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Questions for the new number 2
In Beijing they have been celebrating for a while, but today it will almost certainly become official: China has overtaken Japan as the second largest economy in the world.
It's easy for economists to be sniffy about "psychologically important" landmarks which are measured in dollars and cents. "Purchasing Power Parity" (PPP) estimates of national income, which allow for the fact that a dollar goes a lot further in China than it does in Japan, have put China second in the world ranking for years.
In PPP terms, Chinese gross domestic product (GDP) is more than twice Japan's; in that sense, China is already much richer than the nominal rankings suggest. But it is also much, much poorer. It may be number two by size, but ranked by income per head it is about 95th: slightly above Namibia, but behind Belize. China's average living standards are now roughly a fifth of America's. That is where Japan was in 1950.
And yet, this 'nominal' landmark comes at a time of real importance for China and its global role. Suddenly, it seems, we all care what happens to China. And we all seem to have a view on how the next stage of its extraordinary economic and political transition will unfold.
Historically, the birth of new economic superpowers has caused great global instability - and conflict, more often than not. Much ink has been spilled on how China's role will affect the global balance of power.
Some, such as the US commentator and foreign policy expert, Les Gelb, say that China will not be as disruptive as Germany or Japan were, in the first decades of their development, because China's sheer size, and poverty, mean they have to put economic development before anything else. On the other side, Stewart Patrick, writing in the November/December edition of Foreign Affairs, is one of those who warn that China could be more of a "spoiler", long term, than the White House likes to think.
These are interesting geopolitical questions for the rest of the world to ponder. I want to very briefly list the big economic questions for China and its government, as they get used to being number two.
First, does it really want to have a global currency? This might sound like a small piece of the puzzle, but it actually gets to the heart of whether China is ready to be an economic superpower. As I discussed in my recent blog about the dollar's status (link to "Exhorbitant Privilege" blog from Davos), even if China overtakes the US in terms of national output, its currency won't be a serious rival to the dollar until China opens its capital account and frees up its financial system.
Put it another way - the authorities have to be willing to not just let foreign investors put money in China, but for Chinese people to send money out. And they have to take the consequences of those inflows and outflows for the value of exchange rate. There's not much sign that the government is ready for that kind of loss of control, even if the leadership are taking small steps towards boosting the yuan's global role.
Second, does China's government really want to move to a consumption-based economy? Aside from the size of its population, the two most striking facts about China's economy are its extraordinarily high investment rate and its low consumption. China's gross investment rate in 2009 was 46% of national income, up from 32% in the late 1990s. The flipside to rising investment has been declining consumption by households, which has fallen to only 36% of GDP.
As in Japan and South Korea in the 60s and 70s, very high levels of investment has produced a large quantity of growth - but its quality leaves a lot to be desired. Hundreds of millions of people have been lifted out of poverty since 1980, but Chinese living standards have not grown nearly as fast as the country's economic growth ought to imply.
Why? Because throughout this period of rapid development, the government has put industry and exporters first. Wages and the exchange rate have been kept artificially low and, as I wrote in detail a few months ago, households have had their savings constantly taxed away, by state-controlled banks offering interest rates well below the rate of inflation - if they offer an interest rate in savings at all. (The financial system doesn't provide reliable finance for smaller private companies either, which is why the corporate savings rate is also unusually high in China.)
Again, China's leaders say they want to move to a more consumption-based economy. But as a simple matter of arithmetic, China cannot raise its consumption, or reduce its national savings rate - not to mention its counterpart, which is China's enormous current account surplus - without also reducing its rate of investment. And that is not a simple matter of arithmetic at all.
Of course, China is acquiring the external trappings of a consumer-based economy; go to Beijing or any other major city and you'll see plenty of people ostentatiously spending a lot of cash. But that is scratching the surface. For those national savings and investment numbers to change, and for ordinary households to get a larger share in the country's success, the entire axis of China's economic policy-making needs to shift, so it stops revolving around exporters and producers, and revolves around households and consumers instead.
China's leaders are not very far down that road today. Indeed, some might question whether they were on it at all.
http://www.bbc.co.uk/blogs/thereporters/stephanieflanders/2011/02/questions_for_the_new_number_2.html
It's easy for economists to be sniffy about "psychologically important" landmarks which are measured in dollars and cents. "Purchasing Power Parity" (PPP) estimates of national income, which allow for the fact that a dollar goes a lot further in China than it does in Japan, have put China second in the world ranking for years.
