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Is China the new Japan?

  • Author:naky
  • Source:www.diecastingpartsupplier.com
  • Release on:2015-11-26
The new Chief Economist at the IMF, Maurice Obstfeld, posed a challenging question at the end of his first major policy conference in charge last week: “Is China the new Japan?” This question has been asked before, usually in the context of the massive credit bubbles in the two economies. The deflationary lessons from Japan’s imploding bubble in the 1990s are often thought to be relevant to China’s credit bubble in the 2010s, and this story is far from over.

Maurice Obstfeld, however, had something more specific in mind. He cited the work of the late Ronald McKinnon, a distinguished international economist who argued in the 1990s that Japan was being forced into deflation by an overvalued exchange rate. That, in turn, stemmed from the political pressure exerted on Japan to correct its current account surplus by raising the value of the yen. The implied threat, notably (but not solely) from the US Congress, was that direct trade controls would be imposed on Japanese exports if the exchange rate were “artificially” held down.

China has been subjected to similar threats from the US and others in recent years, and has responded by allowing the inflation adjusted valuation of the renminbi to rise by 60 per cent in the past decade. Even in the last 12 months, with China suffering from deep deflation in its manufacturing sector, the real value of the renminbi has been dragged upwards by 15 per cent because it has been largely fixed against the appreciating US dollar.

But that choice may have increased deflation risk within China, because overall monetary conditions have remained fairly tight as manufactured goods prices have plummeted. Presumably this is what Maurice Obstfeld had in mind when he compared China now to Japan two decades ago.
How serious is the risk that China will follow the Japanese route into chronic deflation?

The McKinnon thesis, as applied to Japan, was as follows. Throughout the 1980s and 1990s, Japan ran a huge current account surplus, and was accused by other nations of “manipulating” its exchange rate in order to achieve this. Under threats of direct trade controls, Japan allowed the yen to rise massively in two major phases, from 1982-88, and from 1990-95. McKinnon argued that the yen had never been undervalued in the first place, and that the Japanese current account surplus was instead due to an endemic shortage of savings in the US, matched by a permanent excess of savings in Japan.

So far, it has persisted with a “prudent” monetary policy, cutting interest rates less than in line with falling inflation rates, especially in manufacturing. Real interest rates have therefore been rising. Meanwhile cuts in the reserve requirement ratios in the banking sector have only replenished the liquidity drain that has been driven by capital outflows from China this year.
This process does have some similarity to what happened in Japan from 1995 to 2012, but it stems mostly from a voluntary choice by China, not from a liquidity trap imposed from the inappropriate foreign exchange polices of other nations.

If China wants to escape from its deflationary trap, it still has the weapons to do so. But it will have to accept some weakening in the exchange rate. And the longer it waits, the more intractable the problem will become.