China in international imbalances

China’s fast-growing economy faces an unprecedented problem: how to deal with its unsustainable ‘twin surpluses’ without damage to itself and the global economy

By Yu Yongding

Global imbalances

The global economy is suffering from serious imbalances characterised by a persistent deterioration of the US current account deficit, marked increases in oil and raw material prices and excessive international liquidity. The US Bureau of Economic Analysis announced on March 14 2006 that the US deficit reached seven per cent of GDP in 2005. The deficit is expected to increase further in the future, due to growing consumer demand for imports and to a rapid growth in interest payments to foreign holders of US government securities. Rapidly rising oil prices and imports explained about two-thirds of the increase. But US trade deficits increased with every major region of the world and the largest increase was with China, from whom the US does not import oil.

At the same time, the Chinese economy is suffering from serious imbalances of another kind, characterised by a rapid increase in the so-called ‘twin surpluses’ (where China has, at one and the same time, both a current account surplus and a capital account surplus), a persistence of excess investment, acute energy shortages, a deterioration of the environment and a rapid widening of income gaps, while the economy is growing at breakneck speed.

Few people in China believe that its current account surplus is sustainable in the long term and even fewer believe that running a large current account surplus is desirable for the country. The changes we are likely to see in China’s growth strategy will have major implications for global imbalances and international finance.

China’s ‘twin surpluses’

The economics of development assumes that developing countries should run current account deficits and capital account surpluses, using foreign saving to achieve an investment rate higher than what their domestic saving rate can support. As their economy matures they will reduce their debt liability until finally they become a country with a positive net international investment position.

China does not fit this pattern. Although a developing country with a very large capital account surplus every year since the early 1980s, China has also been running a current account surplus consistently since the early 1990s. These persistent ‘twin surpluses’ have resulted in a continual increase in foreign exchange reserves. By the end of 2006, China’s foreign exchange reserves will have surpassed 1 USD trillion, making it the largest foreign exchange reserve holding country in the world.

The twin surpluses imply that foreign funds obtained through foreign direct investment (FDI) and exporting are not fully utilised to buy foreign goods, technology or managerial skills, but instead have flowed back to the US government bond market. So why does a developing country like China run a large current account surplus and why does it attract so much FDI given that it has excess savings?

The current account surplus

The first and most popular explanation for China’s current account surplus is the saving-investment gap. While China’s investment rate is very high, its saving rate is even higher.

The second factor contributing to China’s current account surplus is government policies – especially the three export promotion policies, the so-called ‘self-balancing’ regulation, exchange rate policy and tax rebates. In the early stage of reform, the government demanded foreign investors guarantee the self-balancing of foreign exchanges for important foreign investment projects. In other words, FDI was to be entirely export-oriented. It is also undeniable that China’s exchange rate policy is conducive to China’s trade surplus and current account surplus. Before the Asian financial crisis, China’s exchange rate was set according to the production costs of exports in order to maintain these exports’ competitiveness. During the Asian financial crisis, the Renminbi (RMB) was pegged to the US dollar. Besides a relatively undervalued currency, tax rebates are another very important policy instrument. Tax rebate-related frauds are rampant and as a result many enterprises export solely in order to obtain tax rebates.

The third factor is China’s position in the global division of labour. Commencing in the late 1980s, a new international division of labour began to take shape. The lowering of communication and transportation costs together with the liberalisation of trade and investment regimes enabled corporations to fragment and internationalise the production process. As a result of the development of international production networks, processing trade became the dominant form of trade among less developed countries.

China’s current account surplus and trade pattern were shaped to a large extent by FDI that flowed in as vehicles for the formation of international production networks. The destination of FDI inflows into China was in turn facilitated by the Chinese government’s policy in favour of processing trade, which was motivated by its fear of a current account deficit and its desire to allow China’s comparative advantage in labour intensive products to have full play. Because of the increasingly important role played by multinationals from developed countries and by Taiwanese Original Equipment Manufacturer (OEM) firms, the bulk of FDI flowed into manufacturing sectors such as electronics, automobiles, family appliances, office machines, measuring and checking instruments, telecommunications equipment, pharmaceuticals and chemicals. As a result of changes in the regional and sectoral distribution of FDI, China was more and more deeply locked into the international production networks and its trade became increasingly dominated by processing trade.

Since China entered the World Trade Organisation (WTO) in December 2001, FDI from multi-nationals has increasingly been concentrated in capital-intensive heavy chemistry, large-scale infrastructure, highly technological industry and the service industry. Each of these bear less relation to the international production network. At the same time, multinationals grow more interested in China’s domestic market rather than using China as a platform for re-export. However, these new developments will not change the dominant position of processing trade in China in the near future.

The FDI puzzle

We can see that China attracts plenty of FDI. The question is why, given that it has excess savings?

