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The writing is on the wall: China is the world second largest economy and the growth rate has slowed sharply. The wages are rising, so that the fabled army of Chinese cheap labor is now among the most costly in Asian emerging economies. China, in the last thirty years has brought hundreds of millions of people out of poverty, but this miracle would stall unless China can undertake another transformation of becoming an innovation nation.

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Ten years ago Brazil was beginning to enjoy the financial boom from China’s growing appetite for commodities and raw materials. The two countries were a natural fit. Brazil had what Beijing needed – iron ore, beef, soybeans, etc. and China had what Brasilia desperately wanted – foreign exchange to address budget deficits and cost overruns on major infrastructure projects. It was a marriage made in heaven – for four or five years.

The post What a difference a decade makes in Brazil appeared first on OUPblog.

The Chinese New Year begins on 8 February, ushering out the year of the sheep (or goat, or ram) and bringing in the year of the monkey. People in China will enjoy a week-long vacation and will celebrate with dragon dances and fireworks. Given the financial fireworks emanating from China, this is a good time to briefly review some of the major economic news coming out of the Middle Kingdom.

The post Happy new year, China: Recent economic booms and busts appeared first on OUPblog.

China has all but overtaken the United States based on GDP at newly-computed purchasing power parity (PPP) exchange rates, twenty years after Paul Krugman predicted: “Although China is still a very poor country, its population is so huge that it will become a major economic power if it achieves even a fraction of Western productivity levels.” But will it eclipse the United States, as Arvind Subramanian has claimed, with the yuan eventually vying with the dollar for international reserve currency status?

Not unless China battles three economic foes. One is well-known: diminishing marginal returns to capital. Two others have received less attention. The first is Carlos Diaz-Alejandro. Not the man, but the results uncovered by his research on the Southern Cone following the opening up of its capital account that culminated in a sovereign debt crisis and contributed to Latin America’s lost 1980s. If the capital account is liberalized before the domestic financial system is ready, the country sets itself up for a fall: goodbye financial repression, hello financial crash. The second is the “reality of transition”: rejuvenating growth requires hard budgets and competition to improve resource allocation and stimulate innovation, counterbalanced with a more competitive real exchange rate. This is the principal insight from the transition in Central and Eastern Europe (CEE), which was far simpler than anything China faces.

China was able to raise total factor productivity (TFP) growth as an offset to diminishing marginal returns to capital, especially after joining the World Trade Organization (WTO) in 2001, and faster growth was accompanied by a rising savings rate. But TFP growth is hard to sustain. Any developing country targeting growth above the steady state level given by the sum of human capital growth, TFP growth and population growth (the latter two falling rapidly in China) will find that its investment rates need to continually increase unless it can rejuvenate TFP growth. China’s investment rates have risen from around 42% of GDP over 2005-7 (prior to the global crisis) to 48% in recent years even as growth has dropped from the 12% to the 7.5% range. Savings rates have hovered around 50%, reducing current account surpluses (numbers drawn from IMF 2010 and 2014 Article IV reports).

This configuration has forced China to choose between either investing even more, or lowering growth targets. It has chosen the latter, with its leaders espousing anti-corruption, deleveraging, environmental improvement and structural reform to achieve higher quality growth. The central bank, People’s Bank of China (PBoC), has reaffirmed its goal of internationalizing the yuan and liberalizing the capital account.

China’s proposed antidote is to “rebalance” from investment and exports to domestic consumption. But growth arithmetic would require consumption to grow at unrealistic rates, given the relative shares of investment and private consumption in GDP, even to meet scaled-down growth targets. Besides, households need better social benefits and market interest rates on bank deposits to save less and consume more. Hukou reform alone, or placing social benefits received by rural migrants on a par with their urban counterparts, could easily cost 3% of GDP a year for the next seven years as some 150 million additional people gain access to such benefits—quite apart from the public investment needed to upgrade urban infrastructure, according to calculations shared by Xinxin Li of the Observatory Group. And the failure to liberalize bank deposit rates has led to the rise of “wealth management products” in the shadow banking system. These “WMPs” offer higher returns but are poorly regulated and more risky.

Indeed, total social financing, a broad measure of credit, has soared from 125% to 200% of GDP over the five years 2009-2013 (Figure 2 in the July 2014 IMF Article IV report, with Box 5 warning that such a rapid trajectory usually ends in tears). Local government debt was estimated at 32% of GDP in mid-2013, much of it short-term and used to fund infrastructure projects and social housing with long paybacks. Housing prices show the signs of a bubble, especially away from the four major cities. Corporate credit is 115% of GDP, about half of it collateralized by land or property. While the focus recently has been on risks from shadow banking, it is hard to separate the shadow from the core. Besides, WMPs have become intertwined with the booming real estate market, a major engine of growth yet the centre of a “web of vulnerabilities” (to quote the IMF) encompassing banks, shadow banks, and local government finances. A real estate shock would ripple through the system, lowering growth and forcing bailouts. The gross cost of the bank workout at the end of the 1990s was 15% of GDP in a much simpler world!

