China's Currency Today

When it comes to China's currency, and their supposed manipulation of it, you've got to keep on top of changing mid-term circumstances and policies. That is to say, what was true a couple years ago may not be true today.

In a past post, which I assigned to several iterations of IPE students, I focused on research from around 2014 that was itself largely focused on the 2012 political debate about Chinese currency manipulation. To my mind, the most interesting factoid there was Gagnon's finding that, while China had been manipulating the value of the RMB after moving to a crawling peg, the large purchases of T-bills that kept the value of the Yuan down had largely stopped in 2011. In other words, by the time Mit Romney was complaining about China's manipulation, the Chinese had already changed their behavior.

Unfortunately, the political debate has not caught up to that reality in the past four years, even while the reality has been changing even further. Indeed, David Goldman invoke Alice in Wonderland imagery in describing the political rhetoric in his column "Alice in Trumperland and China’s currency." (Note: if you are one of my IPE students, you really need to read this article in its entirety.)

Where Gagnon had to dig down into the data on monthly purchases of T-bills to discover China's change in behavior in 2011, Goldman needs only to look at broader measures to see the situation in 2016. Goldman notes the following:

1. The RMB's real effective exchange rate has gone up 40% since 2008. (Note: This is not the Yuan/Dollar rate but the rather the rate of exchange between the Yuan and a basket of currencies.)
2. Since 2008, the annual growth in US imports from China has dropped dramatically since 2008.
3. The trade weighted value of the Dollar has risen over 25% since 2014 while the Yaun/Dollar rate has fallen slightly. This is what dragged the value of the RMB up so much against the other currencies in the world.
4. Chinese refusal to let the RMB fall (more) vs the  Dollar correlated with later drops in Chinese exports. China also had to maintain high domestic interest rates to keep up with the Dollar's rise.

The point here is that if you look at the RMB/Dollar exchange rate, you won't see much movement in the past few years. However, this ignores the fact that the world is bigger than the US and China. To see a little more about what is going on in the world, the graph below shows the trade weighted dollar index from 2000-2016. This shows how the dollar was doing against the major currencies of the world. As you can see below, the Dollar was declining in value from 2002-2008, fluctuated in and after the Great Recession, and then stayed more or less from 2012-2014. Then, BAM!, it shot up in 2014-2016.

Note that from 2002-2008, the Dollar was generally declining in value and, therefore, pegging the RMB to the Dollar meant riding down with the US exchange rate. This meant that the Dollar was not devaluing against the RMB as much as it was against other currencies while at the same time essentially devaluing the RMB against those currencies

However, thing look very different since 2014. The Dollar has shot up in value in the past few years and the Chinese have, apparently to their detriment, not only gone along for the ride, but worked at keeping up. These efforts may be deemed "currency manipulation" but it has been manipulation that has prevented a devaluing of the RMB versus the Dollar (in other words, the opposite of what they would do to maximize exports to the US).

Indeed, if the RMB was fully floating, it would probably have dropped in value versus the Dollar as the latter jumped up in value in 2014. For this reason, one might claim the the RMB is currently overvalued. Again, this is the opposite of what US critics of China claim.

Postscript: Goldman's column alluded to Donald Trump in the title, but the body focused on a talk radio host attacking Cruz. However, Trump does make the standard currency manipulation charges against China in this Op-Ed from November 2015 (reprinted this April). What strikes me when I read it is that the language might be straight out of something written in 2012, including the vague reference to economists estimating that the Yuan is undervalued 15-40%. This runs counter to the tenor of most current commentary about the government trying to prop up the RMB.

  Interestingly enough, the top result Google news search for "China Currency" turns an article in Barron's entitled "Sorry, Trump, but Chinese Currency Is Actually Way Overvalued", with a subtitle of "Amid other bizarre episodes, allegations of China’s cheapening of its currency remain contrary to facts."  (Note: This article largely relies on Goldman's column for its content.)

Factoid: US and China in Latin America

An AP article entitled "Stronger US economy and dollar tighten Latin American ties" has some interesting factoids about the Latin American trade with China and the US. 

According to the article, which cites a Brooking analysis of UN trade data, from 2000 to 2013, the percentage of Latin American exports bound for China increased from less than 1% to 10%. During the same period, the percentage of Latin American exports shipped to the US decreased from 58% to 40%. This is the sort of factoid that fits with the typical rising China/declining US influence narrative.

But wait a minute. China still only absorbs 10% of the region exports while the US absorbs four times as much. Also, if the US share of Latin American exports dropped by 18percentage points while the Chinese share only increased by 10 points, where did the other 8 points go? The article mentions briefly that Latin American trade with the rest of the world also increased, so that's probably where the 8 points went.

So what I see here is not so much a story about the rise of China's influence in the region, as much as one of the region diversifying its exports away from the US. This is the sort of thing that one would expect due to globalization and the US'  Great Recession. Also, it is probably a good thing for the region to be less dependent one economy to absorb the majority of its exports as it insulates it from external shocks due to US economic downturns. Indeed, that is supposed to be one of the advantages of globalization.

Another tidbit in the article is the content of Latin American exports to China versus that of exports to the US. According to the article,  60% of the region's exports to China consisted of commodities while only 5% constituting high tech products. In contrast, 70% of exports to the US were manufactured goods and 20% were high tech goods.While I don't attribute much credence to the structuralist/dependency argument that the region's development is hampered by exporting commodities in exchange for manufactured goods, it is interesting to note that China fits the role of villain in that theory much better than the US.

