1

Part X - The Dominant Causes of the Credit Crisis: The Threat of China’s Bulging Exports
By David Collett

China - The Rise of an Economic Giant Foreign Direct Investments (FDI) in China The Impact of Exchange Rates on China’s trade with United States and Europe The Unsustainability of China’s huge Trading Surpluses

The growth of the Chinese economy over the last two decade is astonishing by any standard. At the current rate of expansion, China would double its economy every 7 to 8 years while most developed economies can only hope to achieve the same feat every 25 to 30 years. China’s rate of growth is unprecedented and it defied many predictions of its eminent demise over the last decade – at least until now. It has led to a belief that its near miraculous growth can continue indefinitely. If it does, the text books on economics will soon be rewritten. Many economists and market commentators who champion free market capitalism sing the praises of the Chinese economy, often expressing their confidence that the Chinese government will do whatever is needed to keep the ship on course or to ensure a soft landing, if and when the economy deflates. In fact, any sign of stagnation in the Chinese economy is regularly considered as good news by some as there is the assumption that it would compel the Chinese authorities to act in some stimulatory fashion causing faster growth. In contrast, they are very critical of any government interference in developed countries’ economies – mostly on the grounds that

2

they will only wreck it further. For these countries, they put their trust in the invisible hand of free markets to save the day. Although China has opened its doors to capitalism to a limited extent, its economy is still mostly centrally planned and controlled. It is a highly regulated economy (relative to developed countries) where central government plays a dominant role. The government has a tight hold on the reins as to how savings and investments are channelled into the economy. Neither is investments primarily profit driven. The focus is mostly on growth at virtually any cost. In other words, they show little regard for the free market principle that capital be allowed to flow freely to the most profitable projects in order to ensure the most productive use of capital. Many believe they are currency manipulators and guilty of dumping heavily subsidized goods on world markets. Since 2009, China has literally opened the floodgates on bank loans to finance preferred domestic industries that gave new momentum to its already huge fixed investment program. They are expanding manufacturing, infrastructure and residential estate at a pace that far exceeds growth in demand. They have transgressed virtually every sacred rule in the book of free market capitalism - and got away with it. China’s economy outperformed the free market economies of the world by a sizeable margin over the last two decades and looks poised to take over the leading role from the United States within the next decade or two. The fact that such an achievement is well within China’s grasp has far-reaching implications for the economic philosophies of the day – how did a centrally planned and regulated economy, at best practising some form of state-capitalism, triumph over free market economies that embrace laissez-faire capitalism? Perhaps we should rather ask - did China accomplish this feat all by itself or did free market entrepreneurs from developed countries play a significant role in making this astounding economic achievement possible? Furthermore, did they help

3

China to the detriment of their own countries’ economies or was it simply an unintended consequence of pursuing their own interest – and did China simply take advantage of the “profit above all else” motive of the capitalists? Although a lot of credit must go to China and the Chinese people for their remarkable achievements, there is strong evidence that suggests that foreign help, rule bending and manipulation might have played a substantial role in making it possible. It also seems that many of the free market economies paid a heavy price in the process. China - The Rise of an Economic Giant During 2010 and 2011, China has surpassed the United States as the world’s top goods producer and Germany as the largest exporter in the world. China is also the world’s largest property developer by far. It is the world’s largest consumer of coal, iron ore and cement and 2nd largest market for luxury goods. China is number one in foreign reserves and effectively became the world’s biggest creditor country. China moved from the 11th largest economy in 1995 to second place in 2010 (by nominal GDP) according to the IMF and World Bank. Its economy grew at nearly 10% per annum over the last three decades. To grow at such a pace as it moved out of its dark ages in the eighties was remarkable enough, but to keep growing at this steep pace for three consecutive decades is beyond comprehension. Doubling its economy again over the next seven to eight years seems like “mission impossible”, but if current trends continue China will achieve it. How did they achieve such phenomenal growth and how did China’s progress affect world growth? Asian countries generally dominated world growth over most of the last four decades, first led by Japan in the seventies and eighties before China took the lead in the middle nineties. However, despite the phenomenal growth generated by Asian countries, world growth slowed over the last four decades. The faster Asia grew the more the developed countries’ growth slowed.

4

The influence of outsourcing, off-shoring, reallocation of capital to the most productive investments, lower wages and other related factors on world growth and globalisation over the last four decades, are discussed in Part II to Part IX of the “The Dominant Causes of the Credit Crisis”. This article will focus more specifically on the trade relationship between China and two of its main export markets namely the United States and Europe. It will also focus on the assistance China received from developed nations in developing its export and manufacturing industries. Foreign Direct Investments (FDI) in China FDI, mainly from foreign multinational corporates, started to flow into China at an increasing rate from the early nineties, slowed somewhat from 1997 to 1999, before picking up steam during the first decade of the 21st century. These foreign investments had enormous benefits for the Chinese economy. Not only did it contribute to investment growth and China’s foreign reserves, but it also made a huge contribution to China’s manufacturing and export industries. Although the FDI amounts are relatively small compared to China’s own internal investments it packs considerably more punch than merely its monetary value. In addition to the value of their capital investments, FDI brought with it the transfer of technology; expertise and access to foreign markets without which China could not have achieved the sparkling results in exports and manufacturing over the past two decades. As shown by the piechart below, more than 50% of FDI went into manufacturing. This huge investment in manufacturing was primarily aimed at the export market.

