Up to the summer of 2008, qualifying China’s economic strategy as a case of mercantilism looked like an open and shut case. China’s global trade surplus had been snowballing, particularly with the EU and the US. Its external account surplus exceeded 10% of GDP, a unique case made even more unique by the huge population size of China – we are not talking about a city emporium economy such as Hong Kong or Singapore, where re-export is a way of life and external trade a multiple of GDP. Since 1994, a peg to the currency of the US, which had the largest symmetrical trade deficit and current-account deficit, literally ensured that the trade imbalance would only get larger until something gave way in either economy.
In the race to the bottom that characterises competition under conditions of globalisation, China seemed to lead the way. Household income relative to GDP had declined to a record low share of 34 %. That China had conceded, after years of stonewalling, a crawling revaluation of its own currency against the dollar looked suspiciously like an indirect admission of guilt. The revaluation was certainly not on the scale of what was needed to take care of the problem, but it was a political recognition of its existence. This revaluation did reach 21% between 2005 and 2008, but at a time when the dollar had entered into a steep decline against the euro, the yen and other currencies. China’s competitive advantage was mostly preserved, albeit redirected.
Even then, various arguments were used to counter the accusation of a mercantilist use of currency valuation to capture surplus value. China was really assembling final products from goods and parts imported from the rest of East Asia, resulting in a triangular trading pattern. Foreign firms were involved in as much as 60% of China’s exports – and the slice of added value accruing to China could be quite small. The classic example used to be the Nike shoe, where design, process, distribution and advertising made up most of the costs, and manufacturing in China was trivially low. The contemporary example is Apple’s iPhone, assembled in China by a Taiwanese firm from imported parts, where it is claimed the Chinese added value is no more than $4 per phone.
Two macroeconomic arguments were also used to defend China’s trade surplus. One was the asymmetry resulting from the conditions of China’s admission to the WTO. As a developing country, it had not had to open up services, capital markets and public procurement, while its massive labour supply ensured a nearly flat level for wages in the assembly sector. The second argument, still widely used, results from the asymmetry with the US itself. For cognoscenti, the argument is not about currency manipulation and mercantilism or protectionism. “It’s the imbalance, stupid”, is the prevailing assumption. Since the US had chosen to run a deficit and favour spending and borrowing over saving and producing, the resulting financing need had by definition to be made up by a corresponding supply from China. The imbalance between US spending and Chinese saving was the factor behind the trade surplus, and not a mercantilist monetary policy. And US economic policy was driving the trend, not China’s own decisions.
It’s not the imbalance, actually
This argument was never correct, since other major economies also run major current-account surpluses with the US, but not necessarily a trade surplus. Japan may not be a good comparison point, since one can argue that a large share of its trade surplus with the US is acquired indirectly, via re-exports through China. But Europe – which has a strong private savings rate and where private capital flows to the US have always been at least as substantial as China’s public flows – nonetheless does not run a major trade surplus with the US, and it now experiences the same level of trade deficit with China as the US. By providing capital to the US and a market for China’s exports, Europe may in fact have unwittingly been the third party that bears a large share of the adjustment in the global economy. Today’s situation for Europe’s public deficits results from what appears superficially as a balance. Large European private savings are exported rather than invested, and low-priced imports from China are preserving consumer purchasing power. In the short term this is a balance. Lower spending allocation is compensated by lower prices for coin summer goods. But in both cases, the diminution in economic activity impairs public fiscal resources.
Until 2008, the US-China imbalance has only mattered politically as a bilateral issue, with the EU, Japan (and others) as bystanders, even when they bore some of the adjustment. Politically, the goals of the Bush administration with China were such that monetary and trade complaints came a distant second, after strategic constraints such as Iraq, Iran, and North Korea.
The global crisis of 2008 has changed all this in a fundamental way, and the case for or against China must be revisited in view of new trends and policies. First, 2009 has been an exceptional year for China’s growth, where net foreign trade has made a negative ( -4.8 %) contribution to GDP, while domestic growth has skyrocketed (+13.9 %). This was made possible by China’s low level of central public debt. The giant size of China’s stimulus and lending “plan” in 2009 (in fact, an irrational and exuberant unleashing of bank lending on top of a powerful programme of public infrastructure and consumer incentives) was made possible, and is hostage to, a policy of near-zero interest rates in China. This is what makes the sterilisation of massive foreign trade surpluses into dollar reserves painless for China’s central bank, because the interest it pays on domestic borrowing remains lower than the interest it receives on its dollar lending. This policy is biased towards domestic hyper growth, since it allows for quasi-free access to capital resources, much like the Japan of the late 1980s. Hence the talk about a giant lending and real estate bubble. In turn, China’s gigantic foreign currency reserves insure the country against a crash landing. However large the true lending liabilities of China may now be (and they include a lot of local indebtedness as well as cross-lending by banks at unlimited levels), the possibility of buying back yuans and draining bad debt remains. Opacity and centralisation also make it highly unlikely that a Chinese Lehman Brothers case might happen.
