Paul Krugman, the 2008 Nobel Prize recipient for Economics, published an Op-Ed in the New York Times on October 23rd arguing that China's low renminbi value is further hurting the global recovery. 

He argues the following.

America needs a weaker dollar to help reduce its trade deficit.  But the dollar has not been allowed to drop because the Chinese have pegged the yuan to the dollar.

Given a large trade surplus and a rapidly recovering economy, China's currency should naturally be rising in value.  But due to the currency peg, China is effectively devaluing its currency.

China's weak currency policy is taking already inadequate demand from other nations, which is a  particularly bad thing to do when world recovery is very weak.

He makes the following conclusion.  In this global recession, China's policy is actually stealing other peoples' jobs.

Then Krugman asks what can be done, and proposes two actions.

1.Encourage China to sell-off U.S. dollars, thus making U.S. exports more competitive.
2.End the tolerance of beggar thy neighbor policies which seek benefits for one country at the expense of others.

Is it likely that China will adjust the target value of the yuan to a reasonable level early enough to help rebalance and recover the global economy?

Krugman poses a reasonable argument, but he fails to address the serious challenges facing China's economy and society. 

Selling-off U.S. dollars, in effect raising the value of the yuan more aggressively, should be done as one of the later measures of a “painful” and “politically difficult” economic restructuring reform package to solve China's deep-rooted deficiencies.

The massive $585 billion fixed-investment weighted stimulus plan was an expedient put in place to maintain high growth rates in order to maintain employment and social stability.  It was never meant to restructure the economy. 

Prior to the growth figures coming out the country's Premier Wen Jiabao told a Cabinet meeting Wednesday that policy will focus on balancing economic growth while managing inflation.  The numbers show that growth is now accelerating.  (Although some observers make good arguments that the figures cannot be trusted. Gordon Chang in a Forbes Op-Ed, writes, “China's economy, for all the stimulus it has received in 11 months, is underperforming.”)  Regardless it is clear that continuing investment-oriented policies will only exacerbate imbalances and dislocations.

The tremendous investment program has divided critics. Some predict inflation and warn that excessive bank loans are causing sharp rises in share and property prices, while others argue that  lending excesses will exacerbate over-capacity and encourage deflation.

Both are likely occurring simultaneously.  Most observes, including the Wall Street Journal, who take the numbers at face value, believe that inflationary pressures pose the greatest threat.  However, Gordon Chang's contrarian view that lending excesses are creating over-capacity leading to deflation agrees more with observations on the ground in China.  Stock and property bubbles are surely forming, but the stimulus has only aggravated the excess production capacity caused by the drop in exports. 

The National Development and Reform Commission (NDRC) warns of obvious production overcapacity in six sectors, including: steel, cement, plate glass, coal-chemical industry, polycrystalline silicon and windpower equipment.

Neither the domestic market nor the export market has really returned, and overcapacity, if not checked, will lead to bankruptcy, unemployment and bad bank loans.

To balance growth during the recovery Beijing has indicated a willingness to take the following actions as they become prudent.

1.redress production overcapacity in six sectors.
2.taper out the stimulus package.
3.raise interest rates - tighten monetary policy.
4.increase controls on lending.
5.raise banks' reserve requirements.
6.raise the value of the yuan.  (Significant appreciation requires liberalization of rural finance.)
7.broaden social security coverage.

The State Council, China’s cabinet, on Oct. 21 gave its first signal that it was considering a tighter monetary policy. It stated that the policy should focus both on managing inflationary expectations as well as securing stable growth. Geoff Dyer of the London Financial Times noted that this was the first time it has mentioned inflation since the global economic crisis hit China last year.  (However, Gordon Chang argues that China is not really that fearful of inflation at this time.)

Bloomberg reports that there have been hints however that increases by the yuan against the dollar are likely to continue as early as the beginning of 2010.  Since November 2008 China halted gains by the yuan against the dollar to help exporters.

Barclays Capital analysts even said on Oct. 22 that currency appreciation may play a role in policy tightening next year as the government tries to control inflation.

In a video interview Sebastien Barbe, senior economist at Calyon Corporate & Investment Bank, predicted that China will likely push rates up again next year at a pace similar to before the crisis.  He expected an appreciation of 5 to 6% per year.

Zhao Jinping, a researcher with the Development Research Center of the State Council, or Cabinet, nonetheless mentioned the elephant in the room, "Weak domestic consumption is the key problem that makes the foundation for recovery fragile. Expanding domestic consumption will be the focus in restructuring the economy."

A reform package which restructures the economy must include the following.

1.reverse the one-child policy
2.liberalize the labor market
3.liberalize financial services (including rural micro-finance)
4.broaden social security coverage further
5.support small and medium sized private enterprises
6.expand domestic consumption
7.raise the value of the yuan to a reasonable level

The reform package must include the “painful” and “politically difficult” items which remain outside the bounds of the massive stimulus package. 

Chinese consumers have had very good reasons for holding back reports the New York Times, and neither the slowdown nor the government’s response has done much to address them. Because of China’s weak social security system, individuals know they must save at a high rate as a hedge against their need to cover most of their own health care and retirement needs.

