Prime Minister Manmohan Singh is currently visiting China and yesterday he too complained about China’s trade surplus. There is still a debate about the structure of China’s balance of trade. There are at least three reasons commonly cited to explain China’s massive trade surplus. First, China’s control of the foreign exchange value of the RMB means that China is able to hold down the value of the RMB to well below its “correct” value, and so Chinese good are unreasonably cheap in foreign countries and foreign good unreasonably expensive in China. This enforcement of savings on the population (or forced low domestic consumption) gives China a mercantilist advantage in trade.
The second argument also relates to China’s foreign currency regime, but in this case it is the abandonment of domestic monetary policy that is to blame for the trade surplus. According to this argument, by locking itself into an undervalued and inflexible exchange rate, China has also locked itself into a monetary trap in which large trade surpluses and capital account inflows force domestic monetary expansion, which ends up largely as overinvestment and excessive expansion in industrial production. Since the country’s production grows at a faster pace than its consumption, the country is forced into a large and growing trade surplus which further feeds the monetary expansion.
The third argument explaining the trade surplus cites China’s natural advantages, specifically an educated but very low-cost labor force capable of relatively high quality production at a fraction of the price required for the same labor in the US, Europe or Japan. In this case China runs a trade surplus largely because it can produce the same things as the rest of the world but much more efficiently. There is a fourth, related argument, which claims that this Chinese “efficiency” is at least partly explained by its refusal to count costs correctly – specifically environmental costs are socialized, financial costs are subsidized, and labor exploitation is permitted and even encouraged by political constraints on the ability of workers to organize and protect their interests.
Although of course all these reasons partly explain the trade surplus, I am thoroughly convinced that it is the second argument that is the most important. It would explain why overinvestment has become such a problem and why in spite of a rising RMB the trade surplus has continued to rise steadily over the past 2-3 years. Because we tend to think of China’s trade surplus as coming largely out of trade with rich countries, the low-cost-of-labor argument has always seemed a plausible explanation for China’s trade surplus, but Prime Minister Singh made a point yesterday of calling on China to do something about the growing trade imbalance between the two countries. It is worth remembering that China is also running large surpluses with countries that have lower per capita income and, presumably, lower labor costs (although to be fair India apparently suffers from a very weak industrial infrastructure, which adds to overall costs). The fact that Singh is so unhappy with the trade relationship suggests that there is more to the matter than low labor costs.
The differences among the arguments of course are not just academic. They will require and result in very different adjustment processes. If the first argument is correct cialis cheap, then a policy of faster RMB appreciation (or faster appreciation plus inflation, as Geng Xiao, of the Brookings Institution, has argued) will largely correct the imbalance. In the process it will result in a shift of Chinese economic behavior from savings to consumption, thus resulting in a much more rapidly rising standard of living for Chinese, and for the rest of the world as Chinese growth contributes to world demand. It will not matter too much when the shift takes place, as long as it takes place fast enough to appease foreign anger and to forestall trade wars.
If the second argument is correct, the policy recommendations are more radical and the expected outcome much more pessimistic. According to this argument China has locked itself into a system of severe monetary imbalances, and the longer this goes on the sharper the adjustment will be. The best policy in this case is to force as quickly as possible an adjustment in the balance of payments that brings monetary policy back into control – by forcing either the trade surplus down or the capital account into deficit. It may already be too late to adjust easily, and even if it isn’t if the authorities are too wedded to the ideology of gradualism to make a rapid adjustment, so in this case I expect that the end game will occur either in the form of runaway inflation, which would eventually cause a sharp contraction in the money base, or in the form of sharply rising inventory leading to equally sharp cuts in production, which is how overinvestment cycles classically ended in the 19th Century.
If the third argument is correct, there is little that can be done in the short run to reduce the trade imbalances but eventually rising wages and salaries (or greater domestic political pressure for companies to absorb the full cost of production) will eliminate China’s greater industrial efficiency. In that case the world will simply have to learn how to adjust to the advantages and disadvantages associated with integrating a large country like China into the world trading system.
Needless to say I will be watching inflation and inventory levels closely, and hoping that the faster RMB appreciation does not spur massive speculative inflows.