15 Responses to “A domestic spending surge is the best thing for China”

Comments

1. Andrew Smithers: I find Martin’s claim that China can continue to sterilise the financing of its foreign exchange reserves highly improbable. Financing them with bank borrowing, to which he refers, is not sterilisation.

   In my comment I questioned how China claims to be sterilising the financing of its foreign exchange reserves and hope to learn from one of the participants but, in a non-command economy at least, sterilisation requires either over-funding or a fiscal surplus.

   With China’s foreign exchange reserves around 40 per cent of GDP rising at 30 per cent p.a., sterilisation requires improbable increases in the ratios of long-term debt or fiscal surplus to GDP.

   Whatever China’s data show, anecdotal evidence points to rising inflation. For example, an article in the 9th October Nikkei Weekly (an English language journal), which comments on the rise in China’s export prices to Japan, attributes part of the price hikes to increasing personnel expenses and points to sharp rises in minimum wage rates in Shanghai (Rmb 690 to 750) on September 1, following similar rises in Shenzhen and Beijing in July.

   A thwarted BS must have an impact on world inflation, though how much is of course questionable. The short-term impact is downward, with second round impacts via the easier monetary policy that it implies, likely to be in the opposite direction. The impact on profits in the rest of the world will, in contrast, be up first and then down. Profits move up and down with capacity utilisation and downward price pressures allow monetary policy to accommodate higher capacity utilisation.

   These are cyclical factors. In addition there may be secular changes in the labour share of output, to which I think Martin is referring, but the strong mean reversion of US profit margins over time (I get an ADF statistic of minus 5.8 for annual data from 1929 to 2005) suggests that such an impact on the US economy is improbable.

   Posted by: Andrew Smithers | October 18th, 2006 at 12:12 pm | Report this comment
   

2. Martin Wolf: Andrew makes three comments.

   First, he doubts whether sterilisation of the monetary impact of reserve accumulations is possible. I understand, of course, that sterilisation demands the sale of bonds or other illiquid securities. But so long as the bonds issued match the accumulation of foreign currency reserves and the interest rate on the bonds is also below the interest earned on foreign currency reserves, there is no evident limit to such sterilisation. The rise in the ratio of debt to GDP is, in these circumstances, irrelevant, since it matches, pari passu, the rise in the ratio of foreign currency assets to GDP (unless or until there is a big currency appreciation). Whether this describes the Chinese situation I am not sure. But it is logically entirely possible.

   Second, he points to evidence of inflation. I do not deny that higher inflation than measured is possible, but modest rises in nominal wages in a country with very rapid productivity growth does not demonstrate a deep inflationary process. It is as likely that they represent the need to pay workers more to offset rising real costs of living (especially of housing) in increasingly congested export-oriented production centres. Such rises in costs are, of course, a function of real economic growth, not inflation.

   Third, thwarted Balassa-Samuelson should indeed have lowered world inflation somewhat, though rising commodity prices (especially of oil) must have offset this effect to some significant extent in recent years. But I don’t think historic mean-reversion of the US profit share means much when the world’s labour force has effectively tripled. This is a vast economic shock. There seems good reason to expect a secular shift away from labour income towards income from capital, until the world’s capital-labour ratio itself reverts to trend.

   Posted by: FT Forum - Martin Wolf | October 18th, 2006 at 1:40 pm | Report this comment
   

3. Stephen S. Roach: There is little argument over the need for a Chinese rebalancing — shifting the mix of its economic growth away from excessive investment and exports toward subpar private consumption. It is not just the conclusion of most economists and international institutions but an endgame also embraced by the Chinese government in its newly enacted 11th Five-Year Plan. The question boils down to one of execution.

   Martin leaves us in the dark on this critical aspect of the problem. In looking at his three China columns as a whole, he leaves little doubt that he endorses an approach centred on the application of conventional macro stabilization policies. This presupposes an important point in the China debate — that the Chinese economy is, in fact, a normal economy that allows for policy traction through standard monetary, fiscal, and currency levers.

   Yet for a still highly fragmented and blended economy — with the State directly controlling at least 35% of the GDP — nothing could be further from the truth. Between them, the four major Chinese banks have over 75,000 autonomous branches. Policy adjustments imposed by the central bank ring hollow in a system where locally-funded branches are driven by local employment imperatives. Similarly, currency adjustments fall on deaf ears in an economy where fully 63% of the spectacular export growth over the past decade has been driven by Chinese subsidiaries of “foreign-invested enterprises” — namely multinational corporations and joint ventures. This could well foil the “renminbi fix” embraced by the Washington and IMF-World Bank consensus as the principal means to fix the Chinese current-account surplus problem.

   Moreover, with state-owned enterprise reform responsible for more than 60 million layoffs since 1997 alone, there can be little doubt as to why Chinese households have boosted precautionary saving in recent years — they have perfectly legitimate fears over job and income security. The lack of well-developed safety net institutions in China — namely social security, pensions, unemployment insurance, and worker retraining programs — underscores this insecurity.

   In short, China faces an uphill battle in converting its growth model from one driven by investment and exports to more of a consumer-led macro framework. It needs, first and foremost, an institutionalized safety net. It also requires new sources of job creation — most likely in its relatively undeveloped labor-intensive services sector.

   Yes, the Chinese consumer is the only answer in the long run. But getting there is far from the standard exercise in the application of stabilization policies that Martin leads one to believe. Until China makes further progress on the road to reform and becomes a fully-functioning macro system, reliance on administrative measures and a quasi -industrial policy may well be the only effective means to steer this blended system.

