We need to go back to fundamentals to get a better perspectives
RECENTLY, I was in Shanghai to attend a research symposium led by Harvard president Drew Faust. Participants included the university’s best and brightest China-hands as well as luminaries from among China’s elite academia.
Deliberations took on “The Chinese Century?”, “China: Dynamic, Important and Different”, “The Moral Limits of Markets”, “Managing Crises in China” and many more. I came away wiser. Indeed, there is so much happening in China to experience, understand and learn.
Visiting Shanghai and Beijing, you cannot but feel China is under siege for running external payments surpluses. A consequence – argued by politicians and others in the United States and Europe, of China’s rigid exchange rate regime.
The debate is as fierce as it is emotional. Of late, China is strongly criticised for artificially depressing (even manipulating) the value of its currency, renminbi or yuan, to the detriment of its trading partners. Indeed, Nobel Laureate Paul Krugman even contended that China had since taken millions of jobs globally, especially from the United States.
To really understand this it requires going back to fundamentals. What caused China’s recent balance of payments (BoP) surpluses?
Causes of imbalance
For China, BoP surpluses are a relatively recent phenomenon. It used to have persistent deficits in the second half of the 80s. Surpluses only came in the early 90s and rose sharply since 2004 (3.5% of GDP or gross domestic product) to reach a high in 2007 (10.8%). The surplus has now moderated but only modestly.
Whereas, serious US current account deficits started years earlier. The literature on China’s surpluses is long. I came across a perceptive study by two young Beita economists at its China Centre for Economic Research, Huang Yiping and Tao Kunyu, who attributed the main cause to asymmetric market liberalisation.
Over the past 30 years, reform was much too focused on product markets (today, 95% of products are determined by free markets). But markets in factors of production – labour, capital, land, energy and the environment – remain highly distorted, driven by the government’s growth-centered policy strategy to push exports.
These cost distortions are equivalent to production and investment subsidies. Both Chinese and foreigners invest massively because of China’s cheap labour, cheap capital, cheap land and cheap energy:
● Labour: China’s abundant and cheap labour is key to its continuing success in manufacturing exports. But labour costs are distorted because (i) the separation of rural and urban labour leads to labour immobility and low pay for rural migrants; and (ii) an out-of-date social welfare system (including health and pensions) means payrolls should be 35%–40% more.
● Capital: The financial system remains repressed, with regulated interest rates and state control of credit allocation; external capital controls are restrictive on outflows. Moreover, the currency is kept undervalued.
● Land: The state owns land in cities and collectives, outside. No market mechanism exists to price land for industrial use; often prices are set low to promote investment and growth.
● Energy: Key energy prices are state-determined and usually subsidised; and
● Environment: Enforcement is random since growth is a given priority. The cost of pollution is not priced in.
All these mean lower production costs and producer subsidies. They artificially inflate profits, raise investment returns and improve competiveness. Economists Huang and Tao estimated these subsidies to be worth a hefty 7% of GDP.
Capital market distortions are the most troublesome, contributing 40% of total; with labour subsidies, 25%. The upshort: These are structural imbalances. Factor distortions are deep. Any credible policy at re-balancing must tackle the root cause, i.e. distorted incentives for investors, producers and exporters. The undervalued yuan is but one element in the entire jigsaw.
The savings-investment gap is by definition the flip-side of BoP surpluses. Attempts to explain the imbalance in terms of savings and investment behaviour will not be useful. Suffice to recognise the common belief that Chinese households save too much is incorrect.
For 15 years, the household savings rate has been stable at about 30%; nothing unusual in Asia. Its stability suggests that household savings are probably not a key cause of the growing BoP surpluses in recent years. Because corporate savings are rising, households’ income share is on the decline.
The exchange rate option
Exchange rate reform in China is sensitive. For the United States and Europe, the yuan scapegoat is political football, with attendant risks of a trade war. Among economists, there are vast differences about what needs to be done. The common prescription is to let the yuan rise by a certain margin (enough to eliminate the undervaluation), but no one knows precisely what this is. Views vary widely.
