The Hindu Business Line : The dragon's trillion

China's forex reserves, largely denominated in dollars, recently crossed the trillion-dollar mark, reflecting the ground reality that most Asian countries are forced to augment their reserves as a consequence of global imbalances in trade and finance. Maintaining its present economic policy, can China play a part in mitigating these imbalances?

China, the largest populated nation that has over the last two decades successfully embraced what it calls a `socialistic market economy', has notched up one more distinction. Its forex reserves, mainly in US dollars, recently crossed the one-trillion mark. This formidable figure is much bigger than the combined reserves of major Asian economies such as Hong Kong, India, Indonesia, Malaysia, Pakistan, the Philippines, South Korea, Taiwan and Thailand.

A higher forex reserve position does not necessarily indicate greater economic strength or financial stability. It just reflects the ground reality that most Asian countries are forced to gradually augment their reserves, as a consequence of the global imbalances in trade and finance. China is no exception.

Export-driven growth

China has been registering double-digit GDP growth rates in the recent past due to a host of favourable factors. Its cheap labour and flexible investment policies have been attracting huge Foreign Direct Investment consistently. It is no surprise that 40 per cent of FDI inflows going into emerging markets reach China.

China is also a major processing hub for goods manufactured in other Asian economies. It earmarks, on average, 45 per cent of its GDP for investment. Its savings rate is extraordinarily high, at 50 per cent of its output level. Its recent entry into the World Trade Organisation has immensely helped its economic progress and its exports, in particular.

The processing and manufacturing industries in China, established by foreign entities, generate substantial net export surpluses. However, the country is not a globally acknowledged player with regard to the export of services based on superior technology and knowledge.

Dual surpluses

China's external reserves doubled in the last 26 months. It has been registering rising surpluses, both on current and capital accounts. The current account surplus has shot up from $17 billion to $162 billion over 2001-05. The corresponding rise in capital account is from $3.48 billion to $63 billion. These dual surpluses obviously aggravate China's trade imbalance problem and cause its external reserves to rise alarmingly.

Chinese policy-makers aim at phased reduction of its dual surpluses through multiple strategies such as stimulating higher domestic consumption, a more flexible exchange rate and interest rate management, besides gradual capital account convertibility, essentially to widen the channels of capital outflows.

China's domestic institutions, unlike its Indian counterparts, now resort to significant outward portfolio investments due to favourable factors such as possession of large foreign currency funds in the hands of the banks that are recipients of huge foreign capital, the rise in the interest rates in the overseas financial markets besides limited domestic investment opportunities.

Flexible exchange rate policy

Bowing to international pressure — especially from its major trading partner, the US — China gave up its currency peg and embraced a floating rate policy in July 2005, by pegging the yuan to a basket of currencies, and thus fell in line with its Asian neighbours. China has been reluctant to revalue its yuan, which is estimated to have been undervalued against the greenback by 25-40 per cent, fearing the loss of export competitiveness, a fall in FDI inflows and erosion in the value of its dollar reserves. Consequent to the free float regime, the yuan has appreciated only by a minuscule 3 per cent, much to the discomfort of the US.

China and global imbalances

Global imbalances are caused by a host of factors, such as an unimaginative and short-sighted exchange rate arrangement in the past, and very low savings and high spending in the US, besides its remarkable productivity gains. Imbalances occur due to the shifting patterns of trade and investment among various economic regimes and uneven rates of growth. Asia's higher exports and the ballooning petro-dollars due to oil price hikes accentuate these imbalances. Global imbalances may witness the risk of disorderly correction.

China generated a trade surplus of $200 billion against the US in 2005. In the normal course, this should have significantly enhanced the value of the yuan. However, China has prevented the yuan's appreciation by buying into the dollar-denominated assets. Its sterilised intervention is not without costs. Its state-owned banks are required to buy government bonds at artificially low interest rates, putting pressure on profitability and exposing them to a high level of non-performing assets (NPAs).

The blame game

The US blames China for contributing to the problem of global imbalances. It demands that China revalue its currency, increase its domestic demand and reduce its savings rate, besides implementing much-needed labour reforms, to reduce its labour arbitrage advantage. In the absence of effective pension schemes, Chinese labour is forced to save more.

China defends its economic policies by arguing that its trade with the US has saved American consumers billions of dollars and millions of jobs. About 90 per cent of US imports from China involve goods that are no longer produced in the US. China is also buying more farm products and aircraft. The US has a chance to participate in China's massive industrial upgrading, infrastructure building, construction of nuclear power plants, environmental protection projects, and so on.

China cites the presence of its huge market and big demand for America's advanced technologies and management expertise. It argues that it has been boosting domestic demand by further opening its markets to US companies, besides encouraging Chinese firms to invest in the US. It recently agreed to let the NYSE and Nasdaq open offices in China, while Washington has agreed to China's joining the Inter American Development Bank.

China defends its exchange rate policy that aims at an adaptive and equilibrium level gradually, while the US argues that there are more risks in going too slow in this regard.

The US' twin deficits

The US is the biggest borrower in the world as its citizens save very little and spend recklessly under the `wealth effect'. The `key currency' status of the greenback is what is saving the US as forex reserves from the Asian economies and the gulf nations constitute an inexpensive source of funding. It is hardly surprising, therefore, that the US has very large twin deficits: its current account deficit at seven per cent and its trade deficit at five per cent of GDP — the kind of figures not sustainable for any other economy.

Obviously, the seigniorage advantage of the dollar is tremendous. The US is guilty of protectionist trade policies, especially in extending farm subsidies, while it preaches prudential fiscal and financial management to other economies.

The solutions

Can China be a part of the solution to the problem of global imbalances? There are remedies, like the one suggested by Japan for an Asian Monetary Fund or the creation of a global currency, as proposed by Joseph Stiglitz, winner of an economics Nobel, or a two-currency reserve system involving the greenback and the euro.

The vital solution, of course, lies in the drastic reduction of the US' twin deficits by radically cutting its Defence budget and imposing higher taxes on its rich people. This way, the dollar's supremacy and the US hegemony can be brought under check.

Can China succeed in its present economic policy and positively contribute to the mitigation of mounting global imbalances? This is the trillion-dollar question.

(The author is Associate Dean, ICFAI School of Financial Studies, Hyderabad. He can be reached at nrkaturi@yahoo.co.uk)