   Posted by: FT Economist Forum | October 18th, 2006 at 3:04 pm | Report this comment
   

4. Nouriel Roubini: One of the points that Martin makes in its interesting column is that the reduction of the Chinese current account surplus (via policies that stimulate domestic demand and reduce savings) may not lead to a reduction of global imbalances as “The shift might merely lead to larger surpluses elsewhere rather than smaller US deficits”. This argument is potentially incorrect based on a general equilibrium analysis. While I am not as much of a fan of the global savings glut hypothesis of Bernanke, an hypothesis that Martin partially supports, it is certainly correct that the excess supply of savings from China (as well as from oil exporters) in the last few years has been part of the explanation of the “bond conundrum” of the last few years: this increase in Chinese and global savings reduced global long term nominal and real interest rates and fed the US housing bubble, the consumption boom and fall in private savings while leading to higher real investment, especi ally in housing. Thus, if China were to significantly reduce its current account surplus, the global supply of savings – for given US fiscal policies – would tend to fall leading to higher global long term rates (this is also consistent with the effect of a reduction of the Chinese current account on their accumulation of forex reserves and their demand for US dollar assets). Such an increase in global real rates would then – everything else equal –lead to higher US savings, a greater pricking of the US housing bubble and lower US investment rates: thus, the rise in US savings and fall in US investment would tend to reduce the US current account deficit, regardless of any additional effect coming from changes in real exchange rates. This genereal equilibrium point confirms that – in the absence of a US fiscal adjustment – a reduction in the Chinese surplus would reduce the US deficit via a crowding out of private spending (consumption and investment), thus potenti ally triggering a US hard landing. Thus, US structural fiscal adjustment is necessary – together with changes in expenditures in China – to ensure that the global rebalancing of the unsustainable global imbalances is orderly rather than disorderly.

   Posted by: FT Forum - Nouriel Roubini | October 18th, 2006 at 4:15 pm | Report this comment
   

5. Willem Buiter: One should not expect the Chinese authorities to do anything to reduce the size of China’s current account surplus unless it is in their perceived national self interest. It also would be quite unethical for governments of rich countries with few very poor people to try to pressure China, a still poor country with hundreds of millions of very poor people, to do things with limited or no benefits for China.

   One benefit from a reduction in China’s external current account surplus is alleged to be that this would reduce protectionist pressures in the USA and Europe – pressures which if turned into protectionist actions would hurt China. To me this is an example of the ‘village idiot (vi) conundrum’.

   Assume the vi believes that unless all sparrows are removed from the trees on the village common, the drought plaguing the village will not end. The theory is bonkers, but the vi firmly believes it. Rather than risking the vi idiot using a shotgun to blast the sparrows out of the trees, causing possible damage to bystanders, sparrows and trees, it may be better to pacify him by bringing in a few sparrow hawks.

   Every village has its idiot(s). The global village is no exception. Senators Schumer and Graham, to name but two of the most famous gvis, believe that protectionist, trade-distorting measures, including exchange rate manipulation aimed at securing an undervalued real exchange rate, cause the current account surplus or trade surplus to increase. The proposition is bonkers.

   There is no causal connection running from protectionism to the size of a nation’s saving-investment balance. In the case of China, for instance, the reservoir of surplus labour in the agricultural/rural sector means that a significant increase in domestic absorption could be achieved without any appreciable change in the real exchange rate (the relative price of traded to non-traded goods), or in any of the standard indices of international competitiveness, simply by shifting resources out of the agricultural sector into both the traded and non-traded sectors.

   What bone then should be thrown to the gvis to stop them from unleashing a wave of protectionism? Nothing more, I would argue, than the ‘delay, distract and divert’ tactics used, effectively thus far, by the US administration. Unfortunately, the EU has succumbed to protectionist lobbying by mainly Italian shoe producers when it imposed anti-dumping duties on shoe imports from China and Vietnam. This, however, took place despite there being no overall EU external current account deficit ‘problem’, so it may not have a bearing on the case for reducing China’s current account surplus.

   Should China desire to reduce its current account surplus, it should not do so by boosting investment. Current investment rates of over 40 per cent of GDP are environmentally damaging and unsustainable. That leaves lower saving rates. There may well be a case for reducing public saving by creating a more generous universal state pension scheme financed out of general revenues.

   Increasing public expenditure on health and education is also likely to be welfare enhancing, although the example of the UK over the past 5 years or so makes it clear that you do not necessarily get an improvement in the quantum and quality of health and education by simply throwing more public money at it. Efficient and equitable provision of key public goods and services requires appropriate incentives and governance structures; creating or enhancing these takes time.

   Rush the job, and the increased public resources will be appropriated as rents by the incumbent suppliers and providers. It would be immoral to encourage China to engage in a wasteful public spending boom. Absorptive capacity is bound to be a binding constraint on the public sector’s ability to expand its own consumption in an efficient manner.

   Encouraging private consumption through tax cuts would also work – the Chinese consumer is likely to be highly non-Ricardian. Whether this is desirable depends on one’s view on the severity of China’s environmental problems.

   Both increased consumption (especially consumption of goods) and increased domestic production are bound to further stretch/tear China’s environmental fabric. Quick fixes for the external current account problem (if there is one) that do long-term damage as regards sustainable growth and development is not something I would wish on China.