I find it even more interesting (one might say ironic) that the leftish (my term) governments of Latin America, who often do attribute credence to structuralism/dependency theory, are the ones who have been so enthusiastic about developing ties with China. Of course, that enthusiasm seems reasonable on political grounds, but it appears to be entirely inconsistent with their economic view of the world. Indeed, it seems as if they have been embracing a sort of Sino-dependency at the same time that trade with the US  exhibits the balanced characteristics that the dependency folks argued that the US dominated world system denied the region.

Economic Impact of Freedom vs Changes in Freedom

One of the interesting trends in development thinking is the increasing importance attributed to freedom and democracy for economic growth. Acemoglu and Robinson talk about it in terms of inclusive versus exclusive and Selectorate Theory does so in terms of large versus small coalition regimes.

William Easterly talks about it in terms of the tyranny of experts which forms the better part of his 2014 book's title, The Tyranny of Experts: Economists, Dictators, and the Forgotten Rights of the Poor.  A long time critic of top down development assistance, Easterly has taken a broader and more abstract view of development economics in this latest work. The tyranny of which he speaks lies in the development community's prioritization of improvements in material well being over improvements in individual freedom and its embrace of benevolent autocrats as the most effective means of achieving this.

While there is a lot of meat on the bones of his book to chew on, one point he made seems particular relevant (at least to me). Easterly argues that changes in economic freedom can be more important in driving high economic growth than the absolute levels of freedom in a country. Therefore, a country may be less free than others but still experience higher economic growth than these freer nations if the less free country is freer than it used to be. After all an internal reform should unlock hitherto untapped economic opportunities and, thus, provide a new impetus to economic growth.

In Easterly's view, this sheds a new light on China's economic boom. While China is decidedly less free than many other countries, it has been undergoing a major liberalization of individual economic rights since 1978. So, while China may appear less free and more autocratic in cross-country comparisons, it is markedly more free and less autocratic in a cross-time comparison with itself. Therefore, rather than being a case in support of the idea that autocratic regimes are good for economic development, China is a case in support of the idea that increasing freedom and lessening autocratic control of the economy is good for economic development. (If that didn't strike you as significant, read it again.)

While Easterly does not explicitly argue the opposite point, that a decrease in freedom may harm economic growth even if a country is still relatively free in comparison to other nations, it may be that this opposite is also true.  This brings to mind the case of Venezuela, which touts itself as a socialist nation and looks to China for inspiration and support. Venezuela rates a freedom rating of 5 (Partly Free) on Freedom House's Freedom in the World Index, which is slightly better than China's 6.5 (Not Free) rating. However, ten years ago, Venezuela had a rating of 3.5, and so has been on a downward trajectory. Indeed a rating of 5 is on the cusp of being in Freedom House's Not Free category.

Of course,  China has been consistently at 6.5 on Freedom House's 7 point scale since the think tank started publishing the index in 1998. This is not surprising since China's major reforms predate this period and Freedom House looks primarily at political, not economic freedoms.

For a measure of economic freedom, we can turn to the Heritage Foundation's Index of Economic Freedom. The Heritage Foundation provides a graph of China's vs Venezuela's rating on economic freedom from 1995 to 2014 (which has resisted my attempts at embedding here, so you need to follow the link). The graph shows that economic freedom in China has been largely flat lined at between 51 and 56 point on Heritage's 100 point scale (though there was a small uptick from 1997-2000) while economic freedom in Venezuela has been trending downward since 2003, dropping from 55 to 36 points. Again this data set does not encompass China's reforms from 1978 to 1995 and is not capturing the biggest reforms in their economy. However, the lack of improvement in China's rating may explain the slowdown in Chinese economic growth and support a prediction of lower growth in the future.

With regard to Venezuela, we see that economic freedoms (as measured by the Heritage Foundation) have been deteriorating over the past decade, both in comparison with the country itself and it's supposed role model, China. Indeed, it is interesting to note that when we switch from an index of political freedom to one of economic freedom, Venezuela goes from the middle of the pack on the former index to fourth from the bottom on the latter (only Cuba, Zimbabwe and North Korea rate lower on Heritage's index). Since the point here is to emphasize cross time comparisons, Venezuela went from the Mostly Unfree category (which included no fewer than 60 out of 175 nations in 2014) on Heritage's index to the Repressed category (a more exclusive club of 27 nations in 2014).

It should be said that we need to avoid relying too much on Heritage Foundation's overall  index as it aggregates no less than 10 separate sub-indexes of what the Heritage Foundation considers to be freedoms. Some of these sub-indexes may be more valid than others in capturing what Easterly means by freedom (such as Business Freedom, Property Rights and Labor Freedom) than others (such as Government Spending, Monetary Freedom and Investment Freedom), again as defined by the Heritage Foundation.

Furthermore, to the extent that the Heritage Foundation espouses what is pejoratively referred to as Neo-Liberal ideology, we need to be doubly careful in our use of their data. Indeed, if one subscribes to the notion that the embrace of Neo-Liberalism (or what Dani Rodrik calls Hyperglobalization) was harmful to economies (especially in Latin America) , we might expect to see increases in the Heritage Foundation's index preceding decreases in economic growth in those cases.

With these caveats in mind, I think that Easterly's idea survives first contact with data and is useful for evaluating development efforts. Of course, there are many more ideas from Easterly to come.

China's Ghost Cities: Bumps on the Road or Highway to Hell

An AFP headline caught my attention the other day, "Some debt defaults 'healthy' for China market: central bank." This is interesting to me because I am currently using Michael Pettis' (2013) analysis of China's economy as my working hypothesis or analytic framework for sifting through information about China's economy (there are others in my head, but this one has been getting a lot of play). According to this view, China's adherence to what Pettis calls the Asian Growth Model has overstimulated investment in China leading to many investments that will never never pay off. In short, without major reforms, the loans associated with these investments will eventually go into default leading to a credit or banking crisis.

One of the things that has been fueling the supposed over-investment is the high level of government spending (both at the central and local levels) on investments. Loans associated with government projects are implicitly guaranteed by the government, which makes them seem like good bets for banks even if the prospects of the investment actually paying off are dubious. Therefore, banks will loan more money to more of these projects than they would to private investors. Also, when you have government banks lending money for government projects, there is always the suspicion that these loans are not being scrutinized enough by the banks.

Therefore, it is interesting to see People's Bank of China (PBC) deputy governor Pan Gongsheng acknowledge the problem by saying "Guaranteed repayment... although it will ensure short-term stability, won’t help the market to effectively differentiate risks and will eventually lead to accumulated risks." Even more interesting is his suggestion that allowing defaults on some of these loan might help the banking system do a better job of managing risk by injecting some risk into the system. Presumably doing so would force banks to be more selective in evaluating and approving loans.

However, there is the danger that doing this now amounts to closing the barn door after the horse got out. This would be the case if Chinese banks had already issued lots of bad loans, or what would be bad loans if they were not based on the belief that payments would be guaranteed by the government. Weakening the payment guarantees on these loans now cannot effect decisions that have already been made.

The question then is whether China already has a dangerous amount of these loans on the books. I have previously discussed the possibility that China's large investments in High Speed Rail might turn out to be wealth destroying in nature.

But, perhaps a better example of over investment may lie in the so-called Ghost Cities of China. These are massive urban development projects that have remained largely uninhabited. Adrian Brown reported on several such examples in a 2011 SBS Dateline Report. The report notes that China was building 10 new cities a year, but found several of the cities remain empty several years after being built. Against a back drop of modern high rises under construction, a Hong Kong analyst likens the urban construction to Pyramid building in that it contributes to measured GDP growth while doing nothing for the quality of the population's life. The report notes that the apartments being constructed are priced way above the ability of most Chinese to afford. So, while there is a huge demand for better housing, these cities remain mostly vacant. The report suggests that China may creating a massive real estate bubble.

About a year later, Yale economist Stephen Roach made the counter argument that China needed to build these cities in anticipation of a massive migration of the population from rural to urban areas. With 15 to 20 million people moving from rural to urban areas each year, Roach argues that China cannot wait to build infrastructure and housing to accommodate them. He points to the city of Shanghai Pudong as an urban project that was empty when it was built in the 1990s, but had grown to a population of 5.5 million by 2013.

However, last September, Brown revisited a city in his earlier report for another Dateline report, and found that little had changed over the previous 2 years except that the government did not want him there. He also found new cities under construction.

Also, this week the Sydney Morning Herald reports that at least one of these cities are now on the brink of financial collapse. The city of Ningbo has $570 million in debt, mostly to banks, and is one the verge of collapse.  The report estimates that there are 10 other cities that y find themselves in a similar situation. As for the migrations of people from rural areas, the report noted that China's workforce has decreased in the last two years and the flow of rural workers to urban areas halved since 2010, from 12.3 million to 6.3 million per year.

If, as PBC's Pan Gongsheng suggests, the government lets local governments default on loans, this will not only jeopardize outstanding loans to these cities but make it much harder for them to get new loans. These cities will need new loans to roll-over current loans and to get additional funds for operating and maintaining their property. Therefore, unless delicately handled, such a change in policy might bring the situation to a head and spark a crisis in more ghost cities. In deed, it might uncover problems in cities that don't appear to be ghosts at first glance.

So, we may have a good old fashioned real estate bubble here. The government, both at the central and local levels, may have acted like a real estate developer that see a trend (i.e., the growth of urban populations and the success of cities like Shanghai Pudong) and bets heavily on it continuing unabated in the future. The trend then abates leaving the developer with a very bad investment and a bunch of bad loans.

Also, we may have something unique to China due to the planned nature of its economy. As suggested by the analyst in the 2011 Dateline report, China may have been using urban construction to meet GDP growth targets. In this scenario, the central government set growth quotas for regional governments to meet. This created an incentive to not only engage in urban construction, but also to focus on constructing high value property like luxury high rises and shopping malls. Doing so inflates the paper value of the property constructed and justifies higher costs of construction which adds to the short term stimulative effect of the project.

The downside of doing this is that, years later, the actual value of the real estate may fall short of the property's paper value and the inflated cost of constructing it. At that point, the value of the property will have to be written down and the loans allowed to default with a negative impact on GDP. Pettis (2013) argues that because of this much of China's recent growth in GDP may turn out to be illusory and show up as future decreases in GDP if/when the loans go into default.

While you might think that this would discourage such  short sighted decision making, the incentive structure of local and regional bureaucrats might encourage it. From the bureaucrat's point of view, meeting the growth target is the key to keeping his/her job and exceeding the target is the key to being promoted. Once promoted, the bureaucrat's responsibilities will shift and the project will become somebody else's problem by the time it collapses. Therefore, the bureaucrat has an incentive to focus on the short term effects of the policy and place minimal emphasis on its long term effects.  Pettis (2013) notes that this is a recognized problem with government planning known as the Commonwealth Effect.

China's Tough Neighborhood

To a lot of people in the US, China appears to be the new Big Bad in the world. China is modernizing its military, acquiring aircraft carriers and has developed a ballistic missile to sink our aircraft carriers. This appears to be evidence that China is trying to assert its dominance in Asia and intimidate other nations. The problem with this analysis is that it doesn't consider the extent to which China is itself dominated and intimidated by other nations.

