China, Currencies and the 'Financial Balance of Terror'

Policy Brief Series Issue 2, Sep 2011

China, Currencies and the 'Financial Balance of Terror'1 Ramkishen S. Rajan and Javier Beverinotti2

Key Points • The US-China economic relationship is arguably the most important bilateral relationship in the world.

• With the US being China’s largest export market and China being the former’s largest creditor, the two countries are mutually dependent within the so-called 'Financial Balance of Terror'.

• A nagging source of conflict in this bilateral economic relationship is the continued suppression of the value of the Chinese Renminbi vis-à-vis the US dollar which some in the US have argued has led to the erosion of America's industrial base and blame as being the root cause of the ongoing global imbalances.

• This brief re-examines the issue of China’s exchange rate from a structuralist perspective which emphasises the critical role played by the real exchange rate in allocating resources internally between tradables and non-tradables, which could have both real and macroeconomic consequences.

• The brief argues that the Chinese under-valuation policy and its hitherto investment-driven export subsidising growth paradigm may not be a viable medium-term strategy any longer for such a large economy and discusses some policy options.

Introduction As the US economy continues to struggle to find any means to re-ignite its sputtering growth engine so as to avoid a double-dip recession, and as domestic political rifts get toned down somewhat, some US policymakers may start looking for an external 'scapegoat' for all the ills inflicting the American economy today. In this

This brief draws on and substantially builds upon Chapter 4 by Rajan, R.S. (2011). Emerging Asia: Essays on Crises, Capital Flows, FDI and Exchange Rate Policy, Palgrave-Macmillan.

1

Ramkishen Rajan is currently a Visiting Professor at the Lee Kuan Yew School of Public Policy, National University of Singapore and Professor of International Economic Policy and Public Policy, George Mason University, USA. E-mail: rrajan1@gmu.edu. Javier Beverinotti is a Research Scholar at the School of Public Policy, George Mason University, USA. E-mail: jbeverin@masonlive.gmu.edu. All errors are our own.

2

Page 2

context, it would not be surprising if the focus shifts back to the large and sustained trade surplus that China has continued to run with the US. The argument that is inevitably presented here is that China’s central bank has continued to 'manipulate its currency', as evidenced by the large-scale reserve accumulation and burgeoning trade and current account surpluses (Figure 1). This 'under-valued' currency has, allegedly, artificially boosted its export competitiveness – 'flooding the US with cheap Chinese imports' and supposedly wiping out US manufacturing – while concurrently making foreign goods to China relatively more expensive, thus limiting China’s imports from the US (Figure 2). While China accounted for almost 20 per cent of US imports, it constituted just over 7 per cent of US exports of goods in 2010. The bilateral trade deficit with China accounts for more than two-fifths of the total US deficit.3 The policy option in this case appears to be straightforward; China needs to stop artificially suppressing the US dollar value of the Renminbi (RMB). Indeed, failure to do so might invite retaliation from some parts of the US government such as the legislation passed by the House of Representatives imposing trade sanctions against China in September 2010.

The intention here on the part of US lawmakers is to treat currency under-valuation as a form of mercantilism or illegal subsidy which could justify countervailing duties or other trade protectionism.4 The US Treasury has, however, resisted labelling China as a currency

Figure 1: China’s Reserves, Trade Balance and Bilateral Exchange Rate, 1998-2011

Source: World Development Indicators, International Financial Statistics and US Census Bureau

The trade data is somewhat misleading as a large part of China’s exports involve processed trade (i.e. importing parts and components and assembling final goods in China) with limited (but growing) value-added elements.

3

Some noted economists such as Paul Krugman have also favoured the US taking unilateral (tariff) action against China’s persistent under-valuation policy.

4

Page 3

Figure 2: The importance of China to US Trade (per cent share), 1987-2011*

* Note: ‘Share of China in US Trade Balance’ is measured against the right axis. ‘Share of China in US Imports’ and ‘Share of China in US Exports’ are measured against the left axis.

