“Chimera” is the term coined by Niall Ferguson to represent the heavenly marriage between China and America that between 1998 and 2007 accounted for about 40% of global growth (Ferguson, 2008). As put by the Harvard Professor, in this marriage “the Chinese did the saving, the Americans the spending. The Chinese did the exporting, the Americans the importing. The Chinese did the lending, the Americans the borrowing”
Yet, today, with the US economy scrambling to find a way to a sustainable recovery after the financial disaster of the 2007-8, many are asking China to re-balance its economy; definitely an indication that this marriage might be finally on the rocks.
That the economies of the US and China have become so intertwined is certainly a sign that times have changed; after years of isolation, the Communist China slowly started to integrate in the world economy, quickly flooding the world with its cheap exports while the Americans, leaving aside years of misunderstandings, soon took advantage of this situation and started to buy cheap Chinese goods, while US companies did not hesitate to outsource their operations in the favourably enterprise zone set up by the Chinese government. Indeed, to date, US are the second-biggest Chinese trade partner and China is the biggest exporter in the world.
Without doubt, China’s rise has been the most successful development story of the past twenty years. It has embraced Capitalism while still preserving an authoritarian government structure of one-party state; it has opened its economy and attracted large flows of Foreign Direct Investments (FDI). From a country on the brink of a famine due to its disastrous central planning system, today China enjoys higher standard of living, to an extent that the number of people living in poverty have decreased to 8% in 2001 from 53% in 1991 (World Bank, 2010).
Nevertheless, the core of Chinese development has been an export–led growth strategy, a policy that has surely taken advantage of its abundant labour force (roughly 20% of world population) and relatively high human capital (typical of former Communist countries), an established, albeit not yet productive Industrial sector and the creation of special economic zones (SEZs) such as the ones in Shenzhen and in Guangdong.
The massive structural change that China undertook helped sustain the miraculous growth that followed the liberalisation of its economy. However, in order to make its exports even more competitive, the Chinese government had to embark on what has become an important milestone in its economic policy, that is the successful devaluation and unification of currency rates at the beginning of 1994 and the eventual peg of the Yuan (renminbi) to the US dollar (Naughton, 1996).
China’s economic arguments for maintaining its currency pegged to the dollar have revolved around the need to maintain and increase the competitiveness of its exports as compared to competing countries. The mechanism (in general terms) is based on the fact that as the renminbi depreciated (hence the price of the US dollar in Yuan increased), China’s US dollar earnings from exports increased and the dollars spent on imports decreased. By keeping the renminbi artificially low, China created a dollar surplus, which in turn meant that the government had to buy the excess dollars (Krugman, 2010). If analyzed in a supply-demand framework, China’s increased exports lead to a proportionate spike in demand for Yuan (as items produced in China would have to be purchased in the local currency). In this situation, in order to maintain the peg, the Chinese government had to increase the demand for other currencies by buying dollars, euro, etc, and thus increase the supply of Yuan, which eventually helped maintain the peg.
The crawling peg system adopted by China could be placed in-between managed floating and the adjustable peg system (Sloman, 2006: 676). Thus the Chinese government adjusts the peg frequently by small amounts as the equilibrium exchange rate changes (ibid). In the short-term, therefore, the central bank of China had to intervene in the foreign exchange market in order to maintain the peg.
According to Fan Gang, a professor at the Chinese Academy of Social Sciences, the two main reasons why China decided to peg the renminbi to the US dollar were to maintain employment in export industries and to prevent its immature financial system from speculation that would occur if the Yuan was allowed to float freely (cited in Corden, 2009). Keeping the Yuan pegged to the dollar made Chinese exports cheaper, which is why China has been enjoying such a rapid export-led growth over the past decade. However, in order to maintain the exchange rate, the People’s Bank of China had to regularly purchase large amounts of dollars which led to more than 700 billion dollars foreign exchange reserves by mid 2005 (Hill, 2009).
The People’s Bank of China has continued undertaking massive purchases of foreign currency ( to keep the exchange rate down, to an extent that in June 2009 it accumulated $2,132bn in foreign currency reserves, over 40 per cent of GDP (Wolf, 2009a).