5

FDI enterprises’ impact on China’s export industry is remarkable. The fact that FDI was responsible for 55% of China’s exports and 68% of its trade surplus in 2010 confirms the huge role played by FDI in China’s development.

The synergy and positive correlation between FDI and exports are also reflected in chart C1 below.

6

The synergy between the accumulated FDI (including reinvestment of profits) and accumulated trade surplus are reflected in chart C2 below. It also gives some indication of the extent to which these two items contributed to China’s huge foreign reserves of over US$ 3 trillion.

7

During the period mentioned in the charts above, most of the developed countries started to build up huge trade deficits while the growth of their manufacturing industries stagnated. These trade deficits had to be financed by creditor countries like China. FDI therefore helped China and other developing nations to develop into fast growing economies, but much of these investments were little more than the transfer of production facilities or processes from developed countries to China (and other developing nations). This is one of the reasons why world growth trended down instead of up over the past three to four decades despite vibrant growth in Asian countries and other developing nations. The Impact of Exchange Rates on China’s trade with United States and Europe Why did foreign investments continue to flow to China at such a rapid pace? The pursuit of profits by multinational companies is the obvious answer. As shown in Chart C2/2 below, FDI’s return on investment is attractive and still growing.

8

Wages in China were not only much cheaper than those in developed countries, but the Chinese workers’ productivity also moved upwards at a faster pace (from a much lower starting point). It enabled foreign enterprises to reduce its production costs so that they could sell their goods at bigger margins in developed countries. In addition, it also gave them greater access to China’s domestic markets. But the trade imbalance between China and its two main trading partners (US & Europe) became so lopsided in favour of China over the last two decades, that one would have expected the Renminbi (Chinese Yuan) to appreciate sufficiently to make Chinese exports relatively more expensive in Euro and US$ terms, resulting in a much smaller trade export surplus or deficit. However, China “pegged” the RMB to the US$ and basket of other currencies with the result that the RMB never appreciated sufficiently against the US$ and Euro to correct the trade imbalance. Chart C3 below shows the movement in exchange rates between the RMB/US$ and RMB and Euro (since inception). The RMB weakened substantially against the US$ from 1985 to 1994 and then remained static until 2006 when it strengthened slightly. The RMB however continued to weaken against the Euro from 2003 to 2008, during which time China’s trade surplus with Europe escalated at a fast pace. The red line on the chart indicates the expected direction of movement of the RMB considering the steep ascent of China’s trade surpluses (black dotted line) with Europe and United States.

9

In chart C4 below, the blue bars reflect the extent to which China’s exports to the United States exceeded its imports (exports divided by imports) from it. Any part of the bar above the brown dotted line represents a surplus of exports over imports for China. The chart shows the strong positive correlation between the RMB/US$ exchange rate and the movement in trade surpluses (as defined above) between the two countries. While the RMB weakened, the balance of trade (surplus for China) moved in favour of China. However, when the RMB became stronger in 2006, the trade surpluses decreased, confirming its sensitivity to RMB/US$ exchange rate.

10

Chart C5 below describes the same scenario with the main focus on the Euro and the growing trade imbalance between China and Europe. The blue line above the dotted black line represents a surplus in China’s favour and vice versa. Europe was a net exporter of goods to China until 1996 and held its own in trade with China until about 2003. Once the Euro started to appreciate against the RMB, the tide turned in China favour. The widening surplus trade in favour of China continued until 2008 when the Global Financial Crisis started to impact trade and the Euro weakened slightly. The delicate relationship between exchange rates and movements in trade imbalances speaks for itself.

11

Chart C6 confirms the delicate relationship between exchange rates and trade imbalances. By depreciating the Lira in the early nineties, Italy held on to a trading surplus until 1998. From 1998 to 2002, the two countries maintained some balance with a small trade surplus in favour of China. As Italy became part of the European Union its trade with China became subjected to the RMB/Euro exchange rate. As soon as the Euro strengthened significantly against the RMB from 2003, the balance of trade tipped decisively in favour of China. Today, Italy is facing a sovereign debt problem that may yet start a new credit crisis. Trade imbalances between two countries are not necessarily problematic as long as any growing deficit with one country is balanced by a surplus with another country. However when trade balances grew so lopsided in favour of one country like China and the beneficiary of such an imbalance prevents its currency from strengthening, you have a crisis waiting to happen.