   Posted by: Willem Buiter, London School of Economics | October 19th, 2006 at 2:07 pm | Report this comment
   

6. Monty Graham: First, while China might not at the present time have any inflation worries (CPI rate of increase is about 1.5 per cent per annum), there is emerging “overcapacity” in a number of key commodity-like products. Monetary policy might thus be usefully deployed (as well as fiscal policy) to combat this. The main role of monetary policy would be to induce a real rate of interest increase; the problem being that, apparently, investment is occurring in sectors where returns are already depressed, and this can only be accounted by a real cost of funds to Chinese firms that is somehow too low. Indeed, in mid-August, the Bank of China attempted to raise interest rates, albeit modestly.

   But, second, account must be taken of the “holy trinity” of monetary policy, notably that a central bank cannot simultaneously control interest rates, control the exchange rate, and have open capital markets. If capital markets are open, and interest rates are to rise, the exchange rate must appreciate; otherwise, any effort to raise interest rates will be futile.

   The question then becomes, are China’s capital markets now sufficiently open that the “holy trinity” is binding? I would submit that the answer is yes (see headline story in Thursday’s FT, wherein it is revealed that China now has a major problem with “hot money” inflow). Given the prevalence of foreign-invested firms in China’s economy, indeed, it seems to me highly unlikely that China can control short term capital movements, even if some specific line items in the capital accounts in principle remain closed. If so, and if the goal is to reduce or eliminate extra investment in depressed sectors, and monetary policy is to be employed (necessary to do so in fact because fiscal policy is likely to be expansionary, as Nick Lardy and Martin Wolf argue), the exchange rate simply must go up. If it does not, real interest rates will remain depressed and, it would seem, overinvestment will continue.

   A final note: A lot of the above reasoning depends upon the correctness of the assertion that there indeed is, by some measure or another, “overcapacity” in China. It seems to me that this issue is not well-address in economic theory. Rather, since at least the time of Lord Keynes, we tend to think in terms of “inadequate aggregate demand” rather than “excess capacity” if and when there is, indeed, some element of underutilised capacity in the overall economy of a nation. But, somehow, in China now, but also in other Asian economies in recent times (Korea in 1998, Japan in 1991), investment continued in sectors where returns were inadequate, resulting in an “overcapacity” that I don’t think that Lord Keynes really had thought much about; this sort of investment just didn’t occur in his, or any economic theoretician’s, thinking (except perhaps in “cobweb” theories of overplanting in agriculture). I am not sure myself why exactly this investment does occur, but it indeed does, and maybe some new thinking is in order to explain this phenomenon.

   Posted by: FT Economist Forum | October 19th, 2006 at 7:47 pm | Report this comment
   

7. Martin Wolf: Some further comments on very interesting posts by Stephen Roach, Nouriel Roubini and Willem Buiter.

   I think Steve is excessively obsessed with what is different about China. I suggest some things are much the same as in other economies. In particular, if the government decided both to spend more and to borrow more, it would succeed in raising the aggregate level of spending in the economy. As Willem remarks (and I entirely agree), this is a non-Ricardian economy: in other words, larger government fiscal deficits, either because of lower taxes or because of higher spending, will lead to an expansion in aggregate demand. Such increases in spending will also reduce the current account surplus. Whether export-oriented businesses are owned by foreigners is irrelevant to this argument. Higher spending will mean higher imports and probably lower exports as well, other things being equal. I agree fully with those who argue that a higher nominal exchange rate is neither a necessary nor a sufficient condition for the external adjustment. But it is a superior alternative to rampant overheating and high inflation, which would, otherwise, be the likely consequence of this policy. But the crucial decision is the additional spending, not the exchange rate adjustment. I also agree with Jeff Frankel’s post in the previous week’s forum that an exchange rate appreciation is now overdue.

   This brings me to Willem’s characteristically incisive post. I would not dare to speak up for village idiots for fear of confirming anybody’s view that I am one. Nevertheless, I am happy to recommend a policy that, as I stated in my columns, seems to me to be both in China’s interest and pleasing to the village idiots. China will be better off if its government now spends more on necessary public services and a safety net. Indeed, such spending may also be a necessary condition for lower precautionary saving by households. I agree entirely (and have said so many times) that higher investment is unnecessary. But the case for higher public and private consumption, in China’s own interest, seems to me overwhelming. I do not believe that the Chinese would have great difficulty in spending more on health and education in poor areas since their organisational capacity is remarkable. But I have no problem in accepting that additional spending should be accompanied by appropriate reforms.

   Finally, let me turn to Nouriel’s argument. He rightly notes that the principal vehicle through which absorption of the Chinese current account surplus within the Chinese economy would affect the rest of the world is higher real interest rates. What would be the general equilibrium effects of that on the global pattern of current account surpluses and deficits. The truth is that I have no idea, because I do not have a general equilibrium model in my pocket. I suggested that it is conceivable that the adjustment would mostly occur outside the US. I agree that it is most unlikely that it would occur only outside the US.

   Make the following desperately simply assumption: the elasticity of supply of savings and of demand for investment, with respect to the real interest rate, is the same everywhere in the world. I am not saying this is true, just that it is a simple assumption. Then the absolute size of the adjustments will be determined solely by the size of economies. The US is about 29 per cent of the world economy (at market prices), China is 5 per cent and so the rest of the world is 66 per cent. Moreover, the US deficit is $800bn, China’s surplus is $200bn and the rest of the world’s surplus (by addition) is $600bn. Now assume the disappearance of the Chinese surplus. The surplus of the rest of the world will, under my assumptions, rise by roughly $140bn (as savings rise and spending is cut) and the deficit of the US will shrink by $60bn, for the same reasons. So most of the adjustment falls not on the US but the rest of the world. Of course, if US savings and spending were much more responsive to changing interest rates than those of other countries, this would not be true.

