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Cause of the imbalance Yu Yongding, a renowned economist and academician of the Chinese Academy of Social Sciences
The Chinese economy is facing a striking imbalance from“twin surpluses,” namely current account and capital account surpluses. The country has taken steps to redress the imbalance, but progress has been painfully slow, and the economy is sinking into a “dollar trap.” China has accumulated $3.1 trillion of foreign exchange reserves, mostly parked in U.S. Treasury securities with low returns. Worse still, the value of those assets is shrinking due to the devaluation of the U.S. dollar.
The reasons for the twin surpluses are complicated. The government promoted exports due to a shortage of forex reserves in the 1980s. Favorable treatment to export companies and heavy tax rebates, as well as undervaluation of the yuan encouraged exports and led to a current account surplus.
Meanwhile, the capital account surplus ballooned due to torrential inflows of foreign direct investment (FDI). Owing to the underdevelopment of the financial markets, it was difficult for many Chinese enterprises to raise funds, so they tried to attract FDI. Foreign investors also favored China thanks to its generous policy incentives, cheap labor and land, as well as lax environmental regulation.
In addition, China allowed foreign investors to acquire equities of Chinese firms and encouraged introduction of foreign strategic investors when it restructured big commercial banks a few years ago. Consequently, foreign capital poured in and added to the country’s forex reserves.
In recent years, the Chinese Government has spared no effort to correct the imbalances by stimulating domestic consumption, encouraging outbound investments and internationalizing the renminbi. But maybe it is time for China to consider allowing the yuan to float freely, while reserving the right to intervene with cross-border capital flows in case of emergencies.
Slick prospect
Louis Kuijs, chief economist, Asia, MF Global
Despite external headwinds, China’s macroeconomic outlook remains relatively favorable. Economic growth is moderating because of the global slowdown and domestic monetary tightening. But growth drivers remain intact, including urbanization, investment and a surge in productivity.
Meanwhile, inflation is likely to have peaked. With food price shocks fading out and softer industrial raw material prices, headline inflation should come down gradually in the coming six months. Policymakers may ease their monetary stance, but less dramatically than in late 2008.
Continued European sovereign debt woes and a lack of medium-term fiscal credibility in the United States and Japan impact the Chinese economy mainly via weakened exports—less so via financial channels.
The Chinese Government intends to put a lot of attention on addressing macroeconomic problems. But in my view, the country’s real policy challenges are the structural ones. They will not be resolved without a substantial policy.
Rebalancing the growth pattern toward more services and consumption requires an array of policies. Some argue that the tightening of the labor market and the ensuing wage increases will largely take care of the rebalancing. However, that is not enough. A set of policies is needed to undo the factors that have amplified China’s investmentdriven growth model.
One set comprises reforms to channel more resources into areas that support sustainable growth, such as improving access to finance for the private sector and service-oriented and smaller firms. The country also should press ahead with scaling up of the state-owned enterprise (SOE) dividend policy to improve the allocation of capital. Efforts are also required to remove restrictions on service sector development and open up more service industries to private investors.
Another important step is to promote reforms to boost urbanization, including further liberalization of the household registration system and land reform.
Financial reforms should include liberalizing the renminbi exchange rate, opening up the capital account and introducing more market-based monetary policies. However,
the key is to proceed in the right sequence in order to avoid financial turmoil.
Sustainable growth drivers Song Ligang, a senior researcher of Crawford School of Economics and Government, Australian National University
Thirty years of torrid growth has resulted in environment degradation and resource constraints in China. More disturbing though is domestic imbalance characterized by a current account surplus, income inequality, over-dependence on investments and exports, overcapacity in certain industrial sectors, as well as a shortage of service providers.
Now a key task for China is to alter the growth mode to rely more on productivity, instead of inputs. In a longer term, the goal is to transform the manufacturing and industrial powerhouse into a knowledge-based economy.
Enhancing productivity is a crucial component in shifting toward a low-carbon economy. Technological progress and innovation hold the key. There is huge potential for China to change the relationship between economic output and carbon emissions through the absorption, mass production and improvement of green technologies. The government can play a crucial role in ensuring that China reaches this potential, most importantly by facilitating the dynamic private sector’s active engagement in this endeavor. A concerted effort to generate and commercialize green technologies would also enable China to quicken the pace of industrial upgrade.
Boosting domestic consumption will take time, but there are some clear reform options. For example, an effective way is to urbanize migrant workers by granting them urban residency, which would change their consumption behavior. Consumption can also be stimulated by deepening institutional reforms affecting labor mobility and the social security system.
Despite the current economic slowdown, the country has several long-term sources of growth, such as human capital and innovation and ideas.
Human capital is the asset that ultimately determines the wealth of China. As the Chinese people invest more in education and enterprises foster the creativeness of employees, the increased human capital will add to industrial productivity and economic vitality.
In the next decade, China will be of greater importance for the world economy. The reason is not that the country can contribute faster growth, but it can generate more ideas and innovations.
Insights from Japan
Ichiro Muto, director of the macromodeling group, research and statistics department, Bank of Japan
China’s growth has been heavily driven by investment, and excessive investments have side effects, which eventually may grow too large to control if the country fails to rebalance its growth pattern.
