There is a naïve belief amongst the Asian Dragon countries (China, Japan, Taiwan, Korea, etc.) that greater exporting is always good--the more a country exports the more competitive it is. This assumption is, however, not entirely correct. A blind pursuit of large and continual trade surplus against one's trading partners can be quite damaging to an economy in the long run.
Let us take some time to understand the nature of exporting. Exporting is nothing more than selling domestically produced goods to foreigners. For that trade to feel good, we must believe that we are selling goods to foreigners at a good profit margin. For example, if we were to sell $10 billion in high tech electronics to global consumers at a negative 10% margin--meaning if the true cost of the goods sold was $11 billion--the national wealth would actually decline by $1 billion as a result of exporting. In this hypothetical scenario, there would be an increase in the country’s holding of foreign reserves by $10 billion, but a decrease in national wealth by $1 billion. Indeed when margins are bad, the more you export the poorer you become.
When we understand the above logic, we would examine currency policy and trade surpluses in a different light. When a country runs a “cheap currency” policy to promote growth in its export sector, this does not directly translates into an increase in national wealth; even if it does directly increase the country’s foreign reserve. To understand the benefits and costs of a cheap currency policy, we must focus on the opportunity costs associated with exporting and the potential resource allocation distortion associated with a “cheap currency” policy. In reality, we find that cheap currency can often lead to high indirect social costs to an economy, as its valuable resources are drained by foreign consumers at below fair market prices.
What happens to the domestic economy when we export?
Goods are produced from combining factors of production such as labor, raw resources, financial capital, physical capital (land, manufacturing plants and industrial equipments), intellectual capital and environmental capital (pollution of water, air and land). When we exports goods overseas, we are really just selling domestic factors of production to foreigners in exchange for their currency. Of course, foreign currency is just foreign government debt, which can be exchanged for foreign goods in the future. These days, it is prudent for export-oriented countries to think carefully about the risk of foreign reserve currency depreciation as well as foreign government default.
When a country runs a “cheap currency” policy to stimulate export, it is essentially (1) selling its valuable domestic factors for production to foreigners at below fair market prices, (2) reducing the amount of resources for domestic production and (3) reduce imports into the economy. Certainly, there are strategic considerations and indirect long-term benefits from a “cheap currency” policy to protect the export industries; I do not discuss these considerations here. Instead, I focus on the direct implications associated with exporting.
When a country strategically targets its currency to a lower value, its resources appear cheap to foreigners. As a result, foreigners would over-consume this country’s productive resources (imagine consumers over-buying at the Christmas sales). The immediate effect is a reduction in the availability of resources for producing domestic goods and services, which puts an upward pressure on domestic prices. Of course, cheap currency also makes foreign goods less affordable to domestic consumers, which then reduces price competition from imported goods and further creates upward pressure on domestic prices.
Cheap currency policy and inflation
One of the most significant effects of a cheap currency policy is domestic price inflation. This phenomenon had been experienced by a number of export-led economies in the past, including Japan, Taiwan and Korea. China’s current acute domestic inflation is, in no small part, driven by its cheap currency policy. Often times, an emerging economy would experience gradual currency appreciation as it engages in exporting its excess labor supply and its land and environmental capital. However, the general tendency for emerging countries has been to pursue a cheap currency policy to reduce domestic unemployment and to increase integration and trading with global economies.
This results in a slower currency appreciation than what would be normal under the free market mechanism. The emerging country's currency would then experience increased global purchasing power as it appreciates slowly against foreign currencies. At the same time, it also experiences reduced domestic purchasing power as resources are over-deployed toward exporting, thereby reducing domestic supply of goods and services and pushing up prices. This is phenomenon is what the Chinese consumers have come to call “external appreciation with internal depreciation” of the RMB.
"Cheap currency"-induced inflation and the proper policy response
However, since the “cheap currency”-led price inflation is not monetary in nature--that is, this inflation is not a consequence of easy money--it cannot and should not be dealt with by tightening the supply of money and credit. The nature of this price inflation is the excess reallocation of productive resources toward the export sector and the implicit barrier erected against foreign imports. To combat this type of price inflation, policy must instead focus on increasing domestic production and reducing barriers to imports. Indeed, greater availability of credit and lower interest rate to assist and stimulate domestic oriented industries would be the more successful solutions to reducing the inflationary pressure driven by inadequate domestic production.
China, which faces significant domestic inflation driven, in part, by the scarcity of domestic factors for production, is unfortunately pursuing a high interest rate and harsh credit rationing policy for its local businesses. This policy is likely to continue to fuel ever higher prices and worsen the inflation problem. Of course, after an extended period of aggressive credit tightening, China can contain price increases by triggering a recession and thereby destroy demand. However, it would seem that the more benign solution for containing prices inflation, would be to focus on increasing supply.
China as a case study
There is very little doubt that the most valuable factors for production in China are concentrated in the export oriented industries—the best management talent, the best educated workers, the most experienced entrepreneurs and private equity investors, the best pollution permit, land rights and government incentives. As China experiences greater prosperity from developing a market economy and from increased productivity and innovation through global collaboration and competition, its domestic consumption demand also rise with the increase in labor income. However, since the rise in domestic wealth is significantly driven by exporting domestic resources, this simultaneously creates scarcity for goods that are desired by Chinese households. To further compound the problem, currency intervention makes the Chinese RMB cheap, which additionally boosts export and reduces import, creating a further reduction in consumption goods for the Chinese households at a time of rising demand.
In the face of the U.S. and European debt crisis, it is a valid question to ask whether exchanging the highly valuable Chinese resources for potentially low quality American and European government debts is such a good trade. This question is all the more pertinent given the highly discounted prices for Chinese resources driven by a cheap RMB policy. As American and European households deleverage (reduce spending to deal with their debt crisis), China may seek to further discount its currency to stimulate American and European consumption. This more aggressive currency intervention would only serve to further export China’s resources at heavily discounted prices to foreign consumers, at a time when those resources are highly valued domestically. The social cost of subsidizing the export industries and distorting resource away from domestic consumption may seem entirely too high.
The Asian economies should certainly take a long hard look at their policy insistence on creating and maintaining an export dominated economy. They should not be so naive as to assume that the more they export, the better off they are. On the flip side, Americans and other Western consumers should be careful to take advantage of the never ending Asian discount sales with ready vendor financing. Good business, ultimately, must be good for both parties if we wish to create long term success for international commerce. On the other side of over-exporting by the Asian countries is the over-consumption and chronic deficit by U.S. and European countries. The path that we have collectively taken appears to lead to a rather bleak destination.
by jason c hsu