One of the most controversial macroeconomic issues of this decade is the question of how China has run such massive trade surpluses and has accumulated so much in foreign reserves over the past 20 years. Generally, developing countries tend to run current account deficits and capital account surpluses, meaning that on net they import both goods and capital investment, which they repay in later stages of development. The benefit is that they can use developed countries’ wealth to fuel domestic investment and growth (Buera and Shin, 2010). China began to follow this strategy at the start of reform and opening in the 1980s. Beginning in 1992, however, domestic demand fell, the economy shifted toward exports, and China began running trade surpluses (Huang and Tao, 2010). While it is natural for some countries to temporarily run current account surpluses and some to run deficits, the magnitude and longevity of China’s surpluses are noteworthy, especially for a developing country.
The current account is the broadest measure of a nation’s economic relationships with the rest of the world. It puts the value of goods and services in the plus column and subtracts imports and returns on investments abroad. A negative current account balance means a country is importing more than it is exporting. Capital must come into the country to “pay for” the imbalance. Think of it this way: If a household spends $10,000 more than it earns, it must borrow the difference – for example, from a credit card company. The household has a current account deficit and a capital account surplus of $10,000. A country is no different. If it runs a current account deficit, it must compensate with a capital account surplus. In China’s case, the reverse is true. China exports much more than it imports and saves at a high rate rather than buying imports, thereby running large current account surpluses and capital account deficits. The extra money that China earns from abroad gets reinvested, among other places, in U.S. Treasuries.
What explains the unusual trade surpluses China has experienced? A number of factors have been identified as possible causes. Most prominently, the Chinese government’s intervention in exchange markets to maintain the RMB-dollar peg has been repeatedly cited as a key factor, since an undervalued RMB would be a type of subsidy on Chinese exports. As when any country pegs its exchange rate, the government maintains the peg by buying or selling foreign reserves to counter market changes in the demand and supply of the domestic currency. Given the demand for the RMB for trade and investment purposes, the Chinese government has been buying foreign exchange, mainly in the form of dollars, and selling RMB to counteract the rising demand for the RMB that would, in a free market system, drive up the value of the RMB (Krugman, 2010). This factor often generates headlines, such as when U.S. Secretary of Treasury Timothy Geithner publicly accuses the Chinese government of currency manipulation as he did in 2010, and when Congress introduces trade sanctions on China in response to currency value assumptions.
The question of whether the RMB is indeed undervalued, as well as whether the undervaluation has a significant impact, is debatable. Cheung, Chinn, and Fujii (2009) use cross-country purchasing power parity samples to evaluate whether the RMB was undervalued in 2006 as well as in 2008. They find the RMB to be five times more undervalued in 2006, yet neither of the tests was statistically significant. The econometric methods used in these tests were also found to lack robustness (Dunaway, Leigh, Li 2006). Moreover, it has been argued that a revaluation of the RMB would not significantly affect current accounts due a likely decrease in imports from Southeast Asian countries that would accompany an increase in exports from the West. The reasoning is that less demand for finished goods from China would cause China to import fewer intermediate goods and raw materials (Garcia-Herrero and Koivu, 2007). Finally, economic theory suggests that to keep its currency persistently undervalued, China would have to cope with devastating inflationary pressures. While inflation has been high, it seems the level of inflation does not reflect the degree to which some argue the RMB is undervalued. In addition, increasing pressures for capital to flow out of China is now suggesting that the currency could indeed be overvalued.1 In sum, the idea that currency manipulation explains the entirety of the imbalance is not convincing.
A second explanation, the savings-investment gap, suggests that Chinese people have a tendency to save more than they invest, which by definition creates current account surpluses. It could be that the Chinese government’s lack of proper social services causes people to save a larger portion of their incomes (Zhou, 2009), or that the underdevelopment of the financial sector causes Chinese to invest a high proportion of their savings abroad, as Corden’s “parking” theory argues (2009). While a current account surplus implies savings exceeding investment, it is still a source of debate as to how and why this gap exists.