In April, Goldman Sachs pointed out that “at the moment, rather oddly, our model suggests that the RMB (yuan) is very close to the price that it should be. This has not always been the case. The model used to suggest the currency was undervalued by about 20% but it has moved by that degree over the past five years.”
However, a 2009 research of Goldstein and Lardy at the US Peterson Institute pointed to a 12%–16% undervaluation. Even if such an adjustment were taken, the West would still prefer it to be larger. Nor will the Chinese do so in one go, given the likely sharp negative impact on China’s desire for exchange stability.
But the weight of recent history looms large. Between the mid-2005 and end-2008, the yuan exchange rate appreciated by 19%, after strengthening by 30% over 10½ years since January 1994. Yet China’s BoP surplus surged during these periods. Despite the revaluation, US-China imports rose 39% during 2005–2008.
Japanese economic stagnation following the US pressure in 1985 didn’t boost confidence – US$1 fell from 240 yen to 160 yen over two years; and then to 80 yen by 1995.
Consequently, growth slowed abruptly forcing more government spending and low interest rates. The real-estate bubble and a year-long slump followed. The 1990s became a decade of lost growth. To this day, the intended aim to fix Japan’s BoP surplus remains just that – an empty aim!
Two lessons have emerged for China: large foreign exchange adjustments cause long-term damage to the economy, and it won’t necessarily help eliminate BoP surpluses.
An often suggested alternative is for China to adopt greater exchange rate flexibility. This looks reasonable enough, but will it resolve China’s BoP imbalances? Empirical studies have shown there is no systematic or reliable relationship between its BoP position and exchange rate flexibility.
Consider this also. Even if a significant yuan revaluation could wipe off China’s BoP surpluses, it still won’t reduce the United States’ BoP deficits. After all, yuan features at only 15% of the US Federal Reserve’s exchange rate basket for the greenback. This simply means a 20% yuan appreciation only translates to a 3% appreciation against the dollar.
Furthermore, the market vacuum left by China would most likely be filled by exports from other low-income countries like India, South Africa, Indonesia and Vietnam, or by even high-tech competitive South Korea and Taiwan. So be careful about what you ask for.
And then, there is the crawling peg or gradual appreciation option. But this creates expectations that can lead to speculation and hot-money inflows. China should have learnt from yuan’s rise in 2007 and 2008. A way out of this dilemma should be familiar: Opt for the compromise it took in July 2005 when China moved off the peg to the US dollar with a material revaluation, which eventually turned out to have little impact on its BoP surplus.
Unlike the United States and Europe, ASEAN plus 4 (India, Japan, South Korea and Taiwan) have remained “cool” on this issue because: (i) China’s continuing growth provides a robust source of demand for the region; (ii) most neighbours have different export profiles from China; indeed, most of their trade complements rather well; (iii) Japan, South Korea and Taiwan have built large manufacturing capacities in China, thus sharing in China’s dynamic exports; and (iv) Asia likes ready access to cheaper manufacturing equipment it badly need, which in turn keeps China’s export machine running.
In the final analysis, many in Asia are likely to mirror any revaluation of the yuan. This is already happening to the stronger Asian currencies as the US dollar weakens.
US unlikely to benefit
Students of economics know better. In the past two years, the United States had trade deficits with over 90 countries. Yet, the United States is pushing for a bilateral solution (“forcing” China to revalue or tax Chinese exports) to essentially a multilateral problem. Both China and the United States have large imbalances with rest of the world. Any credible solution must lie in a multilateral approach. After all, China-US trade accounted for only 12% of the total Chinese trade.
Nevertheless, empirical evidence suggests that a more expensive yuan is unlikely to reduce the US bilateral deficit. A sharp appreciation of the yuan between June 2005 and June 2008 in fact widened the US deficit. Contrary to textbook economics, US imports from China rose by 39%, offsetting increases in China’s US-imports which (even without revaluation) had been increasing since 2002.
Moreover, higher import prices would mean a fall in the purchasing power of US income. But a stronger yuan raises the purchasing power of China’s producers who rely on imported raw materials. Because imports are now cheaper, Chinese exporters can reduce export prices to maintain market share.
