China and the world economy
Tilting at dragons

Oct 23, 2003
The Economist

China is being blamed for too many of the rich world's economic problems

WORRIED about the loss of manufacturing jobs? Anxious about America's
huge trade deficit? Trying to explain the cause of deflation in Japan?
In tough economic times, politicians need someone to blame. And today
the rich world's scapegoat of choice is China.

When George Bush met China's president, Hu Jintao, at the APEC summit in
Bangkok this week, he was under intense pressure from manufacturers and
congressmen back home to persuade China to revalue its currency, the
yuan, currently pegged at 8.28 to the dollar. Bosses in industries from
clothing and toys to furniture and consumer electronics are complaining
about "unfair" Chinese competition. They claim that, by keeping the yuan
artificially low, China is stealing jobs from America and causing a
record trade deficit. Legislation has recently been proposed in Congress
to levy big tariffs on imports from China.

The relocation of manufacturing jobs to low-wage economies has been
happening for years. But concerns are intensifying now that
service-sector jobs, such as software programming and call centres, are
shifting too, as firms take advantage of cheap telecommunications to use
workers in India and, more recently, China.

China-bashing is also popular in Japan, where the country is widely
blamed not only for the hollowing-out of manufacturing, but also for
deflation, as cheap imports push down prices. In the euro area too,
politicians and businessmen are complaining that because China refuses
to let the yuan rise against the dollar, the euro is bearing an unfair
share of the burden of dollar depreciation. The euro has risen by almost
40% against the dollar over the past two years. This week, Giulio
Tremonti, Italy's finance minister, called for protectionist measures
against China.

Is China guilty as charged? It is true that it is running a $120 billion
trade surplus with America, but China's total surplus is small-it runs
deficits with some other countries-and many economists forecast that it
may turn into a deficit in 2004. China's current-account surplus is
expected to be only 1% of GDP this year. Despite foreigners' complaints
about the country's rampant export growth, imports have grown even
faster (see chart). In the year to September, China's exports rose by
32% and its imports by 41%.

At a time when developed economies remain fragile, China's robust demand should be welcomed. America's exports to China rose by 21% during the past year, compared with an increase of 2% in sales to the rest of the world. According to HSBC, China accounted for 70% of Japan's export growth in the first eight months of this year, boosting GDP growth by
0.7 percentage points. Moreover, inexpensive Chinese imports have
benefited consumers (and hence workers). Wal-Mart, which has been a big
job creator, relies on China for many of its cheap products.

American manufacturers accuse Chinese firms of stealing global market
share. Yet Stephen Roach, chief economist at Morgan Stanley, points out
that two-thirds of China's export growth since 1994 has come from the
subsidiaries or joint ventures of foreign multinationals. China's export
boom is partly due to efforts by rich-world firms to remain competitive.
Had these firms not invested in China, they would have been less
profitable and might have hired fewer workers at home. A large
revaluation of the yuan could hurt them.

What of the claim that China's artificially cheap currency has exported
deflation to Japan? The prices of some goods have clearly fallen in
price thanks to cheaper imports, but this cannot cause overall
deflation. Imports from China equate to only 1.5% of Japan's GDP.
Deflation is primarily a monetary phenomenon, not a structural one:
Japan's over-tight monetary policy is the real culprit.

It is particularly hypocritical of Japan to criticise China for its
cheap-currency strategy. The Japanese yen was much more clearly
undervalued in the 1970s, when Japan began to export in large
quantities. China is far from perfect: it still has high trade barriers
in some sectors, but it is more open to trade and investment than Japan
was three decades ago.

A final reason why America should welcome and not bash China is that
Chinese money is helping to prop up America's economy. To prevent its
currency rising, the Chinese central bank has bought huge amounts of
American Treasury bonds and mortgage securities (see chart). Its
willingness to provide cheap credit to the American government to
finance tax cuts and, indirectly, to home buyers has thus underpinned
America's recovery. If China dumped those dollars, American bond yields
would rise further, halting the mortgage-finance boom that has buoyed
consumer spending.

On the other hand China may not be guilty of all the charges: nor is it completely innocent. Even if critics exaggerate the extent to which China is to blame for job losses, the yuan is clearly undervalued. In theory,
countries with faster productivity growth, such as China, should see
their real exchange rates climb, through either a rise in the nominal
rate or increase in wages, or both. China's exchange rate has been
pegged to the dollar since 1994, while wages have been held down by
China's pool of surplus labour.

The clearest evidence that the yuan is undervalued is China's large
surplus on its "basic balance" (the current-account surplus plus net
foreign direct investment), and its build-up of official reserves, which
jumped by $19 billion in September, the biggest monthly gain on record.

The Chinese are right to argue that the yuan cannot be allowed to float
freely until their wobbly banking system is reformed. But they are wrong
to say that pegging the yuan to the dollar is best for China and for
everyone else. By preventing the yuan from rising, China has allowed an
excess of liquidity to build up in the domestic economy, at the risk of
a financial bubble, especially in property. The longer the overheating
continues, the sharper the eventual correction will have to be.

By holding its currency down, China risks inflaming global
protectionism. A rise in the yuan would not halt the long-term
structural shift of manufacturing jobs out of rich economies, argues
Martin Barnes of the Bank Credit Analyst, a research firm, but slow it,
making adjustment less painful; it would also reduce the risk that the
euro would overshoot hugely, and help to defuse trade tensions.

Mr Hu this week rebuffed Mr Bush's demands for revaluation, but said his
officials would set up a study with American government experts to
consider ways of gradually making the yuan convertible. The best
short-term option for China might be to tie the yuan to a broader basket
of currencies, including the euro and the yen as well as the dollar, and
then widen its band to allow an appreciation. This would ensure that the
yuan did not simply follow the dollar downwards.

The heart of rich countries' complaints is an unwillingness to accept
responsibility for their own economic faults. It is easier to point the
finger at China. But the real cause of America's trade deficit is its
low saving rate, the result of surging household borrowing and a big
budget deficit. Similarly, Japan and Europe should not be tempted to use
the cheap yuan as an excuse to postpone much-needed reforms. The proper cure lies at home.