Source: US Census Bureau, US Department of Commerce

manipulator, preferring to try and solve bilateral trade and economic concerns through diplomatic back channels. The US Treasury’s position is no doubt driven in part by the fact that China is the largest external creditor of the US government (China held around US$ 1.1. trillion of US long-term Treasury securities in mid-2010), and the two countries have a highly interdependent relationship critical to the global economy.5 In sharp contrast to the 'us-versus-them' mercantilist point of view, most economists – at least macroeconomists – would argue that focusing on bilateral imbalances is wrongheaded; instead, the emphasis should be on aggregate trade imbalances.6 Moreover, these same economists would generally argue that even if a country is running a trade deficit as the US has been, all that this implies is that the domestic investment rate of the country exceeds its national savings rate and vice versa for a country running an aggregate trade surplus such as China. Thus, the appropriate policy focus should be to deal with savings and investment rates in the countries involved. The exchange rate – the bilateral rate in particular – is a highly limited (i.e. ineffective and possibly inappropriate) tool to deal with what is essentially a macroeconomic phenomenon.

Yet another point of view of the US-China imbalance – popularised by Deutsche Bank economists – postulates that the imbalance is a form of a new Bretton Woods arrangement

5

http://www.gao.gov/special.pubs/longterm/debt/ownership.html

We are rather loose in using the terms of trade and current account imbalances interchangeably, effectively ignoring income receipts or unilateral transfers.

6

Page 4

whereby China and the other East Asian countries (‘the periphery’) have been accumulating reserves by running trade surpluses and exporting their excess savings to the US (‘the centre’).7 The stockpiling of reserves by the periphery, the argument goes, would help build up a competitive capital stock overseas rather than 'waste savings' on low-return domestic projects until the countries’ absorptive capacities are overcome. Thus, in this ‘beneficial disequilibrium’ view of the world, a strategy of monetary mercantilism may be an optimal development strategy from a long-run perspective. In addition, the accumulation of large international reserves (mainly in the US) might act as a type of guarantee against expropriation of US foreign direct investment (FDI) in China – a sort of ‘global swap’ arrangement.8 The clear disconnect and disagreement between the various groups and their perspectives causes significant controversy and confusion. However, there is another angle arguably more insightful to policymakers than any of the above two schools of thought.

This has to do with the critical role played by the real exchange rate in allocating resources internally between tradables and non-tradables (defined below) which could have both real and macroeconomic consequences – the so-called 'structuralist approach'.

The Real Exchange Rate and Sectoral Allocation When economists talk about international price competitiveness, they most often refer to the real exchange rate, i.e. the nominal exchange rate adjusted for relative prices. The real exchange rate is made up of two sets of relative prices: the relative price of traded goods between countries (‘price competitiveness’) and the relative price of tradables and nontradables within a country. Tradable items are goods and services that can be exported and imported, and whose prices are largely determined on the world market while non-tradables are goods and services that are not close substitutes to imports or exports and therefore must be produced and consumed domestically (e.g. housing and health care).

While many commentators have focused on the issue of price competitiveness, arguably of more importance over time is the real exchange rate as a measure of internal relative prices – a factor that has implications for resource allocation within a country.

China’s and East Asia’s development has been rather unorthodox, being centred on suppressing the price of non-tradables relative to tradables. This was done through a combination of import tariffs and export subsidies as well as nominal exchange rate undervaluation. This set of policies led to a massive re-allocation of resources to the exportables and import-competing tradables sector (mainly in manufacturing) while keeping domestic

7

Akin to what happened with some European countries and Japan after World War II.

See Dooley M, Folkerts-Landau D, Garber P. (2004a), 'The Revived Bretton Woods System', International Journal of Finance and Economics, 9, pp.307-313; Dooley M, Folkerts-Landau D, Garber P. (2004b), 'The US Current Account Deficit and Economic Development: Collateral for a Total Return Swap', NBER Working Paper. No. 10727; Dooley M, Folkerts-Landau D, Garber P. (2007), 'Direct Investment, Rising Real Wages and the Absorption of Excess Labor in the Periphery', in G7 Current Account Imbalances: Sustainability and Adjustment, University of Chicago Press.