Realistically, it is not surprising that the relationship between the exchange rate and BoP balance is at best weak. Weaker still is the relationship between the BoP deficit and US job loss.
Here again, empirical evidence is telling. An old friend, Prof Lawrence Lau of Stanford, pointed out in his 2006 research (and corroborated by others in 2008) that Chinese value-added accounted for only 1/3 to ½ of US imports from China. This reflects the importance of efforts by workers and capital from other countries, including the United States.
It is reported the iPod costs US$150 to produce, of which only US$4 is Chinese value added. Most of the components are made in the United States and other countries. It is put together in China and exported to the United States for the full US$150 as imports from China, adding to the US deficit and exaggerating the US job loss!
In reality, imported iPods support a myriad of US jobs up the value chain. Surely, prohibitive tariffs on iPod imports can’t really hurt China. Why cut your nose to spite your face?
China needs a package deal
It does appear slamming China as a “currency manipulator” does not help the United States’ cause. It will probably backfire. Even assuming the yuan is undervalued, exclusive focus on China’s exchange rate policy is, I think, counter-productive. It will unlikely resolve the United States’ persistent external imbalance.
However, as I see it, there is growing awareness in Beijing that greater exchange rate flexibility and a gradual yuan appreciation has to be an element of any credible package of policy measures for China to seriously liberalise factor markets and remove cost distortions. This could well transit over time to a full-market economy. Any exchange rate adjustment has to be viewed in this context.
Nevertheless, these are necessary but not sufficient. China has to embark also on other reforms, including re-designing macro-economic policies that don’t over-emphasise growth, privatising state-owned enterprises and liberalising financial development, striking a better balance in income distribution from corporate to households, and aggressively promoting the services sector development, especially small and medium-scale enterprises. Such a comprehensive rebalancing exercise can be made to work, but will necessarily take time. It’s steady as she goes.
What Are We To Do by TAN SRI LIN SEE YAN
● Former banker, Dr Lin is a Harvard educated economist and a British Chartered Scientist who now spends time teaching and promoting the public interest. Feedback is most welcome; email:
starbizweek@thestar.com.my.
Deliberations took on “The Chinese Century?”, “China: Dynamic, Important and Different”, “The Moral Limits of Markets”, “Managing Crises in China” and many more. I came away wiser. Indeed, there is so much happening in China to experience, understand and learn.
Visiting Shanghai and Beijing, you cannot but feel China is under siege for running external payments surpluses. A consequence – argued by politicians and others in the United States and Europe, of China’s rigid exchange rate regime.
The debate is as fierce as it is emotional. Of late, China is strongly criticised for artificially depressing (even manipulating) the value of its currency, renminbi or yuan, to the detriment of its trading partners. Indeed, Nobel Laureate Paul Krugman even contended that China had since taken millions of jobs globally, especially from the United States.
To really understand this it requires going back to fundamentals. What caused China’s recent balance of payments (BoP) surpluses?
Causes of imbalance
For China, BoP surpluses are a relatively recent phenomenon. It used to have persistent deficits in the second half of the 80s. Surpluses only came in the early 90s and rose sharply since 2004 (3.5% of GDP or gross domestic product) to reach a high in 2007 (10.8%). The surplus has now moderated but only modestly.
Whereas, serious US current account deficits started years earlier. The literature on China’s surpluses is long. I came across a perceptive study by two young Beita economists at its China Centre for Economic Research, Huang Yiping and Tao Kunyu, who attributed the main cause to asymmetric market liberalisation.
Over the past 30 years, reform was much too focused on product markets (today, 95% of products are determined by free markets). But markets in factors of production – labour, capital, land, energy and the environment – remain highly distorted, driven by the government’s growth-centered policy strategy to push exports.
These cost distortions are equivalent to production and investment subsidies. Both Chinese and foreigners invest massively because of China’s cheap labour, cheap capital, cheap land and cheap energy:
● Labour: China’s abundant and cheap labour is key to its continuing success in manufacturing exports. But labour costs are distorted because (i) the separation of rural and urban labour leads to labour immobility and low pay for rural migrants; and (ii) an out-of-date social welfare system (including health and pensions) means payrolls should be 35%–40% more.
