Think win-win to overcome the second Chinese export shock

The first China shock was unleashed in the first decade of this century, following China’s entry to the World Trade Organization in 2001. The initial surge in Chinese exports was based on low wage costs as well as an undervalued currency. 

That is why many believed the shock would eventually dissipate as wage costs increased and the Chinese currency appreciated in tandem with economic development.

The sheer scale of Chinese exports in that decade sent its current account surplus soaring to a peak of 10.1% of gross domestic product (GDP) immediately before the North Atlantic financial crisis. It also undermined manufacturing activity in many other countries. 

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There is now enough reason to ask whether the hypothesis that developing countries such as India were “prematurely deindustrializing" was a structural inevitability or the impact of the extraordinary economic transformation of a large country such as China.

A recent report in the Wall Street Journal asks why China is starting a new trade war. The renewed Chinese drive for more exports of manufactured goods comes after Beijing’s plan to shift from exports to domestic demand as the country’s main driver of economic growth did not pan out as expected. 

The Chinese leadership had hoped that a greater dependence on domestic demand would also create strategic resilience for their country. 

However, the Chinese economy has lost momentum over the past decade. The main vehicle of higher domestic demand turned out to be a construction mania that led to a recent bust in China’s housing market.

So it is back to exports now.

The Chinese reply is that exports are just what is shipped out to the rest of the world after meeting robust domestic demand. Chinese Premier Li Qiang said in June that China was winning in global markets not because of government subsidies. 

The sheer scale of its production facilities helps drive down costs. In other words, it is a matter of productivity rather than trade policy. Though China’s trade surplus is nowhere near the peak it reached in 2007, it has been assiduously climbing since 2018.

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Led by the US, many countries have responded with higher tariffs on Chinese imports, government subsidies to support domestic manufacturing and the occasional outright ban. 

The rising tide of protectionism—partly for geopolitical reasons and partly for economic ones—will inevitably impose efficiency costs on national economies, especially in a world of complex global supply chains that need open borders so that inputs can be shipped across the world with minimal friction.

New trade tensions once again highlight the risks of an unbalanced world economy, with some countries running habitual current account surpluses while others have structural deficits. 

This takes us back to a turning point in economic history 80 years ago—the conference held at Bretton Woods in 1944 that helped design the global economic system at the end of World War II. 

John Maynard Keynes and Harry Dexter White were the two dominant voices at Bretton Woods, though even smaller delegations such as the Indian one made their presence felt. 

The underlying intent was to avoid the mistakes of the previous three decades, which led the world down the abyss of economic collapse, trade protectionism and totalitarianism.

In a recent paper on the Bretton Woods monetary system, which eventually unravelled in 1973, Paola Subacchi and David Vines have identified four themes that the world’s leading economies need to cooperate on in our times: a satisfactory level of global aggregate demand that can avoid the twin pitfalls of unemployment and high inflation; workable processes for the adjustment of current account balances; financing the development needs of less developed economies; and an open international trading system. 

Subacchi and Vines say that these are the same points that Keynes thought were necessary in 1944 for a new world economic order.

The first two—full employment of resources combined with a satisfactory balance of payments—matter in the context of the new trade war. China has pursued policies that suppress domestic demand, create excess savings and then push exports through government subsidies. 

Keynes himself argued that large current account surpluses were threats to global economic stability as much as large current account deficits were. 

So the burden of adjustment should fall on both sets of countries equally, using fiscal policy and exchange rate policies that his student James Meade later explained through a more formal economic model.

The idea that the burden of macroeconomic adjustment should be a responsibility of countries with large current account surpluses as well has contemporary relevance, even though we live in a different era of market-determined exchange rates and free capital flows, neither of which was an element in the 1944 plan decided at Bretton Woods.

The use of industrial policy in response to Chinese industrial policy is a valid response, especially in sectors that have geopolitical relevance. But industrial policy as well as higher import tariffs are not costless for countries using them to counter China. 

Also read: Why China is starting a new trade war

There is also a broader macroeconomic problem that Keynes had quite rightly identified decades ago—that the burden of adjustment should not fall only on countries with current account deficits.