Until the global financial crisis hit, China had achieved export-led high economic growth by keeping its currency at an undervalued level. It is now abundantly clear that the growth model is not sustainable. The People’s Bank of China reinstated the “managed floating exchange rate regime with reference to a basket of currencies” that it had started in 2005 and suspended in 2008, explaining that “a floating exchange rate draws economic resources to sectors driven by domestic demand.” China needs to move to a growth model in which external and domestic demands will be better balanced. The basket of currencies is a device to let the yuan move with the currencies of China’s major trading partners, not with the dollar.
Can China achieve more balanced economic growth? Let us have a look at Japanese experiences to see the perils China may face.
Japan achieved an export-led high economic growth by keeping the yen at an undervalued level, which resulted in an economic structure of excessive production capacity and insufficient domestic demand. Its trade surplus exceeded a level the international community would tolerate. The yen then excessively appreciated, which drove Japan into an unintended restructuring with two major consequences.
First, Japan’s competitiveness as an industrial location deteriorated. As a result, so much production and employment had to move abroad that Japan has lost much of its economic vitality.
Second, because a very expansionary monetary policy failed to stimulate domestic demand, Japan has had to make use of fiscal expenditures year after year for so long that it is now no longer able to achieve even modest economic growth without government expenditures. Public investment in infrastructures contributed to enhancing productivity of the Japanese economy until such investment opportunities were exhausted. Then Japan built airports and ports that see little use. Now the outstanding government debt exceeds 170 percent of GDP.
What is disturbing about China is that People’s Bank of China seems determined not to let the yuan significantly appreciate. It declared that “the basis for large-scale appreciation of the yuan exchange rate does not exist” and has been cautiously managing the yuan exchange rate. If the People’s Bank of China manages the yuan too cautiously in order to secure immediate economic growth, the yuan exchange rate will not be flexible enough to play its expected role in transforming China’s growth model. In that event, China could face three negative consequences.
First, neither the gap between production capacity and domestic demand nor the Sino-American trade imbalance would be sufficiently narrowed. The United States would not cease demanding further yuan appreciation until a concrete result was realized. China could not dispense with the control of capital account transactions and market intervention by the People’s Bank of China to keep the yuan stable.
Second, as a result China would not dare to liberalize capital account transactions; namely, China could not internationalize the yuan. As is well known, an internationalized currency is a convertible currency under free capital movements. A world where the currency of the second largest economy remains inconvertible will be entirely different from the world we now know.
Third, excessive dependence on fiscal expenditure could be perpetuated. The Chinese government has succeeded in fighting the impacts of the global financial crisis with massive fiscal measures. China has both financial resources and investment opportunities in infrastructure, such as building a transport network, that will enhance its economic productivity. However, it should not be overlooked that consumption accounts for less than 40 percent of GDP. It is imperative to realize an economic structure with balanced external and domestic demands. Otherwise, China might end up with an economic structure that will require government expenditures to maintain sufficient economic growth, as has been the case with Japan.
China can avoid these perils by making its economy depend less on external demand and more on domestic demand. It is natural for China to make use of other policy alternatives such as ending tax incentives for certain export items or increasing consumption by raising wages, so as to mitigate pressure on the exchange rate. However, the exchange rate remains the central means to transform the economic structure, which it gave rise to in the first place. As a prominent Chinese economist put it, “adjustment of economic growth model is inevitable, and exchange-rate adjustment is the first step.”
As moving economic resources (labor force, in particular) from one sector to another will cause much pain to the firms and individuals concerned, the Chinese government is expected to quickly expand domestic demand-related sectors. Fortunately, China has the financial resources to speed up this process and to cope with the frictional unemployment the process will inevitably cause.
Japan’s predicament can be traced ultimately to the fact that yen has been a floating currency since the early 1970s. The yen underwent repeatedly sharp ups and downs, appreciating from ¥360 to the dollar in 1971 to ¥79.75 in 1995, forcing Japan to accept unintended structural change.
China has the advantage of a managed floating regime. If the People’s Bank of China manages to keep the yuan basically stable but still flexible enough, as it did for two years since July 2005, China could implement the required restructuring of its economy at its own initiative. If, however, it manages the yuan too cautiously, China will face the above-mentioned perils. Whatever choice China would make, the world would have to live with the consequences.
Mamoru Ishida is an adviser to Itochu Corporation. This article is based on his article “Structural Adjustment: A Japanese Lesson,” written as a message to China and published in The Oriental Morning Post on Aug. 3.