Posted by: Dirk | November 24, 2010

Competitive dragon, crouching (Celtic) tiger

I have recently written about Germany and commented on the question whether it was innovation or policy that is driving the competitiveness of German firms. In my opinion, policy plays a strong role in putting a lot of costs on German workers, who had to face declining real wages for many years. China’s mechanism to increase the competitiveness of domestic firms is a different one. (The following paragraphs build on a joint paper with Finn Körner.)

China manipulates it’s currency by fixing it against the US-dollar. Yes, fixing an exchange rate already is currency manipulation, since the motivation behind this is to control the external value of your currency (while the internal value of your currency might float and become a problem). The FT recently summed up nicely how it works:

Here’s how it works – Chinese companies receive dollars for goods, which they then exchange at the official People’s Bank of China (PBoC) renminbi rate.

To cover the surplus of dollars, though, the PBoC ends up printing fresh yuan that it can then exchange. To avoid any potential inflationary repercussions of this additional money supply, however, the PBoC also offers yuan-denominated bills back into the domestic economy, so as to mop up the extra cash.

The dollars it receives from its exchange operations, meanwhile, are promptly re-invested into dollar-yielding securities and accumulated — rather than spent. (Why? only the Chinese know that.)

For the whole relationship to balance the sterilisation process is hence absolutely essential.

There you have it. An artifically low yuan, the Chinese currency, is the reason behind the strong exports of China. Of course, one should net forget that China in many ways is an export platform for almost the whole of Asia, since many products are assembled in China and enter the trade statistics in the US as Chinese exports, although the Chinese share in value added might be quite low, as Linden et al (2007) have shown for the iPod.

The reason why China does it, I think, is that they need access to technology. The best way to get that is by foreign direct investment, which is attracted by low wages and a competitive exchange rate. I doubt that without those MNEs China could have sustained the growth of the last decade. China is now coming under inflationary pressure nevertheless. A rise in the price of raw materials has led to an outburst of inflation, as the NY Times reports:

China took steps Wednesday to control rising prices at the most basic consumer level. But Beijing faces a severe challenge in preventing higher global commodity prices from igniting broader inflation that could threaten China’s streak of powerful economic growth.

With prices rising this autumn for many commodities like sugar and cotton, the country’s cabinet announced on Wednesday evening that it would impose price controls on food, introduce subsidies for the needy and increase the availability of fuel supplies.

So far, the inflation in consumer goods in China has been largely confined to food and energy, and government policy makers want to keep it that way. But avoiding more general inflation could prove difficult.

The problem, of course, is that inflation has the tendency to spiral out of control as workers react by demanding higher wages, which increases costs for firms, which subsequently would then raise prices, only to find workers demand even higher wages and so on and so on.

The world economy is unbalanced, and the adjustment can take two routes. The first route offers three solutions, which can be combined. Number one, prices. Exchange rates are ‘wrong’ and must be reset in order to balance supply and demand. Demand can also be balanced by increasing (/decreasing) government spending, providing a way to translate the savings of the private sector into aggregate demand. Alternatively, number three, debts are adjusted to sustainable levels, which is more or less like a change in the exchange rate for those that hold foreign debt. This would trigger a huge financial crisis which would demand a solution before it happened.

The second route is via changes in quantities. Net debtors, in order to save, might not find any borrowers, so that the money saved is essentially money hoarded. It is taken out of circulation, which means that demand will fall. With flexible prices, this will lead to falling wages, less income and also less savings. With sticky prices, quantities will adjust which means output falls, unemployment rises, therefore incomes fall and with that, savings. In both scenarios, the act of saving by the private sector will be self-defeating – we have arrived at the paradox of thrift, were an act of saving is an act of pushing the economy slowly downwards.

Facing these two roads, the former looks better than the former. From 1929-33, the road of quantity adjustment was chosen. We are on our way to repeat that mistake. If Ireland’s private sector is saving, then where does that money go? If nobody is jumping in to borrow, then the money is effectively retired – consumption will fall and a deflationary spiral is set in motion, reducing output and employment in Ireland. The prospects of ever repaying the debt owed to the rest of the world will take a dive, and even the German export machine will start to stutter and sputter as demand from the euro zone neighbors will decline.

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