11.04.07
Isn’t China’s trade surplus an indication of the strength of the economy?
Yes and no. It does reflect the incredible dynamism of the world’s fastest economies. Exports are growing and foreign investment is increasing daily. However it did and does come at a cost. Essentially the Chinese kept the Yuan RMB fixed for many years (only recently allowing it slightly appreciate). The exchange rate was maintained to help the export expansion. As surpluses accumulated, the Chinese authorities were faced with a dilemma – to buy up the surplus dollars or let exporters convert them into Yuan, creating a massive increase in the money supply which would lead to inflation. They chose to keep the surplus dollars and as a result are now the largest US creditors. This came at a convenient time for the US as the Bush administration began massive deficit spending to finance the Iraq and Afghanistan wars. Much of the inflationary pressures for the US were “exported” to China who were willing to hold US I-O-U’s. (Greenspan and Bernancke were lucky to have this effect — one point that is consistently ignored in the skill vs luck debate about the Fed.)
We’re now at a turning point. With the housing crunch in the US, the run-up in oil prices and the interest rate cuts, the US dollar has been falling. This will lead to a slowdown in the US economy and an increase in US inflationary pressures. As is already mentioned, China has allowed a small appreciation in the currency and this could accelerate. So China is faced with the same dilemma that Japan faced in the late 1980’s.With the economy built on exports, can it thrive in a period of slower export growth?
