Sunday, November 23, 2014

China Adjusts

BAHRAIN – China watchers are waiting to see whether the country has engineered a soft landing, cooling down an overheating economy and achieving a more sustainable rate of growth, or whether Asia’s dragon will crash to earth, as others in the neighborhood have before it. But some, particularly American politicians in this presidential election year, focus on only one thing: China’s trade balance.

True, not long ago the renminbi was substantially undervalued, and China’s trade surpluses were very large. That situation is changing. Forces of adjustment are at work in the Chinese economy, so foreign perceptions need to adjust as well.

China’s trade surplus peaked at $300 billion in 2008, and has been declining ever since. (Indeed, official data showed a $31 billion deficit in February, the largest since 1998.) It is clear what has happened. Ever since China rejoined the global economy three decades ago, its trading partners have been snapping up its manufacturing exports, because low Chinese wages made them super-competitive. But, in recent years, relative prices have adjusted.

The change can be measured by real exchange-rate appreciation, which consists partly in nominal renminbi appreciation against the dollar, and partly in Chinese inflation. China’s government should have let more of the real appreciation take the form of nominal appreciation (dollars per renminbi). But, because it did not, it has shown up as inflation instead.

The natural price-adjustment process was delayed. First, the authorities intervened in 1995-2005, and again in 2008-2010, to keep the dollar exchange rate virtually fixed. Second, workers in China’s increasingly productive coastal factories were not paid their full value (the economy has not completed its transition from Mao to market, after all). As a result, China continued to undersell the world.

But then the renminbi was finally allowed to appreciate against the dollar – by about 25% cumulatively during 2005-2008 and 2010-2011. Moreover labor shortages began to appear, and Chinese workers began to win rapid wage increases. Beijing, Shenzhen, and Shanghai raised their minimum wages sharply in the last three years – by 22% on average in 2010 and 2011. Meanwhile another cost of business, land prices, rose even more rapidly.

As costs rise in China’s coastal provinces, several types of adjustment are taking place. Some manufacturing is migrating inland, where wages and land prices are still relatively low, and some export operations are shifting to countries like Vietnam, where they are lower still. Moreover, Chinese companies are beginning to automate, substituting capital for labor, and are producing more sophisticated goods, following the path blazed by Japan, Korea, and other Asian countries in the “flying geese” formation.

Finally, multinational companies that had moved some operations to China from the United States or other high-wage countries are now moving back. Productivity is still higher in the US, after all.

None of this is news to most international observers of China. But many Western politicians (and, to be fair, their constituents) are unable to let go of the syllogism that seemed so unassailable just a decade ago: (1) The Chinese have joined the world economy; (2) their wages are $0.50 an hour; (3) there are a billion of them; and (4) Chinese wages will never be bid up in line with the usual textbook laws of economics, so their exports will rise without limit. But it turns out that the basic laws of economics eventually apply after all – even in China.

Like certain other aspects of the US-China economic relationship, China’s adjustment is reminiscent of Japan with a 30-year lag. Japan’s trade balance fell into deficit in 2011, for the first time since 1980. Special factors have played a role in the last year, including high oil prices and the effects of the March 2011 tsunami. But the downward trend in the trade balance is clear. Even the current account showed a deficit in January.

This development has received relatively little attention in the US and other trading partners, which is curious, given that, two decades ago, Japan’s big trade surplus was the subject of intense focus and worry – just like China’s now. At the time, some influential commentators warned that the Japanese had discovered a superior economic model, featuring strategic trade policy (among other attractions), and that the rest of us had better emulate them. Either that, or the Japanese were “cheating,” in which case we needed to stop them.

Most economists rejected these “revisionist” views, and argued that Japan’s current-account surplus was large because its national saving rate was high, which reflected demographics, not cultural differences or government policies. The Japanese population was relatively young, compared to other advanced economies, but was rapidly aging, owing to a declining birth rate since the 1940’s and rising longevity.

That view has been vindicated. In 1980, 9% of Japan’s population was 65 or older; now the ratio is more than 23%, one of the highest in the world. As a consequence, Japanese citizens who 30 years ago were saving for their retirement are now dissaving, precisely as economic theory predicted. As the national saving rate has come down, so has the current-account surplus.

China faces a similar demographic trend, and also a push to unleash household consumption in order to sustain GDP growth. As in Japan, the downward trend in China’s saving rate will show up in its current account. The laws of international economics still apply.

  • Contact us to secure rights


  • Hide Comments Hide Comments Read Comments (4)

    Please login or register to post a comment

    1. Portrait of Jeffrey Frankel

      CommentedJeffrey Frankel

      Reply to Shriya Anand --
      Thanks for your comment/question. I think the major determinants of the US trade balance in general are US macro forces: growth rate, exchange rate, national saving, and national investment. The reason that the US current account has had a downward trend over the last half-century is that national saving has had a downward trend (though the deficit is currently much smaller than in 2007-08). Of course American politicians pay a lot of attention to the bilateral trade balance with China. But economists consider the bilateral balance to be of little significance, beyond the extent to which it reflects China's overall surplus and America's overall deficit.

    2. Portrait of Shriya Anand

      CommentedShriya Anand

      What are the implications of this for the US trade deficit? The US trade deficit is increasing, while China's trade surplus is falling (even if one disagrees with official Chinese data and is not convinced about the magnitude of the change, there is no doubt that there is a reduction in the surplus). Does that mean the composition of American trade is changing, and that the US - China trade relationship is becoming less sizable?

    3. Portrait of Gregor Schubert

      CommentedGregor Schubert

      The laws of international economics still apply indeed.

      This conclusion could have been take one step further to an observation that was only hinted at in this article: The laws of politics also still apply. That is, the political process will forever see exports as glorious, and imports as treason because the mercantilist zero-sum view form gold-standard time still captures the public imagination.

      Thus, accoridng to this politician view of the world, a Chinese current account surplus must be bad for other countries, whose trade deficits destroy jobs. Nevermind that the empirical evidence from the most recent decades always show rising trade deficits for booming economies (US up to 2007, Asian Tigers before 1998, Japan and Korea in the 60s and 70s) that often reverse into surpluses as domestic economies founder (the US trade deficit 2008-2009 - that must have been a great economic time then!).

      The elephant in the room here is domestic aggregate demand: since central banks control the demand within their currency area, the trade balance simply becomes a matter of balancing domestic opportunities of consumption and investment with international opportunities and allowing foreigners to do the same. As GDP is roughly determined by domestic supply and domestic demand management to ensure full employment, trade balances become irrelevant for GDP growth. But if politicians understood monetary policy...well let's just say that is a world we should hope for but not wait for.

    4. CommentedMilo Jones

      Some people called the slowdown of China a year ago. See: "Has China peaked? An exercise in forecasting using Neustadt and May’s History framework: at They key question to me seems to be whether they will be able to maintain political stability as the economy (and employment!) contract. And remember, Japan was a lot richer before its dramatic demographic decline began. Finally, most commentary dramatically overstates the ability of the CCP to "control" events (see"China’s Present, the World’s Future, and the Pretense of Knowledge" at