expectations of college graduates have not begun to adjust to the new reality.

In recent years, many college graduates have been disappointed by the salaries for starting positions. Some may feel they would rather wait for a better first job, since first jobs can strongly influence future career paths. Of course, wages of college graduates tend to rise with experience once employed. Eventually, the costs of waiting will force graduates to accept available job offers.

But are sufficient jobs available? The economic crisis certainly reduced the job market for recent graduates, but evidence suggests that the Chinese economy has bounced back.

The broader trends definitely suggest that the economy will be able to absorb more graduates. First, the economic returns to college education (the percentage difference in wages for college graduates compared with high school graduates) in urban areas have increased tremendously over time, from less than 12 percent in 1988 to nearly 40 percent by the early 2000s, with no signs of declining, and such economic returns are highest for recent graduates. This suggests that increases in the demand for college-educated workers continues to outpace the increase in supply.

Overall, the percentage of the national urban labor force that is college-educated remains less than 10 percent, while global integration and rapid technological change increasingly place a premium on high-skill workers. China’s college graduates have reason to be optimistic about the future.

College Educations, Needed and Desired
Loren Brandt

Loren Brandt is a professor of economics at the University of Toronto. He is a research fellow at the Institute for the Study of Labor in Bonn, Germany. He has published widely on the Chinese economy and has been involved in extensive household and enterprise survey work in China. He is the co-editor of China’s Great Economic Transformation.

China’s urban labor market is fairly sharply divided between workers with urban residency permits (hukou) and migrants from rural areas. In general, the overlap in the job market for these two populations is relatively modest, but it has been increasing over time.

China’s emerging middle class will continue to demand expanded educational opportunities for their children.

Of the total urban workforce of 475-500 million, 60 to 65 percent have urban residency permits (hukou) with the remaining being migrants. A majority of those with residency permits (upwards of three-quarters) work in the “formal” sector in jobs that offer more security, higher wages, as well as the benefits of China’s social safety net. The migrants are more likely to be found in the “informal” urban sector, including manufacturing, construction and services.

For migrants, one huge barrier to jobs in the formal urban sector is their significantly lower levels of education. The most recent arrivals from the countryside have an average educational attainment of middle school (9 years in total), or five years less than their urban counterparts. Migrants are also willing to take the less desirable jobs that urban residents usually avoid.

Estimates suggest that between 2002 and 2008 urban employment grew by nearly 4 percent a year (or 15 million new urban jobs annually), with annual employment growth of migrants outpacing that of urban residents (5.1 percent versus 3.3 percent). Indeed, on the eve of the recent financial crisis, labor markets in many parts of China were fairly tight.

At the end of 2008, total urban employment began to decline and continued to fall through the first half of 2009, but there are indications that urban job growth is now recovering.

The problem facing new college graduates is neither the economy nor the migrants.

Instead, it is the result of a rapid of expansion in higher education and a serious mismatch in the labor market. In 2003, surveys were already pointing to these difficulties. Notably, women, graduates from China’s lower-tier colleges and universities, and those with degrees in education, literature and science were faring more poorly. There were also important regional differences.

Nonetheless, overall there will still be high economic returns for a college degree, and China’s emerging middle class will continue to demand expanded educational opportunities for their children.

China’s educational system needs to do a better job of providing the skills that are valued by the market. On the demand side, other reforms, including those in the financial system, are required to relax constraints facing China’s private sector, which creates jobs. Neither of these changes, however, will happen quickly.


Monday 1 March 2010

China's reserves - what are they good for - not as much as you think

This is the second post paying homage to the Pettis explanation of the role of China's foreign reserves.

The bank of China holds massive foreign reserves. That is agreed. What is far less clear is what these reserves can be spent on. The man in the street might say - "use the money to build hospitals and schools".

Pettis explains how it really works. This is good and well explained economics (certainly better that I could do without spending a lot of time).

It is important that as many people understand the arguments here as possible especially journalists and fellow economists.

What Pettis misses is that whilst the economics is correct he underestimates the importance of the group of losers he labels "exporters" and the associated jobs. Job creation in China is crucial to maintain political stability. These is a cost to maintaining a low RMB value against the dollar but I suspect the Chinese government sees this as a price worth paying (for the time being).

Can PBoC reserves protect China? [China Financial Markets]

So the PBoC cannot give away the reserves without causing an increase in its net indebtedness. This is why I have often said, to the confusion of some of my readers, that Beijing cannot just recapitalize the banks with reserves. A substantial amount of NPLs will one way or another increase government debt. The only way Beijing can recapitalize the banks is by borrowing, or by raising direct (or hidden) taxes. Having the PBoC recapitalize the banks is just another way for the government to borrow, and since almost everyone would agree that losses in the banking system should be paid directly out of fiscal revenues, and not indirectly by the central bank, it would be a very inefficient way of doing so.

So what are reserves good for? As long as China maintains its own currency and denominates all domestic transactions in RMB, the PBoC reserves cannot be used in China. They cannot go to pay doctors’ salaries, to build bridges, to lower taxes or to subsidize consumption. They can only be used to purchase or pay for things from outside China. This means that reserves ensure that China can import foreign commodities and other goods as long as it can pay for them domestically. It also means that the PBoC can ensure the availability of dollars to repay foreign debt and foreign investment.

Here is where a great deal of confusion arises. The US crisis of 2007-08 notwithstanding, we seem implicitly to believe that a financial crisis is always caused by an inability to repay foreign debt and investment, in which case having huge amounts of reserves certainly should protect a country from financial crises.

But this is only partly true. Reserves are useless in preventing domestic debt crises (not totally, because they affect the credibility of the currency, but the RMB today doesn’t seem to suffer from a lack of credibility). As I pointed out two weeks ago, there are many cases of countries with huge amounts of reserves that nonetheless suffered from all kinds of financial crises. It is just that they never suffered from external debt crises.

When it comes to domestic debt crises, large levels of reserves actually can make things worse. Why? Because financial crises are always caused by mismatched and highly inverted balance sheets, and the central bank’s accumulation of reserves is exactly that kind of balance sheet.

Of course when the rest of the country has an equally mismatched balance sheet in the other direction – like when South Korean companies in 1997 had huge amounts of won assets financed by dollar debt – the central bank mismatch enhances financial stability. It acts against the mismatch carried by the rest of the economy, and the net impact is that the economy is less vulnerable to financial crisis. In that sense reserves are a kind of insurance to protect against excessive foreign borrowing. Because South Korea, unlike China today, had too few central bank reserves against the rest of the country’s too-large dollar obligations, its overall balance sheet was mismatched and it was susceptible to a collapse of the won.

But China has very little external debt – certainly very small compared to its reserves – and so this clearly isn’t an issue for China. But then could the huge mismatch on the PBoC’s balance sheet create the opposite risk for China?

Balance sheet mismatches

Yes and no. And this is where another great misperception occurs. Many people in China and abroad have argued that China cannot afford to raise the value of the RMB against the dollar because it would mean that China will take huge losses because of its massive reserves. After all, if the RMB rises by 10% against the dollar, the value of its reserves will have necessarily declined by $250 billion in RMB terms.

This is almost completely wrong – China will not take losses anywhere close to that amount and may probably even take a gain if it revalues the currency. Unfortunately this kind of confused thinking is nonetheless the source of some strange claims. One foreign economist even published a rather loony piece three months ago, which excoriated the Obama administration’s “bogus” trade argument for revaluation as done purely for nefarious and no doubt imperialistic reasons – and to strengthen the conspiratorial air it somehow ignored the fact that nearly every country in Europe and Asia has made the same argument.

Ironically enough, it replaced the very reasonable trade argument with one that is truly bogus, and indicates how foolish and even hysterical the discussion can become. The argument is that the US wants China to revalue the RMB not because of trade rebalancing (wrong, and this makes a common but still annoying mistake about the relationship between the currency and the trade balance) but rather because of a secret American scheme to reduce the amount that the US government has to pay China on its PBoC holdings. Appreciation of the RMB, according to this theory, represents a transfer of wealth from China to the US because it effectively reduces cost to the US of servicing the debt:

If the arguments presented for RMB revaluation by the US administration have no factual basis, why are they being put forward? The real answer lies not in trade but in debt – as other writers, such as Daryl Guppy, have rightly pointed out. In asking for RMB revaluation, President Obama’s advisers were, in effect, asking China to donate $150-$300 billion in RMB to the US via debt reduction.

