China Research

Just in tradition with its past policies, Chinese authorities have launched more recently another small, reversible but potentially significant step of reform towards a further opening of the economy. In the Pudong district of Shanghai, they opened a pilot free zone for hitherto highly regulated service sectors, in particular financial services. As services do not face tariff borders, the border between the Pudong area and the rest of China is determined by the extent of regulatory divergence: a foreign supplier of services is treated less favorably compared to a domestic supplier in the rest of China but not (or less) in the Pudong zone. So, in terms of so-called national treatment, that is non-discrimination between both suppliers in a domestic market, the Pudong zone in a nutshell would meet essential targets of the WTO in freeing international trade in services.

Beyond that trade policy aspect, from a macroeconomic point of view, this zone suggests the questions whether the authorities will allow the RMB to be traded freely without any interventions from the Central Bank and if so, under which assumptions a market rate different from the official rate would emerge and in which direction the market rate would differ. Finally, would the Central Bank accept such a market rate as a signal to adjust its interventions to that rate in order to keep differences between market and official rate small and thus contribute to gradually erode the border between a RMB rate in the rest of China and that in the zone?

Let us assume that a Chinese financial service supplier bets on continuing problems in the US to extend the debt break and perhaps even bets on a (temporary) default. He would offer a financial paper foreseeing a strong dollar depreciation and a stronger RMB.  Admittedly, this is an extreme assumption. But any other supplier seeing a weaker dollar in future for different reasons could bark upon the same tree. In the zone, he finds a partner taking the opposite position thus believing in a stronger dollar.

The result could be a sharp appreciation of the RMB market rate and a much lower RMB/$ rate than the official one. Other suppliers in the zone perhaps would follow suit and would trigger a herding effect.

My view is that for the time being, the Central Bank will not allow the Pudong RMB rate to differ widely from the official rate and that financial suppliers should be well-advised not to believe in a Pudong market rate exclusively determined by the markets rather than by the Central Bank. The reason for my assessment is that in the coming years, China will face two adverse effects in its current still export-driven industrial structure: an adverse price effect of trendwise real appreciation and an adverse income effect of lower demand in international markets.

This will make the transition in employment from exports to domestic demand-driven industries more difficult. Jobs in the export industry will be wiped out long before new jobs in the latter industries will be set up. In this situation, a further push in real appreciation triggered by financial service suppliers will be seen unwelcome. It would expose the already existing “currency mismatch” problem in China more sharply. China has returns in low-yield international currencies and commitments in local currency. An appreciation reduces the value of foreign reserves in local currency.

So, as in the past, the Pudong zone will not be a free market for foreign exchange. China will rely on its past policies. Steps must be reversible. Trials are welcome. So are errors once they can be corrected.

Rolf J. Langhammer
Professor & Former Vice President of the Kiel Institute for the World Economy

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Aiyar et al (2013) define the “middle income trap” as “a phenomenon with hitherto rapidly growing economies stagnating at middle-income levels and failing to graduate into the ranks of high-income countries”. Eichengreen et al (2013) use in a relatively recent analysis the critical “modes” for possibly commencing middle-income trap problems at the GDP per capita range of USD 10 000-12 000 and at the USD 15 000-16 000 level .

Thus, Eichengreen and al rather regard the middle-income trap as a process which can contain several steps. Following Eichengreen et al, China could currently indeed be relatively close to the lower mode – but this still uncertain. Interestingly, Eichengreen et al also conclude that the verification of a middle-income trap situation has shown a sustained reduction in the GDP-growth rate for as much as seven years; so far China has – the strong stimulus year of 2010 subtracted  – noted  five out of these seven years with the declining growth phenomenon (if we define two years with equal official growth rates as shrinking on trend; the average Chinese GDP growth declined during 2009-2013 to roughly 9 percent compared to 11 ½ percent during 2004-2008, with no major changes in average credit growth during these two periods ).

But Eichengreen et al have also found that some other characteristics which until now fit quite well to China and the description of a potential trapped middle-income country. They mention mainly quite high GDP-growth rates before the visible weakening of growth rates, a worsening demographic outlook, very high investment ratios and an undervalued currency. These criteria are very much in line with China’s development in recent years – but still too short-lived for making sufficiently sure about China’s real position in a “middle-income trap” application.

Since we do not know enough about the answer to the question whether China is about to enter the stage of a “middle income trap” or not, it would be very prudent if China could adapt the reasonable economic strategy plans of CPC’s  Third Forum congregation in November 2013 as much as possible. The degree of urgency may be somewhat uncertain – but certainly not the need of putting China fundamentally and structurally forward by new strategies and reforms in a lot of political, social and economic areas.

One should acknowledge that a lot of strategies that are needed for avoiding the trap of a middle-income country according to modern literature (also Agénor et al 2012), actually can be found in the Communist Party’s  60 different reform chapters of the Third Plenum from November 2013.

Interestingly, Agénor and his co-writers add in their article in general terms: “The middle-income trap is avoidable if governments act early – rather than late, when the benefits of cheap labor and the gains from imitating foreign technology are all exhausted  –  and decisively to promote innovation.”

To sum up: China faces the concrete risk to be caught in the middle-income trap – but it is probably not (quite?) there yet.  Many of the most needed urgent policy changes, however, are part of the Third Plenum’s envisaged strategy changes and improvements. Following Agénor’s advice, there is no time to lose for China’s political leaders to meet their own – reasonable – strategies and plans from the Third Plenum with courage and decisiveness.

References

Agénor, P-R et al (2012), “Avoiding Middle-Income Growth Traps”, Voxeu, December 21.

Aiyar, S et al (2013), “Growth Slowdowns and the Middle-Income Trap”, IMF Working Paper 13/71.

Eichengreen, B et al (2013), “Growth Slowdowns Redux: New Evidence on the Middle Income Trap”, NBER Working Paper No 18673.

Langhammer, Rolf (2012), “China Ahead of a Middle-Income Trap?” LNU blog:  www.chinareserach.se, from February 6.

Third Plenum (2013), “The Decision On Major Issues Concerning Comprehensively Deepening  in Brief”, Communiqué: http:/www.china.org.cn./china/third_plenary_session/2014-01/16/content_31212602_15htm

Hubert Fromlet
Visiting Professor of International Economics, Linnaeus University
Editorial board

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