Three weeks ago the Wall Street Journal published my op-ed piece about concern that China may try to make the rebalancing process less painful by allowing the renminbi to depreciate. In the piece I argue that this isn’t as obvious as you might think.
From July 2005 to February this year the renminbi rose by just over 30 per cent in nominal US dollars. Although on a trade-weighted basis, adjusted for changes in relative productivity growth, the revaluation has been much less than 30 per cent, the increase in the value of the renminbi has nonetheless been seen, correctly, as a part of China’s rebalancing process.
But after rising for nearly seven years the renminbi has dropped 1 per cent against the dollar since February, setting off intense speculation about Beijing’s trade intentions. Not surprisingly, the threat of a weaker renminbi making Chinese exports more competitive abroad and foreign imports more expensive in China is raising worries in a world already struggling with weak demand growth.
But these worries may be unfounded. If China is serious about rebalancing its economy, devaluing the renminbi will not result in a net improvement in export competitiveness. China’s export competitiveness will deteriorate no matter what Beijing does to the currency.
...There is a lot more to Chinese competitiveness than the undervalued exchange rate. There are in fact three main mechanisms that explain the relatively low price of Chinese exports abroad, all of which transfer income from Chinese households to subsidise Chinese producers, albeit in very different ways.
The sources of China’s export competitiveness
The currency regime is certainly one of them, and the mechanism is fairly easy to understand. An undervalued currency spurs export competitiveness by subsidising the local cost component for manufacturers. These implicit subsidies are effectively paid for by Chinese households in the form of artificially high prices for imported goods. Since all households, except perhaps subsistence farmers, are effectively net importers, an undervalued currency is a kind of consumption tax that effectively reduces the real value of their income.
The second mechanism, the difference between wage and productivity growth, does the same thing, but with a different set of winners and losers. Chinese workers’ wages have grown more slowly than productivity for all but the last two years of the past three decades, which means that until two years ago workers have received a steadily declining share of what they produce. Manufacturers benefit from this process because their wage payments are effectively subsidised, and of course the more labour-intensive production is, the greater the subsidy they implicitly receive.
The third mechanism, the most important, is artificially low interest rates, which in China have been set extremely low. These reduce household income by reducing the return households receive on bank deposits, and in China, because of legal constraints on investment alternatives, the bulk of savings is in the form of bank deposits. Artificially lowered interest rates, however, increase manufacturing competitiveness by lowering the cost of capital. Of course the more capital-intensive a manufacturer is the more it benefits.
All these subsidies goose economic growth by subsidising producers, but they distribute the benefits in different ways. The greater the local production component, the higher the subsidy created by an undervalued currency. The more labour intensive the manufacturer, the greater the subsidy created by low wages. And finally the more capital intensive the producer, the more it benefits from artificially low interest rates.
The mechanisms also distribute the costs in different ways. An undervalued currency hurts households in proportion to the value of imports in their total consumption basket. Low wages hurt workers. Low interest rates hurt households in proportion to the amount of their savings as a share of income.
As China rebalances, by definition Chinese household income must rise as a share of total GDP. This is the important point that is often forgotten in the debate about Chinese competitiveness. In the aggregate, as China rebalances, the net impact of changes in all three mechanisms must result in reduced subsidies to Chinese manufacturers and so, at least initially, in reduced Chinese competitiveness abroad.
If Beijing wants to rebalance, and it decides anyway to devalue the renminbi, it just means that Beijing must raise wages or interest rates all the more in order to force a real increase in the growth rate of household income. Any improvement in Chinese export competitiveness achieved by devaluing the renminbi, in other words, will be fully made up for by a deterioration in Chinese export competitiveness caused by rising wages or rising interest rates.
This is ultimately what rebalancing means. One way or another as China rebalances it will lose competitiveness abroad because it must raise the cost of production in favour of household income. In exchange, however, China’s domestic market will become a bigger source of demand as Chinese households benefit from rebalancing. Over the long term Chinese growth will be much healthier and the risk of a Chinese debt crisis much reduced, but over the short term, unless there is an unlikely surge in global demand, China cannot both rebalance and improve its trade performance.
How China rebalances, then, will mainly reflect domestic priorities and political manoeuvring. If China revalues the currency, it will disproportionately help middle- and working-class urban households – for whom import costs tend to be important – and will disproportionately hurt manufacturers whose production costs are primarily local (e.g. most manufacturers who are not in the processing trade).
If China however chooses to raise wages, it will disproportionately help urban workers and farmers and will disproportionately hurt labour-intensive manufacturers, who tend mainly to be small and medium enterprises. And finally if China raises interest rates it will disproportionately help middle-class savers and disproportionately hurt large, capital-intensive manufacturers.
These three strategies, in other words, have broadly the same impact on trade competitiveness, although in each case the winners and losers within China will be different. This is why we should not be overly concerned with what happens just to the exchange value of renminbi. As long as China genuinely rebalances its economy, which will be a painful process no matter how Beijing chooses to manage it, Chinese export costs will rise and in the short term Chinese goods will be less competitive in the global markets (although as rising domestic costs force China to increase productivity and innovation, over the longer term they will actually boost Chinese competitiveness).
Which path China chooses to follow should be seen by the world primarily as something that affects the way the costs and benefits of rebalancing are distributed domestically. For the sake of more sustainable and equitable long-term growth, and in the interests of economic efficiency, it is almost certainly much better for China and the world if Beijing raises interest rates than if it revalues the renminbi, but since raising interest rates is likely to be opposed by the very powerful groups that benefit from excessively cheap capital, Beijing may instead put more focus on raising wages, which comes mainly at the detriment of economically efficient but politically weak small and medium enterprises and service industries.
Michael Pettis is a senior associate at the Carnegie Endowment for International Peace and a finance professor at Peking University’s Guanghua School of Management. He blogs at China Financial Markets.
China's exports retreat is inevitable
China needs to rebalance its economy. However it chooses to do this – and the value of the renminbi is but one available mechanism – its short-term export competitiveness will suffer.
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