A third set of explanations for China’s large trade surplus beginning in the 1990s focuses on industry and investment relocation. As manufacturing centers moved from Southeast Asia to China through the 1990s and 2000s, especially in final goods production, trade surpluses shifted from Southeast Asia to China (Huang and Tao, 2010). This theory is simple but empirically speaking is not sufficient to independently explain the magnitude of China’s current account surpluses over the 2000s. A similar theory proposes that Chinese government domestic policies emphasized growth without first creating a financial system capable of soaking up the excess savings produced by rising levels of national income. One of the most important goals of the central government is maintaining high levels of employment, which causes policymakers to focus on growth (Fan, 2008). The resultant growth yields high levels of savings that, in the absence of a sophisticated financial system with attractive home investment options, end up flooding abroad.
Finally, the demographics theory contends that the high number of Chinese of working age during the 1990s and 2000s resulted in high growth and high savings. The sheer size of the labor force produced excess output, making exports more viable and leading to high levels of national savings, two forces that jointly put upward pressure on current accounts. (Zhu, 2007)
These theories can be divided into those that impact exports and imports and those that impact savings and investment. Currency manipulation and industry relocation quite clearly affect a nation’s net exports, while growth policies and demographics theoretically influence both net export and net foreign investment.
Further, these theories are in many ways interrelated, and are certainly not mutually exclusive (Huang). For example, demography, exchange rate policy and pro-growth policy were motivating factors behind the relocation of manufacturing sectors from Southeast Asia to China. Demographics and pro-growth policies also both had an effect on the savings and investment gap. We might even argue that high levels of savings yielded a surplus of RMB, prompting the government to intervene in currency markets through the purchase of dollars. Any attempt to differentiate these effects would likely be in vain.
New Factor Market Distortion Theories
The newest theories of note attempting to explain the source of China’s current account surplus revolve around factor market distortions. The issue is explored in Song, Storesletten and Zilibotti’s “Growing Like China” (2011), published in the American Economic Review, and Huang and Tao’s “Factor Market Distortion and Current Account Surplus in China” (2010), published in Asian Economic Papers. The papers both identify uneven reform policies as the source of imbalances in the Chinese economy. While Song, Storesletten and Zilibotti’s model attributes imbalances to the transition from an economy dominated by State Owned Enterprises (SOEs) to an economy powered by private enterprises, Huang and Tao’s model considers imbalances in the liberalization of product and factor markets as a type of producer subsidy, which leads to high savings and therefore to high net exports.
The factor market is the market for factors of production. The principal factors of production in any economy are labor, capital and natural resources, but economists have more recently added human capital, intellectual capital and entrepreneurship to this group. Price distortions in factor markets can hugely impact an economy, because factor prices are a significant component in a firm’s decision about how much to produce. Huang and Tao (2010), economists at Peking University, argue that asymmetry between China’s liberalization of factor markets (the market for inputs) and product markets (the market for goods) cause domestic distortions that directly lead to a current account surplus. Similarly, Song, Storesletten and Zilibotti (2011) construct a model of asymmetries in China’s reform and opening in which they show that because China’s reform has been characterized by a transition from large SOEs to domestic private enterprises (DPEs), this has contributed to the current account surplus. Because DPEs are less dependent on external financing (financing from outside the firm), the authors argue that this transition reduced investment demand in China, producing current account surpluses.
Song, Storesletten, and Zilibotti’s Transition Model
Song et al. begin by considering the question of how China was able to maintain high growth and high return to capital while also sustaining current account surplus and amassing foreign reserves. Neoclassical open economy models would predict high returns to capital to attract foreign investment, causing current account deficits-not surpluses. The authors postulate that China’s bucking of the trend could be related to the nature of China’s reform. Their model shows that as a reforming economy (for example, China over the past two decades) reallocates resources from inefficient SOEs with access to financial markets to private enterprises with limited access to funding, domestic savings will increase faster than investment, causing a trade surplus.2
The authors construct a two-sector model of the Chinese economy, dividing Chinese firms into inefficient SOEs with access to finance and highly efficient private enterprises with limited financial access. Throughout the post-1992 reform period, China’s financial sector was still largely controlled by the government. As a result, loans were offered at will to SOEs with necessary connections, but not to private enterprises. According to the authors, SOEs grew inefficient, depending on their liquidity advantage to stay in the market, while private firms were forced to operate very efficiently to overcome financial constraints.
