Reconsidering Revaluation

The Wrong Approach to the U.S.-Chinese Trade Imbalance

David D. Hale and Lyric Hughes Hale

From Foreign Affairs, January/February 2008

Summary:  Politicians in Washington are clamoring for currency revaluation in China to reverse China's trade surplus with the United States. But the trade imbalance is not the threat they make it out to be, and a stronger yuan is not the solution. Everybody should focus instead on properly integrating China into the global economy.

DAVID D. HALE is an economist and Chair of Hale Advisers LLC. LYRIC HUGHES HALE is Founding Publisher of www.chinaonline.com.

The real challenge, as Beijing well understands, is helping China integrate its booming economy into the international system. As China's growth rate continues to rise, many in China, including Zhou Xiaochuan, the head of the People's Bank of China, have begun to worry about inflation, which is now at its highest level in 11 years. China's foreign exchange reserves now exceed $1.4 trillion -- equal to approximately 50 percent of GDP. During the past two years, the Shanghai stock-market index has risen from 1,000 to 6,000. Last May, the trading volume on the stock markets in Shanghai and Shenzhen exceeded that on all the stock markets of the rest of Asia and Australia combined. Today, China accounts for five percent of all global stock-market activity.

So far, China's monetary policy alone has failed to curtail its very high growth rate, now over 11 percent. The People's Bank of China cannot use one common tool to restrain the stock market, regulating margin debt, which allows investors to use borrowed funds in order to buy stocks: such debt does not exist in China. It has instead responded by steadily increasing bank reserve requirements and nudging up interest rates. But if it raises interest rates sharply, it could attract capital inflows from foreign investors, which would bolster the currency. Higher interest rates could also keep even more Chinese money at home. Neither outcome would slow down the economy. Chinese policymakers will therefore need to look beyond monetary policy and focus instead on reforming tax laws, increasing consumer spending, encouraging capital outflows, and changing the regulations governing Chinese corporations.

China traditionally refunded to producers the 17 percent value-added tax (VAT) on production inputs that was paid on exports. But last June, it announced that it would phase out the VAT rebates on 25 percent of the products it exports. It has eliminated rebates on energy-intensive goods such as coal, refined copper, primary aluminum, crude steel, and activated carbon, all of which are produced in industries suffering from overinvestment. China will maintain the VAT rebates on higher-value-added products, such as machinery, because it regards them as the locomotive for growth in the future.

Due to its growing domestic market and the sheer scale of its manufacturing activities, China has managed to accrue corporate and government savings at an unprecedented rate. But the transition to capitalism has been rocky and imperfect. China's failure to pay corporate dividends has swollen corporate treasuries, leading to a cycle of overinvestment in capital equipment and to a form of corporate speculation on the stock market that is similar to the Japanese practice of using surplus capital for short-term, high-risk investing, known as zaitekku. A change in the regulations governing Chinese corporations that would force them to pay dividends to all shareholders would cure a major distortion.

Ultimately, China will also have to shift to a new policy that boosts domestic consumption and reduces the country's dependence on exports. Consumer spending has not kept pace with overall GDP growth: its share of GDP has slumped from 50 percent in the 1980s to 36 percent today. Consumption has been eclipsed by huge gains in capital spending and exports. The government has made some moves to increase consumer spending, such as introducing measures abolishing the taxation of farmers and increasing government spending on health care and education. Nevertheless, Chinese households still have the world's highest savings rate -- between 23 and 25 percent. This is because the country's social safety net remains so inadequate that many people save more in order to pay for education, health care, and retirement. Ironically, to decrease the household savings rate and boost consumer spending, the government will have to reinstate some socialist policies that disappeared in the 1990s.

Beijing is also trying to slow the growth of its foreign exchange reserves by encouraging more capital outflows. Last May, Beijing changed the rules in this area, permitting Chinese special investment funds to invest in foreign equities and foreign firms to invest in Chinese equities. The change produced an immediate rally on the Hong Kong exchange, where Chinese institutions routinely buy "H" shares, shares of Chinese companies approved for listing in Hong Kong. (These sell at a significant discount compared with similar shares on the Shanghai exchange due to lower retail demand and a smaller market.) The Chinese government magnified the rally by announcing that it would give Chinese citizens more freedom to purchase Hong Kong equities and allow mutual funds to invest in a wider range of foreign markets. China hopes that this strategy of encouraging capital outflows will succeed in the same way that it did in Japan a few years ago -- by reducing bloated foreign exchange reserves and bringing the economy into lasting equilibrium.

A GLOBAL PLAYER

Despite Beijing's understandable reluctance to cave in to U.S. demands, the odds are good that China will eventually change tack and allow its exchange rate to appreciate more rapidly due to political pressure from Washington. But exchange-rate appreciation will have a far less significant impact on China's trade surplus than the economic policy changes China is already pursuing. For the past 30 years, China has been engaged in a complex process of integration into the world economy. No matter how many sensible economic reforms are implemented in Beijing, much of the burden for integrating China into the global economy will fall on the international community. And this process will require more than unilateral efforts by the United States to protect its own interests; it should instead be approached as a multilateral issue that will affect almost every nation on earth.

The time has come for a broad international effort to integrate China into the global economy. The United States should reform the traditional G-8 summits to include China as its ninth member. The G-7 (the group of highly industrialized states) admitted Russia during the late 1990s, and China is a far more important economic player now than Russia was then. Indeed, there cannot be a serious discussion of global economic issues without the active participation of Beijing. The admission of China to the G-8 process would create a major global forum in which the leading industrialized countries could discuss the impact of China's export boom on other nations' economies and address the environmental impact of Beijing's growing demand for commodity imports and energy resources. In the end, only a skillful combination of structural reforms in China and coordinated multilateral efforts will create a more balanced economic relationship between Washington and Beijing.