Why China will still depend on export-led growth

Midnight. The sound of heavy rain. And Kishore Kumar’s voice.
“Munna bada pyara, ammi ka dulara, koi kahe chaand koi aankhon ka taara,” went the song.

“Why are all the FM channels suddenly remembering Kishore today?” she asked.

“It’s August 4. If Kishore was still around, he would have turned 81,” I explained.

“Kishore Kumar at 80. Sounds strange.”

“Why?” I asked.

“I have this theory that some people should never age.”

“And that list includes you?”

“Ha ha. That wasn’t funny. But tell me, do the Chinese listen to Kishore Kumar?”

“How would I know? I have never been to China.”

“But you keep explaining to me about China and the role it has played in the financial crisis all the time. So I thought you would know this answer as well.”

“Ah. Now I get the point. Why go round and round on this? Ask me your question directly,” I said.

“Well we have been talking about the yuan and how China recently let the yuan float against the dollar. What do you make out of that? Any new point?”

“Well there is an interesting point. You see, when lots of dollars come in, people bringing in these dollars into China, sell dollars and buy yuan. This pushes up the demand for yuan. At that point, China’s central bank enters the market and starts to sell yuan and buy dollars. This ensures that there are enough yuan going around in the market, and its value does not appreciate.

But what this does is that it increases the supply of yuan within China and increasing money supply can lead to inflation in daily life. But that is not happening. Do you know why?” I asked.

“No. Tell me.”

“See, the Chinese central bank has to ensure that their move to manage the value of the yuan does not lead to inflation. How do they do that? They sell Chinese government financial securities and buy yuan. These securities are bought by investors. This ensures that yuan are sucked out of the market, and inflation is controlled.

The cycle is repeated over and over again. But there is a catch — interest needs to be paid on these financial securities. Now take into account the fact that China has foreign exchange reserves of around $2.4 trillion, which it has earned largely through exports. When all this money was coming back into China, the Chinese central bank would have first sold yuan into the market and then bought it back by selling financial securities. China needs to pay interest on this humungous amount of money to keep inflation low.”

“But this humungous foreign exchange of $2.4 trillion must also be invested somewhere and that investment must also be earning money,” she interrupted.

“Yes. As I have told you in the past, this money is largely invested in financial securities of the US government. And interest rates in the US are very near close to 0% at present. So the Chinese are not making much money on the foreign exchange invested in the US. And at the same time, they have to pay interest on it as well.

This has led to a situation wherein China also has to keep its interest rates low, so that it does not have to pay a huge interest amount of interest on all its foreign exchange. As Raghuram Rajan writes in his book Fault Lines - How Hidden Fractures Still Threaten the World Economy, “If interest rates in the US are very low, China also has to keep interest rates low. Doing so risks creating credit, housing, and stock market bubbles in China.”

So, in that way, Chinese interest rates are linked to the interest rates in the US and cannot be raised till the interest rates in the US go up.”

“So this is another way through which China and the US are interlinked.”

“Yes. They have become like Siamese twins. But there is a bigger repercussion of this. As Rajan writes, “the low interest rate has other adverse effects: it reduces household income and, somewhat perversely, may force households to save more in order to build a sufficient nest egg for retirement. It thus depresses household consumption and makes China yet more dependent on foreign final demand.

” Which means that in order to grow, China will have to continue to expand exports to the debt-laden US, which should really be cutting back on consumption,” I explained.

“Interesting. Tell you what, let’s go for a walk on the sea face.”

“Now?”

“Yeah. Worried of getting wet?”

“Nah. Was wondering which Kishore song I should sing now.”

“And what do you have in mind?”

“Ek ladki bheegi bhaagi si, soti raaton main jaagi si…”

(The example is hypothetical)

References: Fault Lines - How Hidden Fractures Still Threaten the World Economy, Raghuram G Rajan, Collins Business, 2010