A significant group in US Congress reckons that China’s undervalued exchange rate is the source of China’s edge in world markets, and the growth of its current account surpluses, and is rolling out legislation that would impose trade penalties on China to offset what it sees as an unfair advantage.

Where have China’s current account surpluses come from? Will an appreciation of the Chinese RMB get rid of them as quickly and simply as some seem to think? Are the associated imbalances in the global economy likely to go away any time soon? And, if not, how can we live with China’s surpluses in the meantime?

Yao Yang, a distinguished Chinese economist who is deputy head of the China Center for Economic Research at Peking University, this week warns that Chinese current account surpluses are a structural consequence of the ‘double transition’ in the Chinese economy and are likely to be around for some time. Last week David Vines was urging that they needed to be got rid of as quickly as possible.

Current account surpluses emerge when a country produces on balance more than it spends at home and the resultant net savings flow into international capital markets. China and other East Asian surplus economies, as well as Germany in Europe, have been pouring a growing pool of net savings into international capital markets allowing current account deficit countries, notably America but also countries like Australia, to spend more than they save at home. Chinese savings take pressure off global interest rates and fund investment (as well as consumption) globally that would otherwise not have been able to take place. In principle it is good and efficient for net savers to fund net spenders internationally in this way, as they do routinely within national economies if the net spenders are using the savings productively for the long term. Such international financial intermediation needs to be robust and efficient – a task made difficult across borders because of the weakness and absence of international regulation.

The double transition that Yao explains describes two big changes taking place in the Chinese economy. The first is rapid industrialisation and the migration from the countryside to the cities that sustains it. The other is the extraordinary demographic transition that has taken place since China introduced the one-child policy in 1979. The double transition has shaped China’s growth model since integration into the world system through accession to the WTO.

How does the double transition account for Chinese surpluses?

First, the availability of ‘unlimited supplies’ of labour from the countryside keeps industrial wages and consumption low and siphons income to enterprises and the government who are big net savers. Second, as low cost supplies of labour dry up and wage incomes rise, a relatively high proportion of household incomes go towards savings in preparation for a society that will age dramatically in 15 to 20 years. High net savings derives from these structural features of Chinese growth. The same features were present in Japan. China exhibits them on a grand scale.

Yao concludes that while other factors, such as the exchange rate, distortions in factor markets and prices, a weak financial sector, and investment-oriented government policy strategies, contribute to China’s current account surplus, it is the double transition that is its most fundamental cause. This, he says, requires new ways of thinking about how to deal with China’s and, for that matter, the world’s imbalance problems.

Certainly focusing on the nominal exchange rate alone is unlikely to fix the imbalance problem quickly. This is an economy that can sustain substantial appreciation of its currency and will continue to generate external surpluses as did Japan through a similar phase of development. The implementation of wide-ranging structural reform is one part of the solution. That will take time. China’s large current account surpluses are associated with pervasive distortions in factor markets, which repress costs of manufacturing production and artificially improve Chinese competitiveness. Currency adjustment alone cannot correct the overall external imbalance — that would require a massive and globally disruptive exchange rate adjustment that is neither economically nor politically feasible.

Similarly, America’s damagingly low savings rate before the subprime crisis was caused by a number of factors. Depreciating the US dollar by a huge margin is unlikely to lift the US savings ratio substantially and needs to be averted to avoid international financial collapse.

There is no denying that exchange rates are one important parameter determining exports, imports and, therefore, the imbalances. Hence, gradual adjustment of exchange rates (not only the RMB/US dollar rate) is one thing that has to be managed internationally. A complementary agenda is the structural reforms that are necessary both in China and in North America to deal with the root causes of the imbalance problem in each the national and the global economy. And an important agenda too, as Yao suggests, is strengthening the mechanisms and management of international financial intermediation (transferring savings from savers to investors and deserving spenders) so as to utilize the savings created by the surplus countries efficiently.

Other countries, notably India, will become as exporters of savings even if savings from China dry up when it finishes the double transition. These are problems that we need to get used to managing in the international macro-economy with the success of economic transformation in emerging economies like those of China and India.