The arithmetic of this is simple. China’s holdings of US dollar assets, chiefly Treasury Bonds, are around $1.5 trillion, or 10.2 trillion RMB. A 10 percent devaluation of the dollar vis-à-vis the RMB would reduce the value of these holdings to 9.3 trillion RMB, and a 20 percent dollar devaluation would reduce their value to 8.5 trillion RMB. In either case the U.S. is asking for its debt to China to be reduced by 10-20 percent in RMB terms. It may now be seen why President Obama’s advisers have a vested interest in not examining the factual situation of China’s trade. They are seeking a large debt relief package.

Sigh. The arithmetic is apparently not as simple as it seems. When one of my central-bank seminar undergraduates showed me this article in December, he was chortling with glee at its bad economics and suggested I used the article to teach the freshman class – the assumption being that no PKU finance student above the level of freshman could have ever made this kind of conceptual mistake. Perhaps not, but certainly anyone writing about currency policy should have at least done the math first.

Although this article is more confused than most about the impact of an appreciation on central bank reserves, it is worth explaining why it is wrong so as to address the less excitingly conspiratorial mistakes made by the merely confused. First, can an appreciation of the RMB reduce the cost to the US government of its debt obligations? Of course not.

The US government transacts almost exclusively in dollars, raises dollars in the form of taxes and borrowing, and owns dollar assets. Since it will pay exactly the same number of dollars to Chinese investors after the change in the RMB value as it did before the change, simple arithmetic should indicate that there will be no impact at all on the cost to the US of repaying the debt. After all, if a revaluation of the RMB causes the euro to drop against the dollar (a highly plausible outcome), could it possibly be true that the USG would reduce its payments on $100 of obligations owed to Chinese investors while increasing its payments on $100 of obligations owed to European investors? Exactly how would this work?

Are there no winners and losers?

It wouldn’t. The claim is nonsensical and violates simple arithmetic. But if the RMB is revalued are there no losses and gains anywhere? Yes, of course there are, but the distribution of these gains and losses is completely different from what this article claims, and depends wholly on the structure of various balance sheets. In a nutshell, anyone who is net long dollars against RMB loses, and anyone who is net short dollars against RMB gains.

First of all, will China as an economic entity lose? Leaving aside the vigorous discussion about whether an RMB revaluation will increase or reduce China’s long term growth prospects (I think it will), the net balance-sheet impact of a revaluation depends on whether China is net long or net short dollars. There is no precise way of answering this question, because every single economic entity in China implicitly has some complex exposure to the dollar (by which I mean foreign currencies generally) through current and future transactions, but generally speaking China is likely to gain from a revaluation because after the revaluation it will be exchanging the stuff it makes for stuff it buys from abroad at a better ratio. The value of what it sells abroad will rise relative to the value of what it buys from abroad, and if we could correctly capitalize those values on the balance sheet, it would probably show that the Chinese balance sheet would improve with a revaluation of the RMB.

Some people might make a more sophisticated argument that since China is a net creditor – i.e. it is net long dollars – it will lose by a revaluation of the RMB. This argument also turns out to be wrong, but for more complex reasons, and to explain why I have to put on my former-trader’s hat and explain the difference between a real loss and a realized loss.

If you believe that the RMB is undervalued then you must accept that China takes a “real” loss every single time it exchanges a locally produced good or asset for a foreign one. It does not “realize” the loss, however, until it revalues the RMB to its “correct” value.

In other words, the PBoC, as the representative of China’s net creditor status, will immediately realize a loss when the RMB revalues, but this loss did not occur because of the revaluation. It occurred the very day the trade took place. When a Chinese producer sold goods to the US and took payment in US dollars, there was an unrealized economic loss equal to the undervaluation of the RMB. This unrealized loss was passed onto the PBoC when it bought the dollars from the exporter and paid RMB.

