Hong Kong based economist Chi Lo argues that while China is benefiting from 'benign' deflation on the back of the productivity growth boosting exports, this may be adding to the 'malign' deflation of some of its neighbours, still suffering from the legacy of previous overcapacity.
Recently, the Japanese have been crying foul with regard to China's currency, arguing that the Yuan is undervalued and thereby providing the country with an unfair export advantage. What's your view?
Lo: I think that's rubbish. It's partly an attempt to move the focus of attention from the much-needed structural adjustments in Japan's economy, which are facing opposition from entrenched local vested interests.
But many non-Japanese analysts also argue that the currency is undervalued, and Goldman Sachs, for example suggests it could appreciate by 15% under market conditions. In particular, some point to the fact that the the rapid growth in China's US dollar reserves shows that the central bank has been buying US dollar to dampen pressure on the Yuan.
But how can that be? For that to be true, ie that China's is taking unfair advantage through an artificially weakened currency, there would have to be inflation in China, with surging exports pushing up domestic and import prices. That's simply not the case. What is true, and is far more pertinent, is that China's export sector has seen enormous productivity improvements, especially since 50% of the exports come from relatively well-managed foreign firms producing out of China. The point about productivity growth, and hence lower prices, is that it is a totally legitimate form of competition, it's not cheating in any way, as an artificially low currency is. China's low export prices are also due to an almost unlimited supply of domestic labour, which means that wages are not growing in proportion to output gains, and thus helping to keep all prices low.
So what is driving China's exports?
Demand. The point about exports is that they are driven by demand as well as the currency. If you look at the export situation of most Asian countries during and after the Asian financial crisis, they were still not managing to sell abroad. In contrast, China, despite not devaluing its currency, has continued to see its export performance surge. So it's not all down to the currency. What you can see now is that there is real demand for Chinese goods all over the world, especially as international consumers move down from the higher-end products to more modestly situated products. What Japan is finding, and many of China's other neighbours, is declining markets for their own exports - hence the complaints.
You mention productivity gains, but what about the highly unproductive state sector?
But the state sector has seen enormous downsizing in past years, while the private sector has been growing strongly. China's bankruptcy law, which could be passed this year, is facing such a delayed implementation because it's targeted at some of the top 3000 state firms - and the ramifications of closing those giants down will be tremendous. We've also seen an up tick in the earnings of listed companies since 1999, assuming you believe the published data - and it is getting more reliable under China Securities Regulatory Commission mandated reforms.
Still, the Yuan is unofficially pegged against the US dollar, which has been sinking like a stone, certainly against the Euro. Also, given China's huge capital and current account surpluses, there should be upward pressure on the currency.
That is absolutely true. But the dollar's weakness is only a relatively recent phenomenon, over the past year - it neglects the fact that exports have been going up even when the Yuan was stronger, since it was beating out exports from other countries. Anyway, the whole issue of capital account liberalization is a very tricky one for a developing country in view of the destructive volatility of international capital flows. It's not possible to claim that China is closing its capital account and pegging itself against the dollar simply to keep its currency low and boost exports. There are other, even more important issues of economic stability at stake. Secondly, to be frank, no one really knows what the true value of the Yuan should be, since data out of China is so contaminated. For instance, we don't have a reliable inflation rate, or income and labour productivity data, so the arguments that the RMB is undervalued lacks validity.
Referring back to your earlier point about prices in China not keeping pace with productivity gains, does that mean deflation in China is qualitatively different to the other parts of Asia - benign, rather than malign?
Yes. Unfortunately, China is one of - but by no means the only source - for deflation in for example, Hong Kong and Taiwan. Two very important other sources of deflation are the huge overcapacity now being worked out, left over from the earlier dotcom boom, and a huge debt burden that has cut into consumer spending. Previously, excessive demand balanced excessive supply, but that demand is slowing down. 'Malign' deflation like this is savage. It eats away at consumer confidence and makes debt more expensive to repay. I believe that while in many areas China is on a growth track, despite lower prices, many parts of Asia are in trouble.
