China: focus on domestic demand, not the exchange rate

The question of the US reaction to China’s exchange rate policy continues to rumble in Davos, though the absence of the US policymakers makes the debate somewhat one-sided.

The response by Chen Siwei (former Vice Chairman of the People’s Congress and now Chairman of the Global Council for the Future of China), to the remarks of US Treasury Secretary, Tim Geithner, about China’s manipulation of the RMB exchange rate, can be translated as follows:

‘I don’t quite understand why he had said these unwise words, may be just to get the approval from the Senate. What I know is that he is a smart guy. I just hope he will just talk the talk and walk the walk when he is officially in office”.

The sensitivity is understandably extreme.

As I remarked in yesterday’s blog, domestic demand, rather than the exchange rate, is the real issue. The implication of my analysis, as I indicated yesterday, is that domestic demand needs to grow by at least 12 per cent a year in real terms.

A further implication is that, in current circumstances, it makes far more sense for China to have a target for the growth of domestic demand than for growth of GDP. This is an essential shift in policymaking.

It is agreed by informed observers I have spoken to here that the rate of growth of the Chinese economy in the last quarter of 2008 and first quarter of 2009 is not above 2 per cent. This is concealed in the 6.8 per cent year-on-year growth reported for the fourth quarter. Behind the collapse in growth is the weakness in exports (41 per cent of China’s exports go to the US and Europe) and real estate investment. I was told by a very well-informed Chinese economist that the fiscal boost should still deliver 7 per cent growth this year. If so, that would be remarkable.

Unfortunately, this is the wrong sort of growth: more investment, in a country crying out for higher consumption; more heavy industry, in a country desperately in need of more jobs; more state enterprise, in a country needing more private enterprise and more capacity, in a country suffering from excess capacity. China could produce 600m tonnes of steel, for example, but needs only 400m.

What is needed is a big structural shift in the economy towards consumption. Unfortunately, household disposable income is less than 40 per cent of GDP. This makes the creation of a thriving mass consumer market impossible in the short term. If the Chinese government had a demand target, as I suggest, it might address this issue more forcefully.

Two other points might be added.

First, it is not good enough to argue that China’s real exchange rate has remained roughly constant over many years (with significant fluctuations). A country with China’s characteristics – very high growth of productivity in manufacturing indeed – should have a strongly appreciating real exchange rate

Second, I am not stating that the US should abjure action forever. The rebalancing must start soon. If China remains part of the problem, it may need to be prodded. I don’t think the rest of the world can be infinitely patient on this point, however strongly Chinese officials may react.

There is a real risk of protection – maybe even an import surcharge. That was the threat from the US in 1971, when it forced appreciation of the yen and D-Mark. It could conceivably happen again. US officials should indeed cool it. But the Chinese should not assume that the issue will magically disappear if they protest enough. It will not do so.

Martin Wolf is associate editor of the Financial Times and chief economics commentator

Davos blog 2009

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