In PPP terms, Chinese gross domestic product (GDP) is more than twice Japan's; in that sense, China is already much richer than the nominal rankings suggest. But it is also much, much poorer. It may be number two by size, but ranked by income per head it is about 95th: slightly above Namibia, but behind Belize. China's average living standards are now roughly a fifth of America's. That is where Japan was in 1950.
And yet, this 'nominal' landmark comes at a time of real importance for China and its global role. Suddenly, it seems, we all care what happens to China. And we all seem to have a view on how the next stage of its extraordinary economic and political transition will unfold.
Historically, the birth of new economic superpowers has caused great global instability - and conflict, more often than not. Much ink has been spilled on how China's role will affect the global balance of power.
Some, such as the US commentator and foreign policy expert, Les Gelb, say that China will not be as disruptive as Germany or Japan were, in the first decades of their development, because China's sheer size, and poverty, mean they have to put economic development before anything else. On the other side, Stewart Patrick, writing in the November/December edition of Foreign Affairs, is one of those who warn that China could be more of a "spoiler", long term, than the White House likes to think.
These are interesting geopolitical questions for the rest of the world to ponder. I want to very briefly list the big economic questions for China and its government, as they get used to being number two.
First, does it really want to have a global currency? This might sound like a small piece of the puzzle, but it actually gets to the heart of whether China is ready to be an economic superpower. As I discussed in my recent blog about the dollar's status (link to "Exhorbitant Privilege" blog from Davos), even if China overtakes the US in terms of national output, its currency won't be a serious rival to the dollar until China opens its capital account and frees up its financial system.
Put it another way - the authorities have to be willing to not just let foreign investors put money in China, but for Chinese people to send money out. And they have to take the consequences of those inflows and outflows for the value of exchange rate. There's not much sign that the government is ready for that kind of loss of control, even if the leadership are taking small steps towards boosting the yuan's global role.
Second, does China's government really want to move to a consumption-based economy? Aside from the size of its population, the two most striking facts about China's economy are its extraordinarily high investment rate and its low consumption. China's gross investment rate in 2009 was 46% of national income, up from 32% in the late 1990s. The flipside to rising investment has been declining consumption by households, which has fallen to only 36% of GDP.
As in Japan and South Korea in the 60s and 70s, very high levels of investment has produced a large quantity of growth - but its quality leaves a lot to be desired. Hundreds of millions of people have been lifted out of poverty since 1980, but Chinese living standards have not grown nearly as fast as the country's economic growth ought to imply.
Why? Because throughout this period of rapid development, the government has put industry and exporters first. Wages and the exchange rate have been kept artificially low and, as I wrote in detail a few months ago, households have had their savings constantly taxed away, by state-controlled banks offering interest rates well below the rate of inflation - if they offer an interest rate in savings at all. (The financial system doesn't provide reliable finance for smaller private companies either, which is why the corporate savings rate is also unusually high in China.)
Again, China's leaders say they want to move to a more consumption-based economy. But as a simple matter of arithmetic, China cannot raise its consumption, or reduce its national savings rate - not to mention its counterpart, which is China's enormous current account surplus - without also reducing its rate of investment. And that is not a simple matter of arithmetic at all.
Of course, China is acquiring the external trappings of a consumer-based economy; go to Beijing or any other major city and you'll see plenty of people ostentatiously spending a lot of cash. But that is scratching the surface. For those national savings and investment numbers to change, and for ordinary households to get a larger share in the country's success, the entire axis of China's economic policy-making needs to shift, so it stops revolving around exporters and producers, and revolves around households and consumers instead.
China's leaders are not very far down that road today. Indeed, some might question whether they were on it at all.
http://www.bbc.co.uk/blogs/thereporters/stephanieflanders/2011/02/questions_for_the_new_number_2.html
America: First time among equals
It's not a fair fight, the currency war between the US and China - but it's more evenly matched than most of us has ever seen. And as we saw in yesterday's sharp fall in the dollar, it has the potential to cause the rest of the world a lot of trouble.
Whether in the economic arena or the political one - it's been a long time since the US could pick on someone its own size. When it comes to a currency war, China's peculiar economic system lets it come pretty close.
The US spends as much on national defence every year as the rest of the G20 combined. That speaks to its unique geopolitical standing. Its economic firepower stems not just from its position as the world's largest economy but the "exorbitant privilege" of having the world's reserve currency.
