China’s desire to be a world economic leader is legitimate, but too tight an embrace of global finance could kill the very stability that has marked the country’s rapid ascent
China sprung a surprise on world markets last week. The Chinese currency renminbi (less formally known as yuan) lost its value against the U.S. dollar by nearly 3 per cent between August 11 and 13. This was its sharpest weekly fall in over two decades.
With the devaluation, China’s manufactured products are going to get cheaper. In other words, with one U.S. dollar — whose value relative to renminbi increased from 6.2 to 6.4 following devaluation — you can now purchase more Chinese goods than before.
The devaluation announcement came within days of China’s export figures for July recording a negative growth, owing mainly to the slow pickup in demand from developed-country markets. Naturally enough, one interpretation was that the devaluation was an attempt by the Chinese authorities to boost export demand for its manufactured goods. Some commentators argued that the Chinese action might trigger a new global currency war — where other countries too devalue their currencies to compete with China — as had happened during the Great Depression of the 1930s.
Reason to devalue
The People’s Bank of China (PBOC), China’s central bank, soon stepped in to clarify. It said that the devaluation marked the transition to a flexible, more market-based system of determining China’s exchange rates. In contrast, the system that existed until now was one in which the value of the Chinese currency (especially in relation to the U.S. dollar) had largely been fixed by the government.
If PBOC’s claims are true, it is likely to be a component of a larger, national strategy to internationalise the renminbi. China wants to see the renminbi emerge as a currency for international trade and finance, like the dollar. It also plans to build Shanghai into a global financial centre, rivalling New York. As a preliminary step, China is trying to get the renminbi included in the basket of currencies in International Monetary Fund (IMF)’s Special Drawing Rights (SDRs). The IMF has set a precondition that China should remove restrictions on foreign capital flows and shift to a flexible exchange rate system. Expectedly, the IMF welcomed PBOC’s announcement.
It is to be noted that China has had strict controls on foreign capital movements across its borders, at least until recently. Such controls have been effective in filtering out volatile, short-term capital flows, which are often harmful to the economy, while at the same time encouraging Foreign Direct Investment. In contrast, India has, over the years, liberalised its capital account substantially, attracting relatively large volumes of short-term capital flows.
China’s remarkably fast export-led economic growth during the 2000s occurred in an enabling environment provided by a stable exchange rate and tight capital controls. In fact, the stability in China’s currency rate has been a factor that helped other East Asian economies to achieve steady and fast growth.
All this, however, has come at a cost. To maintain a stable exchange rate, China has been investing a significant part of its foreign exchange earnings in U.S. treasury bonds, despite their very low returns. Beijing has thus been effectively transferring a share of its hard-earned savings to the U.S. This, in turn, has fuelled consumption demand in the U.S., helping it overcome the problems caused by trade and government-budget deficits.
Break free of bonds
China’s strategy to break free of its mutually dependent relationship with the U.S. has multiple prongs. One, China aims to derive its future growth more from domestic markets and services rather than from exports of cheap manufactured goods. Two, Beijing is trying to strategically deploy its large foreign exchange assets into initiatives such as Asian Infrastructure Investment Bank (AIIB) and the ambitious ‘One Belt One Road’ project. It would also like to replace the ‘dollar-zone’ in East Asia with a viable ‘renminbi zone’.
By opening the doors to global finance as part of its plan to internationalise its currency, China, however, may be forsaking the very stability that has been the hallmark of its economic ascent. The boom in its stock markets and the subsequent crash last month is clearly a sign of things to come. Many Chinese firms are highly indebted. According to one estimate, China’s debt to GDP (Gross Domestic Product) ratio is as high as 282 per cent. China has also witnessed substantially large outflows of foreign capital this year.
China’s economic and investment growth has slowed down in recent months. The country has poured billions of dollars into investments in infrastructure and other basic industries, especially after the 2008 global economic downturn. But this has not been matched by rising demand for these industries, either domestic or foreign, leading to the creation of excess capacities. For instance, the rising numbers of unsold flats have resulted in a slowdown in construction activities and a reduction in the demand for its steel and cement industries. Wholesale prices in the country have been on a downward spiral. The slowdown in China is threatening economic prospects in many other parts of the world too, particularly in countries that are suppliers of commodities to China.
In these trying times, what China should perhaps do is to implement policies that favour real wage increases and greater income distribution, thereby boosting domestic consumer demand. China’s claims to a leadership role in the world economy are legitimate. But in staking these claims, it should avoid getting into a deeper embrace with global finance. The beast that is international finance has triggered many an economic collapse in the past, and China is not immune to its treacherous charms.
India, meanwhile, has a large trade deficit with China, accounting for as much as a quarter of India’s overall trade deficit. With the devaluation of the yuan, imports from China are going to climb up, worsening India’s deficit. The competitive disadvantages of Indian manufacturing sector vis-à-vis the Chinese one arise mainly from India’s poor infrastructure, which translates into higher costs for Indian firms in areas like power and transport. These disadvantages can be overcome only with massive investments, especially public investment, of the kind that China has made for over two decades.
The continuing stagnation in demand for Chinese goods, especially from developed countries, underlines the importance of domestic markets for growth in India as well. Therefore, like China, India too needs policies that enable better employment creation, greater redistribution of incomes, and rejuvenation in domestic demand.