Sunday, February 20, 2005
Roaring China punches her weight and shows how to help the world's poor
Posted by David Smith at 11:00 AM
Category: David Smith's other articles

Today, when Gordon Brown boards the plane for China — his first visit in eight years as chancellor — some of the interest will be in whether this bout of globe-trotting, after last month’s six-day visit to Africa, is preparation for the job of foreign secretary.

For Brown himself, however, this visit to Beijing, Shanghai and Shenzhen should be a voyage of discovery. China is contributing hugely to the global economy. Last year’s growth rate of 9.5%, in the face of measures by the authorities to cool the economy down, surprised many. But it was consistent with the performance of the past 25 years.

Over a quarter of a century China’s average growth rate has been 9.4%. In the early years, this was largely a curiosity. More recently it has become a necessity. Without China’s contribution — about a third of global growth over the 2001-3 period — the world economy would have been much weaker.

What is the impact of China? We know of the country’s huge appetite for natural resources. It accounts for up to a quarter of worldwide demand for copper, aluminium, tin and zinc. Steel producers, accustomed to weak demand in the West, have been enjoying a bonanza thanks to Chinese demand. A third of the increase in oil demand last year came from China, helping to drive up oil prices.

What is less commented on is the effect of this demand on the global distribution of income. Gerard Lyons, chief economist of Standard Chartered, described China in recent evidence to the Commons Treasury committee as a “Robin Hood economy”, boosting commodity-producing economies, not least those in Africa. Trade between China and Africa is growing rapidly, to the point where it is much more important to the continent’s prosperity than Brown’s poverty-relief efforts.

Britain’s trade, in contrast, does not benefit that much from China’s boom. Exports there last year were just under £2.4 billion, 1.2% of the UK total. Imports were more than £10 billion, giving an £8 billion deficit, a record.

Africa and the other commodity-producing countries are not the only places benefiting from China’s boom. A large part of Japan’s recent economic success is attributable to its role in supplying the Chinese leviathan with capital and other equipment. Asia’s emergence from the economic and financial crisis of the late 1990s has much to do with trade with China. China has a large and rising trade surplus with America but a deficit with the rest of Asia.

This has become the key battleground in one of the debates on China — the question of whether the currency, the renminbi or yuan, should be revalued. The Chinese authorities, as has become clear, won’t be pushed by external pressure (most notably from John Snow, the US treasury secretary) to shift the currency peg from the present 8.28 to the dollar, despite a rising trade imbalance with America.

Informal talks in London two weekends ago between the G7 and the Chinese finance minister and central-bank governor got nowhere on this issue. The message from Beijing is that China does not want outside advice on its currency, or on much else. It will decide.

There is, indeed, an assertiveness about China’s approach that was not there even a year or so ago. Then, China seemed pleased to be recognised as a player at all, and grateful to be welcomed into the World Trade Organisation. Now it is finding its voice, and making it clear it will not be pushed around. That is also true on the commercial front, with Lenovo’s announcement late last year of its purchase of IBM’s personal-computer division.

The sensible response by the world’s older advanced economies, said Lyons, is for them to embrace China in their gatherings. That should mean places for China and India — the other emerging giant — on an expanded G7/G8 (the first applies to finance ministers, the second to leaders) in the near future. That is not yet on the horizon.

What about the currency question? Stephen King, chief economist at HSBC, backs the Chinese authorities in their claim that pressure for an early rise in the renminbi’s value is misplaced. A rise would not, he says, make much difference to an ingrained American trade deficit that hit a record $617 billion (£332 billion), 5.3% of gross domestic product, last year — $162 billion of it with China. Such is China’s labour-cost advantage, with manufacturing wages of $800 a year against $29,000 in America, that any plausible currency rise would be a drop in the ocean.

King also points out that because China’s trade surplus with America is starting to be mirrored by a deficit with Asia, it is not clear in overall terms that the renminbi is overvalued. Not only that but a stable currency has served China well. Changing it could expose the country’s immature financial system to strains it might not be able to cope with. Mexico in 1994 and Thailand in 1997 are examples of the problems that can arise.

These are good arguments. But the present situation is also causing serious strains. China’s efforts to maintain the peg have required a currency intervention that makes Britain’s Black Wednesday efforts look like a tea party. The country’s reserves rose by $100 billion in the final quarter of last year alone, topping $600 billion.

