China’s Growth Model

According to some preliminary estimates (link), China’s trade balance is on the course for a significant surplus this year. IMF’s annual forecast of current account balance predicted China’s trade surplus at $334 billion in 2010 or roughly 6.2 percent of China’s GDP. The IMF’s medium-term forecast suggests a growing trade surplus by 2015 when the surplus is estimated at a little more than 8 percent of GDP.

Recently, Dani Rodrik questioned (link) the persistence of China’s mercantilism based on persistently low exchange rate. The partial fixation of the exchange rate then stimulates export-led growth model and, consequently, results in a large trade surplus which translates into foreign exchange reserves, thus enabling China’s central bank to foster exchange rate intervention to defended the targeted yuan exchange rate against the U.S dollar. The implications of China’s growth model extend beyond the scope of effects on country’s economic growth, investment and current account balance. China’s export-led growth model has tremendously affected the macroeconomic performance of developing nations. The exports of developing nations in the European, Japanese and U.S markets basically substitute, not complement, China’s exports to the markets of advanced countries. The persistent lack of the appreciation of renmimbi thus forced the economic policymakers of other developing nations to either adopt the same model of exchange rate intervention or lose the export share in developing countries. This intuition is underlined by the theoretical and empirical support.

In 2007, Hausmann, Hwang and Rodrik demonstated (link) that the pattern of specialization by developing countries predicts the subsequent economic growth, suggesting that the share of exports in advanced countries is highly positively correlated with the rates of economic growth. If China shifted the main source of economic growth from export-led model to domestic consumption, the renmimbi would have to appreciate considerably. Contrary to the assertion that China’s exchange rate undervaluation hampers the economic growth, industrialization and development prospects of developing nations, the OECD recently stated that developing countries would be hurt significantly if the renmimbi exchange rate were allowed to appreciate. There is also an empirical support for the particular assertion. The OECD recently estimated (link) that, if China’s output grew by 1 percentage point, the output of developing countries would decrease by 0.3 percentage point.

The empirics supports the argument I mentioned earlier – China’s exchange rate misalignment inevitably hinders the growth prospects and industrialization of developing countries. The essential question in the course of economic development is what is the best model of growth for developing countries to boost industrialization and development frontiers.

One possibility is the so called surplus model. Historically, growth models of low-income countries were primarily based on exporting natural resources to the rest of the world. Countries such as oil-rich gulf states, Botswana and Argentina became wealthy. Such growth model heavily depends on export demand in other countries. The most notable failure of this growth model is that it doesn’t encourage the diversification of economic activity. Thus, countries such as Libya have sustained relatively high levels of GDP but, at the same time, rather depressing domestic indicators. For instance, Libya’s GDP per capita is at almost the same level as Chile’s GDP per capita, but Libya’s unemployment rate is 30 percent – almost three times the average unemployment rate in countries with the same level of GDP per capita. When foreign demand deteriorates, these countries experience the Dutch disease – an overheating economic activity and overvalued exchange rates that discourage investment, entrepreneurship and typically result in higher unemployment rates.

Industrialization and economic development mostly depend on domestic structural change based on the adopting the institutions of macroeconomic stabilization and the rule of law. China’s exchange rate policy of renmimbi undervaluation is a failed temporary growth model that is set on the unsustainable course. Without shifting the major engine of growth from export-boosting exchange rate undervaluation to consumption-based growth, Chinese economy will no longer be able to sustain high productivity growth rates. Letting the renmimbi appreciate by free floating could significantly boost the potential for institutional change in China and other developing nations. Therefore, the systemic abuse of macroeconomic policy by exchange rate undervaluation would no longer be feasible and the costs of failed exchange rate regime for developing countries would diminish substantially.

1 comment to China’s Growth Model

  • Josh

    I don’t see many facts here backing up the arguement of Chinese currency undervalued. When the export industry collapses in China because of over-valuation of its currency, you will see the true effect of renminbi appreciation on its economic growth. If renminbi is not appreciated, the salaries of migrant workers will. One way or the other, the chinese economy will be equilibriated. Except that, appreciation of renminbi is good for currency speculators and foreigners, while the appreciation of workers’ salaries is good for chinese. I am sure that Chinese take a note of Japanese economic failure due to bending to American pressure. For them, it would be better off to have a limited trade war with United Staes than to substantially appreicate its currency. The reason is simple: The demand for further appreciation of renminbi will not end even if it appreciates another 20%. Second, yielding to American pressure will be perceived as a weakness by Chinese people. Such perception will make the population more difficult to control. No ruler in China survives after showing its weakness or defeated by foreign forces. In fact, standing up to the pressure from foreigners will gain more support from the domestic population.

    It is also highly doubtful on the economic model calculation. many of the calcalations are agenda rich and grossly simplified or outright exaggerated.

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