Appreciation of the yuan may help reduce China’s trade surpluses, but could hurt its high and sustained growth, which is of vital importance for both China and the world.
Pressure has been rising for China to devalue its currency. Even commentators sympathetic to China such as Paul Krugman or Arvind Subramanian have now joined the bandwagon and accused China or practicing predatory mercantilism. China's large trade surpluses have given credence to perceptions that China’s currency is undervalued and hence that China is maintaining high levels of export growth at the cost of high deficits and employment losses in other countries. Is it in China's interest to run large trade surpluses? And accumulate reserves soon to approach the value of its entire GDP, to prevent the currency from appreciating? Probably not. The question then is, why would China do it?
Understanding why, and understanding the exact nature of China’s trade surpluses, is important not only as a matter of intellectual accuracy, but also because it provides the basis for a more enlightened and constructive economic policy dialogue among nations.
The answer comes in three parts. The first has to do with the growth dynamics of a rapidly growing economy such as China. China consists of three distinct economies: (a) the traditional economy, mainly rural, engaged in agriculture; (b) a more advanced economy, mostly labour-intensive manufacturing, that produces goods competing in the international markets and that domestically compete with imports; and (c) a sophisticated economy producing more capital-intensive goods — from machine tools to spare parts for airplanes. Growth depends on the speed at which labour moves from A to B and B to C. This process is neither easy nor simple. It is in fact extraordinarily complex. Witness the fact that very few economies have been able to bring it to completion.
When implemented successfully, however, as it was in Japan and Korea and now in China, it can collapse into a few decades what today’s industrialised economies of the West have taken centuries to accomplish. The reason for this is that it is easier to learn than it is to invent, and developing economies can take advantage of technologies already developed in industrialised economies. As labour moves from low to higher productivity activities, powerful dynamics are set in motion. In any developing economy, labour productivity in urban areas is much higher than in rural areas, often by a factor of six to eight. The faster an economy can absorb modern technology, the larger this differential is and the faster it can grow. Rapid economic growth of above 7 per cent per year over long periods of time of the kind we see in China, or that we saw in the past in Japan, Korea and Brazil (before the stagnation started in the 1980s), is based on the labour surplus moving from A to B and C.
The second part is related to the role of the exchange rate in this process. Since labour productivity varies considerably from A to B to C, the exchange rate appropriate to one of the three sectors is not appropriate to the other. There was a lively discussion among economists in Brazil in the 1960s as to whether the same exchange rate that enabled the (more modern) south of the country to develop was appropriate for the (more traditional agrarian) north-east. A persuasive case was made that the two economies were structurally not a common currency area. The conclusion was that the north-east’s development had been held back because the exchange rate at which the south could develop made production in the north-east uncompetitive. Exchange rate misalignments can destroy the dynamic change of shifting resources from the low-productivity to the higher-productivity parts of the economy. They can simply interrupt the process of transferring resources from low-productivity to higher-productivity uses — which is the way developing economies catch up with advanced ones.
The third part is related to the effects of speed. An economy like China growing at 10 per cent per year is like a car speeding at 200 miles an hour. At such speeds small deviations — small miscalibrations — cause very large departures from balanced paths. And this is how China’s trade surpluses can be interpreted — a deviation from a balanced trajectory. Not as a goal of policy, but as the result of some parts of the system not being adjusted to the movement of others. China’s policy makers have been seeking to increase domestic consumption, so that savings-investment imbalances could be reduced. Ensuring consumption growth at faster rates than GDP growth (to rebalance the trade account) requires a large number of structural reforms — related to pensions, housing, profits distribution (or lack of it) of public enterprises, among others.
Summing up, rather than the simple result of a misaligned exchange rate, China’s trade surpluses should be seen as the result of deviations from a complex growth path in which many moving parts need to come together to avoid gross imbalances. Appreciation of the exchange rate may help reduce China’s trade surpluses, but this could be at the risk of damaging an accomplishment — high and sustained growth in what was one of the poorest countries on earth just 30 years ago — that is of critical importance not only for China but also for the world. Witness the pull effect on the global economy through which China has contributed to the global recovery.
The author is Country Director, India, at The World Bank