 China lives in a fairly tough neighborhood. It shares a border with Russia, North Korea, India, and Vietnam. South Korea, Taiwan, and Japan are also close by the Chinese coast. According to Global Firepower's ranking of military power, four of these nations (Russia, India, Japan and South Korea) are among the top 10 most powerful militaries in the world.  Taiwan falls in the top 20 and Vietnam comes in at 23rd. China can only count the troublesome North Korea as an ally, though it does have good relations with neighboring Pakistan, Kazakhstan, and Myanmar. (In contrast, the United States borders Canada, ranked 16, and Mexico, ranked 33rd. Among the top ten most militarily powerful nations, 6 are close allies of the US.)

Not only are China's neighbors well armed, but there is a history of armed conflict between them and China. While most Americans are aware that China was North Korea's ally in the Korean war and may be aware that China was invaded by Japan in what would become World War II, but many are not aware that China has had conflicts with other neighbors since then. China has fought wars with India in 1962, with Russia (the the Soviet Union) in 1969 and with Vietnam in 1979. Of course, China has an ongoing dispute with Taiwan over its de facto independence, a subdued dispute over its annexation of Tibet, and administers a portion of Kashmir.   In short, China does not have to look far to find security concerns, even if the United States wasn't in the picture.

Among all the regional threats it faces, in many ways, Japan looms the largest. While the United States may be China's biggest military threat or rival,  Japan is the traditional enemy. From the typical American's point of view, World War II started with Pearl Harbor, but, from the Chinese point of view,  the War of Resistance Against Japan had been going on for 3 1/2 years by December 7th 1941. Though estimates vary, Rana Mitter estimates that 14 million Chinese died in the war and a news article in a 2005 China Daily article cites a figure of 35 million Chinese dead and wounded.  Also, there is little dispute that the Japanese committed many war atrocities. Indeed, the photos taken by Japanese soldier are still circulated on Chinese websites.

In his 2020 book, Modernizing China's Military, David Shambaugh argues that anti-Japanese sentiment runs deep among officers of the Chinese People's Liberation Army (or PLA):

The anti-Japanese sentiment one encounters among the PLA at all levels is palpable. Distrust of Japan runs deep, transcends generations, and is fairly virulent among the generation of PLA officers in their forties and fifties. Japan stimulates an emotional reaction not evident even in anti-American diatribes. In conversations with PLA personnel, Americans are regularly subjected to the view that the United States is naïve to consider Japan as an ally or partner, and they often counsel the United States to be wary of Japanese intentions and military ambitions.

It is interesting to note that the virulently anti-Japanese "PLA officers in their forties and fifties" would now be in their 50s and 60s which is generally the age of generals in the military. For instance, China's Minister of Defense, Chang Wanquan, is a general who was born in 1949, making him about 65 years old. You will also notice that the Minister of Defense is not a civilian, as is the case in most Western nations. While one might be tempted to dismiss Chinese concerns about Japan's military ambitions as overblown, one cannot deny that they exist, especially in the Chinese military.

One might also ask how overblown those concerns are. Despite its constitutionally mandated pacifism, Japan is one of the top ten nations on Global Firepower military power index. With an economy only a bit smaller than China's, it could spend as much as China on its military and its ties with the US ensure that it would have access to the best technology available. Not to mention, the Japanese are no slackers when it comes to producing high technology themselves. Therefore, it is probably not much of an exaggeration to say that the only weapons the Japanese don't have are the ones they don't want.

Furthermore, the Japanese appear to have been edging up their military capabilities over the past few years. Nothing illustrates this better then the picture below that shows the latest two generations of Japanese "helicopter destroyers" side by side. The smaller ship is the DDH-181 Hyuga class ship (of which Japan built two, commissioned from 2009 and 2011) and the larger one is the DDH-183 Izumo class ship (which is to be officially commissioned next year while another ship of the class is currently being built).

One would be excused for commenting that these ships look very much like aircraft carriers, or what passes for them in navies other than f the USN. While the Japanese claim that these ships are for anti-submarine warfare, it is not hard to imagine that they could be used for amphibious or strike operations with some modification and the acquisition of the right aircraft (say the V-22 Osprey and the F-35B, though there are some technical complications involved in using the latter). As it stands the Japanese are already embarking only half as many helicopters as these ships can accommodate, thus keeping a good amount of capacity in reserve. Also, it is worth noting that all the European navies combined only have four carriers between them (though the British are working on two more). [Okay, this is just one weapons system, but I think it gives you a better visceral sense of Japanese modernization than simply quoting a defense expert or citing planned Japanese military purchases.]

Of course, one sticking point with the carriers is that, by law, Japan is not allowed to have "aircraft carriers", hence the name "helicopter destroyer".  But, one look at these ships and the growth in size between the two classes of ships suggests that the Japanese are either fudging their law or hedging their bets against a future change in it. If you are a Chinese general ( they don't have admirals or a separate navy for that matter), you probably see this as proof that the Japanese are not constrained by their laws as much as they claim and are a growing military threat that might grow faster in the future.

Then, there's the US. As the largest military in the world, the US must be reckoned with, and that reckoning has become increasingly difficult over the years. Suppose you were General Chang Wanquan. When you started your career in 1969, the US was embroiled in Vietnam and the North Vietnamese were able to put up a good fight. US air power was fierce some but Russian supplied surface to air missiles and fighter aircraft put a serious dent in it (there actually were North Vietnamese aces in those days). Vietnamese ground forces took disproportionate casualties, but, again, they could inflict enough casualties on US forces to eventually make the US go away.

In general, this boded well for China's defense strategy which was based on Mao's concept of a war of resistance. This plan relied on what is known as strategic depth and involves retreating in the face of a strong invading army to draw them into the interior of the country. Then, when the enemy is weakened by long supply lines and the demand of holding large amounts of territory, harassing attacks are used to sap their strength. The when the enemy is weakened enough that they begin to pull back, an all out offensive is launched to drive them out of the country. With many technical variations, this was the general plan and the Chinese prepared for it by amassing a large cheaply equipped military with and even larger reserve force, distributing forces around the country with the intention that they fight were they live, and locating strategic industries and military resources in the interior of the country.

For twenty years, this is more of less the plan and, though there are increasing concerns about the technological inferiority of Chinese weapons, it seems like a workable plan. Then, in 1991, the plan goes to hell when the US blows through Iraqi forces, which were better equipped than most Chinese forces,  in Operation Desert Storm. So, when Chan Wanquan becomes a Division Commander in 1992, the PLA is in the process of rethinking its doctrine and coming to terms with the fact that it needs to modernize its weapons systems and forces. (Shambaugh, 2002, p. 69-74)

In 1999, when Chan Wanquan was a Major General directing the University of National Defense, the NATO air war in Yugoslavia, provides more sobering lessons. Western air forces appeared to be able to obliterate air defenses better than those possessed by China and to attack targets with long range precision guided weapons with impunity. This rendered the concept of geographic strategic depth as meaningless and provided a chilling example of what the US and Japan might do to China if it invaded Taiwan (Shambaugh, 2002, p. 74-76).

At the same time, China's rapid economic development has changed the nature of what the PLA has to defend. The growth of the Chinese export industry has shifted manufacturing, and much of the population, from the interior of China to coastal regions. The need to import large volumes of industrial import and export equally large volumes of export overseas means that the PLA can no longer be content with simply defending China's borders, much less do so with a plan that involves retreating to the country's interior (tough that plan was dropped in the 1980s).

Of course, the US has arguably not fared so well in Afghanistan and Iraq. However, the difficulties that the US faced in fighting a counterinsurgency campaign, which would have been very heartening to the Chinese when they were planning to fight a protracted war of resistance back in the 1970s, may be of little comfort to them in their current situation. Indeed, the demonstrated difficulty of counterinsurgency might be downright chilling if the PLA considers the possibility of occupying Taiwan itself. Furthermore, if one focuses on the early more conventional phases of the war in Afghanistan and Iraq, the US demonstrated an increased ability to rapidly rapidly government military forces with relatively few ground forces of its own. This might suggest to them that, even if they took Taiwan, they would not be able to keep it for long.

The overarching point here is that, even though the Chinese military has been modernizing and developing new capabilities, the bar they need to jump over has been rising as well. Though their military capabilities have been increasing, both the demands placed on it (in terms of what they need to defend) and the militray capabilities of potential opponents have also been increasing. It is hard to say whether their capabilities have lost or gained ground on their security demands and potential opposition. In that context, the prospect of a US pivot towards Asia is probably a fairly frightening thing to China's defense planners and this is something to keep in mind as you interpret Chinese actions.

Factoids: Looking at GDPs in the World

    Here's something for both my classes this term. The four graphs below display information about World GDP and the GDPs of 8 large nations (the US, European Union, China, Japan, China, Brazil, Russia and India). GDP is gross domestic product and it measures the final value of all goods and services produced in a country. Thus, it is one way to measure the size of an economy.

    The first graph below displays the total GDP of the world (in red) and the GDP of the United States (in blue) as reported by the World Bank.

     In 2012, world GDP stood at $72.4 trillion and US GDP was $16.2 trillion. What you should notice in the graph is that world GDP has been growing at a faster rate since 2002 than the US (7.6%/year for the world vs 4% for the US).  You will also notice that the world had two flat spots in GDP growth from 1981 to 1985 and 1993 to 2001 (albeit with a little step up in the middle). Finally, you will notice that the world economy took a big hit after the 2007-2008 Banking Crisis. Where the US economy shrunk by 2.1% from 2008 to 2009, the world economy as a whole shrunk by 5.1% in the same year.

     The next graphs displays the GDPs of the four largest economies in the world: the US, EU, Japan, and China. Though the European Union is not a nation, and did not technically exist prior to November 1, 1993, I like to think of it as economic actor in the world. Note that in the graph below, US GDP is again represented by the blue line, which allows you to put these nations in perspective to the previous graph.

     What we see in the graph above is that the US and EU nations (the red line) have always been roughly equal in terms of GDP. Of course, the EU's GDP appears to fluctuate wildly but that is a function of the changes undergone by the former communist nations that joined the EU in 2004 (keep in mind that the EU data represents the combined GDP of all current EU members even before they joined the EU and, indeed, before the EU existed).  What is perhaps more interesting to note is the havoc that the Banking Crisis and then the Euro Crisis has played on EU GDP (as evidenced by the downs and ups in the red line since 2008).

     The next thing to look at is the green line representing Japan's GDP. You can see that, in the mid 1980s, Japanese GDP started gaining on US GDP. Actually, when you take inflation into account (which this data does not do), the Japanese economy was growing faster than that of the US in the 1970s.  This was the era of US paranoia about Japan displacing the US as the largest economy in the world. People worried that Japan was using unfair trade practices to grow at the expense of US trade and employment. The Japanese were also buying US government debt, private companies and real estate (notably Rockefeller Center in NY). There was a great concern (very similar to concern voiced today about China) that the US would become subservient to Japan as a result. Nothing captured the feeling of that time better than the artwork used on the 1987 edition of Paul Kennedy's book The Rise and Fall of Great Powers shown below:

     However, things did not work out that way at all.You can see from the green line that Japanese GDP peaked in 1995 at $5.33 trillion and then dropped to $3.91 in 1998 (ouch!). Japan would not surpass its 1995 peak in GDP until 2010. Though Japan's economy languished for closer to 15 years, this what is often referred to as a Lost Decade of economic growth.

