This blog addresses this question by speaking to, firstly, the relationship between exchange rate intervention and the current account outcome in China, secondly, discussing the possible reasons or justifications for Chinese policies and developments that have led to this outcome, and thirdly, analysing the implications for other countries, particularly the United States, of China’s current account surplus and rapid growth. This culminates in a discussion on how Chinese surpluses have been related to the current world credit crisis. Is China to blame?
I—Relationship between exchange rate intervention and the current account outcome
There are two reasons explaining why China’s current account surplus increased so sharply after 2005. The first is that the current account balance has not been planned by the central authorities but rather has been an unplanned by-product of a variety of developments and policies. Exchange rate policy, as reflected in intervention in the market, has just been one part of the story.
The second point is that exchange rate policy can and does affect the surplus: if it were desired to reduce the surplus a policy that brought about significant real appreciation could achieve it. The overall picture is that there has been both an acceleration of the rate of growth of exports and a decline in the rate of growth of imports.
If the Chinese authorities were really determined to reduce or even eliminate the surplus they could presumably do so by sufficient nominal appreciation of the exchange rate. In order to maintain internal balance this would have to be associated with an easing of monetary policy leading to an increase in real expenditure. Just as variations and flexibility in monetary policy can roughly achieve and maintain internal balance, so a flexible exchange rate policy might be able to achieve and maintain an external balance objective. However, as discussed below, China has had other policy objectives in this area.
II—Possible policy reasons for this outcome
The Chinese current account surpluses, and especially the big increases in them since 2005, are by-products of various developments, such as productivity improvements, but also of a variety of policies, including, of course—perhaps crucially—exchange rate policy.
There have been two parts to Chinese exchange rate policy. The first part is ‘exchange rate protection’. Namely, a policy designed to maintain profitability and employment in the export sector by means of undervaluation of the exchange rate. The second part is to maintain a stable exchange rate, avoiding both a floating rate and sharp changes in a fixed-but-adjustable rate.
The third policy area regards China’s foreign exchange reserves. For some years after the Asian crisis of 1997-98 China, as well as other East Asian countries, deliberately built up foreign exchange reserves as a form of self-insurance. Since 2006, however, China’s reserves have been well above the level that seemed to be required.
The fourth set of policies concerns private and corporate savings, with the result that national savings by households and private and public corporations have been remarkably high. Also, notwithstanding reported increases in average urban wages, unskilled worker wages have not increased because of continuous urban migration. The outcome has thus been a persistent increase in company profits and savings.
Although these policies seemed desirable and necessary, the net result of the current account surplus and intervention in the foreign exchange market has been that by 2008 the central bank held nearly $US2 trillion of reserves, a substantial part held in the form of US Treasuries.
Reserves of this magnitude are perhaps justifiable as a by-product of these policies, outlined above. What’s more, they may be justifiable on a short-term basis as a ‘parking’ space for Chinese assets until the public administration system is healthy enough to guarantee the assets reach provincial and local-level governments. But, it is widely felt, these reserves are not necessarily an asset, and hardly in China’s long-term interests. The asset ‘parking’ reached an unsustainable degree after about 2007.
III—Implications for other countries, particularly the US
The world general equilibrium effects of the Chinese surplus cannot be analysed on their own. They must be aggregated with the effects of all the other surpluses (the main surplus countries having been China, Japan, Germany, the various oil exporters, and East Asian developing countries other than mainland China).
These surpluses led to a fall in the world real interest rate. This fall in the real rate of interest led in many countries, especially in the United States, to a credit boom and thus to increases in borrowing both for investment and for consumption. This process led many countries into deficit—necessary to help maintain an equilibration between the surplus and deficit countries.
Thus, along with political-policy-induced deficit, the surplus countries worldwide helped push the US into deficit. Furthermore, if the US had not shouldered as much of the worldwide deficit as it now has, the worldwide credit-boom would have been greater, and other countries would have had to borrow, thereby necessarily forcing themselves into further deficit.
IV—Is China to blame for the current credit crisis?
There is no reason to imply that the worldwide credit imbalance, and China in particular, are responsible for the current credit crisis. The role of the international capital market is to allow for these imbalances by intermediating between lenders and borrowers.
Thus, there were several steps to the story. First there was the large surplus (or “savings glut”) coming principally from Japan, China, the oil exporters, and Germany. Then there was the lack of sufficient demand for funds for fruitful investment for a variety of special reasons. Finally, there was the response in the world capital market, leading to a “search for yield”, excessive leverage, unwise lending, and so on. Hence China played a role in initiating this sad story, although in 2007 the Chinese surplus was only 21.4 per cent of the total worldwide surplus.
In sum, China’s entry into the world economy has certainly been a major shock. The Chinese emphasis has been on export expansion rather than just import substitution. This approach has been consistently urged on developing countries by advisors from developed countries, and in this Chinese case has been notably fruitful. In the final analysis, the Chinese shock is one that should be lived with, adapted to, and not resisted.
See my full chapter here [pdf] from this year’s China Update: China’s New Place in a World in Crisis.
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See the video of Max Corden’s presentation: