Why China’s forthcoming economic transition is bigger than you think and why its exchange rate is still the key

China is on the verge of making a number of important economic transitions.  First, China is on the cusp of becoming the world’s largest economy.  Depending on how you measure it, this could quite possibly happen by 2020. Second, as a result of the lagged effects of its one child policy, China is aging and in the next 3 years or so, labour force growth in China will turn negative.  Third, China’s officials must now (having spent 5 years dealing with the fall out of the global financial and European crises) get serious about reforming an economy whose economy former premier Wen Jiabao famously described as unsustainable, uncoordinated, unbalanced, and unstable, into one that that none of these. If Torrens was one of China’s new crack squad of policy makers responsible for all this (TH wanted to think up an interesting acronym but failed), he might do the Le Freak.

Which could lead to this:

There is a lot that can go wrong, and if it does, it will affect you.

China’s economy is big and complex. Every day, 1.3 billion people and millions of firms make billions of economic transactions trying to do the best they can, while government authorities seek to guide them, the best that they can, in the direction that they think is right.  How can we possibly make sense of all that.  And how can you fix it if it needs fixing? The answer, of course, is to simplify and simplify down to the most important elements of the issue you want to think about.  TH reckons that there are three essential bits:

1)      While investment is declining in relative importance, it will still be the most important contributor to China’s growth.

2)      The labour supply will soon begin to shrink.

3)      Productivity growth will still likely be pro-manufacturing.

If you put those together what do you get?  1) If nothing else changes, the capital-intensive manufacturing sectors will likely continue to grow faster than the labour-intensive services sectors.    If nothing else happens, then the supply of manufactured goods will increase while growth of its services sectors will be constrained.  2) If nothing else happens, this will create an excess supply of goods that flows into global markets, and drives net exports up.  While the rate at which this process will take place will be slower than the boom years in the mid 2000’s after China reformed its state-owned enterprises at the turn of the millennium, it will quite likely describe the sort of growth that China can expect going forward.  That is, if nothing else happens, China will find itself stuck with the same growth model that it had in the lead up to the Global Financial Crisis.

Of course something else might happen.  The government is seeking to introduce social safety nets that will transfer income from China’s corporate sectors and reallocate it to China’s aging households.  This should reduce spending on investment and increase it on consumption.  This is an important part of the rebalancing that most people have in mind.  Does this help China to rebalance in the way that Wen Jiabao would have wanted?

Since investment spending tends to go on goods like machinery and equipment, or iron and steel, while consumption spending will go, at least partly, on services, these reforms means that there will be a change in the composition of Chinese expenditure, away from goods and into services.   And because services are not readily tradeable, but goods are, this policy will cause China’s propensity to import to fall.  In other words, while this demand-side policy will reduce import demand, it will come at the same time as the above mentioned supply-side forces continue to be pro-manufacturing.  As a result, if nothing else happens, net exports will start to rise again.

There will be some benefits though. The transfer of income to aging households will help them pay for age related spending on health services and simple domestic services. It will make households happier, but it won’t rebalance the economy, there will be an excess supply of goods and an excess demand for services.  And, since it reduces the amount of resources available for investment, it will slow growth for China’s next generation.

Torrens can hear some of the economists in the room jumping up and down and saying  “Hang on, China is a market economy and in a market economy prices adjust to get rid of excess demands and supplies.”  Torrens’ reply, … “Exactly!.”

If there is to be one single lesson for China’s elite crack squad of policy maker since Smith penned his Wealth of Nations 235 years ago, it is that markets, by determining the “right” prices to balance demand with supply, are the most efficient way of coordinating those billions of daily transactions to bring about a desirable out come.

In this case, the most important price is the one that eliminates the excess supplies of internationally traded goods and excess demands for domestic services – and that price  is the exchange rate.  That is because the exchange rate is effectively the price that determines how much a local restaurant meal is relative to an internationally traded colour TV.  Just ask any Aussie or Canuck, If, in response to the excess demand for services, the exchange rate appreciates and TVs get cheaper as happens when your currency appreciates from between 50 and 65 US cents to the US dollar to trading at par, then households will buy more of them and firms will make less of them.

The same would be true in China. The imbalances between the supply of goods and demand for services would be largely eliminated.  The economy will be better coordinated.  Economic activity will be more sustainable and stable.

It is for this reason that China must make greater progress developing the still nascent framework for a truly market determined exchange rate. If not, China’s economy will not make the difficult transitions that it needs to, and in five years time, it will be the world’s largest economy that is unsustainable,  uncoordinated, unbalanced, and unstable. And that is something we should all be worried about — just like  it was when the United States was that way in 2008..

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