     Then there is China whose GDP is represented by the purple line in the graph above. Clearly, China has had an astounding amount of economic growth. They have surpassed Japan in GDP and are gaining on the US and EU as Japan was in the 1980s. However, unlike Japan, China has a much larger population than the US and EU. Therefore, one would expect their economy to eventually surpass the US and EU in size. The question is will they continue on a path of sustained growth or will they experience a setback similar to Japan's. That's a deeper question for another time (which even then cannot be answered with certainty) but it is a possibility worth keeping in mind.

   In 2001, Jim O'Neil coined the term BRIC to refer to Brazil, Russia, China, and India as a set nations whose economic growth might shift some economic power away from the existing advanced economies. The graph below shows the GDP of the BRIC nations fro 1989 (the first year in which the World Bank has data n the Russia Federation's GDP) through 2012.

  The main thing you can see in the graph above is that China has decisively left Brazil, Russia and India in the dust. Indeed, the combined 2012 GDPs of the other three nations amount to only $6.1 trillion, $2.13 trillion short of China's $8.23 trillion GDP. So much for the BRICs. There is only China.

     Another thing worth pointing out here is the Lost Decade that Brazil (the purple line) experienced from 1997 to 2005. Also, you might notice that Russia's GDP (green line) has not done so well since 2008. Juts note these things for now.

   The final graph shows the share of world GDP accounted for by each of the big four's GDPs.  That is to say, it displays the GDP of the US, EU, China and Japan as a percentage of world GDP. This is an important statistic because a nations ability to effect the world economy is roughly proportional to the size of its economy relative to that of the rest of the world.

   What we see in this graph is that the US starts out with 38% of the world's GDP in 1960. This percentage declines a little bit in the 1960s  before dropping rapidly in the 1970s to end up at just below 26% in 1980. Then the world economy hits that 1981-1985 flat spot in growth mentioned in conjunction with the first graph presented above and the US percentage of world GDP climbs back up to above 34% in 1985. Then the world starts growing faster again, and the US percentage drops back down to below 26% in 1995 (basically in the middle of the 1993-2001 flat spot in world economic growth). From this point, the US percentage climbs to above 32% in 2001-2002 before starting to decline to its present point at around 22%.

     What one might take from this is a picture of the US having a diminished but roughly stable (at least within the 25-35% range) percentage of world GDP from 1970 to 2000. This percentage (and the influence it gives the US) has stated to decline to new lows since 2002 and is likely to continue in the future. The other point to keep in mind is that this is not due to a decline in the US economy as much as it has to do with strong growth in the world.

     Of course, a big part of that growth comes from China's rapidly rising GDP. China is still a minor player with only about 11% of the world economy, which is far below Japan's 1995 peak at almost 18% of world GDP. Still, China is rising in relative size and, if it surpasses the US in GDP it will necessarily have a larger percentage of the world's GDP.

     But what about the red line representing the EU whose GDP represents 23% of the world GDP . To be sure the EU didn't exist before 1993 and only existed in its current form (i,e., with all its current members) in 2007. And, yes, in its current form it isn't quite like a nation (for instance the entire EU does not use the Euro). But it is potentially a powerful player in the world economy that both China and the US may need to accommodate in the future.

    Indeed, it is probably the case that no one nation will ever be as large as the US was relative to the world economy in 1960s, or for that matter, from 1970 to 2000. Managing the world economy will probably require coordination between the US, EU and China (and perhaps India if it grows in proportion to it very large population).

Shifting Hegemony in the Future

Whether it be in news commentary or in my students' discussions and essays, there is a lot of concern about China's rising economic influence and what it means for the United States' position in the world. Many seem to think that China's economic growth will enable it to replace the US as a global hegemon.

The Boogie Man Du Jour?:

It is tempting to lump concerns about China in with past concerns about the Soviet Union and Japan that didn't pan out. As Paul Krugman pointed out in a 1994 Foreign Affairs article,  "The Myth of Asia's Miracle" (also available here and here),  the rapid economic growth in the Soviet Union and Warsaw pact nations in the 1950s and 60s provoked worries in the west that the Soviet bloc would outgrow them and actually deliver on Kruschev's threat to bury the west. These concerns proved false, in part, because they were based on projecting past performance forward in a linear fashion that did not account for the possibility that growth rates might slow down. In hindsight, the collapse of the communist economies makes the hand wringing of the 1960 look somewhat foolish.

Similar concerns were raised about Japan in the 1980s when, according to Krugman, a projection of their growth rates from the 1960s and 1970s suggested they would surpass the US in per capita income in 1985 and total output in 1998. Yet, neither of those things were close to happening when Krugman wrote in 1994 and, 20 years later, Japanese per capita income still lags about 10% behind that in the US while their GDP is less than half of that of the US. Though Japan hasn't collapsed on anything like the scale of the Soviet Union,, the concerns about "Japan Inc."  that were so prevalent in the 1980s now seem, if not foolish, at least overblown.

