May 30, 2007
The right way to respond to China’s exploding surpluses
What is the most important high-level dialogue in international economics? The answer is not the discussion among the finance ministers of the Group of Seven high-income countries. It is the “strategic dialogue” between China and the US. This is not because the latter will produce answers, but because it asks the right question. The biggest challenge in international economic policymaking is the incorporation of China. This, to his credit, Hank Paulson, the US Treasury secretary, has recognised. But his bilateral approach will fail. The G7 should, instead, be replaced by a multilateral body that can address such issues more effectively.
To understand the challenge, we must appreciate what makes China’s impact special. Experts often describe today’s globalisation as the “second globalisation”, to distinguish it from the “first globalisation” between 1870 and 1914. In the earlier era the rising economic power was the US and the UK was by far the world’s most important exporter of capital. But China is now emerging as both the world’s most dynamic economy and its largest source of capital. This helps explain a signal feature of our era: the combination of rapid growth with low real interest rates.
China’s current account surplus has exploded in recent years from a modest $46bn in 2003 to $250bn last year. This puts Japan’s $170bn surplus of 2006 in the shade. China’s current account surplus last year was 9.5 per cent of gross domestic product, more than double the highest ratio Japan has ever achieved, 4.3 per cent of GDP in 1986. If one adds the balance on flows of long-term capital (net foreign direct investment), the surplus in China’s “basic balance of payments” reached 12 per cent of GDP last year.
To put this in historical context, UK net foreign investment was 8 per cent of gross national product between 1905 and 1914. What makes China’s position even more extraordinary is that gross domestic investment itself appears to be more than 40 per cent of GDP. Thus China both is the world’s largest exporter of capital and has the world’s highest ratio of domestic investment to GDP. This is capital accumulation on a grand scale.
Yet the tale does not end there. In China’s case the government has been the direct source of the capital outflow. This has been a by-product of its interventions in the currency market aimed at keeping the renminbi down against the US dollar. Thus, between 2003 and 2006 the country had a cumulative current account surplus of $525bn, together with a $228bn net inflow of FDI. These were almost perfectly offset by its $777bn accumulation of official foreign exchange reserves. By March of this year, the reserves had reached $1,202bn, the biggest in the world and more than two-fifths of China’s GDP.
The reserve accumulations are not, it should be stressed, in response to inflows of speculative “hot money”. They reflect a policy of shipping out the foreign exchange received from huge trade surpluses and inflows of long-term investment, to keep the exchange rate down (see charts).
Is this behaviour desirable and, if not, what should be done about it?
A good argument can be made for the proposition that this pattern of behaviour is indeed desirable. It is desirable for the rest of the world because it lowers real interest rates, thereby allowing more spending. It is desirable for China, some economists also argue, because rapid export growth is the best way to generate sustainable economic expansion and higher employment.
The arguments against the pattern, however, are also strong, in my view stronger. So long as the counterpart trade deficits are concentrated in the US, there is a risk of protectionist action, particularly as the latter’s economy slows down. More important, it is hard to believe that vast accumulations of low-yielding foreign assets, so vulnerable to the almost inevitable appreciation of the renminbi against the dollar, make sense for the Chinese themselves. Indeed, the Chinese leadership itself has repeatedly declared its intention to rebalance growth, which has depended unduly in recent years on the growth of investment and the external surplus. Over the past two years, the expansion in net exports generated close to a quarter of the growth of GDP. This cannot continue much longer. At some point rather soon, demand has to grow at least as fast as GDP, if not rather faster.
In a thought-provoking recent paper*, Nicholas Lardy of the Peterson Institute for International Economics in Washington argues that the present development path has many evident disadvantages for China itself: household consumption is too low, at a mere 38 per cent of GDP in 2005; growth is too dominated by the coastal regions; employment growth ran at only 1 per cent a year between 1993 and 2004; energy consumption is too high; and the low domestic interest rates that result, in part, from foreign currency interventions distort the financial system and encourage wasteful investment.
