US-China economic imbalance: Alternatives to appreciating the Chinese yuan

Author: Xiao Geng, Brookings Institution

Recent debate has focused on how to increase US exports and savings and increase Chinese imports and consumption in order to correct the trade imbalance between the US and China. In America in particular, focus has been placed on Chinese exchange rate policy. American leaders would like the RMB to appreciate significantly and quickly. They hope that this would lead to an increase in US exports and employment.

Yet Chinese leaders regard pressures to appreciate and protectionist measures from the US as unfair, and as detrimental to China’s development. They place emphasis upon structural and institutional reform in order to increase Chinese consumption and to bring about more efficient domestic investment.

What accounts for this considerable gap between views in China and the US?

The US argument for a sustained appreciation of the RMB is based upon both short-term concerns about China’s large current account surplus, and long term concerns relating to China’s high growth, rapid urbanisation and industrialisation, low national debt, and low fiscal deficits.

For its part, China is concerned that appreciation or a premature end to its link with the dollar would bring about financial instabilities such as speculative capital inflows, associated asset bubbles, and nominal shocks to employment and business in its external sector. China is also wary of how currency appreciation might encourage the destabilisation of capital inflows and discourage private Chinese firms and financial institutions from buying dollar assets, especially if they are likely to continually depreciate in RMB terms.

Beijing has not forgotten how the large appreciation of the yen brought about by the 1984 Plaza Accord created massive asset bubbles that burst in 1989, creating a two decade-long period of sustained deflation without eliminating Japan’s trade surplus.

But nominal exchange rate adjustment is not China’s only tool for correcting trade imbalances. If China pegs the RMB to the dollar, China can still use inflation to achieve a rapid increase in its price level relative to that in the US, or a real appreciation of the RMB against the dollar. Relative price levels between economies tend to take into account the nominal exchange rate and adjust price levels for the gap in inflation rates between two economies.

Because of these two points, the Chinese approach to exchange rate stability thus far has focused on ‘inflation first and appreciation second’, which places priority on creating employment, increasing wages and productivity, and price liberalisation rather than addressing trade imbalances through adjustments of the nominal exchange rate.

Given that the Chinese approach is likely to remain constant, it is important to consider some alternative policy options, particularly certain structural and institutional reforms.

First, in order to reduce savings and inefficient investment, China needs to privatise and deregulate large state-owned enterprises. China’s savings rate reached as high as about 55 per cent of GDP during 2007-2008, with a current account surplus of about 10 per cent of GDP. Corporate savings amount to about half of the national savings, and a major contributing factor are the savings of China’s State-owned enterprises (SOEs).

SOEs are not allowed to pay high salaries to their employees and do not distribute dividends. They do not generate purchasing power when the prices of their shares increase. This has created huge capital gains with no wealth effects on consumption. In addition, the high-savings of SOEs are often used to invest in over-capacity sectors.

Household income still accounts for only 35 per cent of China’s national income, and China will not be able to significantly raise the wages and productivity of its workforce in the near future. To improve domestic consumption, therefore, China must create an investment environment conducive to investment in sectors with large domestic consumption potential.  In sum, at present, investment is the most important variable for eliminating China’s current account surplus, and for absorbing China’s savings internally.

Especially now, it is important that investments be made more efficiently. In the past few years cheap money, or a low interest rate, has allowed for huge and often inefficient investment in China’s export manufacturing sector, driving down prices of ‘Made in China’ products. As the US’s current zero interest rate policy is likely to bring capital flows into China in anticipation of higher investment return, the current availability of cheap money is likely to continue. Because of this, it is important that China improve its capital control mechanisms to allow orderly cross-border capital flows for more efficient investments with higher returns both domestically and internationally, while limiting the speculative flow of capital and inefficient investments.

Another overlooked problem contributing to the global imbalance is factor price distortion in the Chinese economy. This must be addressed if the global economy is to be righted. Price distortions are caused by a number of factors, including local governments’ offering of cheap land as part of efforts to attract foreign invested enterprises, weak property rights, rudimentary carbon-emission standards, weak enforcement of environmental protection laws, and a lack of a social safety net, which makes the cost of labor low now, but has hidden social liabilities for the future.

Given the huge potential for cross-border investment and debt financing between the US and China, a stable RMB-dollar exchange rate fits both countries’ long-term national interests. And in the long-term, certainly after 2020 and perhaps during 2025-2035, the RMB is likely to become a fully convertible international currency. But for this to happen, the Chinese economy must first complete its structural and institutional transformation into a fully modernised market economy with a more democratic political system. Until then, the US and China should look for long-term policy options that are realistic and benefit both countries.

Xiao Geng is director of the Brookings-Tsinghua Center for Public Policy in Beijing and senior fellow of the Brookings Institution in Washington DC.