A Nobel Winner's Rx for China

Robert Mundell thinks China must fix its gaping trade balance on its own terms, but faces a serious backlash if it waits too long

Robert Mundell won the Nobel Prize for economics in 1999 and is widely known for his theoretical work on the development of the euro, the interplay among exchange rates, inflation, and economic growth, and his advocacy of supply-side economics. He also has developed some interesting views on the startling economic rise of China.

The Columbia University economics professor spoke with Asia Correspondent Frederik Balfour on May 4, during a swing through Hong Kong, about how Beijing should deal with China's burgeoning global trade surplus and the dangers of allowing the yuan to appreciate too rapidly. Here is an edited version of their conversation.

What should China's number one priority in macroeconomic management be?

The first thing China needs to do is bring its balance of payments into equilibrium. How they do this should be up to China, not the rest of the world. But they can't go on accumulating $200 billion a year in foreign exchange.

In my opinion, it would be vastly better to bring it into equilibrium around the current exchange rate without a sharp appreciation that would upset their whole macroeconomic strategy of maintaining strong growth with low inflation. China had a fixed exchange rate from 1997 to 2005, and it made a change towards slow, steady appreciation around 3% to 5% per year. I think that policy is not the right one.

So how should China bring its balance of payments into balance?

First it should move in the direction of relaxing exchange controls and in the direction of convertibility without going all the way. Second it should stop sterilizing the monetary effects of purchasing foreign exchange [by selling bonds to mop up the increased money supply]. This will increase absorption [total spending], imports, and total spending by people in China.

Would this affect inflation?

It's a mistake to think it is inflationary. The risk of inflation is very slight because the supply potential is enormous if you expand demand. Part of total spending will fall on imports and on exportable products to the extent Chinese buy more of their own goods instead of sending them abroad.

Why are the Chinese such huge savers?

The large savings comes about through population policy. Historically, Chinese had children as durable goods to provide for retirement. When the one-child policy was introduced, it cut off this form of social security so the Chinese turned to high savings—instead of investing in children, they invested in savings for their old age.

How does the current situation affect asset prices of things like property and stocks?

The disequilibrium in China is a balance-of-payments surplus—…excess demand for money, and sterilization frustrates it, and stores up excess demand for money for next year and perpetuates the disequilibrium. If you satisfy excess demand for money, this doesn't create a change in demand for assets. However, the long-term trend is up in a rapidly growing economy.

It's sometimes believed that the U.S. is at fault for spending too much and saving too little—do you agree?

People don't necessarily spend beyond their means without realizing they have to pay it back. In the U.S. it's a great big supermarket of future income streams from capital assets, stocks, and bonds people that have. It offers the best income streams in the world, and everyone wants to get into them. When the rest of the world buys more of those [assets] than Americans buy from the rest of the world, this imposes on the U.S. that excess of spending over income that is the current account deficit.

What advice would you have for Vice-Premier Wu Yi when she meets with [U.S. Treasury Secretary] Hank Paulson in Washington later this month, given the current sentiment of protection in the U.S.?

I would advise her to do something to stabilize the U.S. balance of payments and do it in a way that's good for China. You could appreciate the exchange rate but that's bad for China.

Also, tell her to do the best she can to meet the objections and complaints about intellectual property rights and treat very seriously issues such as food supply chain.

What would happen if China stopped buying U.S. treasuries with its additional reserves?

This would have a little impact possibly on interest rates—a small impact. If China stopped buying foreign exchange assets, the balance-of-payments situation would change. The U.S. has a deficit in large part because other countries finance it. If the rest of the world stops financing it, the deficit will go away.

But I don't want the U.S. deficit to go away, because the U.S. deficit is very good for the rest of the world. Right now, it's fuel for growth of the world economy and supplies liquidity to the world. But in the long run we have to take some burden off the United States from the dollar's role as the global currency.

How much longer will the dollar remain the principal global currency?

The dollar has been the major world currency since early World War I, when it replaced pound sterling—and it's going to continue for a long time to come, as long as the U.S. remains the No. 1 power and the most innovative power, and as long as the U.S. economy is strong.

When will China become the most dominant economy?

It will be a long time before China's s standard of living will approach the U.S. It might be 100 years; I see the dollar era lasting another century.

What do you think of China's building up a fund like Singapore's Temasek to spend its huge hoard of reserves? (See BusinessWeek.com, 3/12/07, "China's Giant New Investment Agency".)

China has built up $900 billion in foreign exchange reserves in the past decade, vastly more than any other country in history. The rest of the world, and particularly the U.S., has allowed China to do this. It's absolutely important that China use these reserves responsibly.

What does responsible investment mean?

The whole question of using it as a way to take over companies—if not done responsibly—would be rejected in many countries and they would be shut out. The whole spirit of the world economy would be lost.

Isn't there too much paranoia about the rise of China and that was why its oil company, CNOOC, was thwarted from buying Unocal?

Yes, this example was a warning that this issue is a very sensitive one to the rest of the world.

How does that compare to the rise of Japan and its purchase of Manhattan real estate properties and media companies in the 1980s?

There was [some] fear of Japan buying too many properties and increasing control in the 1980s, and the U.S. reaction was the Plaza Accord when they forced Japan to appreciate the yen [leading to] serious damage to the Japanese economy. China should look at the example carefully. That's why it's not in China's interest to have a big appreciation forced upon it.

Finally, what do you make of the big discrepancy in prices for Chinese shares with dual listings which are so much higher in China than in Hong Kong?

This big gap between prices of shares in Hong Kong and China is an element of the lack of financial integration and the fact that the yuan is not convertible. It's waving the flag that shows China's financial development is still immature.