First, due to the under-development of the financial markets, though there may be excess savings for the economy as a whole, it is very difficult for many potential importers of capital goods to raise funds domestically to finance imports. Yet it is easy to attract foreign funds thanks to preferential policy towards FDI. Sometimes enterprises simply sell their foreign exchange obtained via FDI to the central bank (the People’s Bank of China) and use RMB to buy capital goods produced locally. As a result, while there are increases in the levels of FDI and in foreign exchange reserves, there are little or no changes in the current account. Essentially, China’s domestic savings are being intermediated by foreign capital markets for domestic investment.

Second, even if funds can be raised domestically, due to capital controls it is difficult for potential importers to convert their RMB funds into foreign exchange so that foreign goods can be brought. Attracting FDI is still a better option.

Third, despite the fact that the returns required on FDI are much higher than the yield on US treasury bills, FDI is the cheapest form of foreign capital for myopic enterprises and local governments. In other words, under current governance arrangements, from the point of view of local governments and individual state-owned enterprises, FDI is a ‘free lunch’. Who cares about payments in the form of investment income, if the payments are due in five to 10 years’ time? Faced with excessively lavish concessional conditions – low tax rate, long tax holiday, hidden subsidies in energy use, lax regulations of environmental protection, free infrastructure and low or negative rents on land use – what more can foreign investors hope for? So the interests of local governments in attracting FDI and those of foreign investors in providing FDI coincide perfectly.

Fourth, China’s fiscal system and institutional arrangements give local governments great incentive to attract FDI. One reason is that FDI is indispensable for increasing tax revenues at local levels. Another reason is that it is a common practice in China that officials at all levels of government are assigned targets for FDI attraction. Those who attract the largest amount of FDI are the most likely candidates for further promotion.

Fifth, in order to give new impetus to the recent reform of state-owned enterprises and commercial banks, the merger and acquisition of Chinese firms by foreign investors and the acquirement of shares by ‘international strategic investors’ in China’s commercial banks are encouraged. Consequently, capital flows in and adds to the existing stock of foreign exchange reserves.

Where does all this FDI come from? The single biggest FDI provider is Hong Kong, followed by the Virgin Islands. The latter alone accounted for more than 19 per cent of China’s total attraction of FDI in 2005. Though difficult to verify, anecdotal evidence suggests that a very large proportion of China’s FDI is rent-seeking round-tripping FDI.

Why China must take action

Inside China, a consensus has been reached that the twin surpluses are neither desirable nor sustainable. There are a number of reasons why China will take action to correct its imbalances, and these actions will undoubtedly have important consequences for the global imbalances.

First, as already explained, China’s current account surplus is achieved as a result of severe market distortions. For example, the competitiveness of energy-intensive export products is achieved through hidden subsidies in the form of the under-pricing of energy resources. The same is true of land-intensive export products.

Second, the over-dependence on processing trade for the current account surplus, which in turn is based on the availability of low-skilled but well-disciplined cheap labour, is damaging the potential for future improvement in China’s human capital and risks permanently locking the Chinese economy into a low level on the ladder of the international division of labour.

Third, with trade being dominated by processing trade, China’s economy can be very vulnerable to external shocks.

Fourth, trade frictions will worsen as a result of the increase in the current account surplus. China’s exports are already targeted by the US, the European Union and many developing countries, such as Mexico, Brazil and so on. China’s economic growth will be gravely damaged if these countries take action to restrict Chinese imports.

Last, but by no means least, the accumulation of foreign exchange reserves, as a result of the twin surpluses, is making the Chinese economy vulnerable to US policy decisions. According to some American economists, the US dollar should further devalue by 20-30 per cent. If that happens, China’s losses in its foreign exchange reserves will be tremendous as more than half of the reserves are in US dollars. The dilemma facing China’s central bank is unparalleled in history. With such a huge amount of foreign exchange reserves, it is extremely difficult for China to protect itself.

The twin surpluses have compromised China’s macroeconomic management and are harbingers of inflation and asset price bubbles. Since the middle of the 1990s, the increase in foreign exchange reserves has become one of the most important contributing factors to the increase in reserve money.

In order to control the increase in reserve money, large-scale open market operations have been carried out involving the sale of government bonds held by the People’s Bank of China (PBOC). However, owing to the enormous scale of open market operations aimed at neutralising the expansionary impact of the increase in foreign exchange reserves, in just a couple of years the PBOC sold out all the government bonds it had accumulated as a result of the previous open market operations aimed at increasing money supply to stimulate the economy. Commencing in 2003, the PBOC was forced to sell central bank bills to mop up the liquidity.

The sterilisation debate

One important question is whether sterilisation can be implemented without limit. This is a debatable question. Theoretically speaking, as long as the interest rate paid by the central bank on its bills is lower than the corresponding interest rate on (say) US treasury bills, the central bank should be able to carry on with full sterilisation indefinitely, and hence maintain an effective control of the monetary base.

