High inflation is threatening social stability in China, soaring from 3.3 percent in March last year to 8.3 percent in March this year. As a result, the People’s Bank of China has raised interest rates substantially and increased banks’ reserve requirements. The trick for the Chinese government will be to quell inflation in a way that does not compromise its long-term goal of continued strong economic growth.
China’s accelerating inflation reflects a similar climb in its GDP growth rate, from the already high 11 percent in 2006 to 11.5 percent last year. The proximate cause of price growth since the middle of last year is the appearance of production bottlenecks as domestic demand exceeds supply in an increasing number of sectors, such as power generation, transportation and intermediate-goods industries.
In these circumstances, continuing to raise borrowing costs would be a mistake. To be sure, the prolonged rapid increase in Chinese aggregate demand has been fueled by an investment boom, as well as a growing trade surplus. Thus, lowering inflation would require reducing the growth rate (if not the level) of these two demand components. But Chinese policymakers should focus more on reducing the trade surplus and less on reducing investment spending — that is, they should emphasize the appreciation of the yuan over higher interest rates to cool the economy. A sizeable reduction in aggregate demand through yuan appreciation is achievable without being imprudent, because the current-account surplus last year was 9.5 percent of GDP.
Investment should not bear the brunt of the expenditure squeeze, because today’s investment is also tomorrow’s growth in production capacity; and the production of more goods tomorrow would reduce inflation. Using yuan appreciation as the primary tool to fight inflation implies accepting a temporarily higher unemployment rate now in exchange for a permanently lower unemployment rate later.
As a result, a 1 billion yuan (US$145.7 million) reduction in exports would create more unemployment than a 1 billion yuan reduction in investment spending. But tomorrow’s capacity expansion from today’s investment would mean a permanent increase in the number of jobs created from tomorrow.
Nevertheless, China must be careful. Policy-makers should closely monitor potential changes in the economic conditions in the G7. A deep recession in the US would significantly lower Chinese exports and cut the prices of oil and other primary commodities. In that case, a large yuan appreciation undertaken now would be overkill.
Moreover, the authorities should recognize that yuan appreciation is unlikely to reduce US-China trade tensions. Consider the experience of Japan-bashing in the 1980s, when the yen-dollar end-year exchange rate plunged from 248 in 1984 to 162 in 1986 and then to 123 in 1988. While Japan’s overall current-account surplus declined from 3.7 percent of GDP in 1985 to 2.7 percent in 1988, the overall US current-account deficit only fell from 2.8 percent of GDP to 2.4 percent, because Japanese companies started investing in production facilities in Southeast Asia for export to the US. Japan-bashing continued under a new guise: the additional demand that Japan remove its “structural impediments” to import.
A substantial yuan appreciation would reduce the bilateral US-China trade deficit and China’s overall trade surplus significantly, but it would do little to reduce the overall US trade deficit. In the absence of a generalized appreciation of all Asian currencies and unchanged US policies, possibly only a deep recession could reduce the overall US current-account deficit.
Woo Wing Thye is the New Century Chair in International Trade and Economics and a senior fellow at the Brookings Institution.
Copyright: Project Syndicate
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