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Deflation Out of China?
China needs to reconsider its single-minded pursuit of exports and surpluses
Dec. 3 Hardly anyone visits China without being dazzled by the factories, office buildings and raw ambition. For two decades, the economy has grown about 9 percent a year. Output (gross domestic product) has passed $1 trillion. From 1990 to 2000, the number of phones per 1,000 people rose from six to 178. On a recent trip, the American economist Donald Straszheim asked the interpreter, a new college graduate, how many of his classmates worked for the government. None. Why not? Low pay, boring, dead end.
JUST HOW CHINA evolvespolitically and economicallyis one of the big questions of the 21st century. It is now foretold in the rising anxiety that Chinas economic expansion comes increasingly at the expense of other countries. The theory: Low labor costs and an undervalued currency suck investment and jobs from elsewhere. Legions of multinational firms are relocating in China, whose exports threaten global deflation.
The companies that have moved to China can cut prices to gain market share and force their competitors to follow suit, writes economist Stephen Roach of Morgan Stanley. Consider the evidence. Chinas low-priced exports are up 21 percent in the first 10 months of 2002, although overall world trade is stagnating. It declined 1 percent in 2001 and may grow a meager 2 percent this year.
The story is similar for foreign direct investment by multinational companies. Globally, foreign investment is declining. In China, it has risen 20 percent to $46 billion in 2002 (through October). The new investment is diversifying Chinas exports away from clothes, toys and low-end consumer electronics.
Dell wants its laptops sourced in China because costs are lower, says Nicholas Lardy of the Brookings Institution. Taiwanese companies make basic components for about 60 percent of the worlds laptops. In 2000 these firms had no laptop production in China, says Lardy; now, the mainland represents about 35 percent of their production. Average monthly labor costs for a Chinese factory worker are about $100. Workers are becoming more skilled. The specter is of China progressively attracting most of the worlds factories.
Of course, skepticism is justified. Weve heard this story before. First it was Japan, then South Korea and Mexico. Manufacturing couldnt survive in high-wage, advanced countries. The scare stories didnt come true, for a simple reason. Countries sell abroad so they can buy abroad. China still needs sophisticated products (power plants, industrial machinery, aircraft) that are mainly made elsewhere.
In a series of reports, economist Jonathan Anderson of Goldman Sachs debunks many China stereotypes. Its impressive economic growth merely matches what other Asian countries (Japan, Taiwan) achieved at comparable stages of development. Chinas electronic exports often represent the assembly of imported components, usually from other Asian countries. Despite its growth, Chinas economy remains small: 3.5 percent of global GDP. The United States exceeds 20 percent.
All true. Still, China is not Japan or Mexico. Size alone (population: 1.3 billion) makes it special, and there are other reasons to worry. Free trade, a wonderful theory, says that by specializing in what they do best, all countries benefit. This is usually true. But its less true when theres a world slump, as now. Prices and profits come under pressure. Low-cost producers survive; others struggle. This applies to countries as well as companies. Fears that China will gain jobs and investment at the expense of others are not unfounded.
Deflation is a general decline in prices. It does not exist in the United States, whose inflation remains about 1 percent to 2 percent. Many American economists consider it unlikely. But once started, deflation could feed on itself. Falling prices would squeeze profits, causing companies to fire workers, cut investment or fail. People and firms would spend less, widening the gap between supply and demand and deepening deflation. Although falling prices would normally be good, too much good could be destructive.
Prices of Asian imports have dropped 20 percent in the past five years, says Roach. Again, this would be good if Asian countries spent abroad what they earned abroad. Unfortunately, they dont. Japan pioneered the bad idea of permanently large trade surpluses, a policy now imitated. When countries consistently run surpluses, they accumulate huge reserves of foreign exchange, mainly dollars. Foreign exchange reserves now total $453 billion for Japan (up $58 billion since last December), $257 billion for China (up $42 billion) and $117 billion for South Korea (up $14 billion).
The trading system cannot flourish if too many countries strive for surpluses. This breaks the spending cycle. It subverts the mutual exchange that justifies free trade. China could diminish its surplus by revaluing its currency, the renminbi. Its exports would become more expensive, its imports cheaper. But China refuses, because it too has problems. It is dismantling inefficient state-owned companies. Urban unemployment is unprecedentedly high at 11 percent to 13 percent, says Lardy. There may be 200 million people underemployed in rural areas. Entering the World Trade Organization, China also faces more import competition. China wants all the export-led growth and foreign investment it can get.
The true problem is not China alone. Its Asias collective export obsession, which is self-defeating and deflationary. What appeals to countries individually is disastrous when pursued by all. All countries cannot achieve their desired exports, because markets abroadmainly the United Statescannot absorb them all. There are winners and losers. Japan, once a winner, is now a loser. Its trade surplus reflects low imports, not a vibrant economy. All of Asia needs to base its prosperity more on domestic spending and less on exportsboth for its own sake and everyone elses.
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