2014 began with fears of a hard landing and an impending default by a bankrupt coal mine on a $500 million WMP-funded loan intermediated by a mega-bank. The government eventually intervened rather than let investors take a hit and risk a confidence crisis. And starting in April, stimulus packages were launched to meet the 7.5% growth target, a tacit admission that rebalancing is not working. But concerns persist around real estate. Besides, stimulus will help only temporarily and China is likely to be facing the same questions about growth and financial vulnerability by the end of the year.

With rebalancing infeasible, and investing even more prohibitively costly, virtually the only remaining option is to spur total factor productivity growth: China is still far from the global technological frontier. This calls for a package that cleans up the financial sector and implements hard budgets and genuine competition, especially for the state-owned enterprises (SOEs), while keeping real exchange rates competitive. The real appreciation of the past few years may have been offset by rising productivity, but continued appreciation will make it harder for the domestic economy to restructure and create 12 million jobs a year to absorb new graduates and displaced SOE workers.

In sum, China must heed Diaz-Alejandro. No one knows what the non-performing loans ratio is in China and few believe the official rate of 1%. If the cornerstone of a financial system is confidence and transparency, China is severely deficient. This must first be fixed and market-determined interest rates adopted before entertaining hopes of internationalizing the currency. China must also accept the reality of transition; the formidable remaining agenda in the fiscal, financial, social, and SOE sectors reminds us that China is still in transition to a full-fledged market economy.

The combination of a financial clean up and the policy trio of hard budgets, competition, and a competitive real exchange rate will improve resource allocation and force innovation, boosting total factor productivity growth. But doing this is hard—that’s the essence of the “middle-income trap”. Huge vested interests will be encountered, evoking Raghuram Rajan’s description of the middle-income trap as one “where crony capitalism creates oligarchies that slow down growth”. Dealing with this agenda is the Chinese leadership’s biggest challenge.

The era of cheap China is ending, while the ability of the government to virtually decree the growth rate has fallen victim to diminishing returns to capital. Diaz-Alejandro and the reality of transition are no less important as China seeks a way forward.

Headline image credit: The Great Wall in fall, by Canary Wu. CC-BY-SA-2.0 via Wikimedia Commons.

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By Ronald McKinnon

In late February, the slow appreciation of China’s currency was interrupted by a discrete depreciation from 6.06 to 6.12 yuan per dollar. Despite making front page headlines in the Western financial press, this 1% depreciation was too small to significantly affect trade in goods and services—and hardly anything compared to how floating exchange rates change among other currencies. Why then the great furor? And what should China’s foreign exchange policy be?

Foreign governments and influential pundits continually pressure China to appreciate the yuan in the mistaken belief that China’s large trade—read: saving—surplus would decline. This pressure is often called China bashing. And since July 2008 when the exchange rate was 8.28 yuan/dollar (and had been held constant for 10 years), the People’s Bank of China has more or less complied. So even the small depreciation was upsetting to foreign China bashers.

But an unintended consequence of sporadically appreciating the yuan, even by very small amounts, is (was) to increase the flow of “hot” money into China. With US short-term interest rates near zero, and the “natural” rate of interbank interest rate in the more robustly growing Chinese economy closer to 4%, an expected rate of yuan appreciation of just 3% leads to an “effective” interest rate differential of 7%. This profit margin is more than enough to excite the interest of carry traders: speculators who borrow in dollars, and try to circumvent the China’s exchange controls on financial inflows, to buy yuan assets. True, the 4% interest differential alone is enough to bring hot money into China (and into other emerging markets). But the monetary control problem is more acute when foreign economists and politicians complain that the Chinese currency is undervalued and the source of China’s current account surplus.

However, China’s current account surplus with the United States does not indicate that the yuan is undervalued. Rather the trade imbalance reflects a big surplus of saving over investment in China, and a bigger saving deficiency—as manifest in the ongoing fiscal deficit—in the United States. Indeed, the best index for tradable goods prices in China, the WPI, has been falling at about 1.5% per year—as if the yuan were slightly overvalued.

Although movements in exchange rates are not helpful in correcting net trade (saving) imbalances between highly open economies, they can worsen hot money flows. Thus, to minimize hot money flows, the People’s Bank of China (PBC) should simply stabilize the central rate at whatever it is today, say 6.1 yuan per dollar, to dampen the expectation of future appreciation. Upsetting the speculators by introducing more uncertainty into the exchange system, as with the temporary mini devaluation of the yuan in late February, is a distant second-best strategy for China to minimize inflows of hot money.

In addition, there is a second, less well recognized argument for keeping the yuan-dollar rate stable. In a rapidly growing economy like China’s with large gains in labor productivity, wage levels become quite flexible because wage growth is so high. That is, if wages grow at 15% instead of 10% per year (roughly the range of wage growth in China in recent years), the wage level moves up much faster. But wage growth better reflects productivity gains if the yuan/dollar rate is kept stable. If an employer (particularly in an export industry) fears future yuan appreciation, he will hesitate to increase workers’ pay by the full increase in their productivity. Otherwise, the firm could go bankrupt if the yuan did appreciate.

Thus, to better balance international competitiveness by having Chinese unit labor costs approach those in the mature industrial economies, China should encourage higher wage growth by keeping the yuan-dollar rate stable and so take away the threat of future appreciation. Notice that in the mature, not to say stagnant, industrial economies, macroeconomists typically assume that wages are inflexible or “sticky”. They then advocate flexible exchange rates to overcome wage stickiness. But for high-growth China, flexible wages become the appropriate adjusting variable if the exchange rate is stable. Unlike exchange appreciation, wages can grow quickly without attracting unwanted hot money inflows.

China’s State Administration of Foreign Exchange (SAFE) has now accumulated over $4 trillion in exchange reserves because of continual intervention to buy dollars by the PBC. This stock of “reserves” is far in excess of any possible Chinese emergency need for international money, i.e., dollars. In addition, the act of intervention itself often threatens to undermine the PBC’s monetary control. When it buys dollars with yuan, the supply of base money in China’s domestic banking system expands and threatens price inflation or bubbles in asset prices such as real property.

Thus to sterilize the domestic excess monetary liquidity from foreign exchange interventions, the PBC frequently sells central bank bonds to the commercial banks—or raises the required reserves that the commercial banks must hold with the central bank—in order to dampen domestic credit expansion. Both sterilization techniques undermine the efficiency of the commercial banks’ important role as financial intermediaries between domestic savers and investors. Currently in China, this sterilization also magnifies the explosion in shadow banking by informal institutions not subject to reserve or capital requirements, or interest rate ceilings.

To better secure domestic monetary control, why doesn’t the PBC just give up intervening to set the yuan/dollar rate and let it float, i.e., be determined by the market? If the PBC withdrew from the foreign exchange market, the yuan would begin to appreciate without any well-defined limit. The upward pressure on the yuan has two principal sources:

1. Extremely low, near-zero, short interest rates in the United States, United Kingdom, the European Union, and Japan. With the more robust Chinese economy having naturally higher interest rates, unrestricted hot money would flow into China. Once the yuan began to appreciate, carry traders would see even greater short-term profits from investing in yuan assets.
2. China is an immature international creditor with underdeveloped domestic financial markets. Although China has a chronic saving (current account) surplus, it cannot lend abroad in its own currency to finance it.

Why not just lend abroad in dollars? Private (nonstate) banks, insurance companies, pension funds and so on, have a limited appetite for building up liquid dollar claims on foreigners when their own liabilities—deposits, insurance claims, and pension obligations— are in yuan. Because of this potential currency mismatch in private financial institutions, the PBC (which does not care about exchange rate risk) must step in as the international financial intermediary and buy liquid dollar assets on a vast scale as the counterpart of China’s saving surplus.

Even if there was no hot money inflow into China, the yuan would still be under continual upward pressure in the foreign exchanges because of China’s immature credit status (under the absence of a natural outflow of financial capital to finance the trade surplus). That is, foreigners remain reluctant to borrow from Chinese banks in yuan or issue yuan denominated bonds in Shanghai. This reluctance is worsened because of the threat from China bashing that the yuan might appreciate in the future. Thus the PBC has no choice but to keep intervening in the foreign exchanges to set and (hopefully) stabilize the yuan/dollar rate.

Superficially, the answer to China’s currency conundrum would seem be to fully liberalize its domestic financial markets by eliminating interest rate restrictions and foreign exchange controls. Then China could become a mature international creditor with natural outflows of financial capital to finance its trade surplus. Then the PBC need not continually intervene in the foreign exchanges.

This “internationalization” of the yuan may well resolve China’s currency conundrum in the long run. However, it is completely impractical—and somewhat dangerous—to try it in the short run. With near-zero short term interest rates in the mature industrial world, China would be completely flooded out by inflows of hot money, which would undermine the PBC’s monetary control and drive China’s domestic interest rates down much too far. China is in a currency trap. But within this dollar trap, China has shown that its GDP can grow briskly with even more rapid growth in wages—as long as the yuan-dollar rate remains reasonably stable. And China’s government must recognize that there is no easy way to spring the trap.

Ronald McKinnon is the William D. Eberle Professor Emeritus of International Economics at Stanford University, where he has taught since 1961. For a more comprehensive analysis of how the world dollar standard works, and China’s ambivalent role in supporting it, see Ronald McKinnon’s The Unloved Dollar Standard from Bretton Woods to the Rise of China, Oxford University Press (2013), and the Chinese translation from China Financial Publishing House (2013).

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Image credit: Beijing skyline and traffic jam on ring road, China. Photo by coryz, iStockphoto.

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