   Posted by: FT Forum - Martin Wolf | October 19th, 2006 at 8:20 pm | Report this comment
   

8. Akio Mikuni: In China, net exports create savings or non-consumption. China’s capital investment has built huge production capacities by far in excess of domestic demand or capacities largely dedicated to export markets. In order to utilize the capacities sufficiently, China has to expand exports. Then, rising export proceeds received in China have to be sent back to the US and to prevent the renminbi appreciating against the dollars under the floating exchange rate system. The weak renminbi could preserve her export competitiveness. Capital exports have to be funded with domestic savings, by reducing consumption.

   The Chinese government buys dollars from exporters and send them to the US. Accordingly, exporters can readily obtain the renminbi and use the money to add production capacities, and increase exports further, while the rest of the economy is deprived of the money by capital exports. The saved money which is spent to buy dollars for the account of foreign exchange reserves could have been used for various fiscal purposes to increase consumption. And, under the floating exchange rate system, it seems that net external assets of a surplus nation would be wiped out eventually by the appreciation of its currency. I wrote “Japan’s Policy Trap” published by Brookings Institution with Taggart Murphy which explained how Japan funded capital exports in detail.

   Thus, I argue, contrary to Martin’s, that the starting point is the exchange rate, but not domestic spending. The appreciation of the renminbi which reduce surplus could reduce China’s dependence on the current investment-led and export- led growth. But, unfortunately, it could slow down its economy at the initial stage.

   However, the appreciation of the renminbi give more ammunitions to China to expand domestic spending. First, the strong currency could reduce import costs of oil, natural resources, capital goods such as machine tools and other imports, thus boosting purchasing power of consumers. Second, the resultant reduction in surplus decreases the required amount of capital exports, thus freeing domestic savings from funding capital exports and increasing domestic consumption. China should keep the renminbi at home. Third, to counter the adverse impact of the renminbi appreciation, manufacturing companies domiciled in China have to step up efforts to innovate technology to raise selling prices or to reduce costs dramatically. If successfully carried out, the terms of trade would be improved, and China could start to enjoy consumption-led and productivity-led growth.

   But, I sincerely hope that Japan which has accumulated more external assets than China should let the yen to appreciate and seek domestic growth before China would act.

   Posted by: Akio Mikuni | October 20th, 2006 at 8:02 am | Report this comment
   

9. Andrew Smithers: The impacts of China on world inflation and profits are so important that it calls for a response to Martin’s views set out in his website comment of 18th October “Andrew Smithers makes three comments.”
   Martin claims or hopes that China is sterilising its foreign exchange purchases by the classic route, called “sales of long dated bonds to the non-bank private sector.” He then claims that the growth of such bonds relative to GDP can be sustained so long as the interest on the reserve assets at least equals those on the bonds.
   There are three objections to this: (i) No such market appears to exist, or, if it does, his FT colleagues are remarkably coy about discussing it. (ii) That if it did exist, the growth of the market relative to GDP would be unsustainable because it would lead to rapidly rising costs both through a steepening yield curve and because it would grow exponentially as the debt interest would add to the domestic borrowing. Martin implies that foreign currency interest could be used to offset this, but this is only true for fiscal accounting purposes, unless the interest receipts are converted from dollars to renminbi, which would be incompatible with stabilising the nominal exchange rate.
   Long-term sterilisation of the domestic financing of China’s reserves is thus extremely improbable through bond issuance and, in the absence of an alternative and convincing explanation, remains improbable by any route.
   In today’s FT (20th October, 2006 “How Beijing hit back against hot money” Richard McGregor writes that the Bank of China is “…buying dollars coming into the country and draining the extra renminbi out of the system by selling bank bills.” This is neither the sale of long dated bonds nor are the bills being sold to the non-bank private sector. In a command economy this process might amount to sterilisation, but only if bank lending can be restrained by fiat. It this is occurring in China today, it seems unlikely to be more than a temporary stop gap.
   Martin also claims that a labour shock through tripling of the world’s labour supply has caused a rise in the US and rest of the world profit margins. In theory a labour supply shock should increase profit margins with a jump, after which they would fall back to trend. This is also the actual experience of past labour shocks. For example, the destruction of capital in World War II constituted such a shock, particularly in Europe and Japan. Japanese profit margins which are available for non-financial companies from 1954 show a high starting level followed by a long-term trend fall. It seems likely that the pattern in Europe would have been similar, though I cannot find European data for this period.
   US profit margins have behaved in the past as if the US is a mature economy with mean reverting profit margins that are little if at all affected by external labour shocks.
   Furthermore the assumption that, nonetheless, this time things are different and a China labour supply shock has affected US margins does not seem to fit the data. There has, for example, been no sharp jump in US margins at any time, let alone one that fits with the likely timing of a China shock. If it is thought necessary to try to explain why US margins are currently high, for other than the normal cyclical reasons, the most crying need is to explain why this should have been due mainly to rising margins in finance.
   I attach charts showing from the early 1950s to today (1) Comparing Japanese and US non-financial profit margins. (ii) US total profit margins. (iii) Comparing US financial and non-financial margins. (I am happy to let anyone have the excel file of these charts and their spread sheets on request.)
   If the China labour shock profit theory is accepted, then we have experienced a slow burning shock which has not caused a sharp rise in margins, but a trend rise, which appears to have started in the early 1970s. We cannot compare this with past shocks which have had a different pattern, but we can appeal to theory. This would suggest that as the shock dissipates we will have a long-term narrowing of profit margins in addition to the likely cyclical fall.
   I expect the latter, but I find it difficult to be as pessimistic about the longer term profit outlook that advocates of the China syndrome would appear, by implication at least, to support.

