China and the United States each contributed massively to the large global economic imbalances that emerged in the middle of the last decade. China was far and away the largest global surplus country by the middle of the decade. Its current account surplus reached an astonishing 11.0 percent of GDP in 2007 and for the four years from 2005 through 2008 China accounted for about a fifth of the total global surplus. China's emergence as a large surplus country reflects the rise of domestic savings relative to investment over this period.
The United States was far and away the world's largest deficit country in recent years, hitting a peak of 6 percent of GDP in 2006. For the same four-year period the United States accounted for almost 60 percent of the total global deficit. These very large US deficits reflected our low national savings relative to our national investment.
The imbalances in both countries contributed to the global financial crisis, though lax financial regulation in the United States was undoubtedly a more important underlying cause.
But this situation has changed significantly over the past two to three years. The external imbalances of both the United States and China have declined dramatically. From its 2007 peak China's current account fell by almost half to 6.1 percent of GDP in 2009 and in the first quarter of this year was running at an annual rate of only 1 percent of GDP. Similarly, the pace of official intervention, which prevents the value of the renminbi from appreciating, fell by three-fifths in the first quarter of this year compared to last year. The US current account imbalance also has fallen sharply; the deficit fell to only 2.9 percent of GDP last year, about half the level of 2006.
Given these developments it may appear that the renewed focus by the US Congress on China's currency and its external imbalance is misplaced. In China the Ministry of Commerce now argues that the collapse of China's trade surplus shows that its currency is no longer undervalued and thus appreciation is not warranted. However, I believe that this conclusion is not well founded since the decline in China's external surplus in large part was caused by three factors that are likely to be transitory or already have been reversed.
First, China was the first globally significant economy to begin to recover from the global recession. China's growth bottomed out in the fourth quarter of 2008 and then accelerated very strongly starting in the first quarter of 2009. Thus China's recovery predates that of the United States, its largest trading partner, by half a year and predates European recovery by an even longer period. China's early growth resurgence compared to the rest of the world boosted its imports relative to its exports, cutting the external surplus. But this factor will wane if the US recovery gains traction and Europe begins to recover.
Second, China's terms of trade have deteriorated dramatically over the past year, reflecting a sharp rise in commodity prices. Since China is the world's largest importer of a number of key commodities, sharply rising prices for these goods have added substantially to China's import bill, thus reducing its external surplus. This is unlikely to continue to be such a major factor going forward.
Third, the renminbi appreciated 15 to 20 percent in real effective terms from late 2007 through the first quarter of 2009. This was a major factor contributing to the sharp reduction in China's surplus in 2008 and 2009. But since the first quarter of 2009 the renminbi has depreciated in real effective terms by about 5 percent. This factor is likely to contribute to a rise in China's surplus, probably beginning in the second half of 2010.
Thus I disagree with those who argue that China's currency is no longer undervalued. It seems more likely that China's external surplus will turn upward and that China's contribution to global economic imbalances should continue to be a focus of US policy.
However, the extraordinarily sharp and unexpected reduction in China's current account surplus over the past year surely suggests that there is substantial uncertainty surrounding most estimates of the degree of renminbi undervaluation. Moreover, we should recognize that the virtual disappearance of China's trade surplus, even if only temporary, means that within China it will be politically difficult for the government to quickly resume a policy of appreciation vis-à-vis the US dollar. It also means that if this policy is adopted we are likely to see a slow pace of appreciation, at least until the global recovery strengthens and China's external surplus widens significantly.
Furthermore, even if the degree of undervaluation of the renminbi is very large, a rapid appreciation of the renminbi is not optimal from the Chinese perspective and probably not from the US perspective either. With about 50 million people employed in China's export-oriented manufacturing, the Chinese government will eschew rapid appreciation since that would result in a sharp fall in the output of these industries and eliminate many of these jobs. Their optimal strategy will be a gradual appreciation that would eliminate the growth of China's trade surplus and thus tend to stabilize the output and employment of these industries. In 2008, when my colleague Morris Goldstein and I believed the renminbi was very substantially undervalued, we argued the optimal time frame for eliminating currency undervaluation would be four to six years.1 Our colleague, Michael Mussa, points out that a very rapid elimination of China's currency undervaluation would not be desirable from the perspective of the United States since it would likely "disrupt China's economic growth in ways and to an extent that could not plausibly be offset by other policy adjustments."2 A rapid deceleration in the growth of the world's second largest economy is not likely to enhance global economic recovery, nor would it likely contribute to the recovery of employment in the United States. Indeed, the opposite is more likely.
Ultimately reducing imbalances, whether in the United States or China, requires structural reforms that reduce the gap between national rates of saving and investment. The exchange rate is an important factor that can contribute to this process. But without supporting reform policies in both countries, the results of exchange rate adjustment alone are likely to be disappointing.
In China some progress has been made over the last couple of years to advance this broader rebalancing agenda. This progress is spelled out in greater detail in my policy brief The Sustainability of China's Recovery from the Global Recession, which was distributed by the Peterson Institute in March. The government has taken steps to reduce some of the factor market distortions that have artificially subsidized the production of export goods and goods that compete with imports and at the same time have inhibited the output of services, which are largely consumed at home. In 2009 the government raised the prices of some important inputs, notably fuels, which are predominantly consumed in the industrial sector. This reduced the bias of investment toward manufacturing, contributing to a larger increase in investment in services than in industry in 2009. This is a reversal from the pattern that had dominated Chinese investment for many years. Similarly the government continued to accelerate its build out of the social safety net by massively increasing expenditures on health, education, and pensions. This should contribute to a reduction in households' precautionary demand for savings and thus a reduction in China's large savings surplus. Finally, bank lending to consumers grew dramatically last year, facilitating a remarkable increase in household consumption expenditures.
In addition to allowing its currency to appreciate, the Chinese government should adopt a number of other policy reforms to insure a sustained reduction in its global current account surplus and a successful transition to more consumption-driven growth. Low interest rates on bank loans continue to favor manufacturing (tradable goods) over services and thus contribute to China's external surplus. To address this problem China's central bank should end its policy of imposing a broad range of deposit and lending rates in favor of allowing supply and demand in the market to determine interest rates. Further price reforms would also contribute to sustaining the reduction in China's global current account surplus. For example, while the government last year raised the prices of gasoline and diesel fuel, electric power remains underpriced, continuing to provide an advantage to China's exports. And, after years of discussion, the government should introduce realistic environmental taxes and fees, which would help to level the playing field between industrial growth and exports versus services and consumption.
1. Goldstein, Morris, and Nicholas R Lardy. 2008. China's Exchange Rate Policy: An Overview of Some Key Issues . In Debating China's Exchange Rate Policy, eds.Morris Goldstein and Nicholas R. Lardy. Washington: Peterson Institute for International Economics. Pages 54-55.
2. Mussa, Michael. 2010. Global Economic Prospects for 2010 and 2011: Global Recovery Continues . Paper presented at the 17th semiannual meeting on Global Economic Prospects (April 8).