Op-Ed Contributors

The economic challenges ahead for China

By Xiao Geng (China Daily)
Updated: 2010-09-08 07:28

China's key macroeconomic challenge over the next two decades is to determine how to manage its exchange, interest and inflation rates to facilitate sustainable, stable and efficient economic growth as the Western economies shrink in size relative to emerging market economies.

To appreciate the magnitude of this challenge, one must realize that China's high economic growth rate in the past 30 years has largely been a story of rapid productivity growth and catching up. This is likely to continue for the next two decades as it continues to implement market-oriented reform alongside rapid industrialization and urbanization.

In this context, the price of China's non-tradable goods - such as wages for unskilled labor and property prices - is likely to continue to rise compared with the prices of tradable goods, which are set by global markets. In the next two decades, China's price levels will gradually but steadily converge toward those in the United States through structural inflation or structural revaluation of the yuan - or both.

Since the inflation rate and currency revaluation, necessarily associated with productivity catch-up, can cause distortions, shocks and income redistribution, the critical challenge for Chinese policymakers is to mitigate any potential dislocation created in the adjustment process.

There are two key policies that China can pursue.

First, when structural inflation emerges, it would be critical for China to raise nominal interest rates. This will avoid the asset bubbles caused by negative real interest rates, and will protect the value of bank deposits held by low-income households which cannot afford to hedge against structural inflation by investing or speculating in property markets.

By way of example, China's urban residential real estate prices have risen on average by about 9 percent a year since 1991, but the mortgage rate is only about 5 percent and the one-year fixed-deposit rate is only about 2 percent. Such structural inflation in property and low mortgage and deposit rates imply a very serious problem of negative real interest rates in terms of property investment. These negative real interest rates are at the root of China's property bubbles and associated huge income redistribution from depositors (usually poor) to mortgage holders (usually the rich).

If China cannot maintain a positive real interest rate, the boom and bust cycles in its property sector are likely to continue, leading to serious inefficiency in investment and social instability. Conversely, if China does raise interest rates to a level higher than its structural inflation, it will need adequate capital control mechanisms to deal with speculative capital inflows.

But this problem is solvable, and brings us to the second policy point; China must permit reasonable structural inflation.

Specifically, China need not rely solely on nominal exchange rate flexibility to facilitate its rising price levels. Instead, it can tolerate higher structural inflation and the associated real revaluation of the yuan.

In fact, by allowing for reasonable structural inflation, China can implement a flexible exchange rate regime more easily. With inflation, there will be potential for the currency to devalue when inflation runs beyond productivity growth.

Furthermore, a mixture of inflation and nominal appreciation would create a regime in which the market exchange rates could go up or down. This would reduce the incentive for massive speculative holdings of the yuan. Such speculative holdings have become a key driver of China's foreign exchange reserve bubble.

Since the yuan's peg to a currency or basket of currencies has a stabilizing function, when China pegs the yuan to the US dollar, it need not worry much about runaway inflation. If the inflation rate goes beyond China's underlying productivity growth, the market will expect the yuan to depreciate, which will lead to capital outflows and the tightening of money supply.

There is one final point to be made.

While the debate over the yuan's exchange rate is often framed in terms of global trade imbalances, the exchange rate is a price not just for trade but for assets. In fact, asset markets are much larger than trade markets. Thus, maintaining stable exchange rates to facilitate stable and efficient capital flows between the US and China is more important than using the exchange rate to correct global trade imbalances. In any case, using trade policies may be a more productive way of correcting China's trade imbalances.

In sum, given China's huge foreign exchange reserves, it will be easy for it to defend the yuan's peg and avoid runaway inflation. And, as soon as China starts tolerating reasonable structural inflation and the associated increase in its real exchange rate, the pressure for nominal reevaluation of the yuan will be reduced.

The author is director of Columbia University Global Center for East Asia based in Beijing and a non-resident senior fellow at the John L. Thornton China Center of Brookings Institution.