A key assumption for the model is that DPEs will choose to delegate rather than centralize, and young entrepreneurs benefiting from this delegation of responsibility are assumed to choose to invest in the business. Financing for DPEs thus comes from two sources: whatever funding they can extract from the government-controlled financial sector and the savings of entrepreneurs. DPEs will slowly replace SOEs in the economy as entrepreneurs amass higher savings, reducing the importance of the previous competitive advantage held by the SOEs in access to credit. In order for entrepreneurs to be able to save, we must also assume that excess profits are going to managers and owners, rather than to workers. This would lead to growing income inequality, a phenomenon that was indeed observed during the post-1992 reform period (Song et al, p.204).
During transition, as entrepreneurial savings grew, DPEs began replacing SOEs in many industries. The growing prominence of DPEs dependent on self-financing resulted in a reduced demand for domestic borrowing or investment. Recall that SOEs were absorbing the majority of liquidity. Meanwhile, economic growth fueled by DPEs was increasing gross national savings. People were earning more, while fewer people were benefiting from government social programs that reduced the need to save. While SOEs remained a significant part of the economy, their role continually decreased over the reform period. The result, the authors argue, was a high level of savings coupled with low investment demand. Banks were forced to invest extra funds abroad, leading to high current accounts and growing foreign reserves. One of the safest investments for banks was U.S. Treasury bonds, partially explaining how China owns such a large portion of U.S. sovereign debt. Song et al. consider their model to be a superior explanation to currency manipulation for China’s high growth and increasing foreign surplus, theoretically exonerating China of currency manipulation.
While the model is convincing in that trends it predicts match up nicely with true developments in the Chinese economy, there are several issues the authors fail to resolve. First, the model fails to address the issue of foreign direct investment (FDI). In the model, SOEs are given a low interest rate while DPEs are unable to obtain financing. If the returns to capital during reform were higher than the domestic real interest rate, as the authors’ model implies, FDI would theoretically flood in, correcting for the imbalances that theoretically created current account surplus. During the post-1992 reform period FDI into China did indeed increase rapidly (Garcia and Koivu, 2007, 17). The authors might respond that while FDI did increase, it was still regulated, maintaining imbalance in the credit market.
Second, at late stages of reform, when DPEs had already surpassed SOEs as the Chinese economy’s main source of growth, why would the government continue to maintain barriers limiting the amount of savings that could be invested domestically, where the returns are highest? In other words, it does not really make sense for the government to have continued to restrict financing for DPEs well into the reform period without some ulterior motive. One explanation, though, is that the motivation to continue to impose financial constraints came from maintaining the RMB’s peg, an issue considered in forthcoming sections.
Asymmetric Market Liberalization
A second paper looking at the factor market side, Huang and Tao’s 2010 “Factor Market Distortions and Current Account Surplus in China,” takes a different angle. Rather than considering frictions in the financial market as the source of imbalance, the authors focus on asymmetries in the reform of factor markets. In simple terms, their argument poses that asymmetric liberalization caused artificially low factor prices (for capital and labor) as compared to product markets, which made export of goods more economically viable. The artificially low factor prices acted as an implicit tax on workers and capital owners, reducing consumption and increasing savings. Huang and Tao argue that these two effects in concert increased the savings-investment gap and the export-import gap, boosting China’s current account surplus.
Huang and Tao begin with the observation that in the modern Chinese economy 95% of goods prices are determined by free markets, while the markets for factors of production such as labor, capital, land and energy are still highly regulated. The regulation, they argue, lowers factor prices below market levels, acting as an implicit subsidy for producers. In effect, producers pay a reduced price for factors, but are able to sell their products at near-market prices. This dynamic would lead to imbalances that are reflected in persistent current account surpluses.
In the labor market, China’s Hukou (household registration) system results in migrant workers often being paid below their marginal product, or the true value they contribute to production. Migrant workers from the countryside are not eligible for benefits or labor protections. As a result, abundant cheap labor is readily available. In the capital market, as emphasized in the previous paper, the government-controlled financial system continues to offer low interest loans to SOEs, while regulating foreign investment and loans to DPEs. The authors argue that this results in an artificially low real interest rate. Regarding natural resource inputs, the authors show that the government often offers land to Party members with connections rather than through a true market system. In addition, the central government controls prices of other important inputs, such as energy, and keeps that price relatively low for major producers (Huang and Tao, 2010, p.23)3.
Artificially low factor prices not only act as a subsidy for producers, but also as a tax on laborers and owners of capital. This tax reduces consumption, which by nature increases savings as a fraction of income. The authors argue that this contributes to the savings-investment gap.