This loss, however, will not actually show up until the RMB is revalued, which forces the real loss to be realized (i.e. recognized as an accounting matter). Postponing the revaluation, then, is not the way to avoid the loss – it is too late for that. The only way to avoid future additional loss is to stop making the exchange, which means, ironically, that the longer the PBoC postpones the revaluation of the RMB, the greater the real loss it will take.

So a revaluation of the RMB will not cause any real loss to any Chinese entity today. The loss already occurred but hasn’t been realized.

But wait, if the RMB is revalued by 10%, the value of the PBoC’s assets will immediately decline by $250 billion in RMB terms. Since the Chinese measure their wealth in RMB, isn’t this a real additional loss for China?

No, because remember that the only thing you can do with reserves is pay for foreign imports or repay foreign obligations. And just as the value of the reserves drops 10% in RMB terms, so does the value of all those foreign payments – by definition they must go down by exactly the same amount in RMB terms.

This means that China takes no loss. It can buy and pay for just as much “stuff” after the revaluation, and with less implied PBoC borrowing, as it could before the revaluation – and the real value of money is what you can buy with it. So the real value of the reserves hasn’t changed at all – just the accounting value in RMB, but this simply recognizes losses that were already taken long ago when the trade was first made, and should be a largely irrelevant number (except perhaps for conspiracy theorists).

Wealth is transferred within China

But that doesn’t mean nothing at all happened. Although the Chinese overall balance sheet is probably a little better off with the revaluation, within China there are a whole set of winners and losers. Which is which depends on the structure of individual balance sheets. Basically everyone who is net long dollars against the RMB loses in an appreciation, and everyone who is net short dollars against the RMB wins.

Who loses? Of course the PBoC is a big loser. It has a hugely mismatched balance sheet in which it is long nearly $3 trillion (if everything were correctly counted), funded by an equivalent amount of RMB obligations.

Exporters and their employees, too, are naturally long dollars and so they would lose. They are long dollars because more of the net value of their current and future production less current and future costs is denominated in dollars (they are “sticky” to dollar prices) – for example labor costs, land, and almost all other inputs except imported components are valued in RMB, whereas most revenues are valued in dollars.

Chinese companies with more assets abroad then foreign debt might also lose. Who wins? Nearly everyone else in China, since everyone in the country is short dollars to the extent that there are imported goods in his life. The local tea seller is short dollars if his tea is delivered to him in gas-guzzling trucks, as is the family planning to visit Egypt next year, as is the local provider of French perfumes, as is a teenager who wants to buy Nike shoes, and so pay for the corporate sponsorship of a Brazilian soccer star playing for a Spanish team. Every household and nearly every business in China is, in one way or another, an importer (and this is true in every country), so unless they own a lot of assets abroad they are effectively short dollars and will benefit from an appreciation in the RMB.

Revaluing the RMB, in other words, is important and significant because it represents a shift of wealth largely from the PBoC, exporters, and Chinese residents who have stashed away a lot of wealth in a foreign bank, in favor of the rest of the country. Since much of this shift of wealth benefits households at the expense of the state and manufacturers, one of the automatic consequence of a revaluation will be an increase in household wealth and, with it, household consumption. This is why revaluation is part of the rebalancing strategy – it shifts income to households and so increases household consumption.

So a revaluation has important balance sheet impacts on entities within China, and to a much lesser extent, on some entities outside China. But since it merely represents a distribution of wealth within China should we care about the PBoC losses or can we ignore them? Unfortunately we cannot ignore them and might have to worry about the PBoC losses because, once again, of balance sheet impacts.

The PBoC runs a mismatched balance sheet, and as a consequence every 10% revaluation in the RMB will cause the PBoC’s net indebtedness to rise by about 7-8% of GDP. This ultimately becomes an increase in total government debt, and of course the more dollars the PBoC accumulates, the greater this loss. (Some readers will note that if government debt levels are already too high, an increase in government debt will sharply increase future government claims on household income, thus reducing the future rebalancing impact of a revaluation, and they are right, which indicates how complex and difficult rebalancing might be). In that sense it is not whether or not China as a whole loses or gains from a revaluation that can be measured by looking at the reserves, and I would argue that it gains, but how the losses are distributed and what further balance sheet impacts that might have.

