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

by Frederik Balfour

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.