In summary, Huang and Tao argue that government regulation in factor markets subsidizes industry production while taxing labor and capital. The subsidy effect increases net exports at a given exchange rate, while the tax increases net foreign investment at a given real interest rate through its effect on savings, jointly causing current account surplus. The strength of the paper is that it points to one element that is clearly observed in the Chinese economy that affects both the export-import gap and savings-investment gap that contribute to current account surplus.
On the other hand, it is unclear whether the government’s interference in the financial market, the market in which the authors estimate the largest distortion, subsidizes or taxes production. The authors argue that government regulation of financial markets artificially lowers the price of capital, subsidizing production. However, Song et al. demonstrate that the regulation also decreases the liquidity available for DPEs, the major source of growth in the Chinese economy. If this were the case, it would seem that government interference on aggregate may have an ambiguous effect on producers, helping enterprises that have connections, but hurting most private firms without access to funding. Given that financial markets are estimated to contain the largest distortions, this ambiguity is troublesome for the authors’ results.
Furthermore, if the Hukou system were reformed and labor mobility improved, while certain industries may be forced to pay higher wages, it may on aggregate benefit economic production. The reasoning is that greater labor mobility would allow workers to seek out industries in which they are most productive. In sum, whether the imperfections illuminated by the authors concretely act to help producers, or whether their effects are ambiguous, is crucial. If the effects are ambiguous, the model does little to explain China’s current account surplus.
The current account balance reflects import-export and savings-investment dynamics. The two models analyzed above jointly have explanatory power regarding both of these dynamics. Song et al. demonstrate how financial frictions during the reform period caused lower investment demand and higher savings. Huang and Tao consider imperfections in Chinese factor markets as producer subsidies, causing excess production that affects the import-export dynamic. In this sense, these models can be seen as complements.
As far as how these models relate to the earlier theories explaining trade surpluses, they are not mutually exclusive. However, the relationship between currency manipulation theories and factor market distortion theories does prompt a chicken-egg question.
It could be argued that by pegging the RMB to the dollar at an artificially low rate, the Chinese government has forced itself to introduce subsequent imperfections. The financial market is a good example. Both papers discuss how interest rates are artificially low in China. The theory posed in Song et al. depends on the assumption that the Chinese financial market exhibits certain frictions. As open-economy models tell us, pegging one’s currency necessitates loss of control over domestic real interest rates. It could be that financial market imperfections that form the basis for these theories arise out of the government’s maintenance of an artificially low currency peg. Perhaps the reason that the government limited DPEs’ access to credit was to reduce demand for the RMB and maintain the peg. This reasoning would indicate that revaluing the currency would correct the imbalances in the economy that produce persistent trade surpluses. The authors, though, claim that their theory shows currency revaluation is not a magic bullet.
On the other hand, it could be that market imperfections of the sort illuminated in Song et al. and Huang and Tao caused currency intervention policies. Perhaps the government ended up having to purchase U.S. Treasury bonds because of the excess savings predicted in the “factor market distortion” models. If this is the case, the government should worry less about revaluing and more about fixing internal market imperfections. Deciding which phenomenon causes the other is extremely difficult. In reality, the currency intervention and factor market distortion are likely closely intertwined.
The observations made in both Song et al. and Huang and Tao’s papers are helpful in understanding the source of China’s high current account surpluses throughout the 2000s. While it is difficult to know the true magnitude of the effect of the theoretical imbalances the papers describe, they provide a conceptual framework for understanding Chinese current account surpluses outside of the tired currency manipulation narrative. There are indeed deeper issues at play. In this vein, China should focus both on managed exchange rate revaluation and reducing domestic financial frictions and factor market distortions to correct imbalances in the future. Moreover, the U.S. government should understand that the root of imbalances likely digs deeper than simple currency controls.
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- For example, see analysis by the Bank of America; http://www.zerohedge.com/news/bank-america-charts-four-crash-landing-systemic-endgames-china. ↩
- Recall that when savings exceed investment, capital will flow out of a country, causing positive net foreign investment and a capital account deficit. Net foreign investment equals net exports, so the country will necessarily then run a trade surplus. ↩
- Huang, in a separate 2010 paper attempts to estimate the scale of the market distortions. He finds distortion to total RMB 2.1 trillion in 2008, with capital, or financial, market distortions making up the lion’s share (Huang, 2010). ↩