While there was a trade deficit in February, this was transitory, likely caused by the spring festival holidays, and China will continue to accumulate large reserves of foreign exchanges this year.

China is moving back toward what happened between 2004 and 2008 where inflationary pressures were high due to large trade surpluses. It is predictable that the Chinese authorities will now deploy a combination of tools to stabilise domestic prices.

The bank reserve ratio is already 19.5 per cent and unlikely to be raised by a large margin. Most likely, interest rates will be jacked up step by step. The benchmark annual lending rate reached 7.47 per cent in August 2008 after five years on an upward trajectory. There is presently still a lot of room before that level is reached as the current lending rate is still only 5.56 per cent.

International observers are more willing to see the yuan’s value rise. Revaluation will discourage the inflow of foreign capital. On the other hand, revaluation might raise people’s expectations of further appreciation and thus invite more foreign capital to flow in. Revaluation will help China only if it brings China’s trade surplus down, and the experience of 2004–2008 suggests that that is not going to happen for only moderate revaluations. That is why some people believe that China should take the bolder step of large revaluation. For the Chinese government this is out of the question because of the heavy risk of unemployment — a cost the government will make every effort to avoid because of its concern about social stability and, in the final analysis, the very legitimacy of the government.

The Chinese authorities will also introduce quantitative controls on bank lending. But the effect of this kind of measure is beginning to have a diminishing effect because banks and other financial institutions have a range of ways of circumventing it. A more effective strategy is for the central bank to expand its sterilisation operations, absorbing the inflationary effect of current account surpluses. In theory, the central bank can sterilise any amount of money supply caused by the inflow of foreign reserves simply by issuing larger amounts of central bank bonds. In practice, it faces two kinds of cost.

The first kind is a direct accounting cost. The interest rate will inevitably increase when more central bank bonds are issued. On the other hand, the interest rate paid on the central bank’s foreign reserves, mostly in US dollars, is low. As a result, the central bank incurs accounting losses when it issues more sterilisation bonds.

The second cost is implicit but potentially has more substantial effects. Sterilisation bonds absorb potential investment and consumption implied by the trade surplus in the current period. But the induced effect is to drive down domestic investment and consumption in subsequent periods. This is because sterilisation bonds are forced savings and are deflationary — they deter further investment and consumption. For example, banks would draw back mortgage lending in response to higher rates paid on the sterilisation bonds. Hence, consumers have to save more in order to buy houses and other goods.

This line of thinking suggests that the central bank’s sterilisation operations are likely to be self-defeating in the long run: it sterilises the money supply caused by today’s trade surplus but is the source of more current account surpluses in the future.

The Chinese authorities have to find new ways to take care of its external imbalances problem directly. One is to increase consumer imports. Right now, only 2.3 per cent of China’s imports are consumer goods. Consumer goods are subject to relatively high tariffs and have value-added or sales taxes levied on them at customs. In addition, customs procedures are complicated and slow. Lowering tariffs on consumer goods and simplifying custom procedures would improve the flow of consumer imports and, because potential consumer imports do not compete that much with domestic products, also have minimal harm on the domestic industry. Take potential imports from the US as an example. They are mostly likely to be brand-name products, furniture, high-end cars and land-intensive agricultural products (such as beef) — in none of which China has comparative advantage.

Opposite to the case of exports, imports have a deflationary effect and help China deal with inflationary pressure. More imports will reduce China’s trade surplus and help balance China’s external payments. Increasing imports is a policy strategy that achieves multiple goals and will be welcomed by the international community. There is no reason why the Chinese authorities should shy away from it.

Yang Yao is Director of the China Center for Economic Research at Peking University.