Zheng Song, Kjetil Storesletten, and Fabrizio Zilibotti argue, based upon their forthcoming AER article, that although China has accumulated nearly two and a half trillion in reserves in the last two decades, "it is wrong, and even dangerous, to blame this on a manipulation of the exchange rate." They argue that the existence of credit market imperfections leading to the need for high levels of internal savings provides a better explanation:
The “real” causes of China’s trade surplus, by Zheng Song, Kjetil Storesletten, and Fabrizio Zilibotti, Vox EU: Over the last two decades, China has run large trade surpluses. Its foreign reserves swelled from $21 billion in 1992 (5% of its annual GDP) to $2.4 trillion in June 2009 (close to 50% of its GDP). The effect of this gigantic build up of reserves has been a source of growing public attention in the context of the debate on global imbalances. This debate has gained momentum during the global crisis. Lobbyists and politicians voice the popular concern that by swamping western markets with its products, China contributes to the failure of domestic firms and job losses. The call for protectionism is mounting.
Did China engineer a trade surplus?
A common argument, especially in the US, is that the culprit of global imbalances is the exchange rate manipulation carried out by the Chinese authorities, who peg the renminbi to the dollar at a low value. According to Fred Bergsten, head of the Peterson Institute for International Economics, the renminbi is undervalued by at least 25% to 40%. This "hostile" policy raises calls for robust retaliation.
While economists have so far opposed any measure that might ignite a vicious cycle of trade retaliations and protectionism, even their front is cracking. Krugman (2010) advocated using the threat of a 25% import surcharge to force China to revalue. Last month, 130 lawmakers signed a letter asking the US Treasury to increase tariffs on Chinese-made imports. On 12 April 2010, Barack Obama openly criticized the Chinese exchange-rate policy in front of Hu Jintao, arguing that currencies should "roughly" track the market so that no country has an advantage in trade. Meanwhile, Senator Charles Schumer called for high tariffs against Chinese imports in order to force Beijing to revalue its currency.
The exchange rate manipulation premise
The manipulation thesis rests on the simple postulate that the imbalance itself is evidence of a misalignment of the exchange rate. Letting market forces determine the exchange rate would restore trade balance.
This argument has weak foundations. What matters is the real exchange rate, not the nominal one. While the Chinese surplus has persisted for almost two decades, the real exchange rate has remained as flat as a pancake (see McKinnon 2006, Figure 3). A misaligned real exchange rate should feed domestic inflation, e.g., by increasing the demand of non-traded goods and stimulating domestic wage pressure. Yet, until very recently it does not appear as if China has experienced any major inflationary pressure – between 1997 and 2007 the inflation rate was on average about the same as in the US. Moreover, wages have grown slower than output per worker (see Banister 2007).
In a recent article on this site, Helmut Reisen (2010) shows that a large part of the alleged undervaluation of the renminbi can be attributed to the Balassa-Samuelson effect (i.e., the fact that non-traded goods do not follow the law of one price and are relatively cheap in developing countries). He concludes that "the undervaluation in 2008 of the renminbi was only 12% against the regression-fitted value for China's income level." This is by no means a large number: “Both India and South Africa (which had a current-account deficit) were more undervalued in 2008.” In summary, while it is reasonable to expect some appreciation of the real exchange rate in the years to come (through either inflation or adjustments in the nominal exchange rate), the government manipulation of the nominal exchange rate is unlikely to be the primary cause of the two-decades-long imbalance.
A “real” explanation: Growing like China
What, then, can account for the Chinese surplus? We believe that the answer lies in real (i.e., structural) factors rather than in nominal rigidities. Let us look at the imbalance from an asset flow perspective: