Now the second largest economy in the world, China will overtake the US by 2025 at the latest. ^[1]

The world is feeling the pressures of China’s rapid development and economic might. Chinese exports are sold worldwide, often in established markets. With a growing hunger for resources, China has become the world’s second largest oil importer and the largest greenhouse gas emitter.

China is on the quest for a better life and has begun to coordinate international diplomatic efforts along with India, Brazil and South Africa; demonstrated most recently at the Copenhagen climate conference.

As the developing world asserts itself on the global market, the rest of the world feels the pain. Developed countries are losing traditional manufacturing jobs, and are forced to upgrade to higher value-added activities, especially financial services.

Specialisation has created so-called ‘global imbalances‘; some countries run high current account surpluses while other countries run high current account deficits and with one of the consequences being excessive liquidity flowing between them. Many attribute this to the recent financial crisis.

On the deficit side, the US, UK and Australia have adopted the Anglo-Saxon model of capitalism and maintain strong financial sectors. The surplus side is more diverse, comprised of the old manufacturing giants, namely, Germany and Japan; the newly emerged ‘world factories’, especially China; and oil exporters.

Here the key to understanding  the imbalances is to think about financial services as a tradable good. Traditional economic theory does not recognise them as such, thus it cannot be used to explain current account imbalances. This is because a surplus country experiencing an increase in wealth would import more until its current account surplus is depleted. Meanwhile, a deficit country faced with high interest rates would cut borrowings in order to rebalance its current account.

Treating financial services as a tradable good, it becomes easier to explain global imbalances. It is not a coincidence that the surplus countries do not have highly developed financial markets. They generally specialise in either manufacturing or in oil exporting. Finance is concentrated in places where efficiency is maximised, namely New York and London. It is no coincidence that the surplus countries have undeveloped financial markets that here ‘money’ is the input of the financial companies in New York and London, just like raw materials bought by any manufacturing company.

Financial markets in the surplus countries cannot channel income towards domestic investment or consumption. Ironically, the American financial market is often blamed entirely for causing the global financial crisis; although the American financial market may be too fluid, financial markets in the surplus countries are too static.

The financial crisis demonstrates the unsustainability of the current pattern of global specialisation. Yet the key issue is not sustainability, but adjustment.

Firstly, painful adjustment is required with the concentration of manufacturing in a few countries. Most developed countries need to create new job opportunities for their citizens..

Secondly, finance is increasingly concentrated in the hands of a few. In America wealth is concentrated in the top 0.1 per cent of the population. Global specialisation has led to what economists call ‘skill-biased’ technological change, which benefits the financial sector disproportionally. Large wage gaps should equalise with international trade according to the factor price equalisation theorem. Developed economies either have to adjust their wage rates down or endure unemployment if enough high-pay jobs cannot be created.

Initially, downward wage adjustment seems unavoidable. Yet, this translates into quality of life deterioration, which partially explains the developed world’s protectionist mood.

The challenge is equivalently severe in poor countries that face. the ‘trade trap’ and are forced to concentrate on exporting resource-based products.

Today, the late comers in Africa and South and Southeast Asia do not have the opportunity to accumulate domestic manufacturing capabilities in a protected environment. Even the emerging manufacturing economies are forced to rethink their growth models with environmental problems, inflationary pressures, and sluggish domestic demand. China’s heavy reliance on manufacturing has led to both internal and external imbalances. The phenomenal growth has not improved ordinary people’s lives.^[2]

China’s large current account surpluses are invested in developed countries with only low returns. To maintain a fixed exchange rate against the dollar, the central bank must accumulate large dollar reserves, leading to constant inflationary pressure. Most Chinese economists agree that serious structural adjustments are needed to correct these imbalances. Increasing domestic demand is at the core of this adjustment process.

Global imbalances are commonly blamed on the surplus countries’ inflexible exchange rate regimes. Some point to China’s inflexible exchange rate regime as the root cause of unemployment in developed countries and the slow recovery in developing countries (see Krugman and Subramanian). However, historical evidence shows that exchange rate regimes are not associated with global imbalances. Germany and Japan both have a floating regime whilst maintaining very large surpluses. Furthermore, China’s trade and current account surpluses surged despite the 20 per cent appreciation in the Renimbi between 2005 and 2008.

Even if China’s adoption of a flexible exchange rate regime slightly helped the rest of the world in the short-term, China’s role has been exaggerated. In the end, economic fundamentals will dictate the game. Unless we reject free trade, the free flow of capital and division of labour, then we will have to live with global imbalances for a time. The problem is not how we correct the imbalances, but how we neutralise the negative consequences. No country alone can accomplish this task; global solutions must be sought.

One solution is to create non-country-specific financial assets that are sufficiently profitable to encourage investment from surplus countries. The IMF’s Special Drawing Rights (SDRs) could be such an asset. Most of the world remains very poor and desperately needs investment. Surplus countries will readily contribute if investments in developing countries are ensured to be profitable. Enlarging and strengthening the IMF and the World Bank would provide assistance. The recent round of the IMF’s recapitalisation and current efforts to create a regional fund in Asia is a good start.

Non-country-specific assets have two advantages; excessive liquidity will be re-channeled to invest in the real economy, reducing the risk of another financial crisis; and developing countries, receiving investment, will be able to improve their manufacturing capacities. China’s involvement in infrastructure building and direct investment in Africa should be welcomed. However, engagement is required by international development agencies. This requires a new international architecture for adjustment.

For a longer version of this article please see here.

Yang Yao is professor and director of the China Center for Economic Research (CCER), Peking University.

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[1] The calculation makes the following assumptions: China grows by 7 per cent per annum and United States grows by 2 per cent per annum, both in real term; China’s inflation rate is 5.9 per cent and the US’s inflation rate is 3.5 per cent, the averages for the period 1981-2008; and RMB appreciates by 2 per cent per annum against the US dollar. If inflation and RMB appreciation are not considered, then China will take over the United States in 2032.

[2] Bai, Chong-En and Qian, Zhenjie. “Who Is Squeezing Residential Income?” Chinese Social Sciences, 2009, No. 5: 22-34.