Such intervention feeds directly into the growth of domestic liquidity. The Chinese authorities have thus been trying to slow the economy with one hand, while acting to boost it with the other. The result is that the overheating risk in China is growing, with inflation rising and property prices booming.

That is why analysts like Lyons think China will see it in its own interest to begin letting the renminbi rise over the next 12 months — in its own time, of course.

PS: What can we learn from failure? Quite a lot, according to an interesting new book. Paul Ormerod, the economist, has written Why Most Things Fail: Evolution, Extinction and Economics (Faber & Faber).

The opening sentence is: “Failure is all around us. Failure is pervasive. Failure is everywhere, across time, across place and across different aspects of life. 99.99% of all biological species that have ever existed are now extinct. More than 10% of all the companies in America disappear each year.”

It sounds pretty gloomy, and you certainly would not get a business bestseller called “How to Fail at Business Without Really Trying”. But Ormerod, who is highly influenced by the writings of the great Austrian economist Friedrich Hayek, sees the economy as constantly evolving and adapting to change. The fittest don’t survive without many falling by the wayside. It is what Joseph Schumpeter, another noted economist, called the process of creative destruction.

Adaptation does not necessarily mean firms go out of business. Ormerod cites Coca-Cola’s disastrous launch of its New Coke 20 years ago. Customers hated it, the company got the worst publicity in its history, and embarrassingly withdrew the drink a few months later.

It adapted, albeit it with its tail between its legs. That is how markets work. Contrast that with a centrally planned system in which the state monopoly drinks producer changed its recipe. Customers would have no alternative but to buy the new product, however much they thought it inferior. The failure would go unchallenged.

In market economies, firms and individuals learn from failure. In planned systems failure is endemic. China, to go back to the main piece, is halfway between the two.

From The Sunday Times, February 20 2005


Couple of points

“King also points out that because China’s trade surplus with America is starting to be mirrored by a deficit with Asia, it is not clear in overall terms that the renminbi is overvalued.”

Doesn’t this in fact indicate that the Yuan in overvalued against Asian currencies – hence the deficit and undervalued against the dollar. This is, I think, an aggregation fallacy - just because the Chinese currency is on aggregate correctly valued doesn’t mean that its correctly valued against all the individual currencies.

In addition, at this stage, in its economic and demographic development, a country like China should optimally be running a large deficit; it isn’t which suggest that either or both currency and market restrictions are distorting capital inflows/trade.

“Such is China’s labor-cost advantage, with manufacturing wages of $800 a year against $29,000 in America, that any plausible currency rise would be a drop in the ocean.”

This is one of those Chinese statistical riddles :- if Chinese manufacturing wages are 800 dollar and growth is 9.5% then GDP per capita/productivity was growing at about 7% for the last 25 years. This would mean real manufacturing wages were around 147$ pa in 1980 – which is well below any reasonable estimates of the subsistence level. One of the figures in there must be wrong.

Secondly, labor cost advantages don’t determine trade flows and exchange rates, productivity levels do. Do these wage rates reflect true productivity differences? I doubt it.

Thirdly it is 10 years since China fixed its currency; If we assume that its tradable sector represents 20% of GDP then if productivity increased by 7% per annum, by the Balassa Samuleson effect, the real exchange rate should have appreciated by about 75%. Since the nominal rate is fixed, for the real rate to be at about the correct level, either the Yuan was 75% undervalued in 95 or there has been a 75% difference in the two countries inflation rates (or some combination of both). Again I don’t think this is plausible.

”a “Robin Hood economy”, boosting commodity-producing economies, not least those in Africa.

Indeed, but it’d be paying a higher price for these commodities if its exchange rate were higher so its questionable whether this is benefiting or fleecing Africa in the long term.

”There is, indeed, an assertiveness about China’s approach that was not there even a year or so ago.

Assertively pursuing a policy that is economically irrational is usually associated with Hubris. Indeed I think the whole things starting to resemble 92 – but from the German perspective. At the time their currency was effectively undervalued against most of the other peripheral currencies in the ERM but everyone felt that it was in their interests to maintain face while Germany pursued increasingly idiosyncratic fiscal and monetary policies. The end result was a currency crisis in the peripheral countries and 10 years of stagnation in Germany. Might not the same thing happen again? Might this year see a currency that is overvalued against the Yuan suffer a speculative attack? Might the Chinese decision to distort its external price structure see it suffer a depression caused by the misallocation of resources? Lets just wait and see.

