My Blog

January 15, 2008

TUE 15 JAN

The cause of China’s trade surplus By Michael Pettis

Prime Minister Manmohan Singh is currently visiting China and yesterday he too complained about China’s trade surplus.  There is still a debate about the structure of China’s balance of trade.  There are at least three reasons commonly cited to explain China’s massive trade surplus.  First, China’s control of the foreign exchange value of the RMB means that China is able to hold down the value of the RMB to well below its “correct” value, and so Chinese good are unreasonably cheap in foreign countries and foreign good unreasonably expensive in China.  This enforcement of savings on the population (or forced low domestic consumption) gives China a mercantilist advantage in trade.

 

The second argument also relates to China’s foreign currency regime, but in this case it is the abandonment of domestic monetary policy that is to blame for the trade surplus.  According to this argument, by locking itself into an undervalued and inflexible exchange rate, China has also locked itself into a monetary trap in which large trade surpluses and capital account inflows force domestic monetary expansion, which ends up largely as overinvestment and excessive expansion in industrial production.  Since the country’s production grows at a faster pace than its consumption, the country is forced into a large and growing trade surplus which further feeds the monetary expansion.

 

The third argument explaining the trade surplus cites China’s natural advantages, specifically an educated but very low-cost labor force capable of relatively high quality production at a fraction of the price required for the same labor in the US, Europe or Japan.  In this case China runs a trade surplus largely because it can produce the same things as the rest of the world but much more efficiently.  There is a fourth, related argument, which claims that this Chinese “efficiency” is at least partly explained by its refusal to count costs correctly – specifically environmental costs are socialized, financial costs are subsidized, and labor exploitation is permitted and even encouraged by political constraints on the ability of workers to organize and protect their interests.

 

Although of course all these reasons partly explain the trade surplus, I am thoroughly convinced that it is the second argument that is the most important.  It would explain why overinvestment has become such a problem and why in spite of a rising RMB the trade surplus has continued to rise steadily over the past 2-3 years.  Because we tend to think of China’s trade surplus as coming largely out of trade with rich countries, the low-cost-of-labor argument has always seemed a plausible explanation for China’s trade surplus, but Prime Minister Singh made a point yesterday of calling on China to do something about the growing trade imbalance between the two countries.  It is worth remembering that China is also running large surpluses with countries that have lower per capita income and, presumably, lower labor costs (although to be fair India apparently suffers from a very weak industrial infrastructure, which adds to overall costs).  The fact that Singh is so unhappy with the trade relationship suggests that there is more to the matter than low labor costs.

 

The differences among the arguments of course are not just academic.  They will require and result in very different adjustment processes.  If the first argument is correct, then a policy of faster RMB appreciation (or faster appreciation plus inflation, as Geng Xiao, of the Brookings Institution, has argued) will largely correct the imbalance.  In the process it will result in a shift of Chinese economic behavior from savings to consumption, thus resulting in a much more rapidly rising standard of living for Chinese, and for the rest of the world as Chinese growth contributes to world demand.  It will not matter too much when the shift takes place, as long as it takes place fast enough to appease foreign anger and to forestall trade wars.

 

If the second argument is correct, the policy recommendations are more radical and the expected outcome much more pessimistic.  According to this argument China has locked itself into a system of severe monetary imbalances, and the longer this goes on the sharper the adjustment will be.  The best policy in this case is to force as quickly as possible an adjustment in the balance of payments that brings monetary policy back into control – by forcing either the trade surplus down or the capital account into deficit.  It may already be too late to adjust easily, and even if it isn’t if the authorities are too wedded to the ideology of gradualism to make a rapid adjustment, so in this case I expect that the end game will occur either in the form of runaway inflation, which would eventually cause a sharp contraction in the money base, or in the form of sharply rising inventory leading to equally sharp cuts in production, which is how overinvestment cycles classically ended in the 19th Century.

 

If the third argument is correct, there is little that can be done in the short run to reduce the trade imbalances but eventually rising wages and salaries (or greater domestic political pressure for companies to absorb the full cost of production) will eliminate China’s greater industrial efficiency.  In that case the world will simply have to learn how to adjust to the advantages and disadvantages associated with integrating a large country like China into the world trading system.

 

Needless to say I will be watching inflation and inventory levels closely, and hoping that the faster RMB appreciation does not spur massive speculative inflows.

 

TUE 15 JAN

China’s loan constraints are biting By Michael Pettis

I am getting very bullish about the growth of capital markets issuance, loan securitization and alternative forms of investment intermediation (both formal and “informal”) in China.  Yesterday the China Securities Journal reported that the PBoC had set the total new-lending target for the banking system this year at RMB 3.63 trillion, against last year’s RMB 2.9 trillion – this represents a fairly tough cap on loan growth (I think about 12% but I need to check).  This comes a week after their two-day conference in which the PBoC failed, surprisingly, to announce new loan quotas.  It seems that if there was a fight over the policy decision, that fight has been resolved.  Separately I read that Reuters claims that December inflation (which will probably be officially reported next week) is likely to come in at 6.5%, which is lower than November’s 6.9% but still much higher than expected (and for statistical reasons represents no real reduction in the rate of inflation).  Maybe this is the reason why the fight has been resolved in favor of tough constraints.

 

Meanwhile new loan issuance in November and December dropped substantially to RMB 87 billion and RMB 48 billion.  For all but the last three months of 2007 new loan issuance has ranged between RMB 200 billion and RMB 600 billion.  This drop is not as dramatic as it seems because new loan issuance is often low at the end of the year, and surges again in the first quarter, but it does suggest that the PBoC is a lot more serious than it has been about constraining credit growth.

 

If they are able to keep it up will it matter to the economy and to their fight against overheating?  Probably not.  Companies are flush with cash, stock and bond issuance are likely to rise, and I expect that as long as China is forced to monetize large capital and current account surpluses money is going to flow into alternative forms of intermediation.  Still, so far it seems my skepticism that the PBoC would really be able to enforce slower loan growth was unwarranted.  The real test comes after the establishment of the new leadership in March.  Will we not see the traditional investment surge, or will the loan growth caps be ignored (or perhaps more likely, will the new provincial leaders discover the joy of financial engineering)?