Source: China Financial Markets
Three weeks ago the Wall Street Journal published my OpEd piece about concern that China may try to make the rebalancing process less painful by allowing the RMB to depreciate. In the piece I argue that this isn’t as obvious as you might think.
From July 2005 to February this year the RMB rose by just over 30% in nominal US dollars. Although on a trade-weighted basis, adjusted for changes in relative productivity growth, the revaluation has been much less than 30%, the increase in the value of the RMB has nonetheless been seen, correctly, as a part of China’s rebalancing process.
But after rising for nearly seven years the RMB has dropped 1% against the dollar since February, setting off intense speculation about Beijing’s trade intentions. Not surprisingly, the threat of a weaker RMB making Chinese exports more competitive abroad and foreign imports more expensive in China is raising worries in a world already struggling with weak demand growth.
But these worries may be unfounded. If China is serious about rebalancing its economy, devaluing the RMB will not result in a net improvement in export competitiveness. China’s export competitiveness will deteriorate no matter what Beijing does to the currency.
To understand why, it is important to see that as part of its rebalancing, China must sharply reduce investment, or at least reduce the growth rate of investment. In principle the adverse impact of slower growth in investment should be offset by faster growth in consumption, but it has proven very difficult for China to raise the GDP share of consumption, largely because, as I noted above, consumption-constraining policies are at the heart of China’s growth model, and indeed at the heart of investment growth models more generally. It will take many years of adjustment before consumption is large enough and can grow into its proper role.
This means that during the adjustment process it is a virtual certainty that growth in China will slow significantly for many years. Why? Because if Beijing brings investment growth down more quickly than can be counterbalanced by an increase in consumption growth, its overall growth rate must slow sharply.
There is however a third source of demand that affects domestic growth – the trade surplus, and this is why there is now so much focus on the value of the RMB. If China’s trade balance improves during the adjustment process, overall economic growth rates should be better than expected. If it deteriorates, growth will be worse. Clearly a healthy trade account will make it easier for Beijing to manage the adjustment process. For this reason many analysts, both foreign and Chinese, argue that by boosting China’s competitiveness abroad, a weaker RMB will provide some relief from the sharp expected slowdown associated with rebalancing.
But they are wrong. If China’s trade balance improves because of a surge in foreign demand (which is pretty unlikely), this will almost certainly be good for the economy and will allow the rebalancing process to be less painful. But if Beijing takes steps to increase China’s competiveness abroad by artificially lowering costs domestically, including by depreciating the RMB, it will have no effect on overall growth for any given level of economic rebalancing.
Why not? Because there is a lot more to Chinese competitiveness than the undervalued exchange rate. There are in fact three main mechanisms that explain the relatively low price of Chinese exports abroad, all of which transfer income from Chinese households to subsidize Chinese producers, albeit in very different ways.
The sources of China’s export competitiveness
The currency regime is certainly one of them, and the mechanism is fairly easy to understand. An undervalued currency spurs export competitiveness by subsidizing the local cost component for manufacturers. These implicit subsidies are effectively paid for by Chinese households in the form of artificially high prices for imported goods. Since all households, except perhaps subsistence farmers, are effectively net importers, an undervalued currency is a kind of consumption tax that effectively reduces the real value of their income.
The second mechanism, the difference between wage and productivity growth, does the same thing, but with a different set of winners and losers. Chinese workers’ wages have grown more slowly than productivity for all but the last two years of the past three decades, which means that until two years ago workers have received a steadily declining share of what they produce. Manufacturers benefit from this process because their wage payments are effectively subsidized, and of course the more labor-intensive production is, the greater the subsidy they implicitly receive.
The third mechanism, the most important, is artificially low interest rates, which in China have been set extremely low. These reduce household income by reducing the return households receive on bank deposits, and in China, because of legal constraints on investment alternatives, the bulk of savings is in the form of bank deposits. Artificially lowered interest rates, however, increase manufacturing competitiveness by lowering the cost of capital. Of course the more capital-intensive a manufacturer is the more it benefits.
All these subsidies goose economic growth by subsidizing producers, but they distribute the benefits in different ways. The greater the local production component, the higher the subsidy created by an undervalued currency. The more labor intensive the manufacturer, the greater the subsidy created by low wages. And finally the more capital intensive the producer, the more it benefits from artificially low interest rates.
