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China's Next Generation Should Look to Zhu

by Arvind Subramanian, Peterson Institute for International Economics

Op-ed in the Financial Times
April 9, 2012

© Financial Times

Remember that issue with the Chinese currency? As markets await this week’s economic data releases from Beijing, it is easy to be complacent over its mercantilist exchange rate policies. Now concern is shifting to whether China has a hard landing ahead.

Foreign exchange reserves have stabilized at about $3.2 trillion. The renminbi has appreciated by about 30 percent against the US dollar since 2005. Despite all this, however, the renminbi problem is still not a thing of the past.

The good news is that there is an opening for the reformist wing of the current Chinese leadership to follow the model of Deng Xiaoping’s protégé and former Prime Minister Zhu Rongji to look abroad to address the problem. It should do so, for the benefit of China and the world.

Leave aside the question of whether the world’s fastest-growing and still-poor economy should be running such large (if shrinking) current account surpluses. The self-insurance motive for building reserves was met at least a trillion dollars ago. Even the desire for export-driven growth has become less attractive because of the overinvestment, inefficiency, and corruption associated with the range of policies supporting mercantilism.

But policies remain mercantilist. By how much? One way of assessing the competitiveness of the Chinese economy is to compare Chinese prices with those of other countries, taking into account that richer countries tend to have higher prices. If a country’s prices are lower than what might be expected given its standard of living, its currency is undervalued (and vice versa). This is the purchasing power parity method for assessing currency valuation.

My calculations suggest that the renminbi remains substantially undervalued, by about 30 percent against the dollar. The mercantilist juggernaut is alive and well.

Unsurprisingly, China’s partners have been exercised by the policies underlying such undervaluation. Discussions are afoot in several international forums—the International Monetary Fund (IMF), the G-20, and most recently in the World Trade Organization (WTO)—to define standards for mercantilist exchange rate policies and to find effective ways of enforcing them.

Not all these attempts reflect rich country grievances. In fact, China poses competitive problems for other developing countries, because it is these countries that are China’s main competitors. In recent research with Aaditya Mattoo of the World Bank and Prachi Mishra of the IMF, we show that China’s exchange rate has a substantial effect on the exports of other developing countries that compete with China in third-country markets. For example, a 10 percent appreciation of the renminbi could increase exports of competitors by between 2 and 6 percent.

How can China definitively address the renminbi problem? The reformers within China are aware that the answer lies in opening up the capital account and freeing up interest and exchange rates. The opposition to reform remains substantial, however, and the leadership transition later this year appears to have sharpened the divide over economic reforms.

But, emboldened (or liberated) by the prospect of relinquishing power later this year, the reformers are increasingly asserting the case for change. The reform-imbued World Bank China 2030 report bearing the government’s imprimatur, the recent moves to open the capital account, and, most striking of all, premier Wen Jiabao’s call to break the monopoly of the state banks, all reflect the new-found zeal for reform.

China’s reformers need all the help they can get to overcome the domestic opposition. It might seem counterintuitive to suggest that a strong, powerful, and fiercely nationalistic country such as China can get help from the outside. But there is a recent historical precedent. About a decade ago, Mr. Zhu shrewdly used accession to the WTO as a way of furthering domestic and external liberalization, often against public and political opinion.

Today’s reformers can similarly harness the lever of international cooperation to help liberalize China’s exchange rate and financial sector policies. The right forum for and design of cooperative efforts will need to be worked out. But how fitting and effective it would be for Mr. Zhu’s protégé, Mr. Wen, to turn to the same source of help at the same twilight stage of his professional career—and for the same laudable reason of pushing through reform.


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