Posted by: Giles at February 20, 2005 07:49 PM

Giles, you’ve highlighted a number of conundrums about exchange rates. I would add: Why doesn’t China buy more goods from the US with all those dollars? That would be a potential win/win situation, compared to the risk from inflating the US trade deficit. Why does China still buy US Treasuries? They must know the risks from a falling dollar and rising interest rates. Why do Americans keep borrowing to consume and not save when they know they already have high debts and there’s a risk of losing their jobs in the next few years?

We can add those to Alan G’s conundrum about 10-year Treasuries only yielding 4% given the risk of rising interest rates and inflation – and the implied question: why do Americans accept an earnings yield of 5% on US equities, given the known risks there?

Perhaps the answers to all these conundrums are in Mr. Ormerod’s book. His view is that economies are chaotic, not linear. In a linear system prudent borrowers and lenders would inhibit lending as indebtedness rose.

In a chaotic system, putting more energy, or cash, into the system leaves the system in the same state. Only at some unpredictable, arbitrary point does the system snap, or crash, into a different state.

Lending continues in a chaotic system because there’s no way of knowing whether the system’s about to crash or not. A crash just becomes more probable as lending continues.

So to your questions, “Might this year see a currency that is overvalued against the Yuan suffer a speculative attack? Might the Chinese decision to distort its external price structure see it suffer a depression caused by the misallocation of resources?”, the answers must be ‘yes’ – well, probably but there’s no knowing how long we’ll have to wait.

Posted by: David Sandiford at February 22, 2005 05:54 AM

Why does the US borrow so much? Because the world / China is prepared to lend to it at extraordinarily low interest rates. The US rationalizes this on the basis that it cant go on for ever so they may as well take advantage while they can.

Why does China / Asia buy so many dollars? Mervyn King makes the interesting observation (Speech 237 BoE) that Asia’s fetish for Dollar Reserves arose after the crisis in ’98. As a result, Asian central banks have spend the last 7 year stocking up to the extent that they now hold 10 times as much reserves as the rest of the G7 put together. Most of that is held in dollars as they believe that the dollar is the best means to insure against speculators or peg their currencies to since the US is the largest export market for Asian countries.

So in effect you could say that the US isn’t really running a deficit – most of its deficit comprises it selling a commodity, US dollar denominated debt, that’s in high demand abroad.

The real problem is that Asia/China has become locked into a cycle of fear here. If it stops buying US debt, its currency appreciates, US interest rate rise and it looses billions on its holding of American Debt. As a measure of how desperate China is to avoid losing face over this issue, its trade surplus is just 50 Bn yet it bought 100bn of us debt in the last quarter alone.

This is clearly a crazy situation, which Merv says has arisen in part because international currency coordination is carried out through the G7, which regrettably doesn’t include the Asian nutter economies.

Still – breaking news is that Korea Central bank president has decided to break it’s peg and stop accumulating dollars. Thailand will/has probably follow suit. Somehow I suspect that China will be last to see the light since its bet itself that it can inflate its way out of trouble. I think ultimately China is therefore going to be the big loser on this one.

Posted by: giles at February 22, 2005 06:16 PM

More breaking news; Korea denies plan to sell US dollar government bond reserves but is planning to diversify into company bonds. The butterfly doesn’t flap.

Still, there is a real problem for China/Asia with what to do with their money.

They must be aware of Japan’s experience when they were king of the castle. Japanese companies paid huge sums for US companies only to find the US companies were really worthless or the US management took them to the cleaners.

At least investments in US government bonds shouldn’t go to zero.

If they hold a 10-year bond paying 4% for ten years then it doesn’t matter what happens to bond prices in the meantime – they’ll get their money back at the end. They can also be sure the Fed will keep ‘inflation’ below 4% for most of the ten years.

But that raises the question: Whose inflation? As you say, if the Asian currencies revalue then the US bonds don’t keep up with the inflated value of the Asian currencies.

Also, Asian countries are in the same position as retirees. Their personal inflation isn’t the same as other people’s inflation. Asian countries buy a lot of commodities and they must have hoped that, commodities being priced in dollars, their dollar savings would keep their value against commodities. Not so.

Nevertheless I’d rather have China’s financial problem right now than the US one.

