McGregor’s long analysis piece in today's Financial Times (free link here) shows why.  It is the best summary of China’s macroeconomic policy challenges – and the contractions associated with China’s current policies – that I have read in a long time.   

If the discussion of macroeconomic policy in the today’s US-China Strategic Economic Dialogue is half as sophisticated, I would be surprised.    

McGregor highlights a series of points that I think deserve a bit more attention. 

One: China’s current development strategy actually hasn’t created many jobs.  At least not given how fast China is growing. 

For all the talk about how China cannot change its exchange rate until its surplus agricultural labor has been absorbed in the export sector, the available data doesn’t suggest that China's export machine has been a job creating machine.   Far from it.   Brazil (that’s right, Brazil) has done better.

“A focus on capital-intensive industry also runs counter to the economic task Beijing often professes to be its most pressing: creating enough jobs for the 15m workers who enter the labour force every year. China created fewer jobs (as a percentage of the workforce) between 1982 and 2006 than Brazil, even though it grew by an annual average of more than 10 per cent compared with Brazil’s 3-4 per cent, the IMF found.”

See the chart – from the IMF – that accompanies the article.  China’s rapid economic growth has translated into rapid job growth.   Talk about myths …

Two: Small moves in the RMB won’t have much impact so long as China’s labor productivity is growing fast.

“China’s increased labour productivity alone over the past two years has been enough to wipe out any cost increases – and therefore any decrease in export competitiveness – from the roughly 7 per cent appreciation in the renminbi against the dollar since mid-2005.” 

China’s huge and still rapidly rising trade surplus – see the chart in the FT – isn’t simply the product of the RMB peg – and the RMB’s real depreciation over the past five years.   A host of other policy changes increased Chinese competitiveness – WTO accession and SOE reform come to mind.  But normally, such changes – along with the strong increase in productivity – would lead to a real appreciation, not a real depreciation! 

Three: China’s exchange rate policy has contributed to high business savings in China. 

It has increased the profitability of the export sector, obviously. 

But it also has led the government to keep interest rates low, reducing Chinese firms’ cost of capital.    As McGregor notes, the currency peg “[ties] the government’s hands on interest rates” and by prompting the government to keep rates low, helps Chinese firms:

“Such policies – low interest rates combined with cheap labour and land – make much investment in China highly profitable for enterprises, with little of the windfall going to workers.  “Households are in effect subsidizing this low cost of capital because of the ceiling on deposit rates” says one China economist, who asked not to be named.   “There has been a huge increase in profits, but they are not getting their share of it.”  

Low deposit rates also make it far easier to hold down the interest rate on the central bank’s sterilization bills, and thus depositors help hold down the (short-run) cost of reserve accumulation.

Four: China’s effort to rebalance its economy aren’t working.   

McGregor doesn’t pull any punches.   The gap between China’s stated goals and the observed results is just too large.

For more than three years, Beijing has shouted from the rooftops that its economy is out of balance: too reliant on exports and investment for growth, with a dangerously high share of output from energy-intensive, polluting heavy industries.

But the plethora of policies rolled out to rebalance the economy has had little, if any, impact, partly because of their timidity and partly because the system is not responsive. Exports are still outpacing imports. Investment dominates at the expense of consumption. And heavy industry is still expanding, ensuring Beijing’s targets for increased energy efficiency have not been met.

I suspect Nick Lardy agrees with McGregor here.

The inability of China’s policy makers to change the basis of China’s growth over the past few years poses something of a puzzle.   One argument is that the center has effectively lost control over the provinces.    Central planning no longer works – in part because local governments don’t respond to the dictates from Beijing, in part because the government no longer fully controls the economy.   Another argument is that Chinese policy makers simply have been unwilling to use the tools that they do have.   Interest rates remain very low.   The RMB hasn’t moved much against the dollar in nominal terms since 2005, and hasn’t moved at all in real terms.

China’s current trajectory poses another puzzle.   In most countries that have pegged to the dollar over the past few years, rising inflation is generating a real currency appreciation.  Argentina and the GCC countries are cases in point.   That is consistent with macroeconomic theory: in principle, a country can target its nominal exchange rate, but not its real exchange rate.

In today’s Wall Street Journal, Matthew Slaughter of Dartmouth (and formerly of the CEA) draws on this theory to argue that China’s policy of targeting its exchange rate isn’t the source of China’s trade surplus, either with the US or with the world.    He writes:

“The real economic forces of comparative advantage that drive trade flows operate regardless of which nominal prices central banks choose to fix.”

However, the argument that the nominal prices set by the central bank have no real impact seems to me to gloss over the central issue:  China seems to have been able to both target its nominal and real exchange rate.      

Chinese inflation generally has been lower than US inflation.   Chinese inflation has picked up a bit recently, but it is basically at the same level as the US.    Inflation hasn’t produced a real appreciation against the dollar.

Nor has it offset the RMB’s nominal depreciation against Europe.   The RMB remains weaker in real terms than it was in 2002.  Incidentally, I don’t the European example supports Slaughter’s argument that nominal exchange rates have no impact on trade.   European imports from China grew at a much slower pace in the late 90s/ first part of this decade when the RMB was rising against the euro than they have more recently.    China’s large bilateral surplus with Europe only emerged after the RMB started to depreciate in nominal terms against the euro.

Some argue that the absence of the kind of inflationary pressures that are so evident in the Gulf is evidence that the RMB really isn’t undervalued.    

But Martin Wolf has argued – I think correctly – that RMB’s nominal price matters, as it induces China to take other policy actions to offset the stimulus from an undervalued exchange rates.  By running a restrictive fiscal policy and by using a policy tool not available in most other countries – administrative curbs on bank lending – China has been able to push up domestic savings.  In effect, by restricting bank lending and thus domestic demand growth China has been able to avoid a surge in inflation.  As a result, it has been able to target both its real and its nominal exchange rate.   (knzn has more on this point) 

If that is the case, allowing the RMB to appreciate would trigger a host of other policy changes that would support a real appreciation in the RMB.   China wouldn’t have to rely on administrative controls as heavily, for example.   Or, perhaps, given that China’s red-hot stock market seems on the verge of pushing the entire economy into overdrive, China might be able to avoid introducing a new round of administrative tightening.

We know what happened back in 2004 when China really slammed on the breaks without letting the currency move: domestic demand growth slowed, and China’s current account surplus surged.   A repeat of 2004 might make Stephen Green’s forecast for China’s current account surplus look conservative …

Update: Martin Wolf — drawing on a recent Roubini paper — has a bit more in tomorrow's FT.  I eagerly await next week's installment, which will lay out Wolf's proposals to slow the truly astonishing current pace of reserve accumulation, in Asia and for that matter globally.