   Charts: US and Japan corporate profit margins
   (After you click the chart link above, please scroll to top to view if you are using Internet Explorer).

   Posted by: FT Economist Forum | October 20th, 2006 at 3:17 pm | Report this comment
   

10. Robert Wade: Richard Cooper (10/13) observes that we do not complain about the large current account surpluses of Germany, Japan, Netherlands or Sweden, which are comparable to China’s in absolute or relative-to-GDP terms, “presumably because they are nearly balanced by private capital outflows”. Ergo, if the Chinese government relaxed controls on residents’ capital outflows and the high latent demand for foreign assets was allowed to come into play, we would stop complaining about China’s current account surpluses. I think “we” would continue to complain. Why? Because there is more involved than economic calculation narrowly construed.

    In my comments on Wolf’s two earlier columns about China’s external economic behavior I tried to draw attention to likely–or at least plausible– “national security” factors in the calculations about the exchange rate and foreign exchange reserves. The main point is that China’s leaders have long been aware of the American propensity to invoke China as the rising external enemy, in place of the Soviet Union, against which the US makes claims to leadership of the “Free World”. Just think how the US Congress in the late 1990s seized upon any pretext to beat China on the head. (For example, a tiny World Bank-sponsored irrigation project in the western province of Qinghai became the subject of a world-wide campaign against the World Bank and the government of China in 1999-2000, led by NGOs with strong backing from the US Congress.) The overt aggression subsided with the War on Terror starting in 2001, to which China signed up. But the War on Terror will probably fade away with the next US administration, and the search will be on for another external enemy. China is the obvious candidate. China’s giant holdings of US dollars and a huge sector of multinational corporations and joint ventures able to lobby the US administration and Congress are handy defences–even if the liklihood of China using its holdings to disrupt the dollar is very low.

    The other national security preoccupation involved in the calculation is the one Cooper refers to: “A big slowdown in the Chinese economy is in no one’s interest, especially in view of the high import content of China’s exports. Why should China’s leaders want to run such a risk?” It would be astonishing if key parts of the Chinese leadership are not acutely aware that long periods of fast growth, such as China has experienced for 20 years, are very rare in the annals of economic development. Brazil is a sobering reminder. It was the “miracle economy” in the 1960s, on track to be the first developing country to break into the ranks of the “developed world”. (Some experts of the time also picked the Philippines.) Subsequently Brazil has remained stuck in much the same relative income and technology position in the world hiearchy as at the end of the 1960s.

    China is still in the “extensive” phase of development (as was Brazil in the 1960s), a point underscored by Roach’s figure of 63% of China’s exports coming from multinational firms and joint ventures. It will face really difficult challenges as it tries to go through the “intensive” phase. And well before then, the tensions around its huge regional income disparities — certainly much bigger than India’s, perhaps the biggest in the world — may boil over. In the face of these instabilities and the cruel dilemmas they pose, China’s leaders are likely to be very cautious about changing policy in a way that might interrupt the export growth machine, even at cost to “the interest of the Chinese people” as Wolf defines it.

    Posted by: FT Economist Forum | October 20th, 2006 at 4:34 pm | Report this comment
    

11. Martin Wolf: Let me comment briefly on what Monty Graham says.

    I have already agreed in my latest column that there is excess capacity in certain sectors, because of an absence of adequate financial discipline. But Monty adds an interesting point, which fits well with the argument of Andrew Smithers about the costs of the pegged exchange rate and sterilisation of the monetary impact of the reserve accumulation.

    In order to limit the capital inflow and so the need to sterilise its monetary effects under the pegged exchange rate, China must keep domestic interest rates below those in dollars. As Monty argues, Chinese controls on capital inflows are porous (though certainly not entirely ineffective). We know that they are porous from the scale of the recent net capital inflows (in addition to foreign direct investment), though these have now apparently dried up, perhaps because China’s interest rates are so low. Theory suggests that when controls on capital inflows are ineffective, interest rates can only be above those in relevant partner countries if the currency is expected to depreciate. Given where the currency is now, that would require a large initial appreciation: overshooting, to be precise.

    So long as the currency is still expected to appreciate, interest rates cannot be above US levels (with freeish capital inflows) and so cannot be used to ration the use of capital. Instead, the Chinese authorities have to rely on administrative mechanisms to control credit and investment. That then makes it far more difficult for them to achieve the desired liberalisation and reform of the financial system. That, to return to Andrew’s argument, is the distortion created by the current policy regime: interest rates (nominal and real) are too low. So the authorities rely heavily on administrative controls on credit expansion and investment. This is also, as Monty argues, a strong argument for exchange rate flexibility.

    An alternative method of adjustment, as I mentioned in the column, would be to allow the overheating: that is, excess borrowing, investment and economic growth. The impossible trinity to which Monty refers – the impossibility of combining free capital movement, monetary policy autonomy and a pegged exchange rate – would then be resolved by abandoning the second (monetary autonomy). This would ultimately lead to a higher price level and so an appreciation in the real exchange rate. But it would also create a great deal of wasted investment, in China and even abroad (in commodity supply, for example). At the end of the process, there would be an economic bust, with a large overhang of bad debt and damage to the financial system.

    That is surely to be avoided. This is why I think the best complement to an expansionary fiscal policy would almost certainly be an appreciation of the currency, aimed at keeping the domestic price level reasonably stable. But whether the currency should be allowed to move upwards so far that the expectation shifts to one of depreciation, instead of appreciation, is a trickier question. While such a change in expectations would allow a faster move towards full liberalisation of the financial system, the appreciation itself would inflict a sharp adverse real shock on the export sector. It would be more sensible, I believe, at least in the medium term, to persist with the combination of controls on capital inflows, sterilisation of the monetary effects of reserve accumulations and control on credit and investment, instead, in order to permit domestic macroeconomic stabilisation and exchange-rate management.

