Posted by: Dirk | January 17, 2011

China in 2011: Inflation vs competitiveness

Two months ago, I looked at the competitiveness of German firms and promised to write something about China as well. The topic is not a day-to-day issue but rather a medium-term issue. What I want to answer is whether the world’s two top exporters, Germany and China, are in their respective position because of free markets left to work or whether the background is one of deliberate economic policy.

While Germany has been relying on a combination of direct and indirect wage cuts  (Lohnnebenkosten; non-wage labor costs) relative to its euro zone neighbors and the rest of the world (the exception proves the rule) to increase the competitiveness of German firms, China went down a different road. It has fixed its currency to the US-$. This had profound implications for both parties involved.

Let me show you the money – and follow the monetary trail of a toy exported from China to the US. The exporter pays inputs, including labor, with yuan, which he either got via the financial system or from retained earnings from the last period. He then ships that good to the US, where he sells it to Wal-Mart. Wal-Mart pays US-$ into a bank account in the US. Since Chinese firms – at least those in the real economy – are not allowed to hold US-$, they transfer them to the People’s Bank of China (PBoC), which is the Chinese central bank.

The exporter gets yuan, which means he is happy and can start produce more. The PBoC now has to find a yuan source to pay the exporter off. If it doesn’t it can print money, but given something close to full employment that will lead to inflation, especially as the more products are exported the more yuan will float the economy. Cutting goods supply and increasing money supply at the same time will very, very likely lead to inflation.

So, the PBoC solves the problem by borrowing from its banks. They just make the banks buy sterilization bonds of the PBoC, which pay quite a low interest rate. The banks then need to offload those bonds, which is not too difficult in a market where consumers are not allowed to invest abroad. Consumers buy the sterilization bonds for an even lower interest rate so everything is fine, except that US-$ are piling up at the PBoC. They bear no interest, so the PBoC invests them into t-bonds, which at least carry a low nominal interest rate.

A big currency mismatch is building up at the PBoC, but at least until today nobody doubted that this would not become a problem. If the value of US-$ denominated assets were to decline, the PBoC would have problems repaying their sterilization bonds. Raising taxes might not work so well in China, since the tax base is small and political considerations might stand in the way of higher taxes (some things are the same everywhere).

While the system of pegging the yuan to the US-$ at a value that is quite low has worked wonders for exporting firms, the disadvantages of the system have become visible in the last years. The interest rates on savings in the banking system are low, and adjusted for inflation even negative. Therefore, people started investing elsewhere, mainly in the stock market and in real estate. Here is the Shanghai Composite Index:

source: Bloomberg

There is no index of house prices in China that I am aware of, but speculation in real estate has been noted more than once in the press (here, here and even here). The recent rise of inflation has been a concern of policy makers in Beijing, as AP reports:

China’s central bank says fighting inflation will receive higher priority this year, raising the possibility of more rate hikes at a time when other major economies are trying to boost growth.

The announcement late Thursday follows repeated pledges by Beijing to cool inflation that jumped to a 28-month high of 5.1 percent in November. Communist leaders worry that sharp rises in living costs might trigger unrest.

A very easy way to fight inflation is to revaluate the yuan vis-a-vis the dollar, in other words, to make the Chinese currency more expensive so that imports get cheaper measured in yuan. This is an old debate, and the NY Times has recently written:

The debate over revaluing the renminbi, a constant thorn in the relationship with the United States, has not advanced much partly because of a fight between central bankers who want the currency to rise and ministers and party bosses who want to protect the vast industrial machine that depends on cheap exports for survival. So far, the battle has made it impossible for China to act decisively — and it is struggling with inflation as a result.

This is political economy at work. Follow business leaders and keep the yuan weak, or follow households and fight inflation while providing a vehicle to transfer present savings into future income streams. You cannot have both. Hu Jintao has recently been submitted to a Q&A by the Wall Street Journal, among others. Here is an extract:

4. [..] Some think that RMB appreciation may curb China’s inflation, what’s your view on that?

China has adopted a package plan to curb inflation, including interest rate adjustment. We have adopted a managed floating exchange rate regime based on market supply and demand with reference to a basket of currencies. Changes in exchange rate are a result of multiple factors, including the balance of international payment and market supply and demand. In this sense, inflation can hardly be the main factor in determining the exchange rate policy.

So, this is the view of Chinese economic policy as it stands. Given the opacity of the political system, it will be hard to second-guess the intentions of policy makers as they put some problems on hold while tackling others… but, is it really easier elsewhere on this planet?


  1. […] the next days, I’ll look at the way China is increasing competitiveness of its exporting […]

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