By BRYAN HILL
AAP Contributing Writer
NEW YORK — Along with Europe, China has been at the forefront of the recent American economic debate. Questions of currency manipulation, trade deficits, and housing bubbles emerge with startling regularity; but all too often in schizophrenic snippets with little or no contextualization.
This article endeavors to provide a holistic and unbiased description of the current state of the Chinese economy: why it emerged as it did, where its risks lie, and where it may be going.
For our purposes the story of the Chinese economy begins around the time of its joining the WTO in 2001. It is during this period that China began what would become a prolonged period of remarkable growth that would catapult it onto the world stage. The obvious question then is, how did this happen?
This is a complex question that has been the basis for much debate, but the general consensus which has emerged emphasizes both certain characteristics of Chinese demography, as well as certain aspects of Chinese public policy. The basic storyline is as follows.
China had certain predispositions which made it a fertile ground for investment and export driven growth. In particular, it had a huge surplus of cheap labor, and it had a small social safety net. The surplus of cheap labor manifest itself in high returns to capital, particularly capital aimed at export driven manufacturing of inexpensive products; and the small social safety net manifest itself in remarkably high savings rates, which in turn motivated higher levels of investment.
China’s public policy reinforced these predispositions and strongly emphasized exports and investments. Of special importance were its capital control regime and its activities in the foreign exchange markets. Its capital controls were likely designed with a dual purpose.
First, to protect China from the kinds of rapid changes in capital flows which have crippled emerging economies all over the world over the past several decades. Second, to minimize appreciative pressures on the Yuan by limiting the ways in which the outside world could invest in China and thus demand for the Yuan.
In terms of its dealings in foreign exchange, Chinese regulations have required the vast majority of dollars which enter the country to be converted into Yuan and ultimately deposited into the reserve system. In addition, they have actively purchased U.S. treasuries and other instruments in great supply. Both of these activities have decreased the international value of the Yuan.
The lower value of the Yuan has helped to boost export growth even further by making Chinese products cheaper to people who are buying them from abroad. Furthermore, high returns in this regard helped to boost investments, which were further amplified by foreign direct investment, a kind of capital inflow which the Chinese did allow.
As a result of their successes in these regards, China has experienced huge trade surpluses. But with these surpluses come increases in the amount of Yuan in circulation because, as we mentioned, most of the dollars which come into the country must be converted into Yuan.
Chinese purchases in the foreign exchange markets have had a similar effect, so there has been a massive pool of liquidity flowing around which manifests itself as inflation. In order to mop up some of this currency, China has increased the reserve ratio at banks repeatedly, thereby decreasing the amount of money in circulation.
In addition, they have sold financial instruments which have brought more of the Yuan back to the Central Bank. Nevertheless, inflation remains a primary concern for the Chinese economy, particularly because it is likely to fuel asset bubbles, like the one some fear may be coming in the housing market.
Generally speaking, this system has been very successful in driving Chinese growth. The question at this point, however, is how sustainable it will be moving into the future. Inflation continues to be a serious concern, and the processes by which China has been curtailing it seem unlikely to be permanent solutions.
The pool of cheap labor may also be beginning to dry up, calling into question the sustainability of growth born unto cheap manufacturing. Demographic changes such as the shifting medium age, as well as societal changes such as improvements to the social safety net, may decrease savings, which in turn would decrease investment.
Finally, China is under significant international pressure to change their economic policies to ensure that the Yuan continues to rise, and that domestic consumption increases, so that the trade gap with countries like America will narrow.
Thus, China is at a serious juncture in terms of their growth – hence all of the discussion of the hard and soft landings. It seems to be generally accepted that the forces that have been driving their economy so well thus far are unlikely to be those which drive it in the future. But the question that remains is: when will the transition to a new model take place? And how fast will it be? And will it be smooth, or will some combination of a housing bubble and decreasing exports to hurting western economies cause a serious slowdown which puts the entire system at risk?
These questions notwithstanding, the “new” Chinese growth model is seen as one where its economy is more akin to most of the world’s advanced economies. That is, domestic consumption will increase, its exports will become more technologically advanced and contain higher levels of value added, the services sector will expand, the Yuan will increase in value, and education, scientific achievement, and environmental sustainability will receive greater emphasis.
Of course no one knows what the future will look like for certain, and the state of the Chinese economy remains crucial to both questions of public policy and economic research. What is more, given the import of the America-China dynamic, discussions of the Chinese economy will inevitably remain at the forefront of the news for a longtime to come. And while this article is by no means exhaustive, and indeed presents an overly simplified model, it endeavors to provide a basic framework from which to build ones understanding of the Chinese economy.
Bryan Hill is a Masters of International Affairs Candidate in the department of International Finance and Economic Policy at Columbia University.