So what is to be done? The answer seems simple: save less and let the nominal exchange rate appreciate faster, to eliminate possible inflationary consequences of such a policy shift. The Chinese government can easily afford to spend more on health and education. It can also usefully set up a modest pension system for those now alive. Moreover, the bulk of Chinese savings are not by households but by the government and corporations, many of which are owned by the government itself (see chart). Savings then are a policy choice, not a given. At 50 per cent of GDP, they also look far too high.
How then, if at all, can the outside world cajole China in a direction that seems to make such sense for the Chinese themselves? Mr Paulson is quite right to approach this question as a discussion of mutual interests. But it is almost inconceivable that the Chinese will grant what will appear to be one-sided concessions to demands from the “sole superpower”. That would be far too humiliating.
The Chinese will need, instead, to participate as equals in a wider global dialogue among the leading economic players. The obvious move is to replace the G7 with a group of four – the US, eurozone, Japan and China. In time, no doubt, India will join, but its time has not yet come. Such a grouping, moreover, should not focus on China alone. It must consider the range of policies adopted in these four dominant economies. Mr Paulson is indeed addressing many of the right questions, but in too narrow a forum. It is time to broaden the dialogue.
*China: Rebalancing Economic Growth, www.petersoninstitute.org
Jagdish Bhagwati: Martin Wolf may well be right. Bilateral talks rarely work with big players, especially when the US wants the big players to do something they do not want to do.
This was the lesson the US learnt, and now seems to have forgotten, in trying to impose managed trade targets on Japan, using Section 301, during the years of Japan-bashing.
But I also wonder what sense it makes for secretary Paulson, an enormous improvement over his predecessor, to keep asking China for financial reforms. That is something the Chinese must decide for themselves, in their evaluation of their own interest. Why is Secretary Paulson so interested in this? One might cynically think that it is part of what I have called the Treasury-Wall Street complex: is what is good for Goldman Sachs also good for the US and, what is more pertinent, for the world economy? I wonder.
Posted by: Jagdish Bhagwati | May 30th, 2007 at 10:38 am | Report this commentMartin Wolf: Jagdish is right: too many US Treasury secretaries think they are secretary for Wall Street. It is a mistake, I think, even politically. It is certainly a narrow view of the US, let alone the global, interest.
Posted by: Martin Wolf | May 30th, 2007 at 2:49 pm | Report this commentCharles Wyplosz: Martin makes two important points: China’s current surplus is driven by very high savings and the US cannot give orders (and, he does not say so, slap import duties as it will). He does not go the next steps, so I will oblige and do it.
If savings is the problem, and it is, what good would a renminbi appreciation do? There are some theories that exchange rate appreciation can reduce saving, but the magnitude of the effect is, at best, minute. The inescapable conclusion is that we should stop pestering the Chinese with calls for appreciation and threats of designating them as currency manipulators, as many in Washington plot to do. There is no doubt that the renminbi is not a free floating currency, but there is no international obligation to let all currencies float. Maybe the renminbi is somewhat undervalued, but that cannot be the ground for aggressive diplomacy. If it is undervalued and China sticks to its exchange rate policy, all that will happen is real revaluation through inflation. Not a great idea, I agree, but that is China’s problem. Let them make that choice as an independent nation.
Much of this huge saving is invested locally, which largely explains one of the most spectacular growth performances mankind ever witnessed, with the added bonus that it benefits about one-fifth of humanity that was extremely poor when it all started. Not all of it can be invested. As Martin notes, a very low interest rate may already encourages excessive investment. So calling for Chinese firms to invest their savings is a bit disingenuous. Sure, the government could spend more, especially on infrastructure, health and social programmes. It is good to pass this sound advice to the Chinese authorities, but then it is for them to decide.
In the meantime, what can they do with this mass of savings that cannot be absorbed domestically? Invest abroad. Not in US Treasuries, but in profitable corporations. This is what they just set out to do with the creation of the State Investment Company. The first big move has been to buy a small stake, with no voting right, in the Blackstone Group. Why so timid a move? Because the Chinese know that they are not welcome in the US, they remember the groundswell of xenophobia when they wanted to buy Unocal, immediately branded a key strategic unit. Would Martin agree that we ought to welcome into the world economy the Chinese savers as well as the Chinese workers?
