Inflation is taking its toll and the Chinese are facing the same adjustments Japan faced, writes Jeffrey Frankel.
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 neighbourhood have before it.
But some, particularly American politicians in this election year, focus on only one thing: China's trade balance.
Not long ago the yuan was substantially undervalued, and China's trade surpluses were very large. That situation is changing. Forces of adjustment are at work in the economy, so foreign perceptions need to adjust as well. China's trade surplus peaked at $US300 billion in 2008, and has been declining ever since. February data showed a $US31 billion deficit, 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 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 yuan appreciation against the dollar, and partly in Chinese inflation. Beijing should have let more of the real appreciation take the form of nominal appreciation (dollars per yuan). 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 2008-10, to keep the dollar exchange rate virtually fixed. Second, workers in China's increasingly productive coastal factories were not paid their full value, as the economy has not completed its transition from Mao to market.
China continued to undersell the world. But then the yuan was finally allowed to appreciate against the dollar by about 25 per cent cumulatively during 2005-08 and 2010-11. Moreover, labor shortages began to appear, and workers began to win rapid wage increases. Beijing, Shenzhen, and Shanghai raised their minimum wages sharply in the past three years by 22 per cent on average in 2010 and 2011. Land prices rose even more rapidly.
As costs rise in coastal provinces, several adjustments 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 such as Vietnam. Companies are also beginning to automate, substituting capital for labor to produce more sophisticated goods, following the path blazed by Japan, Korea and other Asian countries.
Finally, multinational companies that had moved some operations to China from the US or other high-wage countries are now moving back. Productivity is still higher in the US, after all.
But many Western politicians 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 50? an hour (3) there are a billion of them and (4) 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.
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 March 2011 tsunami. But the downward trend in the trade balance is clear. Even the current account showed a deficit in January.
Two decades ago, Japan's big trade surplus was the subject of worry just as China's is now. At the time, some commentators warned that the Japanese had discovered a superior economic model, with strategic trade policy, and the rest of us had better emulate them.
Most economists rejected these "revisionist" views, and argued that Japan's current-account surplus was large because its national saving rate was high, reflecting demographics, not cultural differences or policies. The Japanese were relatively young, compared with other advanced economies, but were rapidly ageing, owing to a declining birth rate since the 1940s and rising longevity.
That view has been vindicated. In 1980, 9 per cent of Japan's population was 65 or older now it is more than 23 per cent, one of the highest in the world. As a consequence, Japanese 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 a push to unleash household consumption to sustain GDP growth. The downward trend in China's saving rate will show up in its current account. The laws of international economics still apply.
Jeffrey Frankel is professor of capital formation and growth at Harvard University.