China’s Dilemma Revisited

Two and a half years ago I wrote a relatively unsophisticated analysis of China’s economic outlook. China’s fundamental position has changed little in that time, but they have come closer to their day of reckoning. This post is intended as a deeper analysis.

China is on everyone’s minds now, not only because they send us cheap imports, but because Americans are increasingly dissatisfied with this arrangement. The crux of the issue is China’s currency policy, which most of the world believes is set “too low” – effectively making China’s exports cheaper than they would otherwise be in terms of other currencies. The US is not the only one upset either, for the sake of its trade balance – India and other developing nations in the area worry that China is forcibly diverting production from their own borders to China, not out of an increased productivity, but because the currency policy makes it cheaper.

There is much talk of an “imbalance” and “rebalancing the world economy”. But the term “imbalance” applied to economic reality implies an objective balance different from the current situation. What justifies the assumption that reality is not by definition balanced? It is not merely the trade deficit that makes us “out of balance” – it is the undervalued Chinese Yuan; the intervention of the Chinese government in currency markets. The term “undervalued” in turn implies an objective value different from the current value, which itself requires a demonstration that consumers would be better satisfied by another arrangement: in this case it requires a demonstration that the pattern of comparative advantage is distorted by undervaluation.

This is not exactly a trivial task, but most economists agree that the pattern is distorted, though they disagree as to the degree. This distortion, though it costs the Chinese government, ultimately brings production to China and hurts other countries competing for that production. In a free market, China would be severely constrained currencywise: flooding the market with Yuan to buy foreign reserves must either cost the government Yuan, or instigate inflation – or both – depending on whether the government spends tax revenue or prints Yuan to fund itself. The latter is just starting to become a worry. The former is what the US means by an implicit subsidy on exports: the government spends money to make its exports more competitive across the board, though in a less direct fashion than a traditional subsidy.

Export subsidies are of course illegal for the most part under WTO law. And because China’s peg acts essentially like an implicit subsidy, the US is considering pressing the WTO for retaliatory trade sanctions commensurate with the Yuan’s undervaluation.

What are China’s options then? it cannot alienate itself from the world market by antagonizing all its export markets, or they will impose retaliatory barriers as they are already threatening. And it certainly cannot revalue to the extent that the US wants, or its exports will suffer. Of course, some argue that since most of China’s exports were once imports, that any rise in the Yuan’s value will simply allow them to import more for export, with a negligible overall change in the trade balance. But the allure of China for investors is not cheap materials; these can be had elsewhere. It’s cheap labor; labor made cheap by the low exchange rate. When it becomes more expensive to produce and assemble there, investors will find another intermediary.

Ultimately, China’s chickens must soon come home to roost. If China doesn’t revalue, trade sanctions will be imposed against it, making its labor advantage useless. If China revalues, all the malinvestment within its borders will suddenly become manifest, sending it into major recession. Either way, its stellar growth record sustained by ever increasing malinvestment through currency manipulation must soon come to an end.