The Nikkei Financial Daily (Market Eye Column)., 8th August 2007
Recent economic data from China are disturbing. Growth is running at 11.9% p.a., which is greater than the government expected and probably too fast to be sustainable. Inflation has picked up and it is generally agreed that the economy needs to slow to prevent the rate rising further.
In these conditions governments and central banks normally seek to slow the economy to bring down the rate of growth. This can be done in several different ways. The choice is between an increase in taxes, interest or exchange rates. If either of the first two methods is used, domestic demand weakens and output slows, but the trade balance tends to expand as exporters seek to offset the negative impact of lower sales at home.
The acceleration in China’s growth is, however, driven by exports, with its external trade balance in the first six months of 2007 up 85% over that of the previous year. A slow down in domestic demand would increase the size and growth of this surplus even further. This is most unlikely to be met with equanimity by the United States or the European Union, in both of which protectionist policies appear to be increasingly popular.
Economics as well as politics suggest that China should be seeking to dampen demand by increasing its exchange rates rather than by raising taxes or interest rates. But this will need to take place in a carefully controlled way. Fortunately, it is extremely unlikely that China will allow its exchange rate to be determined by the market rather than by official intervention, without which, for several months at least, the exchange rate would be likely to fluctuate violently. The uncertainties which this would cause would be likely to result in serious damage to the world’s economy, let alone that of China itself.
The least disruptive way in which China could seek to slow down its growth rate, and reduce the risk of a further acceleration in the rate of inflation, would be for the exchange rate to strengthen. Since the end of 2005 the renmimbi has risen by 8% against the dollar. The dollar has, however, been weak and this is not a sign therefore of general strength. For example, over the same period, the Chinese currency has fallen by 9% against the Euro.
The argument in favour of allowing the renmimbi to rise more rapidly has several different facets. The political one, that I have already outlined, is that without it there the growth of China’s trade surplus will aggravate the pressures which are currently helping the rise of protectionism. In the past, notably in the 1930s, increased barriers to international trade have not only been accompanied by a general deterioration in economic growth worldwide, but have been accompanied by a dangerous rise in international political tensions.
The more purely economic arguments relate to the impact on China’s domestic economy of the increased liquidity which comes from keeping the renmimbi undervalued. As China’s current account surplus expands, the scale of the intervention needed to prevent currency appreciation grows and it becomes increasingly difficult to stop this causing excessive growth in domestic money supply.
The consequences of this are likely to be seen first in a sharp rise in asset prices, such as shares and houses, and then an acceleration of consumer prices. Both these appear to be already under way and, if allowed to continue, will become increasingly difficult to control without a significant relapse in China’s growth.
The fundamental point is that China’s effective exchange rate needs to rise. This can either be done by allowing the renmimbi to appreciate in nominal terms or for China’s inflation to accelerate further. It is in the interests of both China and the rest of the world that the choice is made in favour of a nominal appreciation.
The Chinese authorities are surely very able people and it thus seems likely that the chosen policy will be the sensible one. This is of course by no means certain. The world has plenty of experience of politics getting in the way of sound policy and it is probable that an appreciation of the renmimbi will meet much opposition and unpopularity.