It is time to acknowledge that there are no rights and wrongs, but mistakes and counter-mistakes and, more importantly, huge common interests beyond healthy competition. This means sitting down and talking. Martin is absolutely right to call for dismissing the G8 as a misguided transformation of the out-of-breath G7 and setting up a G4. This is what Peter Kenen, Jeffrey Shafer Nigel Wicks and I proposed three years ago, only to fall on deaf ears. Thanks, Martin!
Posted by: Charles Wyplosz | May 30th, 2007 at 10:20 pm | Report this commentRoland Vaubel: I agree with Martin that the Chinese are making a mistake. We do not know whether China is saving too much. But we do know that China is not investing its savings efficiently. The problem is not just that foreign exchange reserves are low yielding assets. The Chinese central bank prevents the country from importing capital on a net basis: its official capital exports are larger than private capital imports. However, an emerging economy like China ought to be a net capital importer. In particular, it should not export capital to capital-abundant countries like the US. It is this misallocation of the world capital stock which economists should be concerned about.
China’s policy of offsetting private capital imports with official capital exports may be viewed as an attempt to import foreign technology without importing foreign capital on a net basis. Is China’s accumulation of foreign exchange reserves merely the unwanted by-product of an export-oriented exchange rate policy? Is it not also the deliberate but misguided strategy of a proud but economically backward people to get hold of the technological achievements of the West without becoming indebted to and dependent on it? The Chinese, or more precisely their political leaders, want our technology but not our capital.
Posted by: Roland Vaubel | May 31st, 2007 at 10:46 am | Report this commentAndrew Smithers: I agree with Martin that China is unlikely to accelerate the rise in its nominal exchange rate because of external pressure. I suspect, however, that this applies whether the forum for that pressure is bilateral discussions with the US or multilateral ones including the EU.
China is, I think, bound to have a rising real exchange rate, what is in doubt is the relative contribution that will come from increased inflation in China and an accelerated change in the nominal exchange rate.
A rise in the nominal rate is likely to be preferable from the view point of both China and the rest of the world, but a rising real exchange rate by either route will pose problems, particularly for the US.
Martin addresses the question of how China should respond to China’s exploding surpluses, but not how the rest of the world should respond. Provided China’s inflation rate does not rise to a point at which domestic demand in China has to be reined back, the main impact on the rest of the world will be a change in external inflation. From being deflationary in terms of manufactured goods, it will become neutral to inflationary. The maximum point of deflation has already passed, as this occurred while there was spare capacity in raw material output world wide. This seems to have come to an end.
The key issues for the rest of the world are how to cope with the strains that will come from the end of both this deflationary pressure and a slower increase in China’s trade surplus.
Less external deflationary pressure must be offset by less inflationary pressure from domestic demand. This will require a larger output gap than has been needed in recent years, which in turn is likely to mean higher unemployment and a lower profit share of output.
A slow down in the growth of China’s trade surplus will naturally have to be matched elsewhere. If the US deficit is to improve without lower US domestic demand, then a switch in investment towards traded goods will be needed. As the capital/output ratio for the production of traded goods is much higher than needed to satisfy domestic demand, business investment in the US will need to rise as a proportion of GDP and consumption will have to be weak to finance both the improvement in the current account and the higher level of investment.
It will be difficult to accommodate these changes smoothly for political as well as economic reasons. Voters like consumption. If monetary policy seeks to maintain the current output gap, then inflation will not readily fall back and if this is leads to a pick up in inflationary expectations, then the output gap needed to bring them down again is likely to be painful.
The needed rise in investment may be difficult to achieve when profit margins are falling. The weak dollar should, however, help. This should improve profit margins in the output of traded goods, relative to margins elsewhere. As the former have much higher capital requirements per unit of output, higher investment could be compatible with weak profits generally.