Posted by: David Sandiford at February 23, 2005 07:56 AM

The butterfly may not have flapped but we’re definitely in the post pupae stage. By diversifying into corporates the bank has indicated that it is breaking the international dollar’s fiat. Because once you switch to corporate US bonds because they pay a higher return, why not some other countries corporates bonds instead? And once the rest of Asia sees that the Bank of Korea has broken with its dollar fetish and not died, what is to stop then behaving rationally? Nothing, except in China’s case, face.

Or more particularly China’s pre commitment to take another road – inflate its way out of trouble. The problem I see here is threefold - if all the other Asian countries let their currencies appreciate, that puts some inflationary pressure into the Chinese economy. This adds onto the artificial inflation that China is already stoking up and I think that it will be stronger than may expect. Why? Well Chinese markets are only partially free – what typically happens, in say the agricultural markets is that the first 100 bushels of wheat produced are sold to the party at a fixed price with the surplus then trading on the free market. The problem here is that the free markets are therefore quite thin relative to the economy as a whole, so if prices generally start to go up through an increase in the money supply, they could start to rise quite rapidly, since price adjustments will only take place in the relatively small liberalized markets.

Posted by: giles at February 23, 2005 08:10 PM

You'll have seen Korea's denial ... Feb. 23 (Bloomberg) -- The dollar gained after Japan and South Korea said they have no plans to reduce their holdings of the U.S. currency and Taiwan said it hasn't been selling.

The announcements by Japan, Korea and Taiwan, which hold three of the world's four largest currency reserves, came a day after the Bank of Korea sparked the biggest drop in the dollar against the euro in more than six months by saying it planned to change the composition of its holdings.

But I think you're right to point up the significance of this. The problem for these countries, having built up their dollar holdings so much, is how to get down again. I'm not sure US corporate bonds are the answer.

Posted by: David Smith at February 23, 2005 08:46 PM

I'm not sure US corporate bonds are the answer.

Wouldn’t that just be effectively betting on the same horse but at slightly better odds?

But that has to be a better bet than a fling on that old nag, MG Rover. I can’t see why Chinese companies want to pay a lot of money for IBM’s PC business and MG. Both businesses must have lost all their talented staff years ago. China is just buying capacity in two over-supplied markets.

Still, we can enjoy cheering on MG from the stands.

Posted by: David Sandiford at February 24, 2005 07:58 AM

Ganging up: Asian Bellagio Group formed -

Posted by: David Sandiford at February 24, 2005 11:07 AM

Here's a better one - Asia meets monty python

Posted by: Giles at February 24, 2005 02:50 PM

I can’t see why Chinese companies want to pay a lot of money for IBM’s PC business and MG.

Ever watched “Brewster’s Millions”? Good deal - they’ve now got just $999 billion to spend before midnight!

Still it is arguable that 1.5 billion is a fair price to pay for IBM PC - a business that turns over 10 billion –its just not a fair price for a firm that relies on cheap Asian imports.

In effect the US has been double dipping – they’ve sold China some cheap worthless bonds which the Chinese are using to buy cheap worthless businesses!

So I suspect that there’s a fair amount of Zitronverkaufteinfreude (the pleasure one gets from selling someone a lemon) in New York at the moment.

The downside is that its not a good idea to sell someone a lemon twice – so It’d be interesting how directly Levono was financed by the Bank of China.

Posted by: giles at February 24, 2005 08:54 PM

We now have IBM offering ‘concessions’ to overcome US government ‘concerns’, including “preventing Lenovo from knowing the names of IBM's US government customers, physically sealing off buildings in a shared office park and moving thousands of employees to other locations”.

America taught the world to sell. Now they just don’t get it. Doesn’t it occur to them that these hassles will just put off inward investment?

Doesn’t it occur to them that foreign governments are going to look at the US record (e.g. bugging UN Security Council members) and think ‘we’re not giving US companies access to our government and industrial records’?

It doesn’t occur to the US government that foreign governments now see the US as a threat and China as an opportunity.

Posted by: David Sandiford at February 25, 2005 05:30 AM

Its a caveat emptor world David - if the world wants to beat a path to China - so be it - its still an economy no larger than Italy so I don't think that there's as much opportunity as people expect and they're not exactly freindly when it comes to foreign investment either.

I think you'll find this Lenovo business is a bit of a sting - IBM apparently wants to link up with Apple as thats where it sees the future of the market. Its therefore going to be as unhelpful and obstreperous with Lenovo, a possible competitor, as possible.

Posted by: Giles at February 25, 2005 02:23 PM