So then, is China just another economic boogie man in a growing line of them? A strong argument against this would be that China's large population virtually guarantees that will surpass the US in terms of GDP. After all, with 1.35 billion people, they only need to reach a per capita income of around  $12,300 (equivalent to that of Hungary or Poland) to match the US GDP of $16.6 trillion. If China achieved a per capita GDP equivalent to South Korea's ($22, 590),  their GDP would be about $30.5 trillion. So it seems not only possible, but quite probable that China will actually surpass the US in GDP at some point.

However, this begs the question of what that would mean. With an economy equal in size or larger than the US, China certainly could afford an equal or larger military than the US, which would challenge US military hegemony. But what economic advantage would a larger economy confer on China? Would it become the global economic hegemon? To answer this question, it is important to consider the difference between military and economic hegemony.


Military vs Economic Hegemony:

I think it is important to recognize that there is an important difference between military and economic hegemony. A military hegemon is one that possesses so much military capability that it cannot be defeated by any combination of other powers. An economic hegemon is a nation whose economy is large enough that it alone can influence global markets without the help of other nations. On the face of it, these seem to be very similar conditions, as they both involve comparisons of the size of the hegemon to everyone else in the word.

However, in practice, the relevant size comparisons are quite difference. While it is theoretically possible that a military hegemon might find itself in a war against every other power on earth, it is highly unlikely that this wil occur. In any given war, a military hegemon will probably find itself squaring off against a subset of the world's nations, with a large subset of nations sitting out (and perhaps another subset of allies helping it out). The probable outcome of any war will come down to the relative capabilities of the two sides actually engaged in it.

In contrast, when trying to intervene in global markets, the economic hegemon finds itself in a situation where, in essence, nobody is sitting it out. If the hegemon is trying to tip markets in one direction or another, it will find that it is essentially pitting its economic weight against the weight of everyone else in the market. It must not just need to outweigh those actively opposing it, but also everyone who is participating in the market. Therefore, in practice, it actually faces the theoretical extreme that the military hegemon usually avoids.

The point here is that bilateral comparisons of US and China military capabilities are more relevant to questions of military hegemon than are comparisons of economic size to questions of economic hegemony. In the latter case, the more relevant comparison will be the shares of the global economy that each nation's economy constitutes. Therefore, comparing predicted levels of  US GDP to those of Chinese GDP gives us a very incomplete picture of the amount of influence the two nations might wield in the global economy. Instead, what we need to do is look at is the ratio of each nations future GDP to the future Gross World Product (GWP).

Comparing China and US GDP/GWP:

Statistics on gross world product are not something you come across very often, but the Earth Policy Institute has aggregated data on GDP to produce a dataset of GDP in 2010 PPP dollars from 1950 to 2011 (links to xls file). Comparing these figures to Federal Reserve Economic Data on US Real GDP (admittedly in less comparable 2009 chained dollars), one finds that US GDP as a percentage of GWP has declined from around 30% in 1950 to around 20% in 2010. Though these numbers are imprecise due to the different units of measure, this gives one a sense of the declining size of the US economy vis-a-vis the world. Though the FED doesn't have data on real Chinese GDP, if we look at nominal figures for 2010, China's GDP was about 8% of GWP. Given that China's   GDP is rising faster than most nations in the world, it is obvious that their GDP as a percentage of GWP is rising.

But what of the future? Consider the following hypothetical scenario. Suppose we start off with  GWP, Chinese GDP and US GDP in 2011 at 77, 7 and 16 trillion dollars respectively. Then suppose that GWP increases at an annual rate of 4% (the average of its real growth rate in the Earth Institute's dataset, which will underestimate its nominal growth), that China's GDP grows at 6% a year and that US GDP grows at 2.5% per year (both seemingly conservative rates of growth for China and the US). If we project forward through 2057 (an arbitrarily chosen date), the picture that emerges is captured in the graph below. The hypothetical US GDP/GWP ratio is plotted in blue, while the hypothetical Chinese GDP/GWP ratio is plotted in red (I'll explain the orange line in a minute).

The red and blue lines lay out the scenario that most US commentators dread as China and the US swap positions vis-a-vis the world economy. Of course, in this scenario, China is no more a hegemon in 2057 than the US finds itself today, but the trend puts them on track to eventually claim the position the US held in the 1950s.

However, this scenario is flawed by the fact that it projects trends forward in a linear fashion, thus assuming that growth rates will stay about the same for China, the US and the world. It might make sense that the US and world growth rates will stay at about the same annual levels, since the US and world have been able to post that level of performance for decades. But is it likely that China's growth rate will stay the same level, in particular at one 50% higher than the global growth rate?

An Alternate Scenario:

While China has posted higher growth rates in the past, it is more likely that they will see their grow rates decline over time as they become more developed and diminishing returns begin to set in. Indeed, the World Bank reports annual growth rates for China of 10.4% from 1999-2003, 9.3% from 2004-2008, and 7.8% from 2009-2012, so the pattern of decline is already in evidence. Therefore, an alternate scenario might be that China's annual growth rate slows over time to match that of the global economy as a whole (ableit still higher than the US' rate of growth). The orange line in the graph plots a scenario in which annual growth in Chinese GDP starts at 6% and then decreases by 0.5% every 10 years until it hits 4% in 2052.

If we look at the orange and blue lines (instead of the red and blue ones), we see a very different picture of the future. US GDP will be about 10% of GWP and Chinese GDP will be about 15%. Therefore, though the US will have a smaller share of GWP than China, China will nonetheless be much less of a hegemon than the US is today.