    Posted by: FT Forum - Martin Wolf | October 20th, 2006 at 5:22 pm | Report this comment
    

12. Martin Wolf: I would like to comment on the posts by Akio Mikuni, Andrew Smithers and Robert Wade, in that order.

    There is, it appears, a link between what Akio and Andrew are saying. That link is how the Chinese government is creating the excess savings that must, by definition, be the counterpart of the country’s current account surplus.

    If I understand Akio’s argument correctly, he argues something that I also believe, namely, that the exchange rate drives the excess of savings over investment rather than the other way round. In other words, with a pegged exchange rate and successful control over inflation, China’s real exchange rate is more or less fixed (so long as these conditions continue to hold). At that real exchange rate, China has a large excess supply of tradeables, which shows up as the trade and current account surplus that Nick Lardy forecasts at 9 per cent of gross domestic product this year. The Chinese government must then adopt fiscal, monetary, credit and investment-control policies that ensure the existence of a corresponding savings surplus. Should it fail to this successfully, there will be overheating, inflation, an appreciation of the real exchange rate and a reduction in the external surplus that matches the reduction in excess savings.

    I believe this is a fairly accurate description of what is happening to China. Indeed, I have suggested just that in previous posts on this forum. Attentive readers will note that this is a rough mirror image of what I think is happening to the US, where the real exchange rate, set this time abroad, is driving policies that determine the needed excess of investment over savings (or spending over incomes), to offset the foreign savings surplus.

    If Akio and I agree largely on the cause, why don’t we agree on the response? I argue that it would be easier and more acceptable for the government to start by expanding domestic consumption (largely through public spending) and subsequently allow an exchange rate appreciation, to stabilise the economy. This would represent a shift towards making domestic macroeconomic stability the primary goal, with the exchange rate assisting its achievement. A big appreciation, unaccompanied by a domestic spending boost, would destabilise the economy. I do not disagree that such an appreciation would get the Chinese economy to the same end point, as Akio argues, but it would do so only after an uncomfortable period of reduced growth. So I would not advise the government to start with a big appreciation, as does.

    Andrew is making two quite distinct points. The first amounts to the statement that the sterilisation of the inflows of foreign exchange is impossible. His second points concerns the source of the high profit shares in GDP in most high-income countries today.

    I am not going to write any more now about whether China is, in fact, sterilising the reserve accumulation. I relied on work by Jonathan Anderson of UBS on this. I will comment further only if I learn more about the nature of the sterilisation Mr Anderson has estimated. It may be that China is relying only on administrative control over lending and capital formation. Since the government owns most of the banks, it should be able to do this if it wants to for a long time.

    The other question, however, is whether the government could sterilise the inflow, provided it had a working bond market. I do not see why it should be impossible to do so. Assume a pegged exchange rate and effective exchange controls. Assume a persistent trade surplus of 8 per cent of GDP and initial net reserve assets of 40 per cent of GDP, nominal interest rates on foreign holdings (in dollars) of 4 per cent, an interest rate on domestic bonds of 3 per cent, real economic growth of 10 per cent a year, inflation of three per cent a year and, finally, base money at 10 per cent of GDP.

    On these assumptions, foreign currency reserves rise over 40 years from 40 per cent to 87 per cent of GDP and the current account surplus rises from 9.6 per cent of GDP to 11.4 per cent of GDP. Provided the increase in the monetary base comes entirely from reserve accumulations, domestic bonds outstanding remain less than the reserve assets held by the government, while the latter’s net debt outstanding (foreign currency assets less domestic debt liabilities) remain negative (i.e. the government is a net creditor). Moreover, the difference between the income the government earns on its foreign assets and the interest spend on its liabilities is positive. Of course, the government has to borrow domestically each year to refinance the interest due on its bonds. But that is not a big problem, provided the domestic interest rate remains well below the rate of growth of nominal GDP. If the interest rate remains 10 percentage points below the rate of nominal GDP growth, domestic debt outstanding, as a result of sterilisation, reaches only 79 per cent of GDP after 40 years (from 30 per cent now). The yield curve might get steeper, as Andrew suggests, but it has to get much steeper to make a big difference to the outcome.

    In essence, the government is providing domestic bonds to soak up the excess savings that are the necessary counterpart of the current account surplus. This operation seems perfectly workable so long as the rate of economic growth is decidedly above the interest rate on domestic borrowing and the government can control the capital inflow and outflow. If capital inflows and outflows were uncontrollable, however, the situation would probably be unsustainable, since the inflows might become overwhelmingly large.

    As for profits, the picture of financial profitability that Andrew shows is extremely interesting. But I don’t know whether it applies to other high-income countries, all of which also seem to have enjoyed big improvements in profit shares in recent years. My assumption about the “China shock” is that it is taking quite a while to work through (indeed, it is really an Asia shock that began in the 1970s). It has taken a long time for the supply of cheap labour-intensive goods to expand. It was certainly much less sudden than the destruction of the capital stock in the Second World War. In the long run, the global capital stock will rise again, relative to the newly expanded labour supply. But that may take a generation.

    Finally, let me turn to Robert’s views. There are three questions here.

    The first is whether, as a matter of fact, the reserve accumulations have been driven by national security considerations. I don’t believe it. I think they have been the accidental by-product of the decision to stabilise the nominal (and real) exchange rate.

