Households pay for low inflation and cheap yuan
Why haven't we seen more inflation in China? According to the standard economic model, any country experiencing very rapid productivity growth in the tradable goods sector will see a rise in the real value of its exchange rate.
This can occur in two ways. Either the nominal exchange rate will rise or, if it doesn't, the resulting current account inflows will cause monetary expansion, which will cause domestic prices to rise.
This is just another name for inflation. A country that runs large and persistent trade surpluses and a pegged exchange rate should gradually see an erosion of those trade surpluses as rising domestic prices increase the external price of that country's exports.
For the past decade, the rapid growth in Chinese productivity has far exceeded that of its trade partners and has also far exceeded the growth in domestic wages. The natural result should have been a gradual but strong appreciation of the yuan.
But the level of the yuan is set by the People's Bank of China, and its total appreciation in the past decade has been much less than the relative growth in productivity. As a result, China has seen a surge in its trade surplus. As a share of global gross domestic product, China's trade surplus is easily the highest recorded in the past 100 years.
This is all the more striking when you consider that the two previous record holders, the United States in the late 1920s and Japan in the late 1980s, were relatively much larger economies. The US represented more than 30 per cent of global GDP in the late 1920s, and Japan represented 15 per cent in the late 1980s. By contrast, China represents only 8 per cent of global GDP today.
The huge resulting current account inflows, reinforced by capital account inflows, forced an expansion in domestic money supply far beyond the needs of the Chinese economy. Normally, such rapid money growth should have pushed China into an inflationary spiral, which would have then forced a rebalancing of the Chinese economy away from excess reliance on a trade surplus.
But this didn't happen. There have been periods of inflation in China in recent years, and even a brief inflationary scare in 2007 and 2008, but on average inflation has been far less than what was needed to revalue the currency sufficiently.
So what happened? Two months ago, legendary University of Chicago economist Robert Aliber was invited to speak at my central banking seminar at the Guanghua School of Peking University. In a fascinating discussion, he explained that in fact there was another possible resolution of the imbalances caused by relatively rapid productivity growth in the tradable goods sector.
If the nominal exchange rate is not allowed to rise, policymakers can still contain inflation by what economists call financial repression. In the Chinese context, financial repression exists because the vast bulk of Chinese savings is in the form of bank deposits, and the deposit rate is set at extremely low levels.
This has the effect of transferring large amounts of income away from net savers, which for the most part consists of Chinese households, and in favour of net users of capital. Net users, of course, consist primarily of large, capital-intensive businesses, real estate developers, infrastructure investors and local and central governments, including the People's Bank of China, the largest net borrower of yuan in China.
The consequence is that monetary growth is channelled not into household demand but rather into the production of more goods, and the inflationary impact of monetary expansion is muted. Financial repression is an alternative to currency appreciation or inflation.
But according to Aliber's model, financial repression has a cost. It leads to overinvestment, asset bubbles and rising excess capacity. It is also at the heart of the imbalance in the Chinese economy. By transferring large amounts of wealth from the household sector to net borrowers (perhaps as much as 5 to 10 per cent of GDP annually), it creates the large growth differential between national GDP and household income that is at the root of China's very high savings and very low consumption levels.
So China is faced with a difficult policy choice. It can maintain an undervalued exchange rate, it can run the risk of inflation or it can increase the domestic costs of financial repression. How Beijing balances these separate forces will determine the pace and form of its necessary rebalancing.
Michael Pettis is a professor of finance at the Guanghua School of Peking University and a senior associate at the Carnegie Endowment
Low interest rates transfer large amounts of income from net savers, mostly Chinese households, to net users of capital
China's trade surplus as a share of global GDP is the biggest in a century
This is remarkable when one considers that the country's share of global gross domestic product is just: 8%