Why have they failed to make any dent into China’s current- account surplus, which may widen to a staggering 12 per cent of gross domestic product this year? That’s Mystery No: 1. A country’s imports tend to increase in tandem with its domestic economy, and exports rise in line with expansion in the rest of the world. By that logic, China, growing faster than any major economy that buys Chinese goods, ought to have seen some deterioration in its current account. How did it end up with the opposite outcome? That’s Mystery No: 2.

Local investments

The current-account surplus of a country represents an excess of domestic savings over local investments. The latter have boomed in China in recent years. And yet, the current account hasn’t worsened.
How has China managed to engineer such a rise in national thrift, which by now must equal almost half of its GDP, to finance its growing hunger for investments? That’s Mystery No: 3.

Economists have advanced plausible hypotheses that seek to solve each of these mysteries separately. However, there might be a single explanation for all these riddles, says Michael Mussa, chief economist at the International Monetary Fund from 1991 to 2001 and now a senior fellow at the Peterson Institute for International Economics in Washington. In a recent study, Mussa looks at China’s balance of payments as a monetary phenomenon, an approach ideally suited to countries with pegged currencies, and the Chinese yuan, for all practical purposes, is still tied to the US dollar, having risen just 9 per cent since a small revaluation in July 2005.

The key idea is this: Assuming Chinese residents’ demand for purchasing power — the sum of currency and bank deposits — is rising in tandem with economic expansion, there’s growing pressure on the Chinese monetary authority to create more money.

But base money — the sum of currency and reserves that banks keep with the monetary authority — is the central bank’s liability and must be matched by its domestic and foreign assets. So which of the two should the central bank increase?

If it buys domestic assets — government bonds — from banks, it gives people the money they want. This is what happens in developed countries; and this is how they get inflation when the economy grows above its potential.

Suppressing monetary base

But in fast-growing developing countries, most notably China, the approach of the central bank is to buy foreign assets — such as, U S Treasuries — to prevent appreciation in the currency.

Since the resultant growth in base money may spark inflation, an attendant practice is sterilisation: The central bank sells local bonds to deny people the purchasing power they want.

This is what Mussa says has happened in China. The People’s Bank of China added the equivalent of 5.5 trillion yuan ($740 billion) to its foreign reserves between the end of 2003 and 2006. In this period, it whittle down its net domestic assets by 3 trillion yuan, Mussa added.

This left Chinese residents high and dry. They had no option except to save more to get the purchasing power they want.

High Savings, investments

The only other alternative for residents to acquire money was by tapping foreign capital flows. But unlike in the U S, where a subprime-mortgage borrower can access capital from a German bank (and land it in trouble), China’s financial system is much more closed, Mussa says.

Bank credit, which can channel foreign capital to local borrower, is more readily available in China to large state-owned enterprises and to those companies that make exportable goods, which are quite profitable because of a favourable exchange rate. So they invest with abandon.

The net result is high investments, even higher savings, low consumption, more than $1.4 trillion in foreign-exchange reserves and a bloated current-account surplus despite a rise in the price of imported commodities. All of this is happening simultaneously because the central bank is repressing people's demand for money.

Mussa’s analysis stops in 2006. What has been happening since then? More of the same, it seems.

With GDP growing at an annual pace of 11.5 per cent in the third quarter and the inflation rate rising in October to 6.5 per cent, the highest in a decade, the People’s Bank of China is predictably stingy with base money.

Hard landing?

In the first half of this year, base money expansion was 6 per cent even as nominal GDP grew 16 per cent and foreign-exchange reserves jumped by a fifth.

Unless China allows significantly faster appreciation in the yuan, obviating the need for large accretion in foreign reserves, there’s a good chance that people will save even more and the current-account surplus will bloat even further in 2008.

Either that or China’s economy will have a hard landing and demand for money will ebb. That will be more painful to both China and the world.

If you think George W Bush’s administration had a tough time dealing with China, the next occupant of the White House may have it worse.

The writer is a Bloomberg News columnist.

Source: Bloomberg News