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Monday, September 22, 2003

China the Main Beneficiary of the Fed Stimulus?

Andy Xie has a curious argument which amounts to saying that the principal beneficiary of any Greenspan monetary easing will be..........China. This is a result of the fact that its large surplus labour pool means that global labour prices will be increasingly set in China (think Joerg's labour-buffer) and that its position as part of the dollar-bloc will leave it far better placed than others to benefit from any expansionary stimulus.

I believe that structural factors are playing far more important roles than exchange rates at sustaining the superior economic performance of the dollar block.

1. Exchange rates. The euro-dollar rate has rallied by 10% from the beginning of 2003 and by 20% from the average value in 2002. The strong euro has curtailed the benefits of any US recovery to Europe. The euro zone grew its exports by 18% in dollar terms between 1997 and 2002, while Japan and the US did not grow their exports at all. The euro zone was essentially competing against East Asia ex-Japan for market share through competitive devaluation. The euro revaluation, however, has taken the euro zone out of competition for market share.

Japan’s exports have stagnated since 1994. The US recovery may increase Asian demand for Japan’s capital goods. It would not, however, compete against other Asian economies for export market share. Japan gave up on the market share game when it did not devalue its currency during the Asian Financial Crisis.

2. Europe outsourcing. In addition to exchange rates, two structural factors are helping the dollar block. First, Europe is moving toward outsourcing. Relocation of production capacity from Europe to China has been massive in the past few years. Both pull and push factors are at play. China’s improvements in infrastructure and human capital, its growing domestic market and availability of cheap local financing have been major pull factors. Disillusionment with the pace of structural reform and stagnant local markets at home have been the push factors. In this regard, Europe’s corporate sector is following Japan’s for similar reasons.

China is attracting growth from Europe and Japan, which is helping the US indirectly. The US policy makers should think hard about this. China is the most important force in sustaining US living standard today, in my view. The renminbi peg to the dollar guarantees the US financial stability, even as its balance sheet deteriorates. If one only looks at the bilateral trade balance, it would create a highly distorted picture.

Europe and Japan would certainly experience stagnation in this new world. However, both are experiencing population decline. Their focus is quality of life rather than growth. Their pensioner populations are growing rapidly, requiring cheap imports to sustain living standards. The distribution of growth in the world today is far more logical than what most policy makers believe. Growth is not and should not be the game for Europe and Japan.

3. Spreading China industrialization. Second, China’s industrialization is spreading. Geographically, the Yangtze River delta has come of age. Its contribution to China’s export growth has increased from 27% between 1993 and 1998 to 41% since. Its total exports should exceed Pearl River delta’s exports for the first time this year. This region has a population of about 137 million, about double that of the Pearl River delta.

Domestic private enterprises are prominent in the Yangtze River delta’s development. China’s exports were dominated by enterprises that migrated into China from Hong Kong and Taiwan and, later, by multinational corporations. Chinese private enterprises are joining the picture for the first time. Their exports have more than doubled this year. I believe that this is the most important development in China’s competitiveness. This force would eventually broaden China’s exports to most products in the global economy, in my view.

China’s competitiveness does not result from its currency. Rather, it is due to a combination of rapid productivity growth and massive surplus labor. The latter turns the former into a permanent relative price change. For example, when China reduces the production of motorcycles by 50%, it would lead to a permanent reduction in motor cycle prices relative to, say, oil.

China’s productivity increase represents a permanent relative price change between labor and scarce resources. I believe that this point is widely misunderstood. When one company can make motorcycles in China, thousands would follow. Thus, the value of a motorcycle relative to oil would shift from Japan’s labor cost to China’s. Exchange rate adjustments would not be able to push back this force. As China learns to make more products, it will eventually devalue labor relative to scarce resources in general. This is not an exchange rate issue. If China appreciates its currency, it would lead to reduction in nominal wages, which are determined by global demand for Chinese exports.

The China-US axis is not just due to China pegging its currency to the dollar. It is due to (1) China determining marginal production costs and (2) the US determining selling prices due to its large and open market. The renminbi peg links production cost to selling price. It makes perfect sense. If China floats its currency, the renminbi would still track the dollar, in my view.

The China-US axis causes the Fed monetary stimulus to stay within the dollar block. Commercial banks have cut back cross-border lending. Money now flows around the world via FDI and trade. Because China accounts for most of the marginal increase in global trade and FDI, when the Fed increases money supply, it flows to China and quickly comes back into the US treasury market.

Because the China-US axis is determining both production cost and selling price, the rest of the world is also under pressure to peg its currencies to the dollar. Otherwise, no one would want to accumulate capital in its markets -- the risk would just be too high. When the ECB starts to manipulate the euro-dollar rate, I believe the world will finally complete its transition toward the dollar standard.

The hole in the dollar standard is the US’s vast current-account deficit. The level that the rest of the world pegs to the dollar may experience sudden changes from time to time to address this imbalance. The dollar standard, however, should survive for a long time to come, in my view.
Source: Morgan Stanley Global Economic Forum

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