Huang Yasheng of MIT's Sloan School of Business argues in this video lecture that consumption is low for the 700 to 800 million rural residents, because China's economic policies since the beginning of the 1990's have benefited urban residents, and not those living in the countryside.  After the political conservatives defeated former Premier Zhao Ziyang and other reformers in 1989, rural income growth has failed to keep pace with GDP.

China's phenomenal growth during the past two decades has largely ignored rural China, approximately 60% of the population. Huang argues that allowing significant Chinese yuan appreciation before liberalizing rural finance would be like putting the cart before the horse.  700 plus million rural residents, particularly the 250 to 300 million who are still living in poverty, would suffer further under a rapid appreciation of the yuan.

Yam Ki Chan, editor of the Iron Rice Bowl, and a graduate student at Columbia University specializing in China’s banking and microfinance industry, commented on Vikram Akula's recent Op-Ed in the WSJ regarding the development of microfinance in China.  Yam Ki Chan praised his recognition of the problem, but he was disappointed that Vikram Akula did not describe how he saw China liberalizing the sector.  Yam Ki Chan asked, “Allowing foreign investment is definitely one option (which he is, of course, interested in), but what else can China do domestically?”
 
Both Dr. Tarun Khanna, an expert on China's microcredit sector, and a friend, who has consulted in this area for the last five (5) years, indicate that state-offered microfinance substitutes have been historically anemic. Whether this has been due to lack of resources, incompetence or by political design is for the reader to decide.  (The editor of the blog would in fact appreciate learning the views of the reader.) 

The unfortunate reality is that China is not likely to promote liberalization of rural finance as Huang Yasheng and others advocate.  Efforts to scale rural microfinance in China are met with fierce resistance as my friend confirms.  In this YouTube video lecture, Billions of Entrepreneurs, Dr. Tarun Khanna examines microfinance challenges in India and China, and concludes that there is little chance of scaling operations in China.  In China any organization that aggregated to several millions of people would be shut down very quickly.  He provides the premier example: Bangladesh has a microfinance organization, the Grameen Bank, currently the largest in the world, which provides microcredit to 8 or 9 million women. The organization and its founder, Muhammad Yunus, were jointly awarded the Nobel Peace Prize in 2006.  A private enterprise of this size would be impossible in China, because agglomerations, which scaled microfinance could become, are treated with suspicion by the party-state.  Masses of individuals organized for whatever purpose are perceived as a threat to the party fabric.

In addition the prospect of enormous collections of individuals organized financially in these rural areas independent of the central authorities, even if providing only small loans, probably makes the boys in Beijing a bit uncomfortable.  China's tremendous size makes it difficult to rule, and large rural areas of China are under the influence of local gangs and thugs, ruling according to private interest. Many village-level areas are lawless, ruled by different groups - and largely out of the reach of the central authorities.  Increasingly the CCP has less control of large areas of the rapidly morphing China. 

The government reported on their own website that there were 85,000 violent protests on the mainland last year.  Dr. Tarun Khanna estimates that the real number is likely closer to 500,000.  For the masses of disadvantaged citizens this coastal, urban-centered, export-oriented growth model has not served them well economically.

China's impressive growth has been fueled primarily by state-sponsored corporatism through state-owned enterprises, which the stimulus regrettably reinforced.  The stimulus package mostly ignored the small and medium sized private enterprises.  Because of China's recent impressive economic growth much of the world increasingly views China as an economic superpower.  But those who really understand China's economy like Huang Yasheng and Dr. Tarun Khanna realize that China is still a developing nation with a very weak domestic economy.

Krugman's ultimate aim is to help America reduce its trade deficit by means of a weaker dollar.  However China will find it very difficult to sell-off mass quantities of U.S. dollars before creating a vibrant domestic economy.  China's 700 to 800 million rural residents would suffer under a rapid appreciation of the RMB.  Domestic consumption will not expand until rural incomes keep catch up with GDP growth, and rural incomes will not increase until rural finance is liberalized.

Liberalization of finance is just one of six (6) “politically difficult” reforms that China must perform if it hopes to balance its growth and be a be a trusted global trade partner who seeks mutual benefit among nations.  The good news is that these political reforms are mutually supportive.  As just one of many examples, expanding domestic consumption not only comfortably allows Beijing to raise the value of the yuan without injuring rural residents, but it also rebalances trade directly by reducing excess production which otherwise would be exported.

China must first push microfinance in the rural areas to increase the economic welfare of the countryside, and then at that point appreciate the yuan aggressively.  Krugman's pleas for China to raise the value of the yuan to a reasonable level would have significantly more gravitas if he were to support researchers of the State Councial like Zhao Jinping who argue for a restructuring of the economy to bolster weak domestic consumption.  Liberalizing the economy, widening social security coverage, and providing support to small and medium sized enterprises all would work in concert with a policy which would appreciate the yuan to a reasonable level.

Regrettably chances are small that the value of the yuan will reach a reasonable level early enough to help rebalance the global trade before the global imbalances grow into a protracted global recession.  Beijing probably will not budge too far on rural microfinance, and so it will be unable to appreciate the yuan much more than 6% per year.  And because the yuan will not appreciate fast enough, the world economy will suffer weak growth for a long time.

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