My Blog

January 15, 2008

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.

Comments (9) for "The cause of China’s trade s...

There is I think another argument which is that the large trade surplus is the result of underdevelopment of China's financial infrastructure. China has a large amount of savings that needs to be converted into investment, but the domestic institutions are able to do so, so the money travels to the path of least resistance and tries to get out of China to places with better financial infrastructure. This large export of capital needs to be balanced by a influx of imports. By Twofish - 1/15/2008 1:03 AM

What would be useful (and I don't know if anyone has publicly done this in a systematic way is to do a risk matrix. Suppose we think that the surplus is due to item one, but it is actually due to item two, what happens? The reason I'm skeptical of reason two is that I think that China is extremely underdeveloped with an extremely low capital base and so massive investment at this point is not a bad thing. People tend to look at China from the lens of Japan-1990 or Soviet Union-1990 when they were already very developed nations whereas China is closer to Japan or the Soviet Union in 1950. The thing that destroys this argument is 19th century Latin America, and there I would argue (with the caveat that I don't know that much about 19th century Latin America) that the class structure of Latin America inhibited industrial development so that large amounts of capital spending could not get the sources of free labor necessary for industrial development. China doesn't have this problem since you do have sources of labor that aren't bound to the land. The problem with scenario two is that if you try to contract the economy and there *isn't* overinvestment, then you send China into a deflationary spiral. There's also another reason which is Iraq. The interesting thing is that China didn't run a persistent trade surplus until the Iraq War, and the RMB was not undervalued until that time. One explanation for this is that the Bush tax cuts, the Iraq War, and the RMB peg, moved the global economy out of equilibrium. It's interesting that people talk a lot about Bretton Woods II, without talking a lot about what killed Bretton Woods I, which was deficits created by Johnson's Great Society and war in Vietnam. By Twofish - 1/15/2008 1:23 AM

An interesting issue is when the so far oneway-bet of a strengthening renminbi, will reach the tipping-point of turning into the risk of a falling renminbi. Given China's trade-surplus it still seems unlikely, but the running inflation will spur domestic consumption into a new dimesion I think. Simultaneously, the major export markets are cooling down. Foreign companies obviously sofar have not taken so much money out of China, they have just invested into China. So also in the capital accounts, flows could change. After all, the REAL value of the renminbi is falling rapidly, day by day - and at one stage, this could be reflected is exchange rates as well. By a2 - 1/15/2008 8:02 AM

Most of the asian exporters, JP, KOREA or Taiwan run 10% CA surplus to GDP at one time. So I think the problem is not necessarily China's structural constraint on domestic demand. There are some structural issue related to high corporate-public savings from monthly figures, it looked like trade surplus and capital inflow already peaked around 3Q last year and slowing. With US recession now full blown and JP-EU not far behind, the global context for last four year of export-liquidity boom is coming to an end so I think it is increasingly likely that after China move Rmb by another 10-15% to cap local inflation, the Rmb will probabaly peak out around six to the dollar By isaac - 1/15/2008 9:28 AM

Twofish, the argument that China’s trade surplus was caused by its financial underdevelopment, so that Chinese saving, unable to find alternatives at home, “travels to the path of least resistance and tries to get out of China to places with better financial infrastructure” would make sense, I think, if it were private outflows driving the current account surplus. But it isn’t. The outflows are simply the result of the piling up of reserves. On your second point, I agree that massive investment is a good thing for China over the long term, but that doesn’t mean the process must be a smooth one. If you look at the US in the 19th Century you see that the US grew over a long period with very large (mostly foreign) investment but it nonetheless suffered periodic overinvestment and financial crises. It is not at all contradictory to argue both that China needs investment and that from time to time this investment is likely to be unbalanced and lead to sharp adjustments. You are right that addressing reason two may cause a deflationary spiral if it isn’t the real cause of the trade surplus, but not addressing it is also likely to lead to ugly consequences if it is the right reason. Your mentioning Iraq is interesting, and I think that this point actually strengthens the case for the second reason I cite. If the problem is that China locked itself into a rigid currency regime, it implies that Chinese monetary policy is heavily affected by external conditions, and the loosening of monetary conditions caused by the Iraq war would have had to be felt in China. This may have started the self-reinforcing process (what I call the monetary trap) in which China has found itself. Isaac, how long do you think it will take the RMB to move 10-15%? Do you expect a speculative inflows to be a big problem? By Michael Pettis - 1/15/2008 2:27 PM

at this pace of rise, it will only take 2 or 3 quarters By isaac - 1/15/2008 2:53 PM

I think China should improve quality, environment, and finacial system that would automatically adjust the C/A surplus. By M. G. K. MURTY - 1/15/2008 7:06 PM

Hallo I understand Pettis three causes of the trade surplus. And the medecin for each. And the outcome. But I think, we speak about China as it would be sick. I mean: take China as a company. And now: what is wrong with a well running company? What are the problems of China versus the problem of the others? Of US for exampel. US would be happy, it would have a trade surplus; growth in GDP; creating millions of workplaces; ... So I think, actually, there is no reason to believe, that China has really "serious" problems; now. (Besides that it is the country with most 1$/per day-people; but it is devlopping) But the future will bring havy stuff: global stuff. Because of the interconnection of all around the world (ex. North Korea, Mianmar and some Indians in the dschungel of Amazona and Kongo), all will take theire part of the gobal "slow down". The part, that China has to take, will be a serious problem for China. What will happen to China in a "US-recession-->EU landing-->lower growth in India, Lat. America, Afrika"? - inflation is dead - export is detorriating down - production-zones wil become empty of Chinese-worker - ... That is a serious problem: on of those problems, that US has now. So: China-LTD has -at present- only small problems. q.e.d. If China finds a way, to see, that it is no good business-idea, to make business with its partner till the partner is dead, then we could have all a sunny future. (But first, it seems, we have to go through the US-recession) globumedes By globumedes - 1/15/2008 9:00 PM

The growth of India is very different from the growth of China. India is essentially a domestic consumption led growth story while in China domestic consumption is actually reducing. The safe way to grow is to have healthy domestic consumption.. By Mees - 1/25/2008 7:39 AM