China is now roughly at the same stage of economic development as Japan during or prior to the early 1970s.
In the early 1970s, Japan transformed its growth mode from an investmentdependent one to one driven in a more balanced manner by investment, consumption and exports. The speed of capital accumulation decelerated while consumption continued increasing rapidly as a result of a steady rise in workers’ wages. This shift laid the foundation for Japan to maintain a steady growth after the high-growth era in the 1960s.
Japan accomplished the rebalancing because its firms had less incentives to maintain high investment as returns on capital declined. There are a number of reasons for the decline, including a slowdown in technology advancement and the urbanization process. Moreover, the cost of capital increased as Japan raised interest rates in the 1970s, prompting companies to curtail investments.
In China, wage growth is accelerating
due to reduction of surplus labor and a new labor law promulgated in 2008. But interest rates have been regulated far below the return on capital. If China fails to narrow the gap between the cost and return of capital, economic rebalancing will become even more difficult.
China also needs to address some unique problems hindering consumption. It must heighten welfare benefits and reform the household registration system to spur household consumption.
Japan’s rebalancing was easier because its dependence on investments was much more modest. But China is more able to rebalance its economy while maintaining high growth. This will help China prevent many side effects such as a sluggish job market.
Reward and risks Liu Ligang, Director of China Economic Research, ANZ Bank
As the U.S. dollar reels from increasing volatility, worries abounded about the safety of China’s dollar assets, prompting the country to push forward internationalization of the yuan. To achieve that, China needs to open its capital accounts and strengthen convertibility of the yuan.
Opening capital accounts means removing restrictions on capital account-related transactions including FDI, portfolio equity investments, government and corporate bonds and financial derivatives.
Before China opens the capital accounts, it must first undertake domestic financial liberalization. Risks would emerge otherwise.
Domestic financial liberalization involves efforts to liberalize interest rates and reduce entry barriers into financial sectors.
Two possible risks may loom over the Chinese economy:
First, as China allows offshore renminbi deposits in Hong Kong to return to the mainland, the massive capital flows have the potential to complicate China’s efforts to combat inflation.
Second, market-based interest rates in Hong Kong and state-controlled interest rates on China’s mainland have provided arbitrage opportunities for speculators. This poses a daunting threat to the country’s financial stability.
Controls on interest rates also have negative impacts on the growth momentum because households are not appropriately compensated for their savings. Moreover, banks become less motivated to improve their intermediary services and management efficiency. Moreover, marketdetermined interest rates could be an effective barometer of macroeconomic and liquidity conditions.
The Chinese economy is facing a striking imbalance from“twin surpluses,” namely current account and capital account surpluses. The country has taken steps to redress the imbalance, but progress has been painfully slow, and the economy is sinking into a “dollar trap.” China has accumulated $3.1 trillion of foreign exchange reserves, mostly parked in U.S. Treasury securities with low returns. Worse still, the value of those assets is shrinking due to the devaluation of the U.S. dollar.
The reasons for the twin surpluses are complicated. The government promoted exports due to a shortage of forex reserves in the 1980s. Favorable treatment to export companies and heavy tax rebates, as well as undervaluation of the yuan encouraged exports and led to a current account surplus.
Meanwhile, the capital account surplus ballooned due to torrential inflows of foreign direct investment (FDI). Owing to the underdevelopment of the financial markets, it was difficult for many Chinese enterprises to raise funds, so they tried to attract FDI. Foreign investors also favored China thanks to its generous policy incentives, cheap labor and land, as well as lax environmental regulation.
In addition, China allowed foreign investors to acquire equities of Chinese firms and encouraged introduction of foreign strategic investors when it restructured big commercial banks a few years ago. Consequently, foreign capital poured in and added to the country’s forex reserves.
In recent years, the Chinese Government has spared no effort to correct the imbalances by stimulating domestic consumption, encouraging outbound investments and internationalizing the renminbi. But maybe it is time for China to consider allowing the yuan to float freely, while reserving the right to intervene with cross-border capital flows in case of emergencies.
Slick prospect
Louis Kuijs, chief economist, Asia, MF Global
Despite external headwinds, China’s macroeconomic outlook remains relatively favorable. Economic growth is moderating because of the global slowdown and domestic monetary tightening. But growth drivers remain intact, including urbanization, investment and a surge in productivity.
Meanwhile, inflation is likely to have peaked. With food price shocks fading out and softer industrial raw material prices, headline inflation should come down gradually in the coming six months. Policymakers may ease their monetary stance, but less dramatically than in late 2008.
Continued European sovereign debt woes and a lack of medium-term fiscal credibility in the United States and Japan impact the Chinese economy mainly via weakened exports—less so via financial channels.
The Chinese Government intends to put a lot of attention on addressing macroeconomic problems. But in my view, the country’s real policy challenges are the structural ones. They will not be resolved without a substantial policy.
Rebalancing the growth pattern toward more services and consumption requires an array of policies. Some argue that the tightening of the labor market and the ensuing wage increases will largely take care of the rebalancing. However, that is not enough. A set of policies is needed to undo the factors that have amplified China’s investmentdriven growth model.