● Capital: The financial system remains repressed, with regulated interest rates and state control of credit allocation; external capital controls are restrictive on outflows. Moreover, the currency is kept undervalued.
● Land: The state owns land in cities and collectives, outside. No market mechanism exists to price land for industrial use; often prices are set low to promote investment and growth.
● Energy: Key energy prices are state-determined and usually subsidised; and
● Environment: Enforcement is random since growth is a given priority. The cost of pollution is not priced in.
All these mean lower production costs and producer subsidies. They artificially inflate profits, raise investment returns and improve competiveness. Economists Huang and Tao estimated these subsidies to be worth a hefty 7% of GDP.
Capital market distortions are the most troublesome, contributing 40% of total; with labour subsidies, 25%. The upshort: These are structural imbalances. Factor distortions are deep. Any credible policy at re-balancing must tackle the root cause, i.e. distorted incentives for investors, producers and exporters. The undervalued yuan is but one element in the entire jigsaw.
The savings-investment gap is by definition the flip-side of BoP surpluses. Attempts to explain the imbalance in terms of savings and investment behaviour will not be useful. Suffice to recognise the common belief that Chinese households save too much is incorrect.
For 15 years, the household savings rate has been stable at about 30%; nothing unusual in Asia. Its stability suggests that household savings are probably not a key cause of the growing BoP surpluses in recent years. Because corporate savings are rising, households’ income share is on the decline.
The exchange rate option
Exchange rate reform in China is sensitive. For the United States and Europe, the yuan scapegoat is political football, with attendant risks of a trade war. Among economists, there are vast differences about what needs to be done. The common prescription is to let the yuan rise by a certain margin (enough to eliminate the undervaluation), but no one knows precisely what this is. Views vary widely.
In April, Goldman Sachs pointed out that “at the moment, rather oddly, our model suggests that the RMB (yuan) is very close to the price that it should be. This has not always been the case. The model used to suggest the currency was undervalued by about 20% but it has moved by that degree over the past five years.”
However, a 2009 research of Goldstein and Lardy at the US Peterson Institute pointed to a 12%–16% undervaluation. Even if such an adjustment were taken, the West would still prefer it to be larger. Nor will the Chinese do so in one go, given the likely sharp negative impact on China’s desire for exchange stability.
But the weight of recent history looms large. Between the mid-2005 and end-2008, the yuan exchange rate appreciated by 19%, after strengthening by 30% over 10½ years since January 1994. Yet China’s BoP surplus surged during these periods. Despite the revaluation, US-China imports rose 39% during 2005–2008.
Japanese economic stagnation following the US pressure in 1985 didn’t boost confidence – US$1 fell from 240 yen to 160 yen over two years; and then to 80 yen by 1995.
Consequently, growth slowed abruptly forcing more government spending and low interest rates. The real-estate bubble and a year-long slump followed. The 1990s became a decade of lost growth. To this day, the intended aim to fix Japan’s BoP surplus remains just that – an empty aim!
Two lessons have emerged for China: large foreign exchange adjustments cause long-term damage to the economy, and it won’t necessarily help eliminate BoP surpluses.
An often suggested alternative is for China to adopt greater exchange rate flexibility. This looks reasonable enough, but will it resolve China’s BoP imbalances? Empirical studies have shown there is no systematic or reliable relationship between its BoP position and exchange rate flexibility.
Consider this also. Even if a significant yuan revaluation could wipe off China’s BoP surpluses, it still won’t reduce the United States’ BoP deficits. After all, yuan features at only 15% of the US Federal Reserve’s exchange rate basket for the greenback. This simply means a 20% yuan appreciation only translates to a 3% appreciation against the dollar.
Furthermore, the market vacuum left by China would most likely be filled by exports from other low-income countries like India, South Africa, Indonesia and Vietnam, or by even high-tech competitive South Korea and Taiwan. So be careful about what you ask for.