I apologize for such a long post, but I promised several people that I would try to address some of these issues, and it is hard to do so briefly. In short, what the PBoC does to the value of the RMB and how it invests its reserves matter a lot to China and the world, but not always in the way China and the world think. To get it right, we need to keep in mind the functioning of the balance of payments, the PBoC and other balance sheets, and the way the two are interrelated.


Pettis on China's US reserves

The always impressive Micheal Pettis explains how Chinese holdings of US paper works in practice. This is a very good explanation using simple economics.

I cut straight to the economics. It is all about the RMB peg to the dollar. As long as the peg exists China will keep buying US paper. The peg will not go away anytime soon. However, it is correct to assume this is not a position China necessary likes to be in and it would like to diversify away from the dollar.

The situation remains - this is like two drunks holding each other up. One moves and they both fall over.

What the PBoC cannot do with its reserves [China Financial Markets]


Beijing is not Washington’s banker

If China runs a current account surplus, it must accumulate net foreign claims by exactly that amount, and the entity against which it accumulates those claims (adjusting for actions by other players within the balance of payments) ultimately must run the corresponding current account deficit. And as long as China ran the largest current account surplus ever recorded as a share of global GDP, and the US the largest current account deficit ever recorded, and especially since China also ran an additional capital account surplus (i.e. other non-PBoC agents ran a net capital inflow), it was almost impossible for the PBoC to do anything but buy US dollar assets. Given the sheer amounts, a substantial portion of these assets had inevitably to be USG bonds.

This was not a discretionary lending decision. It is the automatic consequence of China’s currency regime, in which it pegs the RMB to a foreign currency, in this case the dollar. Why? Because when the PBoC decides on the level of the RMB against the dollar, it does not do so by passing a law, and making it a capital crime for anyone to trade at a different price. What it does is far simpler. It offers to buy or sell unlimited amounts of RMB against the dollar at the desired price.

No one will sell dollars for less than what they can get from the PBoC, nor will anyone buy dollars for more than what they can pay the PBoC, so all transactions get done at that price. That is how the PBoC (or any other central bank that intervenes in the currency market) sets the foreign exchange value of its own currency.

This means that as long as it wants to set the exchange rate, then, it must take the opposite position of the market. Since the rest of the market is a net seller of dollars (China runs a current and capital account surplus), the PBoC has no choice but to be a net buyer of dollars, which of course it must then invest.

If it stops buying dollars, it must let the market decide by itself on the new equilibrium price of the dollar. In that case the value of the dollar has to plunge in RMB terms (or the RMB soar, which is the same thing) in order for buyers and sellers to match up and for the market to clear. The moment the PBoC stops buying, in other words, the RMB will rise in value – and so it cannot stop buying in anticipation of the RMB rising in value, as the FT article suggested.

Of course the PBoC must fund the purchase of these dollars. It does so primarily by borrowing in the domestic money markets, selling PBoC bills or entering into short term repos (although it also issues some longer-term bonds), or by “creating” money by crediting the accounts of the commercial banks who sell it the dollars.

This means, to simplify, that the PBoC has a balance sheet consisting on one side of dollar assets (and here “dollar” is short-hand for all foreign assets). Against this and on the other side it has a roughly equivalent amount of RMB liabilities (I say “roughly” because when you run a mismatched balance sheet, changes in the relative value of assets and liabilities will create losses or profits).

Here is where things get interesting. China’s reserves are often thought of as if they were a treasure trove available for spending. They are not. They are simply the asset side of the mismatched balance sheet. If the PBoC wanted to “spend” $100, say for example to recapitalize a bank, it could do so, but this would automatically create a $100 dollar hole in its balance sheet. – it would still owe the RMB that it borrowed originally to purchase the $100. To put it another way, the reserves are not a savings account, free for the PBoC to spend as it likes. Reserves are effectively borrowed money.