File photo: Chinese flag. Photograph:( Zee News Network )
Over the last decades, China has pursued a “beggar-thy-neighbor” currency policy to keep the sales price of exports at a low level while maintaining a high-level price of imports.
By Lorenzo Carrieri
China’s economic growth over the last 30 years has astounded the world. Since 1978, under the tenure of Deng Xiaoping, China has embarked on a process of transformation that enabled it to escape economic isolation. Beijing’s government has de-collectivised agriculture and freed foreign exchange transactions in addition to allowing private entities to trade and permitting some foreign investment. Ever since, Beijing has dismissed Maoism and ushered in a new era of capitalism and market reforms, enjoying a sustainable growth rate year after year.
However, notwithstanding the achievements in terms of economic prowess, China seems to be stuck in what is called a “middle-income trap,” and its economy suffers from several shortcomings: high level of corporate debt, an over-reliance on export-driven manufacturing and a high degree of financial repression, to name but a few.
Where is China headed? Where will China’s economy be in 10 years? Is China going to be more integrated into the world economy, either in terms of international trade and investment, or will progress be reversed, especially in light of a trade war with the US and emerging markets’ volatility to a rising dollar?
The main assumption we have to make in order to tackle this question is that China’s economic policy revolves around a slow but steady approach to market-driven reforms. Its transitional post-communist economy maintains the Chinese Communist Party’s (CCP) monopoly on political power while it pursues a more market-driven and services-oriented economic strategy. A tightly controlled political structure alongside a dynamic economy, where economic growth is the key feature that legitimizes political power, China’s approach to international trade and investment has several unique features that allow us to grasp the dynamics of change the country has undergone.
As far as economic international trade and investment are concerned, China’s interest groups sustain economic openness. State-owned enterprises (SOEs) were making the decisions when China began opening up in 1979. At that time, all assets were state-owned, and officials were in charge of regulating — via the enterprises they controlled — corporate governance. Thus, Communist Party officials both deduced and aggregated interests over economic policy, which eventually resulted in bureaucrats having a lot of influence on all economic organized activity and a high stake in maintaining an open system. In addition, China has been developing a vast stock market for decades, which helps SOEs to obtain financing and contribute to the state’s fiscal revenues.
China has learned from the failure of other communist states. While the USSR collapsed in 1991, and all its satellites were crumbling around it, shaken by the 1989 Tiananmen Square protests and squeezed by international sanctions, China decided to adjust its economic policy according to the external constraints of the systemic structure — namely, to depoliticise macroeconomic policies and adjust them to the rule of basic economic equilibria: existence of budget constraints, fiscal and monetary responsibility, a system of market-clearing prices and inflation under check.
Therefore, with the support of the military and the bureaucracy, Deng committed to build a dynamic economy. For him, the only way to preserve the support for the Communist Party was to embark upon a process of overarching economic reforms that would change China’s economy and uplift the well-being at home and increase China’s international prestige and leverage abroad. Economic reforms ahead of political reforms — this assumption continues to be pressed into the Chinese policy-makers’ playbook.
Thus, in the coming years, it seems unlikely that this key feature of the CCP will fade away, especially because it provides the political power with leverage on decentralized economic activity. The party’s legitimacy is strengthened by the fact that the CCP becomes widely recognized for an improvement in living standards, which in turn reinforces its grip on power and raises the cost of opposing it. In regard to this, the last political moves under President Xi Jinping seem to follow in Deng’s footsteps. Xi has been steadily consolidating his grip over the party as he pursues economic reforms aimed at increasing China’s domestic fortunes.
Nevertheless, as far as capital inflows are concerned, China lags behind its peers. On the one hand, although it has implemented new inflow liberalization measures in 2016, its capital account continues to be relatively closed. On the other hand, foreign investment is still restricted to the extent that intangible assets, such as human capital and management techniques for supply chains, are hard to absorb without a more liberalized foreign direct investment (FDI) and foreign portfolio investment (FPI) policy. In regard to this, China’s central bank is carefully loosening control on cross-border capital flows, while policy responses are taking into account domestic financial conditions and stability of the exchange rate.
It is difficult to predict what is going to happen in this regard, but it is likely that China will move forward carefully with an actual floating exchange rate, simultaneously eating into foreign reserves to curb high volatility in order to shore up financial stability. Plus, it is likely that Beijing will follow through with a controlled capital-account liberalization. Thus, China will continue to use what Kevin Gallacher calls “countervailing monetary power” — a string of measures that has helped Beijing (and other emerging markets such as Brazil and South Korea) to offset against the structural power of global markets. From countercyclical regulations to macro-prudential measures, China’s financial institutions will likely continue on the path of curbing the negative externalities of a surge in capital inflow — especially in times of expansionary policy in the US and the EU — and capital flight.
In the coming years, all these measures would likely ease inward FDI, generating positive externalities and knowledge spillovers by importing foreign technology. This could create a situation where Beijing could set up an investment-friendly environment where forces of agglomeration, such as a world-class system of property rights, a sophisticated industrial base, vast labour markets, a high-skilled workforce and specialized service providers will lead China closer to its technological ambitions.
As for trade, China remains a net exporter on the international stage. Plus, it has one of the highest national saving rates worldwide, known as the “Chinese Saving Puzzle.” The two factors are intrinsically correlated. On the one hand, high savings bring about excessive investment domestically, which in turn leads to supply dwarfing demand, low level of consumption, plus a risk of a credit-boom cycle and low growth of income. On the other hand, a high savings rate has engendered a “saving glut” abroad, with large global imbalances and low-interest rates.
