How Can China Reduce Its Reliance on Net Exports?

China’s decision to allow its exchange rate to fluctuate has been welcomed by the United States as a necessary step toward global rebalancing. The upward currency revaluation has lifted some international pressure from China and defused criticism that its artificially low renminbi gives it an unfair trade advantage. Allowing greater exchange rate flexibility also puts China in a stronger negotiating position ahead of the upcoming G20 meeting in Canada. 

Yet despite this positive development, other significant factors will continue to impede China’s transition towards a healthier balance of trade. As long as China continues to subsidize its production growth at the expense of household income, it will have difficulty increasing domestic demand and cutting its reliance on exports.

Michael Pettis, a Carnegie Senior Associate and a leading economist based in Beijing, discussed China’s economic outlook in light of both internal constraints and external shocks. Carnegie’s Douglas Paal moderated the discussion.

A Shifting Paradigm

China’s rapid industrialization was largely achieved through the application of the Asian Development Model, explained Pettis. Under this economic paradigm, high production growth was generated by channeling resources away from households and into subsidies for producers. 

• Need for change: The financial crisis has sapped both the economic ability and political will of the United States to continue absorbing Chinese surpluses through a rising trade deficit, effectively ending the era of the Asian Development Model.

• Enabling factors: In order to achieve healthier, sustainable development, China must shift away from the combination of low wages, exchange rates, and interest rates that fueled its explosive production growth. While it has taken steps to increase wages and let its currency appreciate, the most vital change will be raising its interest rates, which are currently negative in real terms.

• Ending financial repression: Artificially low interest rates have systematically transferred between 5-10% of China’s GDP from households to producers. Until this pattern of financial repression is changed, household income and domestic consumption will remain low.

Coming Constraints

Pettis outlined several factors that will constrain China’s growth and expedite its need for a new development model as the world continues to grapple with economic recovery.

• Inefficient investment: Because China started from a very low level of development, all investment – no matter how poorly allocated – had a positive impact. However, it is now nearing the point where it can no longer absorb such inefficient investment and economic returns will start to shrink.

• Global dependencies: The world is no longer able to leverage China’s growing trade surpluses, which are already the largest in history. Future production growth will thus be limited by the ability of domestic consumption to absorb it.

• An entrenched system: While it is clear that China’s interest rates must increase, it can only do so at the expense of its State Owned Enterprises, whose profitability depends entirely on subsidized interest rates. Consequently, political factors will only allow for very gradual economic adjustment.

The Specter of Trade War

China’s economic outlook has been complicated by the massive trade shock radiating from the Eurozone crisis. As capital stops flowing into former trade deficit countries such as Greece, they will eventually become current account surplus countries that can no longer finance themselves. Pettis warned that these growing surpluses must also be balanced elsewhere through rising deficits, raising the specter of an ugly trade war. 

• Deflection of responsibility: China’s currency appreciation is a response to the imbalances and does not help to absorb the European surge in surplus. Its policy of financial repression and slow renminbi revaluation is effectively forcing others to bear the brunt of adjustment in response to the Eurozone crisis.

• Dangerous trade tensions: In absence of the ability to manipulate its currency, the United States will likely try to impose tariffs and quotas in effort to prevent its trade deficit from ballooning. Such a policy, while politically straightforward, is combative, inefficient, and may give a green light to other countries, particularly in the East Asian region, to protect themselves and raise barriers to trade.