8

Page 5

consumption of tradables low. This generated significant surpluses of tradable goods which were exported overseas – especially to the US, thus helping East Asia generate large and sustained trade surpluses (defined as an excess of production over consumption of tradables).

These trade surpluses, in turn, were channelled into the US and elsewhere; helping infuse liquidity and keep the costs of credit low, contributing to trade deficits there.

The conundrum is why this under-valuation of the relative prices of non-tradables – which is a form of industrial policy – persisted. In particular, lowering the production of nontradables relative to consumption has not pushed up their prices relative to tradables. This would be what most economists would expect to happen, referring to it as the real exchange rate being ‘mean reverting’. In other words, while policy makers can manipulate the nominal exchange rate, they cannot control real variables for any length of time.

Conventional wisdom is that East Asian countries were able to continue this policy by keeping a lid on the domestic demand for non-tradables via financial repression which kept credit reigned in while maintaining a high degree of fiscal restraint (since governments tend to spend more on non-tradables). While China and other East Asian countries used this combination of macroeconomic policies, it would be hard to argue that non-tradables demand was as heavily suppressed as some economists seem to suggest. This is because of the rapid pace of infrastructural and real estate development and overall credit growth evident..

While non-tradables may not have grown as rapidly as the tradables, they have, nonetheless, grown quite rapidly. So something remains amiss.

Of course, the easy answer is that these countries – most notably China – have an abundance of labour that helped keep the wage costs and thus price of non-tradables down – this is the so-called Arthur-Lewis classic dual-sector model where wages are set in the rural sector where supply of labour is almost perfectly elastic.9 While this may have been true in the early stages of industrialisation, the data suggests that wages have started rising fairly quickly since the early years of the last decade (the so-called 'Lewis turning point').10 In addition, there is the broader question as to why, in the era of non-commodity based currencies, countries would ever want to bias production towards the tradables sector. Drawing on older development economics literature, Dani Rodrik has offered a justification for East Asian countries’ under-valuation policies.11 He offers two distinct arguments as to why tradables (in the modern sector) are under-provided in a state of market equilibrium.

Kirkpatrick C, Barrientos A. (2004), 'The Lewis Model After Fifty Years', Development Economics and Public Policy Working Papers No.9/2004, University of Manchester.

9

Anecdotal evidence pointing to wage-price pressures and labour unrest in China is growing. For instance, see Peaple, A. (2010), 'China's Rising Workers', Wall Street Journal, Monday, May 31; Pomfret, J. (2011), 'As Inland China Grows, Contest Intensifies for Labour', Reuters, Thursday, February 24. For More Systematic Evidence on China’s Real Wages Rates, see Tao Yang, D., Chen, V. and Monarch, R. (2009), 'Rising Wages: Has China Lost Its Global Labor Advantage?', mimeo, The Conference Board, New York.

10

Rodrik, D. (2008), 'The Real Exchange Rate and Economic Growth', Brookings Papers on Economic Activity, fall, pp.365-412.

11

Page 6

Firstly, tradables production is more sensitive to institutional quality compared to non-tradables and thus weak institutions act as a relative tax on tradables. Absent a country’s ability to repair its weak institutions and overall business environment, real exchange rate depreciation could be a sort of subsidy to offset this ‘tax’ (what is sometimes called ‘the second-best argument’ ). Secondly, one must look beyond the static resource reallocation effects and focus on dynamic gains derived from favouring export-linked manufacturing. These benefits could be in the form of learning-by-doing and demonstration effects that are external to the firm. Thus, left to themselves, markets would under-provide such goods and government intervention could jump-start growth via real exchange rate under-valuation to internalise these externalities.

Taking this argument further, by channelling resources towards producing tradables, there may also be some positive productivity spillovers to the non-tradables sector, helping to increase output despite the relative decline in price. In other words, there may be dynamic expansionary effects, which balance, if not outweigh, the static contractionary effects.12 These and other policies have worked in tandem to turn China into a manufacturing powerhouse (‘factory to the world’) in a fairly short period of time (Figure 3).

