by Michael Pettis
Three weeks ago the Wall Street Journal published my OpEd piece about concern that China may try to make the rebalancing process less painful by allowing the RMB to depreciate. In the piece I argue that this isn’t as obvious as you might think.
From July 2005 to February this year the RMB rose by just over 30% in nominal US dollars. Although on a trade-weighted basis, adjusted for changes in relative productivity growth, the revaluation has been much less than 30%, the increase in the value of the RMB has nonetheless been seen, correctly, as a part of China’s rebalancing process.
But after rising for nearly seven years the RMB has dropped 1% against the dollar since February, setting off intense speculation about Beijing’s trade intentions. Not surprisingly, the threat of a weaker RMB making Chinese exports more competitive abroad and foreign imports more expensive in China is raising worries in a world already struggling with weak demand growth.
But these worries may be unfounded. If China is serious about rebalancing its economy, devaluing the RMB will not result in a net improvement in export competitiveness. China’s export competitiveness will deteriorate no matter what Beijing does to the currency.
To understand why, it is important to see that as part of its rebalancing, China must sharply reduce investment, or at least reduce the growth rate of investment. In principle the adverse impact of slower growth in investment should be offset by faster growth in consumption, but it has proven very difficult for China to raise the GDP share of consumption, largely because, as I noted above, consumption-constraining policies are at the heart of China’s growth model, and indeed at the heart of investment growth models more generally. It will take many years of adjustment before consumption is large enough and can grow into its proper role.
This means that during the adjustment process it is a virtual certainty that growth in China will slow significantly for many years. Why? Because if Beijing brings investment growth down more quickly than can be counterbalanced by an increase in consumption growth, its overall growth rate must slow sharply.
There is however a third source of demand that affects domestic growth – the trade surplus, and this is why there is now so much focus on the value of the RMB. If China’s trade balance improves during the adjustment process, overall economic growth rates should be better than expected. If it deteriorates, growth will be worse. Clearly a healthy trade account will make it easier for Beijing to manage the adjustment process. For this reason many analysts, both foreign and Chinese, argue that by boosting China’s competitiveness abroad, a weaker RMB will provide some relief from the sharp expected slowdown associated with rebalancing.
But they are wrong. If China’s trade balance improves because of a surge in foreign demand (which is pretty unlikely), this will almost certainly be good for the economy and will allow the rebalancing process to be less painful. But if Beijing takes steps to increase China’s competiveness abroad by artificially lowering costs domestically, including by depreciating the RMB, it will have no effect on overall growth for any given level of economic rebalancing.
Why not? Because there is a lot more to Chinese competitiveness than the undervalued exchange rate. There are in fact three main mechanisms that explain the relatively low price of Chinese exports abroad, all of which transfer income from Chinese households to subsidize Chinese producers, albeit in very different ways.
The sources of China’s export competitiveness
The currency regime is certainly one of them, and the mechanism is fairly easy to understand. An undervalued currency spurs export competitiveness by subsidizing the local cost component for manufacturers. These implicit subsidies are effectively paid for by Chinese households in the form of artificially high prices for imported goods. Since all households, except perhaps subsistence farmers, are effectively net importers, an undervalued currency is a kind of consumption tax that effectively reduces the real value of their income.
The second mechanism, the difference between wage and productivity growth, does the same thing, but with a different set of winners and losers. Chinese workers’ wages have grown more slowly than productivity for all but the last two years of the past three decades, which means that until two years ago workers have received a steadily declining share of what they produce. Manufacturers benefit from this process because their wage payments are effectively subsidized, and of course the more labor-intensive production is, the greater the subsidy they implicitly receive.
The third mechanism, the most important, is artificially low interest rates, which in China have been set extremely low. These reduce household income by reducing the return households receive on bank deposits, and in China, because of legal constraints on investment alternatives, the bulk of savings is in the form of bank deposits. Artificially lowered interest rates, however, increase manufacturing competitiveness by lowering the cost of capital. Of course the more capital-intensive a manufacturer is the more it benefits.
All these subsidies goose economic growth by subsidizing producers, but they distribute the benefits in different ways. The greater the local production component, the higher the subsidy created by an undervalued currency. The more labor intensive the manufacturer, the greater the subsidy created by low wages. And finally the more capital intensive the producer, the more it benefits from artificially low interest rates.
The mechanisms also distribute the costs in different ways. An undervalued currency hurts households in proportion to the value of imports in their total consumption basket. Low wages hurt workers. Low interest rates hurt households in proportion to the amount of their savings as a share of income.
Because they boost economic growth at the expense of households, these three mechanisms cause the economy to grow much faster than household income. This is the root of China’s unbalanced economy – household income has grown so much more slowly than the economy that household consumption over the past three decades has collapsed as a share of GDP. Rebalancing in China means by definition, however, that the household consumption share of GDP must rise, and the only effective way to do this is by raising the household income share of GDP. Revaluing the currency is one way of doing so. It increases the real income of households by reducing the cost of imports, and it raises local production costs for manufacturers.
But it is not the only way. Raising Chinese wages increases household income too, while increasing labor costs for manufacturers. Finally, allowing interest rates to rise benefits households by increasing the return on savings, and it raises costs for capital-intensive manufacturers.