However, there are several obstacles to the continuation of full sterilisation. One is that the continuous purchase of low yield central bank bills and the increase in the share of low yield assets in the total assets will worsen the commercial banks’ profitability, which in turn will create a long-term negative impact on the fragile banking system. Therefore, faced with a continuous increase in foreign exchange reserves, the central bank will have to make choices among three contradictory objectives: a tight monetary policy, a healthy financial system and exchange rate stability. Faced with an extremely high growth rate of fixed assets investment and a steady increase in the investment rate, the PBOC will have no choice but to tighten monetary policy greatly. At the same time, comprehensive policy measures will be taken to reduce the increase in foreign exchange reserves.

Sustainable solutions to restore balance

China’s current balance of payments position is not sustainable in the long run. If China fails to utilise foreign capital effectively and obtain a decent return on its outbound investment and lending, it may suffer from current account deficits as a result of ballooning investment income outflows.

To reduce the current account surplus, the saving-investment gap should be reduced by increasing either consumption or investment. Because China’s current investment rate is already too high, the focus should be on increasing consumption. In order to do so, government expenditure on public goods must be increased in areas such as social security, health care, transport infrastructure and education. The government’s recent decision to increase funding for rural development will achieve the result of ‘killing two birds with one stone’.

It is worth noting that the most important source of high saving is not the household sector but the enterprise sector. State owned mega-firms have parked huge amounts of funds in banks. This must be addressed.

Preferential policies towards FDI should be scrapped so that domestic and foreign investors are given equal treatment in terms of credit access, tax arrangements, environmental requirements and so on. As a result, the level of round-tripping FDI will be reduced and the flow of FDI that is not viable without all sorts of subsidies will cease.

The export promotion policy should also be gradually scrapped and policies which particularly favour processing trade should be adjusted. Imports should be allowed to increase, especially of strategically important goods and materials. Of course, while doing so, international markets should not be destabilised.

Financial reforms should be speeded up. Small and medium enterprises should not be discriminated against. Corporate bond markets should be developed and stock markets made more effective. The reforms should seek to allow domestic savings to be channelled effectively to enterprises, therefore reducing the need to attract FDI to obtain credit. Foreign-funded enterprises should be allowed to tap China’s domestic capital market, reducing the need for new cross-border FDI. At the same time, Chinese enterprises should be encouraged to invest abroad both in the form of greenfield investment and mergers and acquisitions.

Capital account liberalisation should be carried out in a smooth and orderly manner. However, the completion of financial reform and the revitalisation of China’s financial institutions (and banks in particular) must precede the final liberalisation of the capital account, that is, to make the RMB convertible.

The RMB exchange rate should continue to appreciate gradually. However, empirical evidence has shown that the so-called ‘expenditure-switching’ effect of nominal exchange rate changes is small in China as well as in the US. As a result, to use the exchange rate change as an instrument to achieve trade balance might lead to considerable exchange rate volatility. Abundant experience also shows that overemphasis on exchange rate policy in the correction of current account imbalances may not only fail to achieve the goal of correcting the trade imbalance, but may also cause tremendous hardship to the countries concerned. After the 1985 Plaza Accord, and despite the dramatic revaluation of the Japanese Yen and the slide of the US Dollar, the US trade deficit failed to improve in any significant way, but nonetheless caused tremendous hardship to the Japanese economy. While recognising the limitation of exchange rate policy, I personally support action on the exchange rate front.

In conclusion

Over the past 26 years, China has achieved tremendous success in reforming and opening up its economy. China has become the fourth largest economy in the world, the third largest trading nation and the largest foreign exchange reserve holding country. Yet it faces increasingly serious structural problems. Its investment rate is approaching 50 per cent of GDP and rising. Its current account surplus surpassed USD102 billion in 2005, and will probably be higher in 2006. China’s foreign exchange reserves will surpass the threshold of USD1 trillion very soon. China’s environment is deteriorating continuously, and its energy shortage is acute.

To correct the imbalances, the Chinese government must adopt a comprehensive program aimed at achieving a more balanced and sustainable growth pattern. Whether this strategy will be successful is dependent on how well the Chinese government is able to balance the short run necessity for high growth with the long run necessity for structural adjustment. On the one hand, China’s twin surpluses are a result of long-term imbalances and cannot be changed overnight. On the other hand, caution is not an excuse for inaction.

Global imbalances are not sustainable in the sense that these imbalances are not in the long-term interests of China and other Asian countries, and they should be and will be corrected, no matter what the US government says and does. However, a drastic correction is neither inevitable nor desirable. To achieve an orderly correction, more international consultation and policy coordination are needed. To my mind, this is the key task faced by national and international agencies around the world today.

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A condensed version of the 2006 David Finch Lecture delivered on 17 October at the University of Melbourne. The Lecture was established through the generosity of C. David Finch, a distinguished alumnus of the University. The full paper has been published in Australian Economic Review, March 2007, 40: 1.

Professor Yongding is Academician of the Chinese Academy of Social Sciences, the Director-General of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences, Professor in the Academy's Post-Graduate School and President of the China Society of World Economics. He was formerly the academic member of the Monetary Policy Committee of the People's Bank of China and a member of the National Advisory Committee of the 11th Five Years Plan of National Reform and Development Commission.

Volume 1 April 2007