The fact that most of the foreign currency reserve (70%, ref) are in dollar-denominated securities, and a large proportion of these are in U.S. government bonds also had the unintended effect of helping finance the U.S. current-account deficit at very low interest rates. Still according to Ferguson (2008),"without those low long-term rates, it's hard to believe that the U.S. would have bubbled the way it did between 2002 and 2007".
Indeed, with the American shopping malls full of cheap goods made in China and the US consumer engaged in a buying spree thanks to a nearly costless borrowing financed by the same Chinese currency intervention, it is not coincidental that the US trade deficit with China reached worrying heights of -268,039.8 in 2008 (US Census Bureau, 2010).
The record US trade deficit with China, as well as the claims that the Yuan was largely undervalued after so many years of rapid growth, were constantly putting pressure on China to let the Yuan float freely against the US dollar. Although since July 2005 China has introduced more flexibility in its exchange rate by linking it to a basket of currencies (the euro, yen and the US dollar), Morris and Lardy (2009) argue that the change to a crawling peg system has had very little effect in practice.
China allowed the Yuan to rise by 21% against the dollar in the three years to July 2008 but since then it has more or less kept the rate fixed (ibid).
In spite of calls for a stronger renminbi and threats of protectionist measures such as tariffs on Chinese steel pipes and tyres have started as early as 2005, the worst crisis since the 1929 crash has certainly exacerbated the unsustainability of the current imbalance. In fact, the current US administration in its stimulus bill passed in January 2009, with the inclusion of the controversial “Buy America” provision that bars foreign steel and iron from the infrastructure projects laid out by the $819 billion economic package (Faiola, 2009) has effectively tried to stimulate the domestic production in order to save jobs and help the heavy industry at the expense of otherwise cheap imports (a Trade diversion in practice).
Despite the relative success of these measures, the US trade deficit with China has slowly decreased - at December 2009 it was -226,826.1 (US Census Bureau, 2010). In order to re-balance the world economy it is required that the renminbi reflects its true value, hence an appreciation of the currency that mirrors the growing status of the Chinese economy.
On the other hand China has had a ‘good crisis’ (Wolf, 2009); the high Chinese saving rate helped finance a massive fiscal stimulus programme of 4 trillion Yuan or $586 billion (The Economist, 2009). It was targeted at increasing the very low household consumption, which in 2007 was just 35 per cent of GDP (Wolf, 2009a). As shown in the graphs below (ibid), the government recovery programme has certainly facilitated a surge in Chinese domestic demand and the shrinking of its current account.
China’s government apparatus is also aware that time has come for the Chinese to let loose the dormant spending power of a high-saving population and shift to a new economic model that abandons its reliance on investments and exports; as also said by the Prime Minister Wen Jiabao “we should focus on restructuring the economy, and make greater effort to enhance the role of domestic demand, especially final consumption, in spurring growth” (cited in Wolf, 2009b).
Nevertheless, despite the fact that the huge trade surplus has almost halved, the nature of the stimulus focused on state-investment that will probably increase its current account surpluses once again in future (The Economist, 2009) and the government is still accumulating foreign currencies to keep the exchange rate pegged. It has been deaf to the international chorus of voices calling on China to allow the renminbi to appreciate; indeed, the Chinese intervention in the exchange rate market is looking every day as a disruptive manipulation of the global economy.
According to Wolf (2009a), China has lost its “liberty of insignificance”, or rather that its actions nowadays, have a huge impact on the rest of the world. It is argued that a stronger Yuan would help rebalance China’s economy towards domestic spending by increasing the purchasing power of Chinese consumers, as well as give China’s central bank more control over inflation by having more freedom in setting adequate interest rates (The Economist 2010b). Although such an appreciation could cause a wave of job-cuts in the export sector of the Chinese economy, the increased domestic purchasing power will contribute to a gradual restructuring towards services that tend to be rather labour-intensive and hence likely to mitigate the impact of this restructuring (The Economist, 2010c). Short-termism, protectionist and nationalist sentiment on behalf of China’s ruling elite that results in further postponing or even stubbornly refusing action is likely to make the avoidance of a trade war between the US and China, a trade war that is likely to result in not only a huge welfare loss for both countries but also in a suffocation of world-wide economic recovery. Ambition and pride, one would argue, have been both the blessing and the curse of great states – the question this time is whether the world is prepared to pay the price.