As Martin Wolf argued in yesterday's FT [registration required], that means America will win this currency war - because it has a limitless capacity to print dollars. But China also has some unique weapons at its disposal - which America would not have, if the shoe were ever on the other foot. It can withstand the dollar onslaught for a lot longer than anyone else.
Why? Because there is no other country with a large economy - but a communist financial system. True, foreign banks have come to China in the past decade. True, they now have a new financial regulatory and supervisory authority that looks a bit like the FSA. But that is where the similarities end. Most banks are state-owned and all of them are still very much state-controlled.
This means that China can resist more upward pressure on its exchange rate, for a longer period of time, than any other government in the world, because it has a greater capacity to neutralise the impact on the domestic economy.
Sorry, this is complicated. But trust me, it's important.
In a normal Western financial system, governments can't hope to absorb large inflows of capital and hold down their currency and keep control of domestic interest rates. If they intervene to prop up the dollar (and keep their own currency cheap), that raises their foreign reserves, which in turn would usually push up the domestic monetary supply and create inflation. They can raise interest rates to tackle that problem, but that tends to make the inflow problem even worse, by making the country that much more attractive to foreign investors.
That is basically the dilemma being faced by Brazil, some of Central and Eastern Europe, and most of the emerging Asian economies. Thanks to loose monetary policy in the US and elsewhere, investors are flooding their economies with cash, in search of higher returns.
As I mentioned last week, this could do a lot of damage to their economies. In that sense, they are already victims in this battle to re-balance the global economy: some more innocent than others.
In Brazil, which has a flexible exchange rate, the government has put a tax on capital inflows, with only modest success. Where exchange rates are controlled (primarily Asia), there's been massive intervention to stop the currency going up - some of it even larger, as a share of their economy, than China's.
All of them try to "sterilize" those interventions, selling assets into the market to mop up the cash and prevent it turning into inflation. But there's a limit to what they can do. In a normally functioning financial system, building up hundreds of billions of dollars of reserves will massively distort asset prices and financial activity in the domestic economy, even if you prevent the immediate hit to inflation.
Which brings me to China and its repressed financial system. America would be quite happy for China's inflation rate to go up instead of its exchange rate: domestic inflation ought to make Chinese exports less competitive in the US, just as a change in the nominal exchange rate would.
But of course, that's exactly what the Chinese don't want. So, like most countries that intervene in exchange market, it tries to sterilize those flows. Here is where the repressed financial system comes in handy: not only can it require the banks to buy an enormous amount of low-interest government bonds, but it can also instruct them to hold a lot more cash in reserve at the central bank.
According to Nick Lardy, a renowned expert on the Chinese financial system at the Petersen Institute for International Economics, in the first half of 2008 alone, a three-percentage point increase in this reserve ratio forced banks to deposit an extra RMB1.3 trillion with the central bank. From 2002 to 2008, the authorities raised the reserve ratio 21 times, taking the rate from six to 17.5% (eat your heart out, Basel III).
Of course, the banks don't like this. But they don't get a choice. They can also comfort themselves with the knowledge that the money they're losing on all these forced investments in low-yield investments is at least partly offset by the profits they make on their domestic deposit accounts, which all receive interest rates far below the rate of inflation.
That low rate of return on savings is the government's doing as well, and for economists, it is the hallmark of a repressed financial system. It's a massive "stealth tax" on household savings, the proceeds of which accrue to banks, the government and, in China's case, exporters.
As Nick Lardy and others have argued, this is not safe or sustainable for China's economy. It pushes savings into the black economy, and adds to the problem of global imbalances because Chinese households are not benefiting as much as they should be from the nation's growth, and they have to save a lot more to feel secure.
But when it comes to China, we know that the unsustainable can continue for a very long time. We found out this week that China's foreign exchange reserves had risen by $194bn in the three months to September - one of the biggest increases on record (see chart below). At least $100bn of that was due to purchases of foreign exchange. (For reference, then the Bank of Japan intervened, to such acclaim, last month it spent about $25bn.)
As we saw yesterday, the longer this war continues, the greater the collateral damage will be for other economies, caught in the crossfire. And the more it will come home to the US administration that we really are living in a new world.
http://www.bbc.co.uk/blogs/thereporters/stephanieflanders/2010/10/america_first_time_among_equal.html
The US spends as much on national defence every year as the rest of the G20 combined. That speaks to its unique geopolitical standing. Its economic firepower stems not just from its position as the world's largest economy but the "exorbitant privilege" of having the world's reserve currency.
