June 08, 2015
Dean Baker
The Guardian, June 6, 2015
View article at original source.
Last month the I.M.F. announced that China was no longer managing its currency. The basis for this claim is that China’s central bank is no longer engaged in large-scale interventions in currency markets and its trade imbalance is within a normal range. After being as high as 10 percent of GDP in 2007, China’s trade surplus is now just over 2.0 percent of its GDP. With this drop in the trade surplus, the I.M.F. was effectively declaring mission accomplished.
Before we all break out the champagne, it is worth giving this one a bit more thought. First of all, China deserves credit for an extraordinarily large adjustment in its trade balance with remarkably little disruption to its domestic economy. An 8.0 percentage point drop in its trade surplus is equivalent to a loss in annual demand of more than $1.4 trillion in the U.S. economy. It is difficult to envision the United States seeing this sort of hit to demand, without massive unemployment and other negative consequences. The fact that China was able to maintain an extraordinarily rapid pace of growth throughout this period is a testament to the effectiveness of its ability to manage its economy.
But just because there has been an enormous reduction in the size of the trade surplus does not mean that it is at a satisfactory level. The textbook story is that capital is supposed to flow from slow growing rich countries to fast growing developing countries like China. The logic is that capital is plentiful in rich countries, but relatively scarce in developing countries. Therefore, it should get a better return in developing countries.
This means that investors in rich countries should want to send their money to China in search of higher returns. Flows of capital from rich countries to China would mean that China is running a trade deficit rather than a trade surplus. So even though a trade surplus of 2.0 percent of GDP is much better than a surplus of 10 percent of GDP, China still has some way to go before its trade situation is in line with what the textbooks predict.
In this respect it is worth noting the contrast with the United States. As a result of moderately more rapid growth in the U.S. than the euro zone last year (2.4 percent in the United States compared to 0.9 percent in the euro zone), the dollar rose rapidly against the euro and now the U.S. trade deficit is rising as a result. If China’s currency were following normal market patterns, we would expect the country’s much more rapid pace of growth (it’s projected to grow by close to 7.0 percent in 2015) to lead to a higher priced currency, which would put push its trade surplus toward deficit. The fact that this is not happening is compelling evidence that its currency is still being controlled by the government.
An important factor in this equation that is generally left out of discussion is the $4 trillion in foreign exchange reserves being held by China’s central bank. This stock is way out of line with what would be expected for an economy of China’s size. If we use six months of imports as our yardstick (a common rule of thumb) then China has more than $3 trillion of excess reserves. This stock of foreign reserve holdings almost certainly is keeping down the value of the yuan against the dollar and other freely traded currencies.
This is the exact same logic as the Federal Reserve’s holdings of more than $3 trillion in government bonds and mortgage backed securities. Almost everyone would accept that holding this stock of assets raises their prices and lowers interest rates compared to the scenario in which private investors had to absorb all of these assets. The same story applies to the dollars and other reserve currencies held by China’s central bank. This means the huge stock of foreign exchange reserves is keeping down the value of the yuan, even if the Chinese central bank is not currently acquiring more reserves.
Finally, this is a big deal for the simple reason that the United States has no easy mechanism for replacing the demand lost to the trade deficit. We filled the demand gap in the 1990s with a stock bubble and in the last decade with a housing bubble. But if we don’t want to see another round of bubble generated growth it is difficult to see how the U.S. economy gets back to full employment without getting the trade deficit down. And with the employment to population ratio of prime age workers (ages 25–54) down by 3 percentage points from its pre-recession level, we still have a long way to go to get to full employment.
