Michael Pettis on RMB "Appreciation" and Rebalancing

Many people have been arguing that the RMB has been appreciating againt the dollar and that rebalancing has begun. Michael Pettis says, in nominal terms, yes, but in real terms, not so much.

So what does it all mean? Just this: the claim that one of the key components of rebalancing – an appreciating currency – has been occurring may be vastly overstated or even simply wrong. There has been little or no real appreciation of the RMB and there may actually have been some depreciation....

Moreover, not only currency appreciation is involved in the rebalancing equation. There are also real versus nominal interest rates and wage growth, as well as productivity.

There are some interesting implications of this constellation of adjustment processes that are worth examining. To summarize, there are three important causes of the consumption imbalances that are plaguing long-term growth prospects in the Chinese economy. One of these, the undervalued exchange rate, hasn’t changed much in the past year and so has not contributed to rebalancing. The second, excessively low [real] interest rates, has gotten significantly worse in the past year and so has exacerbated the imbalances. The third, lagging wage growth, has gotten much better and so has contributed to Chinese rebalancing.

What is the net effect of the three processed? Unfortunately there is no real way of comparing the impact of each variable, and so there is no real way of judging the net effect. All we can do is look at household consumption and its relationship to GDP growth, and infer the net impact from that.

If the World Bank analysis is correct, and if household consumption growth has been slowing, it suggests that because the imbalances are getting worse, not better, the adverse impact of declining real interest rates may be greater than the positive impact of rising wages. Or it may suggest that there is a lag in the impact and we will just have to wait out the end of 2011 before we can determine what has really happened....

Factoring all this, Pettis concludes:

China isn’t yet rebalancing. The way that its growth model works suggests that it cannot happen except with a sharp contraction in investment growth, something we are not seeing, and the empirical evidence so far seems to support the theory. It will probably take a couple of years of this kind of unbalanced growth before this point is more widely recognized, but I suspect that another year or two of stagnant consumption as a share of GDP is finally going to convince policymakers. Until then, expect more of the same, and with it rapidly rising debt levels.

Read his entire analysis at China Financial Markets, Rebalancing through Wage Increases. This is an excellent summary of what is likely happening in China now, in spite of what you may be hearing.