Economies can usually maintain reasonably good levels of output provided that they adjust smoothly rather than sharply to change. I suspect that the main risks of sharp change will arise:-
(i) If inflation picks up in China to the point where the authorities stamp down on domestic demand, thus making the trade surplus balloon.
Posted by: Andrew Smithers | May 31st, 2007 at 1:11 pm | Report this comment(ii) If protectionism in the US leads to a more rapid rise in imported inflation.
(iii) If monetary policy is relaxed in the US too soon in response to a rising output gap, and inflationary expectations pick up.
Ronald McKinnon: Martin accurately covers enormous ground on China’s exploding current account and trade surpluses. China’s saving surplus is absolutely huge by any historical standard just as America’s persistent saving deficiency over the past 25 years is unprecedented for a mature industrial country.
However, Martin is wrong to emphasise one-sided saving adjustment by China - or, I would add, other high-saving Asian economies such as Japan. Attempts at one-sided adjustment by East Asia will be frustrated unless American absorption falls relative to income, ie, net saving increases. This is not a theoretical proposition but comes from the balance of payments identity linking the national income accounts on both sides.
Martin is quite right in emphasising that the G7 is the wrong forum for addressing this global imbalance. A stripped-down forum including China-Japan leading an Asian group, the United States, and perhaps the eurozone is the way to go. To be effective, any international agreement must be two-sided. The US agrees to reduce absorption by, say, raising taxes while the Asian countries do the reverse. Such an agreement may seem fanciful and unlikely, but it is the only way the global imbalance can be eliminated.
It would be a huge mistake to reach for the wrong variable, the exchange rate, to solve the saving imbalance. Exchange rate changes have no predictable effect on saving behaviour on either side. But exchange rate changes can still be very destabilising in a macroeconomic sense. The forced appreciations of the yen in the 1980s into the mid-1990s imposed severe deflation on Japan, followed by a lost decade, but without “correcting” Japan’s current account surplus measured as a share of Japan’s slumping GDP.
Posted by: Ronald McKinnon | May 31st, 2007 at 4:57 pm | Report this commentBrad Setser: I agree with the core of Martin Wolf’s policy recommendation: rather than holding the renminbi down and using policy to restrain domestic demand, China should allow the RMB to appreciate and take policy stems to stimulate domestic demand. The World Bank’s latest quarterly shows that net exports contributed over 3% to Chinese growth in Q1. So long as net exports are contributing so strongly to growth, stimulating domestic demand risks true overheating, so exchange rate adjustment seems to be a necessary part of the broader adjustment.
I do have a question about the proposed G4 though. The IMF tried something similar, though with a slightly different grouping, in its multilateral consultation on global imbalances, and the results were rather disappointing. Concessions to a multilateral group are easier to make than concessions to a specific country, but the G2 of imbalances hasn’t exactly shown much willingness to adjust their current policies in any context.
I have been struck by the willingness of key countries to commit ever growing sums to the defense of the status quo. China’s reserve growth is currently closer to $50bn a month (April supposedly was $45bn) than $20bn a month, and monthly global reserve growth is now around $100bn.
The argument that exchange rate changes won’t have an impact on savings/ investment gaps and thus won’t generate adjustment is an important one. However, my read of the recent evidence suggests a bit more grounds for optimism that Dr McKinnon’s assessment. There do seem to be potential links between changes in exchange rates and changes in the savings and investment balance.
The very large rise in China’s savings to GDP ratio over the past few years, for example, seems correlated with the real depreciation in the dollar and RMB that started in 2002. It doesn’t seem like too much of a stretch to argue that the RMB’s real depreciation from 2002 on played some role in increasing corporate profitability and business savings – and it now seems fairly clear that the rise in business savings accounts for most of the recent rise in national savings.
In a previous column, Dr. Wolf argued that sustaining the real depreciation brought about by the RMB’s nominal depreciation also required that China’s government to direct its policy toward restraining domestic demand growth (notably with administrative curbs on bank lending to slow investment growth). That too likely contributed to the large recent increase in the savings and investment gap. The oil exporters seem to have been less effective at restraining domestic demand, and are now experiencing rapid inflation/ a real appreciation.
