China Trip Report

Nouriel and I put pen to paper and laid out our take on China.

Our paper reflects on the trip we took there last month, along with the reading we did to prepare for the trip.

There is nothing new here about the peg; we laid out our assessment of China’s most likely course as soon as we got back. I suspect the real debate in China is not "the current peg" v. "change," but rather "what kind of change."

As we indicated before, many technocrats are well aware of the downside of a small move, namely, that "speculators" and ordinary Chinese citizens alike would start to bet on the next move. A small move probably would not have a meaningful impact on China’s overall trade balance, slow capital inflows into China, slow China’s extraordinary reserve accumulation, or provide China with more monetary room to maneuver. However, a big move still might be more than China’s political leadership can stomach at this time --

Our trip report covers far more than just the renminbi peg.

China is one of those rare countries that both the right and the left hold up as an example. Someone like Reagan-era guru Arthur Laffer claims that supply-side economics explains China’s success:

What China has done since 1978 is unbelievable. They have become a supply side, sound money country. ... China has fixed the yuan to the dollar. They followed sound money and big tax cuts and as a result are really coming out of the development stage as being a very serious and positive power in this world.

Joe Stiglitz is not exactly close to Arthur Laffer on most economic questions, but he too sees much to like in China. China, after all, hardly followed "Washington Consensus" policies and it now has the fastest growth in the world. To Martin Wolf and others, China offers the best evidence out there that trade promotes development.

Everyone likes a success story.

Nouriel and I, however, try to make the case that China’s current growth model is about to run into real limits. In some sense, that is not saying much: try forecasting out 35% y/y export growth with a base of $600 billion; try imagining an economy where 55 cents of every renminbi earned is saved, with roughly 50 cents invested at home and 5 cents invested abroad.

China’s government does more than just control the exchange rate; it also regulates lots of other key prices. And the renminbi is not the only thing that is currently too cheap. Gas is too cheap; the government has kept domestic prices from rising as much as world prices (helping the auto industry, and real estate developers building on the sixth ring road around Beijing). Land is too cheap --actually, land is not something that in general you can formally buy; China is still Communist after all. But the right to build an apartment building on former farmland or a traditional neighborhood is worth something. In China, a developer doesn’t have to buy out the person working the land; he has to buy out the local party -- that is a huge source of inequity, and the root cause of much social tension. The close ties between the Communist party (and the Chinese state) and the real estate industry are not hard to explain: the Chinese state controls the two things any real estate developer needs, land and, through the state banks, credit.

And credit is very cheap in China. Interest rates are very, very low. 5% nominal is next to nothing in an economy that growing by almost 15% in nominal terms. No wonder demand for credit (at that price) far exceeds supply -- particularly now that the central bank is limiting bank lending to try to cool the economy.

And, as Chinese economists like Hu Angang have noted, cheap credit makes it attractive to substitute capital for labor inside China, even though in global terms, labor is still quite cheap in China. Consequently, the overall impact of the peg on employment consequently may be more ambiguous than many argue. The peg supports employment in the export sector, but it also encourages the substitution of capital for labor throughout the economy, and thus reduces, to a degree, overall demand for labor.

Consequently, the oft-made argument that China needs an undervalued exchange rate to provide employment growth is incomplete. The undervalued exchange rate is one of the reasons why credit is cheap right now in China.

Incidentally, I am not quite sure how Robert Reich came to the conclusion that China’s peg let it "avoid surges of hot money from worldwide speculators." Speculators love nothing more than an easy target like a peg. Right now China is attracting tons of hot money, both from Chinese citizens bringing funds stashed overseas back home and from the "overseas" Chinese seeking to invest in mainland China. And that money has to go somewhere. A domestic credit boom is not the most obvious recipe for financial stability.

One of the hardest things to do is to move away from a model that has worked reasonably well to date. But Nouriel and I suspect that is what China now needs to do: China’s massive reserve accumulation is but one of many signs that China’s economy has its own internal "imbalances" -- imbalances that currently seem to be getting worse.