Figure 3: Share of World Exports (per cent), 1970-2010

Source: World Development Indicators

See Rajan, R.S. and Beverinotti, J. (2011), 'Real Exchange Rate Undervaluation, Resource Allocation and East Asian Growth', Journal of International Development, forthcoming.

12

Page 7

China’s Policy Options Alleging market distortion is easy; providing specific evidence is tougher. However, leaving this issue aside, we are left asking why China should change its policy stance if its development strategy based on an under-valued real exchange rate has succeeded. To be sure, there are a few real concerns here.

1.

Apart from US pressures – which may be counter-productive – the foregoing externalities story is unlikely to hold sway. Indeed, over time it is generally believed that the productivity of the tradables sector will outpace that of non-tradables and wages will have to start rising as the country develops, as already evident. This inevitably puts upward pressures on domestic non-tradables prices and therefore the real exchange rate (the so-called ‘Balassa-Samuelson’ effect). Thus, maintaining an under-valuation policy will magnify distortions.

2.

Of further concern are the growing costs of holding low-yielding foreign exchange reserves denominated in a rapidly depreciating US dollar. The inability of the US to agree to a credible plan to return to a fiscally sustainable medium-term path – along with Standard & Poor’s rather knee-jerk downgrading of the US government’s credit rating – suggests that the US dollar will continue to lose value, especially against Asian currencies. The lack of alternative viable investment vehicles, combined with China’s substantial US dollar holdings, will likely limit its ability to threaten to diversify its reserve assets, let alone do so (the so-called ‘Financial Balance of Terror’ described

by Larry Summers). Any currency diversification can only be gradual. However, it would make more sense to try and prevent further accumulation of reserves.13 This, in turn, implies allowing for a combination of relatively faster exchange rate appreciation of the RMB as well as greater capital account deregulation to reduce balance of payments surplus pressures.

3.

With sustained sluggish growth in the US and most of Europe, it is unlikely that China will be able to keep exporting its excess production of tradables unless it can find comparable new markets. A more sustainable strategy is likely to be one allowing real exchange rate appreciation and reorienting production and consumption towards non-tradables.

4.

Notwithstanding a deep global recession, it is likely that China will face greater inflationary concerns from domestic resource constraints and commodity pressures globally. The ongoing currency intervention effectively implies greater monetary creation, which has to be mopped up. However, that in and of itself is getting harder and costlier to deal with in view of the intense balance of payments pressure. Thus, unless

13

This is especially so because of inflationary concerns and costs associated with monetary sterilisation.

Page 8

there is a willingness to accept higher overall or asset price inflation going forward, faster nominal appreciation would mitigate some of these pressures.14

So, the Chinese under-valuation policy and its hitherto export-subsidising growth paradigm, one powered by investments, may not be a viable medium-term strategy any longer for such a large economy. Greater currency flexibility and steady appreciation of the RMB is required. Recognising this, on June 19, 2010 the People’s Bank of China (PBC) announced that it would abandon its currency peg to the US dollar and manage the RMB more flexibly against a currency basket.15 Authorities had made a similar announcement on July 21, 2005, when they started allowing the RMB to gradually appreciate vis-à-vis the US dollar. That policy was put on hold from July 2008 as China returned to a firm US dollar peg with the onset of the global financial crisis because of concerns about export and growth slowdown and global deflation at that time. Between June 2010 and June 2011, the RMB has appreciated by a mere 5 per cent against the US dollar and a meagre 2.5 per cent in a trade weighted sense. So while there has been a somewhat greater degree of RMB flexibility over the last year, it remains extremely heavily managed and has experienced a relatively low rate of currency appreciation, especially in comparison to some other labour intensive Asian counterparts such as India and Indonesia. Once one accounts for the likelihood that Chinese worker productivity has outpaced most of its counterparts and inflation thus far has been relatively more moderate than some of the other labour-intensive Asian countries, there has been very limited real currency adjustment despite the policy proclamation (Figure 4).

