More Puzzles

Reading through a Bloomberg piece on China's trade surplus I was struck by this paragraph:

"China's trade surplus swelled to $18.8 billion in March, a monthly record, as exports soared, the customs bureau said yesterday. The gap, which is set to top last year's record $102 billion this year, is leaving the economy flush with cash that's been channeled into investment projects. "

This made me sort of stop in my tracks and read it again, since my first response was 'well that's good isn't it", that's what development is all about. Well apparently no, since:

"The IMF yesterday said China should loosen its grip on the currency to support government efforts to slow investment. Too rigid currency controls reduces the efficiency of the central bank's monetary policy, the fund said."

So the issue isn't exactly that China is making too much money, and thus being able to move its population into productive activity (this is called development I think) it is that they may be doing this too quickly. But how do we know this? I would argue that we have only a very vague idea of how quickly an economy like the Chinese or the Indian ones can grow, indeed I have just put a post on this very matter on the Indian Economy Blog.

My feeling is that basically people can't believe what is happening, so they are rationalising their disbelief into 'concern'. Basically the issue is not growth per-se in China, but distorted growth, which is partly due to an undervalued currency, and partly due to inefficient banks and capital markets. But the presence of many of these distortions is hardly surprising in the context of a newly developing economy.

The main areas of concern are obviously property, although rising properties prices in China are just as (if not more so) sustainable as they are in the US, and insofar as there is 'froth' it is in the most globally influenced sectors of the Chinese economy. The other distortion is of course in exports, and this is, at the end of the day, what the fuss is all about.

China's growth is in some significant part being driven by exports, and the distortion is producing a positive feedback process: exports are producing extra cash which are feeding more exports, since there are not deemed to be other projects which are attractively profitable as an alternative. This rate of export growth is, naturally, unsustainable, but I would say that the great worry in the event of a slowdown globally isn't a hard landing inside China itself, I think they have the means to avoid this, it is not, after all, a fully market economy, no, the worry is what happens to all those exports that are being produced, and what will they do to global prices in the event of a slowdown? And todays warning from Rodrigo Rato that housing may be significantly slowing may encourage the Chinese to maintain their current currency value rather than lettting it rise.

One last point, China's economy doesn't of necessity have to become flush with cash as a result of a protracted surplus (with the implication that this process is inflationary), a brief history of the recent history of Japan reveals that, where the problem has been deflation, not inflation.

The issue is what happens to the money. Normaly central banks have some kind of sterilisation policy or another:


"Sterilization (or neutralization) policy is a specific combination of monetary and exchange policy. When the central bank buys or sells foreign exchange the money supply increases or decreases. The purpose of sterilization policy is to offset this effect. The mechanism is for the central bank to sell securities at the same rate that it is buying foreign exchange, and to buy securities at the same rate that it is selling foreign exchange. In reality, therefore, neutralization policy involves an exchange of foreign reserves and bonds."

The main concern then is really the effectiveness of this sterilisation process in the context of an economy where there is still a lot of unofficial money floating about, and where the value of the currency is guaranteed. This is what, at the end of the day, the IMF is getting at when it says "currency controls reduces the efficiency of the central bank's monetary policy".