On the surface also, China’s growth has began rebalanced towards domestic consumption, as evidenced by huge growth rates for housing and auto industries, by a rise in social outlays, and by an increased share for private consumption in China’s GDP. Helped by a global trade recession, China’s political economy might be entering a virtuous circle, where the dependence on external growth is slowly decreasing. The current-account surplus has fallen from 9.4% to 5.8% of GDP in 2010, a high but not unsustainable rate.
Yet the devil is the details. China’s household income is decreasing relative to GDP, even in 2009. What is increasing is borrowing by households (as well as by companies and administrations), and also massive infrastructure spending – which includes outlays indistinguishable from individual spending. China has made a huge and concerted effort to buoy its domestic economy, and as such it has contributed to increase global demand minus China (when in all preceding years it decreased global demand minus China). But it is a voluntary and artificial policy, which carries with it bubbles and excess investment. The size of China’s infrastructure investment is such that it has fuelled a new boom for global energy and raw material prices.
Here we come to a ridiculous consequence. The US Treasury was not asking seriously for a renminbi revaluation when China’s policy was decidedly mercantilist. Now it is doing so in the very month when, for the first time in six years, China’s trade balance turns negative, and China is giving unofficial hints it might resume a crawling peg to the dollar. True, there is an artificial element in this trend. To a degree, China can turn on and off its purchases of energy and raw material, stocking and destocking when it sees fit. Timing purchases and a trade deficit for Secretary of the Treasury Tim Geithner’s visit to Beijing seems astute.
Nonetheless, China’s macroeconomic policy and balance have changed. Public, banking, and private indebtedness are growing. Wage flexibility downwards – to retain an external edge – reached a peak in late 2008-2009. It may well be that China’s huge leap forward in infrastructures (25 airports, 50,000 kilometres of bullet trains, a gigantic expressway system, all of it underpriced to users) brings with it a new advance in productivity. Nonetheless China is consuming ever-increasing amounts of capital investment. With it have also come wage increases, particularly in the export-processing sector. This is only the second time in the past 25 years that these wages rise quickly, the last occasion had been in 2007-2008.
Labelling China as a currency manipulator or to stick the label of mercantilism on its economic policies is not without validity. But the consequences should be clearly seen. Either the label comes with no penalties and it simply undercuts future bargaining power vis-à-vis China, or it does trigger trade sanctions with teeth. The EU, which has no permanent need for Chinese public lending, might well enact them before the US does. The economic and psychological shock from a ceiling on external demand would prick China’s confidence bubble, particularly the so-called “middle-class” borrowing and housing boom. The resulting bust for debtors – public and private – would precipitate the sale of currency reserves by China’s central bank in order to shore up domestic reserve ratio and bail out some imprudent lenders. True, in previous cases China has shored up banks with foreign currency reserves. But this time, the magnitude of the debts and the claims that can be made would necessitate a conversion of the reserves into domestic currency. Since an investment-led domestic boom would end at the same time, deflation would occur much more surely than inflation. Rebalancing towards domestic growth and consumption would end. Freed from excess currency reserves, the renminbi would be likely to fall, not to rise. China’s export competitiveness would increase again, bringing exactly what we are trying to avoid – another phase of export-led growth.
There is every indication that China’s leadership is trying to steer a middle path – a token adjustment to the exchange rate, with a widened exchange band (we don’t know if it will be a fixed or crawling exchange rate). Given the present trade results, it is likely that this will result in almost no currency appreciation. So long as these trends remain incremental, Chinese purchases of US public debt will not diminish substantially, thus helping to stabilise international finance.
Justified by their own investment and lending bubble, helped by an apparent trade deficit and by the reluctance of China’s neighbours to bear the consequences of a trade war on their own investment in China, the country’s leaders are unlikely to accept a significant revaluation of the renminbi. That semi-official spokesmen and second track figures are hinting a measure of goodwill is mostly a show of public diplomacy in advance of Secretary Geithner’s China trip.
A better solution
The efforts of China’s main trade partners – the EU and US – would be better invested at this point on ensuring a steady rebalancing of China’s economy towards genuinely private – e.g. household - purchasing power and consumption. Reaching a “second opening” of the Chinese market (after the “first opening” with WTO accession in 2001), with better access to China’s capital market and service sector, public procurement, carries more promise than the simple tool of currency revaluation.Diversifying the domestic avenues open to China’s savers would likely be the greatest service that China’s partners could render to achieve both a rebalancing of China’s economy and ultimately a sustainable rise in domestic consumption and imports. Until now, China’s savers have been the biggest losers in the game, and a trade war would exacerbate their losses, as they are ultimately the deep pockets into which the Chinese government is digging to sustain economic growth.