Figure 4: Trade Weighted Exchange Rates for China, India and Indonesia (Index), Jan 2009-Jun 2011

Source: World Development Indicators

14

As of June 2011 year-on-year inflation (CPI) in China was hovering at 6.5 per cent.

15

See the People’s Bank of China: http://www.pbc.gov.cn/english/detail.asp?col=6400&id=1488.

Page 9

Beyond the exchange rate, China’s rebalancing plan away from production and export of tradables to greater domestic production of non-tradables and greater consumption requires a milieu of appropriate domestic structural reforms, including removing domestic cost distortions, building a more effective social safety net, as well as greater institutional reforms of the state-owned enterprises (SOEs).16 That China needs structural reforms geared more to market determinations – not least the importance for the country to undertake a series of internal price reforms to address severely distorted prices – has been widely discussed.17 The Chinese authorities have recognised the need to rebalance the economy, outlining reforms in the 12th five year plan (2011-2015) approved by the National People’s Congress in March 2011.18

Conclusion Real exchange rate under-valuation in China has likely led to sectoral re-allocation of resources which in turn has helped transform it into an industrial and export power, not unlike many of its East Asian counterparts in the 1970s to 1990s. These policies have also contributed to external imbalances with the US and other countries (the same could be said of Germany for that matter which has been running trade and current surpluses). However, there are signs that the efficacy of this set of policies of real exchange rate under-valuation may be nearing its limits, especially in view of the deteriorating debt situations and growth outlooks in the US and Eurozone economies as well as acceleration in inflation.

This said, it is not at all apparent that even if China does revalue the RMB significantly over time, the US current account deficit will see any perceptible/significant improvement.

The Japanese experience in the mid-1980s may be relevant here. The Plaza Accord, which led to a sharp revaluation of the yen, was accompanied by a decline in Japan’s bilateral trade surpluses with the US and the rest of the world. However, the overall trade deficit of the US vis-à-vis Asia was largely unaffected as the US started to run larger trade deficits with other East Asian economies and most recently with China as Japanese manufacturers started to produce final goods from their lower cost neighbours for exports. The experience of the China’s consumption share of GDP in 2010 was around 30-35 per cent compared to 55-70 per cent for other large Asian economies like India and Indonesia as well as large advanced economies like Japan and the US. This in turn is due to the low and declining share of labour income in GDP compared to large and growing profits of SOEs which maintain large retained earnings.

16

For instance, see Huang Y and Tao K. (2010), 'Causes and Remedies of China’s External Imbalances', China Center for Economic Research Working Paper No. E2010002, Peking University, Beijing.

17

At the 2011 annual meeting of the Boao Forum for Asia (BFA), President Hu Jintao stated, 'In the next five years, China will make great efforts to implement the strategy of boosting domestic demand, especially consumer demand, and put in place an effective mechanism to unleash consumption potential. We will ensure that consumption, investment and export contribute to economic growth in a coordinated way.' See http://en.ce.cn/subject/201 1boao/2011boaon/201104/15/t20110415_22366593.shtml 18

In fact, as can be seen in Figure 1 above, while China’s aggregate trade (and current account balances) which peaked in 2007 has been declining, its bilateral imbalances with the US have persisted (Figure 2).

19

Page 10

Plaza Accord underscores the fallacy that we live in a world with a two-country axis, especially in this day and age where countries such as China are linked through regional and global production networks. For the US, what would be more relevant is not simply limited to what China does with the RMB. Finally, for other countries in Asia, having a rebalanced China whose growth is increasingly driven by internal demand will add a much greater degree of durability to the region’s economic outlook in the face of an increasingly volatile global economy.

The Lee Kuan Yew School’s Briefing Room Series is edited by Toby Carroll, Senior Research Fellow at the Centre on Asia and Globalisation, and Claire Leow, Senior Manager for Research and Dissemination at the Research Support Unit. Feedback should be sent to: research.lkyschool@nus.edu.sg