Should-Read: Brad Setser: China’s Dual Equilibria

Should-Read: Brad Setser: China’s Dual Equilibria: “Not just multiple possible exchange rate equilibria… at least two different possible macroeconomic equilibria…

…In the “strong” yuan equilibrium, outflows are kept at a level that China can support out of its current goods trade surplus…. A larger “on-budget” central government fiscal deficit—together with an expansion of social insurance—keep demand up, even as investment falls. In the “weak” yuan equilibrium, China lets the market drive its currency lower—and a weaker currency increases the trade and current account surplus. Such surpluses would finance sustained capital outflows in excess of half a trillion dollars a year without the need to dip further into China’s reserves. The resulting surpluses would be shockingly large…. A larger trade surplus would also provide support for the economy. As investment slows, China would in effect pivot back to exports–and it wouldn’t need to use the central government’s fiscal space to support demand. Both are plausible…

The modern way to maintain an undervalued currency isn’t to intervene to weaken your currency. It is to step back and allow the market to drive your currency down–-And then intervene to resist subsequent pressure to appreciate (and rebuild reserves) when the market turns…