And then, there is the crawling peg or gradual appreciation option. But this creates expectations that can lead to speculation and hot-money inflows. China should have learnt from yuan’s rise in 2007 and 2008. A way out of this dilemma should be familiar: Opt for the compromise it took in July 2005 when China moved off the peg to the US dollar with a material revaluation, which eventually turned out to have little impact on its BoP surplus.
Unlike the United States and Europe, ASEAN plus 4 (India, Japan, South Korea and Taiwan) have remained “cool” on this issue because: (i) China’s continuing growth provides a robust source of demand for the region; (ii) most neighbours have different export profiles from China; indeed, most of their trade complements rather well; (iii) Japan, South Korea and Taiwan have built large manufacturing capacities in China, thus sharing in China’s dynamic exports; and (iv) Asia likes ready access to cheaper manufacturing equipment it badly need, which in turn keeps China’s export machine running.
In the final analysis, many in Asia are likely to mirror any revaluation of the yuan. This is already happening to the stronger Asian currencies as the US dollar weakens.
US unlikely to benefit
Students of economics know better. In the past two years, the United States had trade deficits with over 90 countries. Yet, the United States is pushing for a bilateral solution (“forcing” China to revalue or tax Chinese exports) to essentially a multilateral problem. Both China and the United States have large imbalances with rest of the world. Any credible solution must lie in a multilateral approach. After all, China-US trade accounted for only 12% of the total Chinese trade.
Nevertheless, empirical evidence suggests that a more expensive yuan is unlikely to reduce the US bilateral deficit. A sharp appreciation of the yuan between June 2005 and June 2008 in fact widened the US deficit. Contrary to textbook economics, US imports from China rose by 39%, offsetting increases in China’s US-imports which (even without revaluation) had been increasing since 2002.
Moreover, higher import prices would mean a fall in the purchasing power of US income. But a stronger yuan raises the purchasing power of China’s producers who rely on imported raw materials. Because imports are now cheaper, Chinese exporters can reduce export prices to maintain market share.
Realistically, it is not surprising that the relationship between the exchange rate and BoP balance is at best weak. Weaker still is the relationship between the BoP deficit and US job loss.
Here again, empirical evidence is telling. An old friend, Prof Lawrence Lau of Stanford, pointed out in his 2006 research (and corroborated by others in 2008) that Chinese value-added accounted for only 1/3 to ½ of US imports from China. This reflects the importance of efforts by workers and capital from other countries, including the United States.
It is reported the iPod costs US$150 to produce, of which only US$4 is Chinese value added. Most of the components are made in the United States and other countries. It is put together in China and exported to the United States for the full US$150 as imports from China, adding to the US deficit and exaggerating the US job loss!
In reality, imported iPods support a myriad of US jobs up the value chain. Surely, prohibitive tariffs on iPod imports can’t really hurt China. Why cut your nose to spite your face?
China needs a package deal
It does appear slamming China as a “currency manipulator” does not help the United States’ cause. It will probably backfire. Even assuming the yuan is undervalued, exclusive focus on China’s exchange rate policy is, I think, counter-productive. It will unlikely resolve the United States’ persistent external imbalance.
However, as I see it, there is growing awareness in Beijing that greater exchange rate flexibility and a gradual yuan appreciation has to be an element of any credible package of policy measures for China to seriously liberalise factor markets and remove cost distortions. This could well transit over time to a full-market economy. Any exchange rate adjustment has to be viewed in this context.
Nevertheless, these are necessary but not sufficient. China has to embark also on other reforms, including re-designing macro-economic policies that don’t over-emphasise growth, privatising state-owned enterprises and liberalising financial development, striking a better balance in income distribution from corporate to households, and aggressively promoting the services sector development, especially small and medium-scale enterprises. Such a comprehensive rebalancing exercise can be made to work, but will necessarily take time. It’s steady as she goes.
What Are We To Do by TAN SRI LIN SEE YAN
● Former banker, Dr Lin is a Harvard educated economist and a British Chartered Scientist who now spends time teaching and promoting the public interest. Feedback is most welcome; email:
starbizweek@thestar.com.my.
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