    The second is whether it is sensible to keep the exchange rate down and accumulate reserves, to influence US behaviour. I agree with Robert that inviting US companies into China is a sensible strategy. But that does not depend on either the reserve accumulations or the trade surplus. Most US investment into China is oriented towards the domestic market, not exports. (It is, I think, Asian businesses, not Western ones, that invest most heavily in export production from China). The current account surpluses themselves are an irritant to the US, even if that is only because of what Willem calls the “village idiot syndrome”. Finally, in a conflict the US would probably sequester China’s assets. That would not help China very much.

    The third question is about the impact of this strategy on the stability of China’s growth. Here I agree that the Chinese authorities would be rightly reluctant to endanger a successful development strategy. For this reason, they do need to be cautious. But cautious is not the same thing as immoveable. I don’t believe China is in any danger of becoming Brazil by pursuing a somewhat more balanced growth path.

    Posted by: FT Forum - Martin Wolf | October 22nd, 2006 at 10:16 pm | Report this comment
    

13. Martin Wolf: Here is a final word on sterilisation in China, on the basis of a communication from Jonathan Anderson of UBS. The central bank has issued $400bn equivalent of short-term central bank sterilisation bonds. These are liabilities of the People’s Bank held by banks, but not counted towards the banks’ reserve requirements against domestic lending. Only free deposits at the PBC do that. This is an unorthodox, but, I would have thought, effective way to sterilise the impact of foreign currency interventions on the money supply in Chinese circumstances.

    Posted by: FT Forum - Martin Wolf | October 24th, 2006 at 2:06 pm | Report this comment
    

14. Yu Yongding: The talk in the town has been how to adjust China’s growth strategy since the new leadership took over more than three years ago. Decision-makers have realized that China cannot carry on with its old growth strategy characterized by export-driven and FDI driven, no matter how successful it has been. Charles is wrong to say that “the Chinese intend to travel a similar route and it will be very, very hard to convince them that it is the wrong way.” The problem is that China’s growth pattern is a result of the old strategy implemented for 26 years and hence is impossible to change it over night. China’s adjustment made in recent years is basically in line with Martin’s description in his recent two articles.

    Most Chinese economists agree that the following things should be done as soon as possible:
    • Reduce the current account surplus by reducing the saving-investment gap. To achieve this objective, public expenditures on safety net and so on should be increased.
    • Preferential policies towards FDI should be cancelled and domestic investment as well as FDI should be given equal treatment in term of credit access, tax treatment, and environmental requirement and so on.
    • Export promotion policy (tax rebate in particular) should be abolished or adjusted.
    • Financial reforms should speed up. SMEs should not be discriminated against. Corporate bond markets should be developed.
    • FFEs should be allowed to tap China’s domestic capital market, so that there will be less need for cross-border FDI.
    • Chinese enterprises should be encouraged to invest abroad gradually both in the form of Greenfield investment and Merges and Acquisitions.
    • Capital account liberalization should be carried out smoothly and in an orderly manner.
    • RMB exchange rate should continue to appreciate. This is a more efficient way of correcting China’s imbalances.

    The main difference among Chinese economists is about the pace of revaluation of RMB exchange rate. The majority of Chinese economists worry the negative impact of a fast revaluation on the economy, especially on employment. A minority emphasize the negative impact of a slow revaluation on the economy. Yes, some believe that China’s interest lies in maintaining a highly competitive real exchange rate for as long as possible. But, as far as I know, this is not Chinese government’s policy.

    “But can China currently invest domestically its huge savings, which stand at about half of its GDP?” My answer is that the obstacle to do so is mainly institutional. According to a World Bank report, profitability of foreign funded enterprises in China is 22 per cent. Why cannot Chinese enterprises achieve some results even remotely similar? China’s policy in the past has been resulted in crowing out domestic SMEs. The main reasons why China has to park its resources in US treasury bills include the under-development of the financial markets, local competition in providing concessions for FDI attraction, discrimination against domestic SMEs in terms of taxes, use of lands, access to bank loans, legal protections and so on. Of course, to adjust is easier said than done. But if policy adjustment is made, situation may change more quickly than expected.

    On the whole, I agree with Martin that China should lower its growth rate of FAI and stabilize its investment rate before too late (meaning before having created huge deflationary press by creating huge excess capacity). China should increase its consumption. But policy stimulation should be adopted with adequate caution. First, China’s statistics is very missy. I have no idea on how high China’s investment rate is and so is China’s growth rate of FAI. Second, I have doubt about the frugality of urban residents. Go the shopping malls in Shanghai, Beijing and other major cities to have a look yourself. Third, the single most important factor contributing to China’s past high growth is the high investment rate supported by the high saving rate. What will be the consequences of a significant fall of the investment rate and a rise of the consumption rate are hard to tell. However, one thing is very clear that the income gap between the rich and poor should be narrowed and the rampant capitalism in China should be contained, and the poor should be given opportunities to enjoy a decent life. This is not only a matter of macroeconomic control but also one of social justice.

    “Does anyone seriously believe that a 20 per cent appreciation – the number indicated by Martin – will eliminate the surplus of a country that saves half of its GDP?” I for one do not believe that 20 per cent appreciation will eliminate China’s surplus. Japan, Taiwan and many other economies fail to eliminate their surpluses decades after huge revaluations. However, the purpose of revaluation is not to eliminate trade surpluses. Rather, in the long-run it is aimed at improving resource allocation, promoting structural adjustment (tradable vis-à-vis non-tradable, upgrading trade structure, and so on), which implies that the exchange rate should be allowed to reach or approaching its equilibrium level.