The mechanisms also distribute the costs in different ways. An undervalued currency hurts households in proportion to the value of imports in their total consumption basket. Low wages hurt workers. Low interest rates hurt households in proportion to the amount of their savings as a share of income.
Because they boost economic growth at the expense of households, these three mechanisms cause the economy to grow much faster than household income. This is the root of China’s unbalanced economy – household income has grown so much more slowly than the economy that household consumption over the past three decades has collapsed as a share of GDP. Rebalancing in China means by definition, however, that the household consumption share of GDP must rise, and the only effective way to do this is by raising the household income share of GDP. Revaluing the currency is one way of doing so. It increases the real income of households by reducing the cost of imports, and it raises local production costs for manufacturers.
But it is not the only way. Raising Chinese wages increases household income too, while increasing labor costs for manufacturers. Finally, allowing interest rates to rise benefits households by increasing the return on savings, and it raises costs for capital-intensive manufacturers.
Domestic priorities
As China rebalances, by definition Chinese household income must rise as a share of total GDP. This is the important point that is often forgotten in the debate about Chinese competitiveness. In the aggregate, as China rebalances, the net impact of changes in all three mechanisms must result in reduced subsidies to Chinese manufacturers and so, at least initially, in reduced Chinese competiveness abroad.
If Beijing wants to rebalance, and it decides anyway to devalue the RMB, it just means that Beijing must raise wages or interest rates all the more in order to force a real increase in the growth rate of household income. Any improvement in Chinese export competitiveness achieved by devaluing the RMB, in other words, will be fully made up for by a deterioration in Chinese export competitiveness caused by rising wages or rising interest rates.
This is ultimately what rebalancing means. One way or another as China rebalances it will lose competiveness abroad because it must raise the cost of production in favor of household income. In exchange, however, China’s domestic market will become a bigger source of demand as Chinese households benefit from rebalancing. Over the long term Chinese growth will be much healthier and the risk of a Chinese debt crisis much reduced, but over the short term, unless there is an unlikely surge in global demand, China cannot both rebalance and improve its trade performance.
How China rebalances, then, will mainly reflect domestic priorities and political maneuvering. If China revalues the currency, it will disproportionately help middle- and working-class urban households – for whom import costs tend to be important – and will disproportionately hurt manufacturers whose production costs are primarily local, e.g. most manufacturers who are not in the processing trade.
If China however chooses to raise wages, it will disproportionately help urban workers and farmers and will disproportionately hurt labor-intensive manufacturers, who tend mainly to be small and medium enterprises. And finally if China raises interest rates it will disproportionately help middle-class savers and disproportionately hurt large, capital-intensive manufacturers.
These three strategies, in other words, have broadly the same impact on trade competitiveness, although in each case the winners and losers within China will be different. This is why we should not be overly concerned with what happens just to the exchange value of RMB. As long as China genuinely rebalances its economy, which will be a painful process no matter how Beijing chooses to manage it, Chinese export costs will rise and in the short term Chinese goods will be less competitive in the global markets (although as rising domestic costs force China to increase productivity and innovation, over the longer term they will actually boost Chinese competitiveness).
Which path China chooses to follow should be seen by the world primarily as something that affects the way the costs and benefits of rebalancing are distributed domestically. For the sake of more sustainable and equitable long-term growth, and in the interests of economic efficiency, it is almost certainly much better for China and the world if Beijing raises interest rates than if it revalues the RMB, but since raising interest rates is likely to be opposed by the very powerful groups that benefit from excessively cheap capital, Beijing may instead put more focus on raising wages, which comes mainly at the detriment of economically efficient but politically weak small and medium enterprises and service industries.
China urgently needs to rebalance its economy, both to avoid the risk of a domestic banking crisis and to reduce its excessive claim on global demand. How it chooses to do so, however, should not be constrained by too much focus on the value of the RMB. The exchange rate is only one of the mechanisms, and not even the most important, that will determine the price of Chinese goods abroad. It is domestic politics that will determine the form in which the rebalancing takes place, but as long as rebalancing occurs, the world should not overly emphasize the role of the currency.
Do not expect, in other words, that China will steal export share from the rest of the world while rebalancing its economy by depreciating the RMB. Increasing competiveness in export markets is not compatible with rebalancing. As China rebalances it has no choice but to reduce its export competitiveness. Even if Beijing devalues the RMB, this will not improve Chinese competitiveness abroad because Beijing will have to raise wages or interest rates all the more.
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