China’s short term domestic economic policy in the last period has in large part been directed at dealing with the overheated situation of house prices. The key issue in China's international economic policy continues to be the trade surplus – highlighted by the announcement of a $29.7 billion positive trade balance in July. The aim of this article is to look at some underlying interrelations between these two key issues. As will be seen they are not separate but interconnected.
The real situation in China’s trade
The last two years in China’s international trade, including the July 2010 data, have provided a clear factual test between two theories regarding China’s trade surplus.
- The first, strongly promoted by US 'neo-con' circles, argues that the key factor in China’s trade balance is the RMB’s exchange rate. Therefore, it states, the decisive step to keep down China’s trade surplus is to revalue the RMB. The factual evidence clearly contradicts this view, as will be shown.
- The second theory, argued by this blog and others, is that the key factor in China’s trade balance is China’s relative rate of GDP growth compared to other economies. Therefore, on this analysis, what is required to keep down China’s trade surplus is that China’s economy should grow rapidly.
As most analysts would evidently agree that both exchange rates and relative growth rates affect trade balances, the key question is which of the two is most quantitatively important. It is this that the trade data clearly answers. The decisive factor has been shown to be the relative growth rate of growth of China’s economy not the exchange rate.
July’s trade surplus, as well the dramatic shrinkage of China’s surplus during 2009 and the first quarter of 2010, did not follow changes in the RMB’s exchange rate but did follow extremely closely the acceleration and deceleration of China’s economy.
These trends are examined in more detail below. An analysis is given of the angle of approach to dealing with China’s trade surplus and dealing with inflationary pressures in the real estate sector.
Test of the two analyses
The present author has repeatedly pointed out the errors in economic theory and fact of those who have argued that revaluation of the RMB is the key to reducing China’s trade surplus so it is not required to list these again - a couple of responses to the new July trade data can be noted below.
For a detailed examination of trade trends prior to the 2008 financial crisis, which are consistent with those analysed here, readers are referred to an earlier article on this blog and Figure 3 below. The crucial factual point shown in these is that as the RMB's exchange rate rose, between 2005 and 2008, China's trade surplus did not fall - as would be predicted by the analysis that RMB revaluation would lead to a shrinking trade surplus. On the contrary, a rise in the RMB's exchange rate was accompanied by an increase in China's trade surplus.The reasons for this were dealt with previously.
Turning to July's trade figures, Sophie Leung and Li Yanping note on Bloomberg: ‘China’s trade surplus reached an 18-month high as exports rose to a record and import gains slowed, adding pressure on officials to allow faster appreciation of the yuan.’
Geoff Dyer in the Financial Times wrote: ‘The pace of increase in exports actually fell last month to 38.1 per cent year-on-year, down from 43.9 per cent in June. However, import growth slowed even more, moving up 22.7 per cent against 34.1 per cent in June. The rising trade surplus will increase the political pressure on Beijing to appreciate its currency more rapidly.’
These authors therefore consider the key issue to mention in relation to trade is the RMB’s exchange rate. They do not draw equal attention to the quantitatively dominant trends shown below.
China’s trade pattern
In the last three months China’s trade surplus has begun to expand significantly – see Figure 1 below, which shows the monthly trade balance, and Figure 2 which shows the monthly balance calculated as a three monthly moving average.
Taking the three monthly moving average, to eliminate the effects of purely short term fluctuations, China’s trade surplus fell steadily from a peak of $39bn in January 2009 to a low of $1bn in April 2010. Since then it has expanded again to $23bn in July 2010.
None of these shifts, however, can be explained by changes in the RMB’s exchange rate as throughout this period, until 18 June 2010, the RMB’s exchange rate against the dollar was entirely stable. After this the RMB's exchange rate moved up marginally, by less than one percent – although this change is too recent to have significantly affected the figures. In short, China’s trade surplus fell, practically to the point of disappearance, and then rose again despite a stable exchange rate.
While China’s trade surplus did not track changes in China’s exchange rate at all, it did track extremely closely the acceleration and deceleration of China’s economy. During the whole of 2009, and right up to the first quarter of 2010, China’s economy was accelerating strongly. The year on year GDP growth rate speeded up progressively from 6.1% in the 1st quarter of 2009, to 7.9% in the 2nd, to 8.9% in the 3rd, to 10.7% in the 4th and finally to 11.9% in the 1st quarter of 2010. Throughout this period China’s trade surplus fell.
In the 2nd quarter of 2010 China’s GDP growth slowed to 10.3%, while China’s trade surplus began to rise.
In short, while China’s trade surplus did not follow its exchange rate it did follow closely the GDP growth rate. China’s growth, not its exchange rate,therefore controlled China’s trade balance.
This analysis that currently China’s trade surplus was controlled by the economy’s rate of growth and not the exchange rate was set out in detail in an article that appeared on this blog in March commenting on a Ministry of Commerce press conference. It noted: ‘the only way to continue reducing China's surplus, as [Ministry of Commerce spokesperson] Yao Jian says, is to take "measures to stimulate imports." This however requires rapid economic growth. China's imports rose faster than exports in 2009 because its economy grew more rapidly than others. While other markets stagnated or declined, China grew at 8.7 percent, and sucked in imports. The most effective way to maintain the import surge is rapid growth.’
