The ugly truth about a renminbi revaluation for Latin America

Ambrogio Cesa-Bianchi, Hashem Pesaran, Alessandro Rebucci, Cesar E. Tamayo, TengTeng Xu, 20 May 2010

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China’s importance in the world economy has increased dramatically over the past 15 years. While world trade has grown by about 40% from the mid-1990s to mid-2008, China’s trade openness has more than doubled over the same period. China is also a very important player in the oil and other commodity markets where a significant share of Latin American exports are supplied. As a result, China’s share of total trade with Latin America has soared from 2% to about 12% since the mid-1990s (Table 1). In the US and the Eurozone (Latin America’s largest trading partners), China today represents about 15% of total trade, about triple its share in the mid-1990s. As Calderon (2009) notes, China therefore affects Latin America through three main channels: direct bilateral trade linkages, trade with major partners, and through the commodities markets.

Table 1. Trade shares: 1995 and 2008

 

In ongoing research at the Inter-American Development Bank (Cesa-Bianchi et al. 2010), we find that these evolving linkages have had a profound impact on the synchronisation of Latin America’s business cycle with China. The research draws on the well known Global Vector-Autoregression methodology (GVAR, see for example Dees et al. 2007). In our GVAR model of the world economy, trade shares link together the 26 largest advanced and emerging economies of the world. Based on a stable econometric specification estimated with quarterly data from 1979 to the second quarter of 2008, we simulate counterfactually the transmission of GDP shocks to major economies using three sets of trade weights for 1980, 1995, and 2008 in order to capture the changing pattern of trade linkages.

Changing Chinese shock

We find that the impact of a shock to China’s GDP has changed dramatically since 1995. According to our estimates, with 2008 trade weights, a decline in China’s GDP growth of one percentage point (e.g., from 10% to 9%) decreases growth in Latin America by about 0.2 percentage points (Figure 1). The same shock reduces US growth by 0.1 percentage point and depresses the oil price by about 2.5%. In contrast, with 1995 trade weights, the same shock has a much more muted effect on the US and no impact on Latin America.

Figure 1. Responses to a one-percent negative GDP shock in China

Source: Cesa-Bianchi et al. (2010). LAC is weighted average of Argentina, Brazil, Chile, Mexico, and Peru.

Thus far China has been a blessing to Latin America. The limited impact of the global financial crisis on Latin America owes much to the improved economic fundamentals of the region and effective international financial support. China helps explain why the region has recovered from this major crisis so much faster than in past crises. Thanks to China, the region’s economic prospects are currently very bright. Growth projections for 2010-11 are back to pre-crisis levels (4% each year, according to the latest IMF WEO), while commodity and asset prices are hovering near their pre-crisis peaks. The main short-term challenge for the region is to manage the boom, with some countries are already showing signs of overheating.

Too much of a good thing is always a bad thing

Not surprisingly, therefore, suffering from excessive capital inflows and exchange-rate appreciation, several Latin American leaders have recently sided with the US and supported calls for a revaluation of the Chinese currency. The reasoning is that a stronger renminbi will induce a change in the composition of China growth, away from exports and toward consumption, while boosting Latin American competitiveness and growth in manufacturing.

But the truth about a renminbi revaluation for Latin America is very different. In the same research mentioned above we find that, in the past, a stronger renminbi has hurt the export sector and led to a GDP contraction in China. Given China’s present grab in the world economy, a stronger renminbi today means weaker world growth and with it weaker Latin American growth. The reasoning behind this pessimistic scenario is that an appreciation may create excess capacity and slow growth if not accompanied by effective expenditure-increasing policies to support domestic demand, and especially household consumption. For instance, our research estimates that a 10% revaluation of the renminbi would reduce growth in China by 0.5 percent, by 0.15% in the US, and by 0.3% in Latin America (Figure 2).

Figure 2. Response to a four-percent real appreciation in China

Source: Cesa-Bianchi et al. (2010). LAC is weighted average of Argentina, Brazil, Chile, Mexico, and Peru.

What can Latin America do?

There is little Latin America can do to influence China’s macroeconomic policies, even though three of the largest countries in the region are now part of the G20. But the region can stay the course and continue to follow good macroeconomic management policies. Amid today’s booming external economic conditions, this means three things.

  • First, countries need to strengthen their fiscal positions. Latin America has learned the lesson of prudent fiscal management during the recent crisis. It must perfect such policies by first reining in any fiscal stimulus designed to support demand during the crisis and then adjust structural balances in keeping with medium-term sustainability considerations under conservative assumptions of growth and foreign financing conditions. This is especially important in light of ongoing developments in Greece as well as Portugal, Ireland, and Spain.
  • Second, Latin American countries should refrain from trying to control exchange rates. History has shown that countries that try to control their exchange rates to prevent speculation end up with more speculation. By letting exchange rates float freely, countries can create more uncertainty in the market, discouraging speculative inflows.
  • And lastly, if Latin America is to improve its competitiveness in manufacturing compared with China, it must invest more in policies that boost productivity. In particular, as the recently published flagship monograph of the Inter-American Development Bank on productivity in the region argues (Pages 2010), the region needs to proceed with structural reforms and improve infrastructure and education, in a context in which transport costs severely hinder technology diffusion and adoption via international trade.

A China revaluation alone is not a silver bullet to rebalance the world economy and solve Latin America’s economic problems. On the contrary, it poses serious risks, and countries must be prepared to deal with the potential negative consequences of a stronger renminbi, which may revalue sooner rather than later.

References

Calderon, C (2009), “Trade, Specialization, and Cycle Synchronization: Explaining Output Comovement Between Latin America, China, and India”, in Daniel Lederman, Marcelo Olarreaga and Guillermo Perry (eds.), China’s and India’s Challenge to Latin America: Oportunity of Threat, The World Bank, Washington, DC.
Cesa-Bianchi, A, MH Pesaran, A Rebucci, CE Tamayo, and T Xu (2010), “On the Transmission of Global Shocks to Latin America Before and After China’s Emergence in the World Economy”, Unpublished manuscript, Inter-American Development Bank.
Dees, S, F di Mauro, MH Pesaran, and LV Smith (2007), "Exploring the international linkages of the euro area: a global VAR analysis", Journal of Applied Econometrics, John Wiley & Sons Ltd, 22(1):1-38.
Pagés, Carmen (2010), The Age of Productivity: Transforming Economies from the Bottom Up, Inter-American Development Bank, Development in the Americas Series, Palgrave Macmillan and Inter-American Development Bank.

 

Topics: International trade
Tags: China, exchange-rate policy, global imbalances, Latin America

PhD student, Catholic University of Milan; Research Assistant in the Research Department, Inter-American Development Bank
Professor Economics, University of Cambridge; John Elliott Chair and Professor of Economics at the University of Southern California; Professorial Fellow of Trinity College, Cambridge
Senior Research Economist in the Research Department of the Inter-American Development Bank
PhD student, Rutgers University
PhD Candidate in Economics at Cambridge University

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