Factor Market Distortion and the Current Account Surplus in China Factor Market Distortion and the Current Account Surplus in China* Yiping Huang Abstract China Center for Economic China’s large current account surpluses not only destabilize its Research Peking University own macroeconomic conditions, but are also a focal point for Yiheyuan Road No. 5, Beijing, global rebalancing discussions. Existing explanations by the litera- China 100871 [email protected] ture fail either to account for the recent surge or to offer action- able policy responses. In this study, we propose an alternative hy- Kunyu Tao pothesis: asymmetric market liberalization and associated cost China Center for Economic Research distortions. These distortions are producer subsidy equivalents, Peking University which contributed to both extraordinary growth performance Yiheyuan Road No. 5, Beijing, and the growing structural imbalances. Our rough estimates of China 100871 [email protected] such factor cost distortions offer some explanations for recent movements of the current account. We argue that China needs to adopt a comprehensive reform package to rebalance its economy. 1. Introduction China’s current account surplus has been the subject of a contentious international economic policy debate for the * This paper is part of the output of the joint research project on “Trans-Paciªc Rebalancing” by the Asian Development Bank Institute and the Brookings Institution and was presented at a project workshop in Tokyo on 3–4 March 2010. A revised ver- sion of the paper was also discussed at the Asian Economic Panel meeting in Incheon on 22–23 March 2010. We wish to thank our discussants Shin-ichi Fukada, Liqing Zhang, Bhanu- pong Nidhiprabha, and Yonghyup Oh for detailed comments on the paper. Barry Bosworth, Masahiro Kawai, Harry Wu, Wing Thye Woo, JoonKyuang Ha, Chalongphob Sussangkarn, Frederick Sjöholm, Ligang Liu, John Knight, Don Hanna, and Prema-chandra Athukorala also provided useful comments. We also wish to thank the Asian Development Bank Institute, the China Center for Economic Research at the Peking Univer- sity, and the China Economy and Business Program at the Aus- tralian National University for support at various stages of this research. Asian Economic Papers 9:3 © 2010 The Earth Institute at Columbia University and the Massachusetts Institute of Technology Downloaded from http://www.mitpressjournals.org/doi/pdf/10.1162/ASEP_a_00020 by guest on 01 October 2021 Factor Market Distortion and the Current Account Surplus in China past several years (Goldstein and Lardy 2008). Politicians in the United States and Western Europe often criticize China’s rigid exchange-rate regime. Their real focus, however, was probably not the exchange rate policy per se but China’s growing trade and current account surpluses. It was argued that, by artiªcially depressing the value of renminbi (RMB), China probably took jobs away from its trading part- ners (Krugman 2010). Recently, some American policymakers again blamed China for helping to cause the sub-prime crisis in the United States. The argument was that China’s large current account surplus lowered the cost of capital and fueled the housing bubble in the United States. This accusation was rejected strongly by Chinese policymakers. However, Chinese economists and government ofªcials have also grown uneasy about the rapidly expanding external sector imbalances. Yongding Yu identiªed a number of reasons why the growing imbalances were not in China’s interest (Yu 2007). He pointed out that a persistent current account surplus meant that China as a low-income economy was exporting capital to rich countries. Rising external sur- pluses often worsened China’s trading relations with its major trading partners. And, ªnally, rapid accumulation of foreign exchange reserves also made China vul- nerable in face of U.S.-dollar adjustment. At least for the past several years, the Chinese government has made improving quality of growth a top policy priority (see, for instance, Wen 2006). It made various efforts to limit export growth and narrow the current account surplus, by lowering export tax rebates, liberalizing import barriers, and increasing exchange rate ºexibility, among other actions. The rapid growth of China’s current account surplus is, in fact, a relatively recent phenomenon. During the second half of the 1980s, China had persistent trade and current account deªcits (see Figure 1). This was probably because at that time, while imports started to expand as a result of domestic economic reform, the export sector was yet to boom. In 1990–92, the current account recorded surprising sur- pluses, due to a sharp downturn in domestic demand following the Tiananmen Square uprising. After Deng Xiaoping’s Southern China tour in 1992, the current account showed a deªcit in 1993, as acceleration of domestic investment boosted import demand, be- fore returning to surplus positions in the following years. The sharpest rise in the current account surplus occurred after 2004. In three years, the surpluses jumped from 3.5 percent of GDP in 2004 to 10.8 percent in 2007. In 2008 and 2009, external 2 Asian Economic Papers Downloaded from http://www.mitpressjournals.org/doi/pdf/10.1162/ASEP_a_00020 by guest on 01 October 2021 Factor Market Distortion and the Current Account Surplus in China demand was seriously dampened by the global ªnancial crisis. As a result, China’s current account surpluses moderated, but only modestly. The latest development is at least indicative that the Chinese government’s policy efforts containing growing surpluses after 2003 have not been effective. The external imbalances continued to deteriorate, although it might be argued that the situation could be worse without the policy efforts. The bottom line is that either the govern- ment has not been aggressive enough or it has not yet found the root cause of the problem. What are the fundamental factors contributing to China’s growing current account surpluses? The literature already offers a long list of explanations about why China’s external surpluses grew rapidly during the past years. These explanations can be grouped into six broad categories: • Measurement errors: The so-called “hot money” inºows disguised in forms of ex- port revenues or income transfers probably exaggerate the current account sur- plus. • Saving and investment gap: The extraordinarily high saving rate, which is determined by various economic and cultural factors, results in a large saving- investment gap and, therefore, a massive current account surplus. • Demographic transition: The change of demography structure affects the labor cost, the saving-investment gap, and the real interest rate, which can inºuence the current account balance further. • Industry relocation: Relocation of industries from other East Asian economies to China in recent years also transfers trade surpluses from these economies to China. • By-product of policies promoting growth: The government policies promoting exports and GDP growth and pursuing full employment boost domestic produc- tion and external surpluses. • Exchange rate distortion: An under-valued currency raises exports and depresses imports, and thus inºates China’s trade surplus. It should be noted that these explanations are not necessarily mutually exclusive. For instance, the perceived exchange rate distortion might be applied as a part of the general policy supporting growth. Changes in the saving and investment gap are the fundamental mechanism behind the role played by demographic factors. All of these explanations are helpful for understanding China’s growing external imbalance problem. However, the saving and investment gap hypothesis is really an 3 Asian Economic Papers Downloaded from http://www.mitpressjournals.org/doi/pdf/10.1162/ASEP_a_00020 by guest on 01 October 2021 Factor Market Distortion and the Current Account Surplus in China Figure 1. China’s current account balances, 1986–2009 (% GDP) Source: CEIC Data Company. identity and does not offer insights on how the problem developed. The by-product hypothesis and the industry relocation hypothesis do not easily generate actionable policy prescriptions to remedy the problem. Demographic transition is also difªcult to reverse, at least in the short term. Finally, the exchange rate hypothesis, although not controversial, could lead to superªcial policy implications. In this paper, we offer an alternative hypothesis: Factor market distortion and the associated producer subsidy equivalent as a result of China’s asymmetric market liberalization approach may cause China’s external imbalances. During the reform period, the Chinese government almost completely liberalized the goods markets, but factor markets remained heavily distorted. These distortions have a general ten- dency to depress factor prices and lower production costs. They artiªcially increase producer incentives, raise investment returns, and improve the international competitiveness of Chinese products. All of these factors boost China’s exports. In addition, they also distort the broad income distribution pattern in favor of the gov- ernment and the corporate sector, but at the expense of household income. This weakens consumption and further boosts external sector surplus (Huang 2010). This paper is organized as follows. Section 2 reviews the evolution and composition of the current account balances during the reform period and then offers a survey of the literature and a critical assessment of the six