The slowing of China’s economy in the second quarter of 2010 shows the same driving force from the opposite perspective – the economy slowed, imports fell, and therefore the trade surplus increased. But the same mechanism, whereby it is China’s growth rate and not the exchange rate that is controlling the trade surplus, continues to operate.
The answer to how to keep down China’s trade surplus is therefore equally evident. It requires rapid economic growth. That in turn, evidently raises the issue of why it was necessary for the Chinese authorities to start slowing the economy from the 1st quarter onwards?
What will happen?
The reason for the recent steps to cool China’s economy are are well known – inflationary risks and pressures. However China did not face generalised inflationary pressure, indicating an overall and fundamental disequilibrium between demand and supply, but a concentrated inflationary pressure in two areas – food and housing.
The 3.3% increase in China’s consumer price index in July was primarily driven by food prices which rose by 6.8%. Non-food inflation remained subdued at 1.6%. The key factor in asset price inflation is housing - the share market in contrast remains lower than its level a year ago. The annual rate of increase of housing prices in July 2010 fell to 10.3% year from June’s 11.4% but this was still too high - hence economic policy makers determined action to cool the housing market.
Therefore the direction of causation is clear. The situation in the housing market is the key factor in inflation. Inflation is the reason China had to slow its economy - and therefore its trade surplus began to rise. A key to controlling China’s trade surplus, therefore, lies in China’s housing market. The chief domestic issue facing China's economy, and the chief international one, are not separate but interconnected.
This is a far from unique situation - both the UK and the US have frequently seen situations in which severe fluctuations in housing prices were correlated with shifts in the balance of payments.
In such situations macroeconomic fundamentals and the immediate economic situation coincide. A balance of payments surplus, of which the trade surplus is the dominant part, is by accounting identity equal to the deficit of China’s domestic investment compared to its domestic savings. To narrow the trade surplus therefore requires either reducing saving - or raising consumption which is the same thing, or increasing investment. Under conditions of inflationary pressure simply raising consumption demand, without an increase in supply, is not called for – adding to demand and not supply will increase inflationary pressure. The macro-economic way to deal with this situation, under conditions of threatening inflation, must therefore be to raise investment.
The situation in the housing market shows both where supply is lacking compared to demand and the target for such investment. Overall China has experienced a major rise in the percentage of fixed investment in GDP since 2008. A further general rise therefore does not appear called for. But overheating in the housing market is sufficiently severe that it clearly needs to be addressed not only by dampening demand, which the Chinese authorities have been attempting since early in the year, but also by increasing supply – that is by a large house building programme. Such a policy has been embarked on, but only recently.
Housing and the trade surplus
The above data therefore shows the angle of approach for a key policy by which China’s trade surplus needs to be tackled. To permit resumption of more rapid growth inflation must be contained. A decisive key to containing inflation is the situation in the housing market. An increase in investment in the housing market will help contain inflationary pressures, thereby putting downward pressure on the trade surplus via more rapid growth, and by increasing investment it will act directly to reduce the trade surplus by shifting the balance between investment and saving.
One of the most important ways for China to tackle its trade surplus is to therefore house building. As large scale housing programmes involves financial risk, experience in other countries is that state action is required to underpin very large scale housing construction. Such a housing programme must therefore be underpinned by the state.
Conclusion
To summarise, the facts show the RMB's exchange rate does not control China's trade surplus - indeed, due to J curve effects if the RMB is revalued this will increase China's trade surplus in the next period. If anyone outside China wants to help reduce China’s trade surplus, therefore, they would urge China to accelerate its economic growth and, to achieve this, to embark on a large scale housing programme to help contain real estate asset inflation. Such a policy, not an increase in the RMB’s exchange rate, which has again been shown during the last two years not to control China’s trade balance, is the real way to keep down China’s trade surplus.
Why the correct policy to deal with the trade surplus meets US neo-con opposition
China's economic policy makers do indeed appear to have decided to
embark on large scale house building. This is evidently linked to the
issue of accelerated urbanisation.
Such a programme therefore needs to be seen not only from the housing
but from the macroeconomic perspective. A prolonged programme of housing
construction is key not only for China's economic development but also
for dealing with its trade surplus.
Such a programme of maintained or accelerated growth, to a greater degree powered by housing construction, is however naturally unacceptable to 'neo-con' circles in the US who, above all, want to ensure that the US’s economy remains larger than China’s and for whom, therefore, rapid growth in China is anathema. That is why they continue to promote a course, RMB revaluation, which would not reduce China’s trade surplus but would lower China's growth rate, rather than one that actually would hold down China’s trade surplus.
Those who are interested in co-ordinated international economic growth, as opposed to playing political games, will therefore hope China successfully increases supply in its housing market and, by co-ordinating this with demand side measures, allows rapid economic growth be maintained. That is a key policy to deal with the trade surplus.
So far China’s economic policy makers have shown a markedly clearer understanding of economic fundamentals and required policy than the US – to which the success of China’s economic stimulus package and the weakness of the recovery in the US bears graphic witness. It is to be hoped that this clear grasp of economic fundamentals continues.
Charts
Figure 3
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