A view through a bus window in Beijing on April 1, 2008
Just before the global financial crisis exploded, the conference halls in China were alive with the rhetoric of economic reform. Hardly a week went by without some think tank or ministry in Beijing toasting the 30th anniversary of China's great opening to the world and outlining what the next phase of China's historic development would entail. At a time when experts and policymakers everywhere were decrying "global economic imbalances," China would do its bit to rectify them.
That meant attacking the problem at the root. Just as the U.S. saved too little while consuming too much, China saved too much and consumed too little. The result was a lopsided international trade scorecard. China ran huge current account surpluses — peaking at 10% of GDP in the first half of 2008 — and as a result accumulated a massive load of foreign exchange, which it turned around and loaned, mostly to the U.S. government, which enabled Americans to go on borrowing and spending. China, policymakers said, intended to break this unhealthy cycle.
Then a not-so-funny thing happened on the way to rebalancing: the worst economic crisis since the Great Depression. The Chinese response to sharp declines in manufacturing and exports has been cheered for its effectiveness. Government stimulus spending and loose credit powered the country's economy to an 8.9% growth rate in the third quarter, and the most recent Purchasing Manager's Index (PMI), a widely watched gauge of economic sentiment released on Oct. 30, rose for the eighth straight month. It now shows "sustained expansion in industrial activity," says Jing Ulrich, managing director at JPMorgan in Hong Kong. At the same time, the U.S.-China economic relationship is not as lopsided as it was a year ago, at least by some measures. The U.S. savings rate has increased to about 4% of GDP (from zero at the recession's onset), and China's current account surplus has fallen from 10% of GDP to about 6.5% of GDP. Both are improving for the same reason: shell-shocked consumers in the U.S., where the unemployment rate is 9.8% and rising, have snapped their wallets shut. Now that it's pouring, they have started saving for a rainy day.
It's the Chinese side of the equation, many economists believe, that remains unaddressed. Far from making the promised progress on needed structural reforms, China has either stood pat in the past year or has probably regressed in terms of taking steps that would reorient its economy toward consumption and away from savings and investment.
One obvious example, which will be front and center when U.S. President Barack Obama makes his first visit to China on Nov. 15, is the exchange rate of Beijing's currency, the renminbi (RMB). After allowing it to rise against the dollar by about 15% earlier this decade, China has since the onset of the crisis kept the RMB's value tightly pegged at about 6.8 to $1. Economists differ on how greatly undervalued the RMB is. The International Monetary Fund and World Bank contend that it's about 15%-25% below where it would be if it were allowed to float freely. Virtually all agree that it needs to move higher, both for China's sake and the sake of its trading partners. An undervalued currency reduces real household income in China by raising the cost of imports while subsidizing Chinese producers who sell their products overseas. As the dollar has declined in value in the past year, so has the RMB — making Chinese goods cheaper in the international marketplace. In other words, China's peg has helped it maintain its share of global export markets at the expense of other countries who let their currencies float. That's exactly the opposite of what needs to happen if rebalancing is to occur.
Ominously for Beijing, the value of the RMB may be one of the few things the fractious American political class seems to agree on. Recently, Paul Krugman, the Nobel Prize–winning economist and columnist for the New York Times — and a steadfast Obama cheerleader — wrote a column ripping Beijing for its "outrageous" currency policy. He was followed late last week by Martin Feldstein, a former chief economic adviser to Ronald Reagan, who made a similar argument in the pages of the Financial Times. Both noted that the RMB-dollar peg is badly hurting economies in Europe and East Asia and that if Obama raises this issue in Beijing (as he surely will), he'll have tacit backing from a lot of precincts.
Does Beijing care? In its response to the financial crisis — the depth of which absolutely stunned Chinese policymakers — China desperately pushed every familiar button to keep its economy from succumbing the way the developed world's did. It has thrown buckets of practically free money at state-owned banks, which in turn loaned it out to mostly state-owned companies in a wide range of industries. Banks also loaned money to real estate developers, who have added inventory to what were already overbuilt residential and commercial markets in several major Chinese cities. And now the government has turned around and acknowledged that the mind-bending surge in bank lending — by June of this year, total lending exceeded the amount for all of 2008 — has done nothing to rebalance China's economy between consumer and producer. In fact it's done the opposite: late last month, the National Development and Reform Commission, an important policymaking body, conceded that it must start implementing rules aimed at reducing overcapacity in several key industries, including steel and petrochemicals.
It isn't just indiscriminate bank lending that has retarded moves toward rebalancing. Outright government subsidies to businesses have increased in the past 12 months. Everything from bicycle makers to textile producers to chemical companies have seen their export subsidies rise because their markets worldwide were shriveling, and a panicky Beijing was spooked by the prospect of massive unemployment if factories shut down. "By transferring wealth from households to boost the profitability of producers, China's ability to grow consumption in line with growth of the nation's GDP is severely hampered," says Michael Pettis, a finance professor at Peking University's Guanghua School of Management. Indeed, although China is also subsidizing some consumer purchases and retail sales in China were up about 15% in the first nine months of 2009, consumption as a percentage of GDP remains today about where it was a year ago: at about a third of China's economy.
U.S. Federal Reserve Chairman Ben Bernanke has long let it be known that he thinks the imbalances between the U.S. and China contributed to the financial breakdown of the global economy. China's excess savings were sloshing around and needed a home, and profligate America was more than willing to borrow those savings. On Oct. 19, Bernanke gave a speech in which he said that while personal savings in the U.S. is now rising, the government had to get its own accounts in better order. He then pointedly noted that "policies that artificially enhance incentives for domestic savings and the production of export goods" have got to go in order "to reduce the risks of [future] financial instability."
That message was aimed at Beijing. It's one that will be reinforced when Obama arrives in China in two weeks. The only question is, will anyone in the Chinese leadership — who may believe the headlines about what economic magicians they've been for the past year — be listening?