Nonetheless, current account surplus to GDP has been falling steadily since 2007. Amongst the main reasons have been a high import volume, more investment, nominal effective exchange rate appreciation, weak demand in major advanced economies and, more recently, a widening of the services deficit. These trends signal that China is opening its massive market to foreign products and services, getting rid of barriers and tariffs on imports. In addition, a current account surplus shrinking is the result of higher consumption by households. Even though private consumption remains very low compared to the global average, the rise of a sophisticated and vibrant urban middle-class keen on foreign goods and services could lead to a huge shift in the Chinese and world trade balance in the years ahead.
Another important sign that suggests a more “integrated” China is the exchange-rate regime. China’s yuan follows a band with a fixed floor and ceiling, inside which the exchange rate is allowed to float with respect to the US dollar and other currencies. Over the last decades, China has pursued a “beggar-thy-neighbor” currency policy to keep the sales price of exports at a low level while maintaining a high-level price of imports. This has brought about a low rate of consumption and an over-reliance on an export-driven economy.
Simultaneously, the Chinese authorities have also taken advantage of currency depreciation and FX intervention through open-market operations and other measures to respond to large capital outflows in 2015-16 that were putting depreciation pressures on the exchange rate. The bottom line is that China has been pursuing a “slow but steady” market-oriented strategy to let its currency float, even in the light of domestic pressures.
In relation to this, the implementation of a proactive monetary policy — including interest rate cuts, open-market operations such as US Treasury securities purchase and stiff financial regulation — are a sign of Beijing’s determination to be integrated within the International Monetary Fund’s Special Drawing Right (SDR) basket of reserve currencies. This elite club of currencies confers members the right to purchase domestic currency in FX markets in order to maintain exchange rates. This move, coherent with market fundamentals, seems consistent with the idea that Beijing will be more and more integrated into the international trade and investment regime in the coming decade, and that preferential trade agreements and investment policies will continue to shape its exchange rate policy.
However, the current trade war with the US could end up hurting China’s economy. With regard to this, several forces come into play. Indirect or direct effects of higher tariffs and barriers might take their toll on international and domestic demand for services such as logistics and wholesale trade, and might also negatively affect business sentiment and investment as a whole.
In tackling this situation, the People’s Bank of China should undertake more aggressive accommodative monetary in order to support demand being hit and promote investment. This could also help to absorb the shocks of trade tariffs, with a declining exchange rate of the yuan that offsets the loss in export competitiveness.
Nevertheless, as a JPMorgan strategists stress, a more accommodative monetary policy could backfire. Not just in terms of downward pressure on the yuan, but also in spoiling Beijing’s attempts to fix macroeconomic imbalances with tighter regulations such as high level of corporate leverage, rapid build-up in debt, and credit distortions. Therefore, the only way out would be to resort to fiscal measures to support exporters and boost domestic demand, while in the meantime taking for granted a cheaper yuan.
The real dilemma for a more globalised China in the years ahead is the so-called Mundell-Fleming trilemma: the impossibility to enjoy simultaneously an independent monetary policy, a liberalized capital account and a fixed exchange rate. Thus far, China’s trade-off has been a mixture of low-interest rates, a loose monetary policy, a de jure monitored capital account liberalization and a currency-managed floating exchange rate. In the years to come, China will find it more desirable to move toward an independent monetary policy and pick one out of capital account openness and exchange rate flexibility. On the one hand, a floating exchange rate could help dampen shocks and address capital flow pressure, while cross-border capital flows regulation could be relaxed instead of being used as tool for macroeconomic policy adjustments.
A Convergence of Problems
In the next decade, China will become increasingly more “globalized.” However, the integration into the world economy will not be as smooth as many scholars think. That’s why the rise of China poses quite a few problems. First of all, there’s an economic order problem. As perfectly addressed by Benjamin Cohen, experts have to account for the issue of systemic flexibility and of China’s intentions. Cohen asserts that monetary systems don’t seem to lack the flexibility to accommodate a newcomer, as demonstrated in the past. However, the question remains whether China will adjust to the status quo and abide by the laws or not.
Second is the question of democracy. In dealing with economic change, China is currently undergoing a process of convergence of problems: the challenge that globalization poses for national sovereignty, popular legitimacy, democracy and economic change. According to Dani Rodrik, this is the global dilemma that every economy faces when entering the global stage. Like in Mundell-Fleming’s trilemma, two out of three are permitted. Since the crackdown on the Tiananmen’s protests, China seems to have undermined the emergence of democracy, maintaining at the same time a national sovereignty in terms of leaving room for maneuver in capital-account liberalisation and monetary policy.
However, an increasingly integrated economy engaged with the international standards might cause China to go easy on national sovereignty, which could eventually be downplayed as compliance with a range of transnational regulatory regimes. In regard to this, China in the coming years will likely be more locked in globalisation and economic change than a decade ago. Think of the accession to the World Trade Organization in 2001 or joining SDR. Beijing has thus decided to achieve economic integration through what Robert Holton calls the golden straitjacket: a tight control of the political structure of the society eschewing mass politics and democratic participation, where national sovereignty and economic change are maintained as the main driving forces.
However, the greatest unknown factor is at home. In fact, the greatest risk for China would be the incapacity of the ruling class to manage the extraordinary economic, social, political, but also urban and environmental, transformations toward which the country is headed. This could eventually lead the Communist Party elite to give up on more economic integration and turn inward to maintain its draconian control over society. At that time, the world will understand in which direction China is going.
(Lorenzo Carrieri is a postgraduate student in economics at the School of Advanced International Studies, Johns Hopkins)
(This article was originally published on The Conversation. Read the original article)
(Disclaimer: The opinions expressed above are the personal views of the author and do not reflect the views of ZMCL)