12

The effect of currency fluctuations on trade imbalances is confirmed by the United States’ growing annual trade deficits since the early eighties. Soon after the US trade deficit with Japan started to grow substantially in the early parts of the eighties, the United States exerted strong pressure on Japan to adopt measures which caused the Yen to strengthen markedly from around 1986. It soon turned the tide more in favour of the United States from 1987 and the deficit stabilised at a lower level which soon reflected on the US total trade deficit as shown in Chart C7. The appreciating Yen was also the beginning of the end for Japan’s exceptional economic expansion over more than two decades. As Japan faded at the beginning of the nineties, another sleeping giant from Asia was ready to take over the mantle from Japan. The RMB depreciated by more than 50% against the US$ from 1985 to 1994 and set the scene for China’s explosive export growth that was yet to bloom fully. The US trade deficit with China grew fairly rapidly during this phase from a zero start, but it was nothing compared to what was still to come.

13

From 1995 to 2005, the US trade deficit with China grew sixfold without any significant adjustment to the RMB/US$ exchange rate. Chart C8 below shows that once the RMB strengthened a little from 2006 onwards, the pace at which the US deficit with China grew slowed a little. However, this RMB appreciation was not enough to make any meaningful impression on the lopsided trade imbalance between the two countries. Chart C8 also shows to what extent the US total deficit (with all countries) followed the same trend as the US/China deficit. Although the United States’ deficit with Europe also grew rapidly from the late nineties till 2005, its subsequent improvement was significant. In 2005, the US/China deficit exceeded the US/Europe deficit by 63% and by 2010 the US/China deficit exceeded the US/Europe deficit by 340%.

14

Based on various purchasing power parity models (Big Mac & Starbucks Latte Indexes), the RMB was about 30% to 50% undervalued in 2010. Comparing the RMB with the Australian dollar is another way to estimate the extent of its undervaluation. Australia’s economy grew at a third of the pace of China over the past 10 years and lagged far behind China in recording trade surpluses, productivity growth and accumulating foreign reserves. The Australian dollar appreciated by around 50% against the US dollar from the beginning of January 2002 to January 2012. In comparison the RMB appreciated by less than 25% against the US dollar over the same period. Based on the fundamentals mentioned above, this limited appreciation of the RMB does not make sense. An appreciation in access 65% would have been more in line with the fundamentals. All of the above strongly suggest that the RMB is substantially undervalued. It is obviously an important factor in the ever widening trade deficits, not only between the United States and China, but also between Europe and China.

15

The Unsustainability of China’s huge Trading Surpluses FDI and an undervalued currency played a considerable role in China’s remarkable success in international trade, especially its trade with the United States and Europe. It also had a direct and indirect impact on China’s rapid GDP growth, especially over the last decade. A substantial part of China’s growth has come at the expense of growth for the developed countries. Accumulating sovereign debt, stagnating growth, growing unemployment and growing budget deficits, however, are putting the United States and Europe under severe pressure to change the escalating trade imbalance. They are now forced to move to austerity. They will eventually be forced to move against China. The current trend in China’s trade with the United States and Europe is simply unsustainable – a significant change in this trend cannot be too far off. China’s attitude of defiance in the face of various accusations that they are guilty of currency manipulation and other forms of double-dealing (subsidies, interest free loans, dumping etc.), comes as no surprise. China’s future growth is heavily dependent on its export industry. As we will show in subsequent articles, China’s domestic consumer consumption is simply insufficient to support their huge growth in fixed investments. Although the United States in particular is aware of the threats of their growing deficit with China and started to exert some pressure on China over the past few years, they have taken no concrete steps to stop the rot. China knows it holds most of the trump cards in this threatening trade war. Big business and multi-national companies have made big investments in China over the past two decades, either by outsourcing or off-shoring the production processes of their goods – reaping the benefits of lower input costs and higher

16

profits. They also invested a lot to get access to China’s domestic markets. This process has been very profitable to them and any form of trade war between China and the United States and/or Europe would probably kill the goose that lays the golden eggs. Big business therefore opposes action against China by the United States or Europe in fear of a possible trade war. Their public justification given for such opposition is of course not the concern for their own wellbeing, but rather their sincere concern for the fragile state of the world economy. When big business’ lobbyists go to work, the US and European governments often listen and obey – after all, some of them have the best government that money can buy. The elephant in the room, however, cannot be ignored for too long. The problem is currently dealt with in the usual way – kick the can down the road. In the meantime China is fast approaching the point where its economic power will become so strong that it may simply bully its opposition into submission, not unlike some developed countries has done in the past. China’s bulging trade surplus, ironically, is not in its own long term interest either but the changes they need to make to do without huge trade surpluses - like the more equal distribution of income to raise consumption - may well prove to be a stretch too far. In subsequent articles we will look at the sustainability of China’s amazing growth, real estate development, savings, fixed investment and consumption.