Given the scale of China’s direct financing of the US (the $300bn plus in expected 2007 Chinese purchases of the US assets will finance about one-third of the United States savings deficit), there also seems to be a rather direct channel through which changes in China’s savings surplus would put pressure on the US to reduce its own savings deficit.
Posted by: Brad Setser | June 1st, 2007 at 6:48 pm | Report this commentMartin Wolf: I thank the members of the forum for their superb comments on this article and apologise for the delayed response to some of their comments.
The big question – posed strongly by Charles Wyplosz and running through the views of others, notably, Ron McKinnon – is that if excess Chinese savings (and deficient US savings) are the cause of the imbalances what good would a currency appreciation do? We have returned to this point on many occasions in this forum. Charles shares with Ron and most other international macroeconomists what I consider the canonical assumption: savings rates are exogenous or, less technically, outside policy control.
I, however, have been trying to argue that for a country like China savings rates are not merely subject to policy influence (obvious enough given the role of the government as a saver), but are directly dependent on the real exchange rate. As Brad Setser suggests, a depreciated real exchange rate has almost certainly raised the shares of profits and so savings in Chinese GDP. So an appreciated real exchange rate is likely to do the reverse - and desirably so, since China should spend more on its own people.
In addition, if the Chinese real exchange rate were to appreciate, the government would act to reduce the savings surplus, to sustain domestic activity at close to “full employment” or whatever that notion might mean for a labour-surplus developing economy, such as China.
Moreover, a similar effect would work in the US, too, in reverse. If the dollar depreciated and real interest rates rose worldwide, US savings rates would rise, partly automatically and partly in response to the normal response of monetary policy to the depreciation.
Yet I am also not entirely happy with just leaving the Chinese to decide things on their own, as Charles recommends. It is conceivable that the Chinese current account surplus could be $500bn or so in a few years. (Please note that this is not a forecast!) I fear that such a surplus could destroy the trading system. That is, no doubt, economically irrational. But irrationality is part of collective human behaviour. Such huge surpluses would be seen as predatory mercantilism by almost all the country’s trading partners, not just the US. So at the least the Chinese government needs to be warned of this grave danger. That is what my proposed G4 (very similar, as the IMF has pointed out, to its new consultative group) should try to achieve.
I agree entirely with Roland Vaubel: China wants western technology, but not its capital (on a net basis). This is partly because the Chinese authorities (quite understandably) fear being at the mercy of the kind of frenzy, followed by panic, that created the Asian financial crisis of a decade ago. I think that some of the massive insurance the Chinese government has bought also makes sense. But can it really make sense to invest 40 per cent of GDP in foreign currency reserves? I very strongly doubt it. I don’t think any democratic government could get away with doing such a thing, particularly when there is so much poverty to address in this vast country.
I largely agree with Andrew Smithers’ interesting analysis. I think we have indeed passed from the deflationary period of China’s emergence to a more inflationary one. When the Chinese real exchange rate starts to appreciate (either through nominal appreciation of the renminbi or higher domestic inflation), as it ultimately surely must, China will even start exporting inflation. It may also then start to spend more relative to output domestically, so reducing its current account surplus. The combination of global higher inflation with a smaller Chinese current account surplus would impose substantial adjustment pressures on the rest of the world. Should it happen quickly, it would indeed be painful. That is why I have long wanted to see a smooth and slow adjustment. Andrew also rightly adds that serious US protectionism would be inflationary. This is yet another argument against it.
Finally, I do not want to add anything further to the voluminous discussion of the exchange rate in this forum between Ron McKinnon and others (particularly me). But I agree with him that adjustment requires changes in the macroeconomic balance, on both sides. Otherwise, we will end up either in a global recession or with serious global inflation. That is why serious policy discussion among significant players is so desirable.
Posted by: Martin Wolf | June 15th, 2007 at 8:01 pm | Report this comment