As Martin Wolf argued in yesterday's FT [registration required], that means America will win this currency war - because it has a limitless capacity to print dollars. But China also has some unique weapons at its disposal - which America would not have, if the shoe were ever on the other foot. It can withstand the dollar onslaught for a lot longer than anyone else.
Why? Because there is no other country with a large economy - but a communist financial system. True, foreign banks have come to China in the past decade. True, they now have a new financial regulatory and supervisory authority that looks a bit like the FSA. But that is where the similarities end. Most banks are state-owned and all of them are still very much state-controlled.
This means that China can resist more upward pressure on its exchange rate, for a longer period of time, than any other government in the world, because it has a greater capacity to neutralise the impact on the domestic economy.
Sorry, this is complicated. But trust me, it's important.
In a normal Western financial system, governments can't hope to absorb large inflows of capital and hold down their currency and keep control of domestic interest rates. If they intervene to prop up the dollar (and keep their own currency cheap), that raises their foreign reserves, which in turn would usually push up the domestic monetary supply and create inflation. They can raise interest rates to tackle that problem, but that tends to make the inflow problem even worse, by making the country that much more attractive to foreign investors.
That is basically the dilemma being faced by Brazil, some of Central and Eastern Europe, and most of the emerging Asian economies. Thanks to loose monetary policy in the US and elsewhere, investors are flooding their economies with cash, in search of higher returns.
As I mentioned last week, this could do a lot of damage to their economies. In that sense, they are already victims in this battle to re-balance the global economy: some more innocent than others.
In Brazil, which has a flexible exchange rate, the government has put a tax on capital inflows, with only modest success. Where exchange rates are controlled (primarily Asia), there's been massive intervention to stop the currency going up - some of it even larger, as a share of their economy, than China's.
All of them try to "sterilize" those interventions, selling assets into the market to mop up the cash and prevent it turning into inflation. But there's a limit to what they can do. In a normally functioning financial system, building up hundreds of billions of dollars of reserves will massively distort asset prices and financial activity in the domestic economy, even if you prevent the immediate hit to inflation.
Which brings me to China and its repressed financial system. America would be quite happy for China's inflation rate to go up instead of its exchange rate: domestic inflation ought to make Chinese exports less competitive in the US, just as a change in the nominal exchange rate would.
But of course, that's exactly what the Chinese don't want. So, like most countries that intervene in exchange market, it tries to sterilize those flows. Here is where the repressed financial system comes in handy: not only can it require the banks to buy an enormous amount of low-interest government bonds, but it can also instruct them to hold a lot more cash in reserve at the central bank.
According to Nick Lardy, a renowned expert on the Chinese financial system at the Petersen Institute for International Economics, in the first half of 2008 alone, a three-percentage point increase in this reserve ratio forced banks to deposit an extra RMB1.3 trillion with the central bank. From 2002 to 2008, the authorities raised the reserve ratio 21 times, taking the rate from six to 17.5% (eat your heart out, Basel III).
Of course, the banks don't like this. But they don't get a choice. They can also comfort themselves with the knowledge that the money they're losing on all these forced investments in low-yield investments is at least partly offset by the profits they make on their domestic deposit accounts, which all receive interest rates far below the rate of inflation.
That low rate of return on savings is the government's doing as well, and for economists, it is the hallmark of a repressed financial system. It's a massive "stealth tax" on household savings, the proceeds of which accrue to banks, the government and, in China's case, exporters.
As Nick Lardy and others have argued, this is not safe or sustainable for China's economy. It pushes savings into the black economy, and adds to the problem of global imbalances because Chinese households are not benefiting as much as they should be from the nation's growth, and they have to save a lot more to feel secure.
But when it comes to China, we know that the unsustainable can continue for a very long time. We found out this week that China's foreign exchange reserves had risen by $194bn in the three months to September - one of the biggest increases on record (see chart below). At least $100bn of that was due to purchases of foreign exchange. (For reference, then the Bank of Japan intervened, to such acclaim, last month it spent about $25bn.)
http://www.bbc.co.uk/blogs/thereporters/stephanieflanders/2010/10/america_first_time_among_equal.html
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