Reports of the death of American economic primacy are exaggerated, as are expectations of future Chinese dominance. The past 15 to 20 years have seen a huge Chinese catch-up with the advanced economies that many are projecting far into the future. But the distortions entailed by China’s chosen mode of development now threaten it with a turbulent period of adjustment to an entirely different and probably uncongenial alternative route forward. Meanwhile, the unwinding of those same distortions will remove artificial barriers to the United States’ competitiveness and thus fuel future economic growth.
China’s fast growth and sheer size have produced a meteoric rise to over 13 percent of world GDP in 2010 measured at comparable dollar prices. But during the last 18 years of China’s supersonic expansion, Beijing has chosen to attach its economy to the United States. It fixed the yuan rate to the dollar in 1994 to stabilize an economy that had just seen inflation accelerate to 30 percent. At the time, that rate reflected China’s competitiveness. Over the period 1995 to 2004, China saw ten years of falling export prices, as idle rural labor was brought into the cities and profitably employed at low wages. The United States’ modestly positive inflation moved bilateral competitiveness sharply in China’s favor.
At comparable purchasing power, China’s GDP moved from 21 percent of the United States in 1993 to 75 percent in 2011. The dollar zone created by Beijing’s exchange rate policy is no longer a tiny Chinese “moon” attached to a huge U.S. “earth”, but a near-equal pair of seriously mismatched economies. The global market values the combined entity at roughly the “right rate,” but the result has been sustained overvaluation of the U.S. arising from the deliberate continuation of Chinese undervaluation.
In such a zone, the undervalued part (China) will tend to inflation, the overvalued part (America) to deflation. In July 2005, Beijing allowed the yuan to start rising against the dollar and by mid-2008 it had gained 18 percent. But clearly this was insufficient, with China’s consumer price inflation accelerating fast in 2006 to 2008 to top 8 percent. Meanwhile, the global economy approached crisis, driven by imbalances partly resulting from the relative cost shifts between the United States and China. The crisis provided China with a temporary relief from inflation at the expense of recession. The onus of the adjustment was temporarily shifted to U.S. deflation.
Beijing’s response to the crisis was re-fixing the yuan to the dollar in mid-2008 and then a massive monetary stimulus in 2009 to 2010. Inevitably, the result was inflation. By August 2010, Chinese inflation was up to 3.5 percent year-on-year from minus 2 percent in mid-2009, a huge 5.5 percent point shift in just over a year. The United States, fearing the onset of deflation, also tried to stimulate its economy. The Federal Reserve’s QE2 sent food and energy prices up 20 percent, pushing the adjustment further onto Chinese inflation, which rose to 6.5 percent year-on-year by mid-2011.
With the yuan allowed to increase against the dollar again since mid-2010, and Chinese wage costs now rising faster than prices, China’s unit labor costs are rising in dollar terms by over 10 percent. In the United States, they are flat to falling. The undervaluation of Chinese costs that Beijing hoped to preserve by controlling the yuan/dollar rate has been eroded at a 10 percent annual rate since late-2009. By mid-2012, the United States could see its relative bilateral competitiveness improved vis-à-vis China by more than 20 percent. China’s refusal to let the yuan appreciate was a blunder. Its real exchange rate has gone up hugely, but through the toxic “back door” of inflation.
The United States, now concerned with preventing government debt spiraling out of control, is engaged in sharp fiscal deflation that won’t be offset much by monetary ease or external growth, as Chinese growth slows down fast while Europe contends with a major recession. The global economy is teetering towards another hard landing in 2012. And from these “ashes” it is the American Phoenix that will rise. Renewed U.S. competitiveness will cause “off-shored” business to return to the United States, boosting capital spending, which cash-rich firms can easily finance. Public sector deleverage and rising household savings suggest the next 3 to 5 years are unlikely to see rapid demand growth, but a rising U.S. production share of what demand there is should ensure reasonable GDP growth.
The same can’t be said of China. Its export-led growth model is rendered obsolete by America’s inability to continue to run huge current account deficits on the back of excessive domestic borrowing. Its huge size compared to previous export-led economies, notably Japan, is a major problem, but China also quite simply is the one left standing as the U.S. music stops. Export-led growth is a dud strategy now the United States is unlikely to be the easy market of first resort.
China’s astonishing 46 percent fixed investment ratio to GDP necessarily involves huge wastage that will have to be curtailed. Much lower growth in future as the strong external demand of the past is no longer there implies much weaker investment growth. But consumer income depends on cash “trickling down” from the export and investment activity that have led the economy. This could be reduced unless the government, and associated state-owned banks and enterprises, willingly accept a much lower share of national income.
There’s little sign of this as the government dares not even raise interest rates above the level of inflation. The reality is that 2012’s tough global environment could herald several years of severe economic turbulence in China.
Charles Dumas is chairman of Lombard Street Research. Diana Choyleva is head of U.K. Service at Lombard Street.