Published 16 December 2006
US Federal Reserve chairman Ben Bernanke has told China it should free its currency from its $US link â€“ a constant call from many US sources for a couple of years as the US economy & currency have declined.
Secondly, Mr Bernanke said China should become a consumer society. Both policy shifts would help the US, now the world’s biggest debtor nation.
Mr Bernanke also suggested some more socialist policies for China, as they’re practised in the US â€“ health insurance, pension plans, more spending on education & social security.
The US’ chief banker made his recommendations in an address at the Chinese Academy of Social Sciences in Beijing, so it wasn’t as though he was lecturing uninvited from afar, but the speech makes interest reading in terms of global trade & currency policy. I’ve run 3 excerpts here â€“ the link to the full speech is at the foot of the page:
China’s economic growth owes much to the extraordinary share of GDP that is devoted to investment in new capital, such as factories, equipment & office buildings, which is partly financed by a very large amount of business saving. However, the rapid pace of investment growth raises concerns about whether new capital is being deployed in the most productive ways.
In particular, some analysts have questioned whether China is getting an adequate return on its investment. For example, from 1990-2001, fixed investment as a share of GDP in China averaged about 33% and the economy grew at an annual rate of 10%. Between 2001-05, fixed investment’s share of GDP rose to about 40%, but the economy’s average growth rate remained about the same, suggesting a lower return to the more recent investment. Comparisons can also be drawn to the rapid development phases of other Asian countries, such as South Korea & Japan. Average annual growth was between 9-10% in South Korea during the 1982-91 period and in Japan during the 1955-70 period; but for both countries during the relevant years investment’s share of GDP was about 30%, lower than it is in China todayâ€¦..
The effectiveness of monetary policy would also be enhanced by greater flexibility in the exchange rate. To maintain the current close link of the renminbi (RMB) to the dollar in the presence of capital inflows (arising from China’s trade surplus or from foreign purchases of RMB-denominated assets), the People’s Bank of China must intervene in the exchange market to buy dollars with RMB. Increases in the domestic money supply will result unless the central bank offsets the effects of these purchases on the money supply by selling bonds to investors, primarily commercial banks, in exchange for RMB – a procedure commonly referred to as “sterilisation.” If dollar purchases by the central bank were not routinely sterilised, the money supply might increase more than desired, possibly leading to an overheating of the economy and inflation.
To date the PBOC has been largely successful in its sterilisation operations, but if it continues to use this strategy it will eventually encounter problemsâ€¦..
Sorting global imbalances by becoming a consumer society
Together with the large trade & current account deficits of the US, the Chinese external surpluses are contributing to the current pattern of global imbalances, which many economists & policymakers have argued are unsustainable in the long run. The Chinese leadership has recognised the importance of encouraging imports and achieving greater balance in China’s international trade, having recently included these objectives in the 5-year plan for 2006-10. In my view, not only would China’s achieving smaller external balances contribute to global financial stability, it would also be in China’s economic interest.
Although China’s extensive participation in the global trading & financial systems has been invaluable for the country’s development, the ultimate purpose of economic growth is to improve living standards at home. Today, about half of China’s GDP is devoted to investment and to producing net exports for the rest of the world, and thus only the remaining half is available for consumption, including government consumption. In particular, household consumption in China last year was only 38% of GDP, down from 45% in 2001. In comparison, household consumption was about 60% of GDP in India in 2004, according to the most recent available data. China’s low share of consumption in GDP is, of course, the counterpart of its high national saving rate.
Policies aimed at increasing household consumption would clearly benefit the Chinese people, notably by improving standards of living and allowing the fruits of economic development to be shared more widely. Such policies, by reducing saving and increasing imports, would also serve to reduce China’s current account & trade surpluses. Putting greater reliance on domestic demand rather than net exports to drive growth would also decrease China’s vulnerability to fluctuations in global demand.
How can China direct a greater share of its output to domestic consumption? Again, increased flexibility in the exchange rate could help. As the Chinese trade surplus has continued to widen, many analysts have concluded that the RMB is undervalued. Indeed, the situation has likely worsened recently; because of the RMB’s link to the dollar, its trade-weighted effective real exchange rate has fallen about 10% over the past 5 years.
Allowing the RMB to strengthen would make imports of consumer goods (as well as capital goods) into China less expensive. Greater scope for market forces to determine the value of the RMB would also reduce an important distortion in the Chinese economy, namely, the effective subsidy that an undervalued currency provides for Chinese firms that focus on exporting rather than producing for the domestic market.
A decrease in this effective subsidy would induce more firms to gear production toward the home market, benefiting domestic consumers & firms. Reducing the implicit subsidy to exports could increase long-term financial stability as well: If China invests too heavily in export industries whose economic viability depends on undervaluation of the exchange rate, a future appreciation of the RMB could lead to excess capacity in those industries, resulting in low returns and an increase in nonperforming loans.
Although more flexibility in the exchange rate would be helpful, the most direct and probably the most effective way to reduce the external surpluses and increase the welfare of Chinese households is to take measures to reduce domestic saving relative to domestic investment.
Thin safety net
Why is domestic saving so high at present? The high saving rate of households, even very poor households, likely reflects the relatively thin “social safety net” in China. For example, only about 14% of the population is covered by health insurance, and pension plans (which, in any case, replace only about 20% of pre-retirement earnings) apply to only about 16% of the economically active population. Combined expenditures by the central government & local governments on education, health, pensions & relief and social security amount to only about 4% of GDP, lower than most other countries at similar income levels. In the absence of a stronger social safety net, Chinese households save at high rates to protect themselves against risks such as unexpected medical expenses and poverty in old age.
A sustained programme of expanding social services has the potential for reducing saving and raising living standards in China and, at the same time, moderating China’s external surpluses. In particular, increased Government spending on health, education & other types of social services would raise both household consumption & government consumption, and thus reduce national saving.
As one means of helping to fund the increase in social expenditures, state-owned enterprises could be required to pay larger dividends to the Government, a measure which I understand to be currently under consideration. Financial reforms that increase the access of households to mortgages, private insurance & other forms of consumer finance would also support higher rates of consumption.
As I have noted, the Chinese leadership has made reducing the trade & current account surpluses an important policy objective. Further, recognising that achieving these goals would be greatly facilitated by increases in consumption and in the social safety net, the Government has instituted or proposed various reductions in taxes and increases in social spending.
Attribution: Fed release, story written by Bob Dey for this website.