    In the short-run, the fixed exchange rate has significantly reduced the monetary independence of the PBOC. “Sterilization – the sale of domestic securities to mop up the excess liquidity generated by official intervention in foreign currency markets – is not merely feasible, but even highly profitable, if one is prepared to ignore the risk of a large ultimate capital loss.” I am afraid this is not the case. It is not just a matter of capital loss vis-à-vis profits for the PBOC. First, the equity-debt swap in the form of FDI inflows vis-à-vis purchasing US treasury bills will create welfare losses for the nation, despite the profit made by the PBOC in implementing sterilization policy. Second, the continuation of large-scale sterilization by forcing banks to buy low yield central bank bills will damage the profitability of the banks and financial efficiency. Owing to the fear of speculative capital inflows that will increase RMB appreciation pressure, the PBOC somehow has to force commercial banks to buy over-priced central bank bills so as to avoid forcing up interest rates in the money market vis-à-vis the Federal funds rate. It is very telling that there are many occasions in auctions when the PBOC fixed the price of the central bank bills, the PBOC failed to sell out bills according to plans. As a result, the share of low yield assets in the total assets has been increasing in banks, which in turn will lead to the worsening of banks’ performance. In other words, China is facing a “trilema”: tight monetary policy, good performance of banks and stability of RMB exchange rates. In the past three years, the PBOC has raised reserve requirement rate five times so as to lessen the burden of sterilization. The eventual consequence of this policy measure is the same as the selling central bank bills to banks: lowering financial efficiency.

    The undervaluation of RMB is not the main contributing factor to China’s current account surplus, let alone the only factor. At least there are four other factors: the saving-investment gap, economic cycles (global as well as domestic), export promotion policy adopted at all levels of governments and China’s position in the global division of labor as processor and assembler. It should be emphasized that processing trade will lead to current account surplus by definition. In 2005, in China’s total exports of USD 762 billion, processing trade accounted for 54.6 per cent. Among China’s USD102bn trade surplus, USD140bn was created by processing trade. To reduce trade surplus, the share of processing trade in China’s total trade must be reduced. However, it is very difficult to reduce the share of processing trade in a short period of time. Net exports of processing trade are highly inelastic with respect to the exchange rate. As was shown during the Asian Financial crisis when the RMB maintained its peg while other Asian currencies opted for floating and devalued significantly. During the period, China’s share of exports to the US and Japan vis-à-vis other competing Asian exporters did not fall. But at the same time, I believe that enough appreciation, together with other policies, eventually will lead to the fall of the share of processing trade in total trade and hence trade surplus. Of course, the pace of revaluation must take into consideration the possible negative impact on unemployment very carefully.

    Posted by: Yu Yongding | November 28th, 2006 at 10:41 am | Report this comment
    

15. Martin Wolf: Professor Yu Yongding has made an important contribution to our debate on the future of Chinese economic policy. This represents a significant statement by an important insider on the state of debate in China.

    I have the following comments.

    First, the list on things on which Chinese economists largely agree is both sensible and encouraging. The important question is how swiftly relevant policies are enacted.

    Second, Professor Yu argues that China could invest as much as half of GDP if reforms were to proceed. I am not entirely persuaded by this. While it is true that in a more efficient policy regime many high-quality projects would emerge, particularly in the domestic small and medium enterprise sector, many highly capital-intensive projects would no longer be financed. To put the point more technically, with an efficient market economy and a 50 per cent savings rate, domestic investment may still end up as less than 50 per cent of GDP at the world real rate of interest (probably about 2 per cent, at present).

    Third, for this reason it does seem to make sense, as Professor Yu agrees, for China to increase its consumption rate (i.e. lower its savings rate). Despite the problems he lists, we agree that more should be spent (and can be spent) on the poor, particularly the rural poor. The government has the means to do this and should, therefore, do so.

    Fourth, I agree, too, that an appreciation of the remnimbi will not, on its own, eliminate the Chinese current account surplus. It is, however, as I have argued in my piece, a natural concomitant of an attempt to increase domestic spending. By appreciating the real exchange rate, China should be able to switch resources into the domestic economy, away from tradeable goods, while containing inflation.

    Fifth, professor Yu provides a persuasive account of the costs of sterilisation, particularly the impact on the profitability and efficiency of the banking system.

    Finally, professor Yu ascribes China’s surplus to four factors, other than undervaluation of the exchange rate: the savings-investment gap, economic cycles, export promotion policy, and the processing trade. He puts particularly weight on the last. I agree that the impact of the real exchange rate on processing trade is modest, since it would predominantly affect the wage component. Chinese wages are so low that a very large appreciation would be needed to persuade companies to shift their processing elsewhere. But the question remains why more of the income earned from processing trade is not spent (i.e. is partially saved, instead). So I am not surprised that exports are dynamic. I am surprised, however, that imports are not growing as fast as exports.

    The conclusion then is that the core of the solution is increased spending in China, predominantly on consumption on behalf of – or by – the poor. Exchange rate appreciation would merely assist with this adjustment.

    Posted by: FT Forums | December 4th, 2006 at 5:35 pm | Report this comment
    

The FT Economists' Forum is a discussion among some of the world's top economists. As a general rule we accept comments from invited members only, but submissions from others will also be considered.

If you are a non-member submitting a comment, please include your relevant academic or financial background.

Post a comment

Name

Mail (will not be published)

As a final step before posting the comment, please type the two words you see in the image beloweight numbers in the audio clip; this test is to prevent automated robots from posting comments.

Type the two words: Type the eight numbers: Unfortunately you provided the wrong reCaptcha answer. Please try again: