Most economists agree that allowing global current account imbalances, notably the US deficit and the Chinese surplus, and their accompanying capital flows to accumulate contributed to the over-leveraging and under-pricing of risk that triggered the crisis. This was recognised at the Pittsburgh Summit in September 2009 where the G20 leaders announced the creation of a new framework to coordinate and monitor national economic policies in order to reduce global imbalances and prevent them from building up in the future.
Finding the right exit door from excessive global imbalances – and defining the appropriate policy responses – will require clear understanding of their causes. If the causes were essentially monetary, then exchange rate policy responses (such as appreciation of the renminbi) will be appropriate. If, in contrast, the global imbalances were primarily structural in nature, then structural policy responses, such as obliging state enterprises to pay taxes or dividends, will be required.
The current debate over “global imbalances” essentially reflects the surpluses in the current accounts of around a hundred countries, most of them classified as developing or emerging, that have grown up in response to the US current-account deficit – the excess of US domestic investment over US national savings. The position is summarised in Figure 1.
Figure 1. Global imbalances in the current account
Source: IMF World Economic Outlook, October 2009 (Data for 2009-2014 based on IMF staff estimates)
The world is bigger than China and the US
The US outspent its national income by an accumulated $4.7 trillion –equivalent to 47.3% of GDP – from 2000 to 2008. Over the same period, China’s accumulated surplus was $1.4 trillion. That is huge by any measure, but by itself only enough to fund some 30% of the US deficit. To fill the gap the US was absorbing three-quarters of world's savings until the collapse of 2008. Another sizeable imbalance has been the current-account surpluses of oil exporters, notably in the Gulf region, where the effect on oil prices of the voracious appetites of the Asian giants has created a second wave of asset build-up.
There is a clear political focus on the bilateral US-Chinese trade balance, but bilateral imbalances are of no economic interest – there are more than two countries in the world. Even if analysed as a bilateral transfer problem between the US and China, the exchange-rate adjustment needed to produce sustainable current account balances may be limited. The US is unlikely to face a secondary transfer problem in terms of pressured export prices, as it is broadly the only debtor country to “affect the transfer”.
How much to revalue – if at all?
Generally, the required scope of dollar devaluation relative to the renminbi will depend on the degree to which lowered absorption in the US and higher absorption in China result in decreases and increases, respectively, in the demand for the same goods. The rising middle class in China and other emerging markets will gradually add to global consumption, presumably along similar preferences as in the advanced countries (Kharas 2010).
China’s surpluses and growing official reserves have raised the volume of calls for China to let its exchange rate appreciate in order to rebalance the world economy. For example, Cline and Williamson (2009) have recently estimated “fundamental equilibrium exchange rates” compatible with moderating external imbalances. They estimate that the required appreciation for the renminbi is more than 20% in real effective terms and 40% relative to the dollar. Ferguson and Schularick (2009) use unit manufacturing wage costs to estimate the degree of undervaluation of the renminbi relative to the dollar and come up with figures between 30% and 50%.
The OECD (2010) has recently recommended a resumption of greater exchange-rate flexibility in order to stimulate consumption and strengthen inflation targeting, acknowledging that more flexibility would translate in practice into renminbi appreciation. The fact that the People’s Bank of China has consistently intervened in the foreign-exchange market – as evidenced by its accumulation of foreign exchange reserves – suggests that the pressure on the renminbi is upward. In addition, capital outflows remain restricted both legally, by regulation, and practically, by expectations of future appreciation.
It is far from assured, however, that an appreciation of the renminbi would impact current account imbalances. Using a large data set, spanning 170 countries and the period 1971-2005, Chinn and Wei (2008) find no robust evidence that the speed of current-account adjustment rises with the degree of flexibility of an exchange-rate regime. Indeed, as Figure 2 shows, over the past decade China’s real effective exchange rate has moved broadly in line with the four other BIICS countries (Brazil, India, Indonesia, and South Africa). Except China (which had a surplus of 9.8% of GDP in 2008), no other BIICS country has run a large surplus on the current account of its balance of payments; indeed, South Africa booked important deficits, 7.4% of GDP in 2008.
Figure 2. BIICS real effective exchange rates (2000 = base 100)
Sources: IFS and own calculation
Appreciation is forthcoming
To be sure, poor-country currencies are normally undervalued in terms of purchasing power parity. In fact, poorer countries do have undervalued exchange rates (due to the Balassa-Samuelson effect), and convergence will imply considerable correction of that undervaluation. Services (and wages) are cheap in poor countries and expensive in rich countries, while prices for internationally traded goods are roughly equalised in a common currency. When the productivity in traded goods rises (while productivity growth for haircuts and other services are very limited), more income is generated and spent on services. The price ratio of non-traded to traded goods will rise. In other words, the real exchange rate will appreciate. Hence, part of the undervaluation ascribed to China’s currency results from market forces that make non-traded goods relatively cheap in poor countries, rather than from deliberate currency manipulation by China’s authorities.
While growing and converging fast, China is still poor. Its per capita income in 2008 was 6.2% of the US’s at market rates and 12.8% at purchasing power parity (PPP)-adjusted rates, according to the latest World Development Indicator data. Figure 3 relates the log of real per capita GDP as a fraction of the US level and the deviations of current market exchange rates per dollar from PPP rates for the year 2008. It shows strong support for the Balassa-Samuelson effect and suggests a well-determined elasticity (0.2) by which the undervaluation of the currency will be eroded during the catch-up toward the US per capita income level. Real exchange rates can thus be expected to appreciate as economies grow, approaching PPP exchange rates as economies converge with US living standards, as posited by the Balassa-Samuelson effect.
This analysis suggests that while (in 2008) the renminbi was undervalued by about 60% in PPP terms, the undervaluation in 2008 was only 12% against the regression-fitted value for China’s income level. The undervaluation of the renminbi widened by roughly 3 percentage points in 2009 as a result of further rapid convergence of China’s per capita income growth relative to the US. Both India and South Africa (which had a current-account deficit) were more undervalued in 2008 – by 16% and 20% respectively, according to the Balassa-Samuelson benchmark.
Figure 3. Per capita income convergence and real exchange-rate appreciation
Source: OECD Development Centre
While the Balassa-Samuelson effect ignores the extent of current-account imbalances and net foreign asset positions, it points to several policy implications for China and the world economy:
- The major part of the undervaluation ascribed to China’s currency results from market forces that make non-traded goods relatively cheap, rather than from the currency-management policies of the Chinese authorities alone;
- A rapid convergence of per capita income to rich-country levels will maintain pressures for a real effective currency appreciation either through nominal exchange-rate upward adjustments or through positive inflation differentials with rich-country trade partners. Put simply, the Balassa-Samuelson effect suggests nominal upward flexibility for the renminbi in line with income convergence if inflationary pressures and asset bubbles are to be contained;
- Any resulting real currency appreciation implies valuation losses on official foreign-exchange reserves in renminbi terms since these are overwhelmingly held in rich-country currencies. China is an “immature” lender in that it cannot yet lend renminbi on the international markets. It therefore has an interest in an orderly reduction of the total level of its foreign exchange reserves through enhancing policies which further encourage outward investment and diversification into non-financial assets
An array of socio-structural explanations for China’s saving surplus (and thus its impact on global surplus and deficits) points to the insufficiency of monetary tools to redress global or bilateral imbalances:
- The Governor of the People’s Bank of China, Zhou Xiaochuan (2009), explains that following the reforms during the 1990s, China’s “iron-bowl” system (promising lifetime employment and welfare) no longer existed and state-owned enterprises stopped providing free pensions and housing. Costs and risk were therefore transferred to households since no effective social security system was available. As the real cost of labour takes time to be reflected in the cost-base of an enterprise, the state-owned enterprises sector became highly profitable and increased its savings while decreasing its contribution to social security1. Corporate savings were further bolstered by the fact that until recently the state-owned enterprises did not have to pay dividends or taxes.
- Wei and Zhang (2009) and Wei (2010) for instance highlight the increasing imbalance between the numbers of male and female children born in China. For every 100 girls born today there are 122 boys, presumably as a result of the “one-child policy”, pre-natal ultrasound screening possibilities and the reduction in fertility. A skewed sex ratio is, it seems, fuelling a highly competitive “marriage market”, pushing up the savings rate for all households (since even those not competing in the marriage market must compete to buy housing and make other significant purchases), driving up China’s savings rate and with it global imbalances.
- The relative importance of the various drivers for savings has recently been tested empirically. Ma and Haiwen (2009) measured the relative importance of a range of variables on the evolution of China’s net foreign asset position – a result of its accumulated net saving surplus – over the period 1985-2007. The estimated coefficients for the real effective exchange rate of the renminbi and for financial development are both insignificant. By contrast, the ratio of domestic and external government debt to GDP and the youth dependency ratio (the proportion of the population under 15) are both highly significant.
Rather than focusing on, say, renminbi appreciation a structural rebalancing of the world economy will need reforms in China’s social, pension and family policies with the motive of raising China’s consumption rate. As emphasised recently by the OECD (2010), overcoming labour market segmentation, unifying pension rights, education and land rights , health care reforms and more fiscal solidarity are China’s prime policy challenges.
Chinn, Menzie and Shang-Jin Wei (2008) "A Faith-based Initiative: Does a Flexible Exchange Rate Regime Really Facilitate Current Account Adjustment?," NBER Working Paper 14420.
Cline, William and John Williamson (2009), “Equilibrium Exchange Rates”, VoxEU.org, 18 June.
Ferguson, Niall and Moritz Schularick (2009), “The End of Chimerica”, Harvard Business School Working Paper 10-037.
Kharas, Homi (2010), “The Emerging Middle Class in Developing Countries”, OECD Development Centre Working Paper. 285.
Ma, Guonan, and Haiwen Zhou (2009), “China’s evolving external creditor wealth and rising creditor position”, BIS Working Papers 286, BIS: Basel.
OECD (2010), OECD Economic Surveys: China, OECD, Paris.
Wei, Shang-Jin. and Xiaobo Zhang (2009), “The Competitive Saving Motive: Evidence from Rising Sex Ratios and Savings Rates in China”, NBER Working Paper 15093.
Wei, Shang-Jin (2010), “The mystery of Chinese savings”, VoxEU.org, 6 February.
Zhou, Xiaochuan (2009), “On Savings Ratio”, Keynote address at the High Level Conference hosted by the Central Bank of Malaysia, Kuala Lumpur, 10 February.
1 The same pattern of GDP growth exceeding household income growth could be observed for India.