Americans are good at outsourcing. The strong dollar policy has been outsourced to China and a few other large emerging economies. According to no one less than Alan Greenspan, outsourcing the strong dollar policy has implied that large central banks abroad can have almost as much impact on the ten-year Treasury rate as the Fed. And I am outsourcing commentary on China to Richard McGregor and Martin Wolf, both of whom wrote articles for the FT’s excellent special report on China.
This clearly isn’t a way to cut costs – but the quality cannot be beat.
All touch on the issues raised by China's $24b September trade surplus -- which provides yet another data point indicating that China's overall current account surplus will reach record levels in 2007. And all help explain why China is only the only country in the world that reports its reserves in trillions. It certainly is the only country that conceivably could have shifted some funds to its investment company and still added about $100b to its reserves in the third quarter, bringing its total reserves to 1.43 trillion.
Martin Wolf – in his FT column as well as in the special report – makes a simple but important point: China, with a rising current account surplus, is still a net drain on global demand.
China’s surging current account surplus, forecast by the World Bank to reach $380bn this year, up from $250bn in 2006, is extracting demand from the rest of the world to the tune of ¾ per cent of the latter’s aggregate GDP. China’s forecast surplus – an amazing 12 per cent of GDP – is twice as big, relative to GDP, as Japan’s has ever been. The analytical point is that offsetting any slowdown in US demand requires faster growth of demand in the rest of the world. This is still more true if, as seems quite likely (and also desirable), US demand growth slows, relative to growth of GDP, and so the US current account deficit shrinks further. In that case, the rest of the world’s demand must rise relative to its output and, ideally, must grow faster than potential output, to ensure full employment of resources. But that is exactly the opposite of what China – vastly the most important of emerging market economies – is now doing.
The conclusion, then, is simple and disturbing. Yes, emerging economies are, with a few exceptions, in a better position to offset a US slowdown and tightening of global credit conditions than ever before. But they are almost certainly going to have to do just that. The difficulty they face, however, is that neither western Europe as a whole, nor Japan, nor, not least, the giant among them, is likely to help the rest very much. China, in particular, is now exporting a big net contraction, not expansion, in demand to the rest of its world, because its supply is growing far faster than its domestic demand. (emphasis added)
Of course, China is still a large net source of demand for a lot of commodities. It isn’t an accident that Australia views China more warmly than the US or Europe. But isn't a net source of demand for other goods. That means, for now, it isn’t helping to offset weakness in US demand for manufactured products, only for commodities.
Richard McGregor makes a similar point, quoting Guo Shuqing, a former central bank vice-governor who now heads China Construction Bank
“... consumption is too low, particularly in education, medical care and other areas, like financial services,” he says. “Government-financed public services are too small, especially compared with the growth rate.”
That is consistent with Kuijs work, along a recent paper from the IMF. All tie the fall in consumption as a share of GDP to the fall in labor income as a share of GDP, not to a rise in household savings.
Martin Wolf, I think correctly, is skeptical of arguments that the recent rise in China’s inflation doesn’t stem from China’s policy of building up reserves to keep its exchange rate from appreciating. He argues that the real puzzle isn’t the development of inflation in China, but rather that it has taken so long for inflationary pressures to emerge.In the longer term, a fast-growing economy with a tightening labour market and a currency that is appreciating very slowly should show higher inflation than the majority of its trading partners. Such an appreciation of the real exchange rate – a rise in the domestic price level relative to the rest of the world – is a normal part of rapid development.
What is surprising, in China’s case, is how long it was before this process began to take hold: after the mid-1990s, inflation remained consistently low and the real exchange rate flat. A part of the explanation has been the ability of the People’s Bank of China to sterilise the impact of the country’s enormous accumulation of foreign currency reserves upon the monetary base or “reserve money” – holdings of commercial banks at the central bank.
Wolf’s policy recommendations mirror, at least in part, those of Guo and Kuijs: Stimulate domestic demand and let the currency appreciate.
And do not slam on the (domestic) brakes to fight inflation:
the big macroeconomic issue of today is not inflation. It is the rapid growth in net exports, soaring current account surpluses and persistent weakness of domestic consumption. China suffers not from excess domestic demand, but a lack of it. Rebalancing the structure of the economy – from exports and investment towards public and private consumption and from massive current account surpluses and huge reserve accumulations towards a more balanced external position – remains the true priority.
Richard McGregor notes that China’s leaders probably never intended to launch on a course that would produce current account surpluses at a level “unheard of for a country of China’s size and weight in the global economy,” or, for that matter, to add an equally unheard of $500b a year to their reserves.
China's leaders are a cautious lot, adverse – at least in some respects – to rapid changes in policy. They opted for a very incremental change in the RMB back in 2005. McGregor:
China’s refusal to allow its currency to appreciate faster remains difficult to fathom. A stronger currency would help damp rising inflation and capital inflows, and provide reduced incentives for exporters – a stated aim of government policy.
But caution, a byword in financial reform, and the need for consensus among powerful ministries, continues to stay the hand of policymakers. So too, according to many critics of the government, does the weakness of Wen Jiabao, the premier, who seems incapable of putting his personal stamp on financial and economic policy.
The irony is that this seemingly cautious policy, one intended to avoid large moves in the RMB v the dollar, has launched China on a macroeconomic path that is anything but cautious. A policy that results in negative real interest rates at a time when the equity market is booming isn't really that cautious. And no large oil-importing country has ever run a 12% of GDP current account surplus in the midst of an investment boom, particularly with oil set to average $70 a barrel.
China's goal may have been to avoid too rapid change, but the result has been any thing but cautious – it set China on a macroeconomic course without any obvious precedent.