Martin Wolf’s FT Forum, 5th October 2006
Andrew Smithers
Response to Martin Wolf’s FT article 3rd Oct 2006 ‘Why Beijing should dip into China’s corporate piggy bank.”
I agree with Martin that China should not seek to reduce investment but savings. This is indeed extremely important. Calls for China to reduce investment threaten to make the current imbalances worse. If measures are taken which successfully reduce intended (ex-ante) investment then China’s domestic demand will fall below it optimum level causing an unnecessary and wasteful loss of output both at home and abroad. The accompanying rise in China’s trade surplus would serve to increase protectionism and coming at a time when demand is weakening in the US will increase the risks of world recession.
Reducing China’s savings will not however, occur simply if state enterprises pay increased dividends to the central government. Unless government spending is increased, this would merely transfer the savings from the corporate part of the state sector to the government part. Equally higher taxation of private sector companies will simply transfer savings from the private corporate sector to the government sector.
What is needed is either a cut in personal taxation, which will be at least partly spend on consumption, or an increase in government spending. This could be financed by increased government borrowing, higher dividends from the state owned companies, or higher taxes on the private sector ones, but increased borrowing should be the short term preference, as the other two approaches might reduce investment and by leaving the net balance of domestic savings unchanged, produce no reduction in China’s trade surplus.
The title and emphasis of Martin’s piece should therefore have been different. It should have called for an increase in the state sector’s dissaving, rather than an increase in its expenditure matched by higher revenues.
China’s exchange rate is bound to rise in real terms. As I have pointed out before, when commenting on one of Martin’s previous articles, this is the inevitable consequence of the Balassa-Samuelson effect on the exchange rate of a rapidly growing economy. China can have a rising real exchange rate either by allowing the nominal rate to rise, or by allowing inflation to rise to levels above those of the developed world. The second approach has been implicitly its preferred one, but the method has produced a dangerous time lag. By pegging the currency to the dollar, China has built up huge foreign exchange reserves, which it cannot fully immunise. Left unchecked this will in time produce domestic inflation from over-expansion of domestic liquidity. But there are long and uncertain time lags between increased liquidity and inflation. This raises the risk that when inflation does pick up it will do so in a rapid way which is difficult to control and which will require a sharp tightening of monetary policy and a nasty and unnecessary loss of output to bring inflation under control.
Bringing the inflation impact forward by fiscal stimulus is one way to reduce the risks of delay. I suggest that the title of Martin’s piece should have been “China should either allow the renmimbi to rise or use fiscal stimulus to ease global imbalances.”