One set comprises reforms to channel more resources into areas that support sustainable growth, such as improving access to finance for the private sector and service-oriented and smaller firms. The country also should press ahead with scaling up of the state-owned enterprise (SOE) dividend policy to improve the allocation of capital. Efforts are also required to remove restrictions on service sector development and open up more service industries to private investors.
Another important step is to promote reforms to boost urbanization, including further liberalization of the household registration system and land reform.
Financial reforms should include liberalizing the renminbi exchange rate, opening up the capital account and introducing more market-based monetary policies. However,
the key is to proceed in the right sequence in order to avoid financial turmoil.
Sustainable growth drivers Song Ligang, a senior researcher of Crawford School of Economics and Government, Australian National University
Thirty years of torrid growth has resulted in environment degradation and resource constraints in China. More disturbing though is domestic imbalance characterized by a current account surplus, income inequality, over-dependence on investments and exports, overcapacity in certain industrial sectors, as well as a shortage of service providers.
Now a key task for China is to alter the growth mode to rely more on productivity, instead of inputs. In a longer term, the goal is to transform the manufacturing and industrial powerhouse into a knowledge-based economy.
Enhancing productivity is a crucial component in shifting toward a low-carbon economy. Technological progress and innovation hold the key. There is huge potential for China to change the relationship between economic output and carbon emissions through the absorption, mass production and improvement of green technologies. The government can play a crucial role in ensuring that China reaches this potential, most importantly by facilitating the dynamic private sector’s active engagement in this endeavor. A concerted effort to generate and commercialize green technologies would also enable China to quicken the pace of industrial upgrade.
Boosting domestic consumption will take time, but there are some clear reform options. For example, an effective way is to urbanize migrant workers by granting them urban residency, which would change their consumption behavior. Consumption can also be stimulated by deepening institutional reforms affecting labor mobility and the social security system.
Despite the current economic slowdown, the country has several long-term sources of growth, such as human capital and innovation and ideas.
Human capital is the asset that ultimately determines the wealth of China. As the Chinese people invest more in education and enterprises foster the creativeness of employees, the increased human capital will add to industrial productivity and economic vitality.
In the next decade, China will be of greater importance for the world economy. The reason is not that the country can contribute faster growth, but it can generate more ideas and innovations.
Insights from Japan
Ichiro Muto, director of the macromodeling group, research and statistics department, Bank of Japan
China’s growth has been heavily driven by investment, and excessive investments have side effects, which eventually may grow too large to control if the country fails to rebalance its growth pattern.
China is now roughly at the same stage of economic development as Japan during or prior to the early 1970s.
In the early 1970s, Japan transformed its growth mode from an investmentdependent one to one driven in a more balanced manner by investment, consumption and exports. The speed of capital accumulation decelerated while consumption continued increasing rapidly as a result of a steady rise in workers’ wages. This shift laid the foundation for Japan to maintain a steady growth after the high-growth era in the 1960s.
Japan accomplished the rebalancing because its firms had less incentives to maintain high investment as returns on capital declined. There are a number of reasons for the decline, including a slowdown in technology advancement and the urbanization process. Moreover, the cost of capital increased as Japan raised interest rates in the 1970s, prompting companies to curtail investments.
In China, wage growth is accelerating
due to reduction of surplus labor and a new labor law promulgated in 2008. But interest rates have been regulated far below the return on capital. If China fails to narrow the gap between the cost and return of capital, economic rebalancing will become even more difficult.
China also needs to address some unique problems hindering consumption. It must heighten welfare benefits and reform the household registration system to spur household consumption.
Japan’s rebalancing was easier because its dependence on investments was much more modest. But China is more able to rebalance its economy while maintaining high growth. This will help China prevent many side effects such as a sluggish job market.
Reward and risks Liu Ligang, Director of China Economic Research, ANZ Bank
As the U.S. dollar reels from increasing volatility, worries abounded about the safety of China’s dollar assets, prompting the country to push forward internationalization of the yuan. To achieve that, China needs to open its capital accounts and strengthen convertibility of the yuan.
Opening capital accounts means removing restrictions on capital account-related transactions including FDI, portfolio equity investments, government and corporate bonds and financial derivatives.
Before China opens the capital accounts, it must first undertake domestic financial liberalization. Risks would emerge otherwise.
Domestic financial liberalization involves efforts to liberalize interest rates and reduce entry barriers into financial sectors.
Two possible risks may loom over the Chinese economy:
First, as China allows offshore renminbi deposits in Hong Kong to return to the mainland, the massive capital flows have the potential to complicate China’s efforts to combat inflation.
Second, market-based interest rates in Hong Kong and state-controlled interest rates on China’s mainland have provided arbitrage opportunities for speculators. This poses a daunting threat to the country’s financial stability.
Controls on interest rates also have negative impacts on the growth momentum because households are not appropriately compensated for their savings. Moreover, banks become less motivated to improve their intermediary services and management efficiency. Moreover, marketdetermined interest rates could be an effective barometer of macroeconomic and liquidity conditions.