Indeed, the US and China may not be the only ones in the 10-15% of GWP band. If India’s GDP surpasses that of the US, as it is expected to do, India will find itself with probably about a 12-13% share of GWP. Furthermore, the EU will probably have a share about equal to that of the US, especially if it continues to add members. Therefore, China may find itself first among a set of 3 or 4 major economic powers that account for about 40% of GWP (undoubtedly someone will come up with a pithy acronym out of C, I, US, and EU). In such a case, China would not be a hegemon so much as the largest member of an oligarchy in which the US is also a member (albeit a junior one).

Now, of course, the future probably won't look like either scenario. Unexpected shocks (especially an economic collapse and/or lost decade in China) will see to that. However, the rising hegemon scenario described by the red and blue lines, and fretted over by commentators, is probably the least likely one to occur as it is based on a linear project of sustained high growth over the course of several decades.

China's High Speed Rail: Wealth Destroying Investment?

On Jan. 14th, SkyNews posted a report on China's high speed rail (HSR) network. The headline was that China was doubling its HSR network and the subtitle was "China builds 6,000 miles of track in the time the UK only debates the merits of constructing 100 miles of high-speed rail line."

This captures the tone of much reporting on Chinese HSR. People marvel at the rapid rate of construction, the vastness of the network, the quality of the service, and the ambitious plans for even more. Indeed, China has constructed 6,000 miles of HSR since 2008 and, as Sky reports, plans to invest the equivalent of 6o billion pounds ($97 billion) in the coming year. So China has a HSR network twice as long as the combined length of Japan's and Europe's networks and is spending heavily make it even larger.

Very often the growth of Chinese HSR is contrasted to the lack of growth in the author's country, as in the subtitle to the Sky News post. Indeed, China's 6,000 miles of HSR are a stark contrast to the US's 0 miles, and proponents of US HSR (notably the  planned LA to San Francisco  route) might be excused for using China's investment in HSR as a rhetorical lever against opponents. However,  seemingly few people ask why China has invested so much more in HSR than other countries, or to question the wisdom of the massive scale of their investment.

One person who does so (albeit indirectly) is Michael Pettis in The Great Rebalancing. Pettis argues that China has been pursuing the Japanese growth model that is based largely on establishing the following three conditions:

1. Undervalued Currency: the central banks systematically intervenes to keep the exchange rate down
2. Low wage growth: labor policies ensure wages grow more slowly than productivity
3. Financial repression:  the government allocates credit and the central bank keeps interest rates below their equilibrium rate (Pettis, 203, p 53)

This last condition is relevant to China's HSR. Pettis argues that China has set up its financial system in a manner that sets interest rates paid to depositors extremely low and ensures that there are few alternatives for savers to avoid them opting out of the banking system. This provides borrowers with a large supply of capital at a low rate of interest. These borrowers generally include, the government, infrastructure investor, and corporations (Pettis, 2013, pp. 60-61). Thus, financial repression provides an excess amount of savings and investment.

While having an abundance of savings and investment can spark wealth generation at first, when the existing stock of capital is low, eventually diminishing returns set in and the return on investment shrinks. However, the artificially low cost of capital encourages investment to continue at an above optimal rate. Pettis describes the situations as follows:

• "The longer heavily subsidized investment continues, however, the more likely that cheap capital and socialized credit risk will fund economically wasteful projects. Dirt roads quickly become paved roads. Paved roads become highways. And highways become superhighways with eight lanes in either direction. The decision to upgrade is politically easy to make because each new venture generates local employment, rapid economic growth in the short term, and opportunities for fraud and what economist politely call rent seeking behavior, while the costs are spread to the entire country through the banking system and over the many years during which the debt is repaid (and most at his rollover continuously)." (Pettis, 2013, p 90)

When reading the above passage, it is hard not to think of China's HSR as analogous to Pettis' hypothetical superhighway (or at least it was for me). Of course, one might argue that China is simply trying to catch up with the more developed world and is avoiding past (supposed) mistakes by building HSR instead of highways. One could argue that, since China is starting from such a low level of capital development that it would be a long time before they were in danger of overbuilding things like their transportation system.  However, Pettis addresses this line of thought, as follows:

• "The problem with this reasoning of course is that it ignores economic reason for upgrading capital stock and assumes the capital infrastructure have the same value everywhere in the world. They don't. Worker productivity and wages are so much lower in China than in the developed world. This means that the economic value of infrastructure in China, which is based primarily on the value of wages it saves, is a fraction of the value of identical infrastructure in the developed world. It makes no economic sense, in other words, for China and have levels of infrastructure and capital stock anywhere near those of much richer countries because this would represent wasted resources - like exchanging cheap labor for much more expensive labor-saving devices." (Pettis, 2013, pp. 90-91)

The above passage gets right to the point I am raising about China's HSR. The primary advantatge of high speed rail is that it is high speed and therefore saves travelers time. Generally, the economic value placed on time saved is parameterized by wages and productivity.  If I earn $20/hour, than spending an hour doing anything else represents an opportunity cost of $20 (i,e., the wages I could have earned). From a societal point of view, if my productivity is $70/hour, than having me do anything else represents an opportunity cost of $70 (i.e., the output I could have generated). So if a trip on a bullet train saves me 2 hours over another alternative, than the value of that savings is either $40 from the individual point of view or $140 from the society's point of view. Of course, this is an oversimplification that ignores, among other things, the fact that individual's generally value their free time at a higher rate than their wage (or else they working), but it gives you an idea of the type of calculation involved.

The point here is that, if we apply the same methodology (however oversimplified) to China, Japan, Europe and the US, the much higher wages and productivity in the last three would suggest that the economic benefit of HSR is much higher in them than in China. Yet China has chosen to build more HSR than all 3 countries/region combined.

This should at least raise an eyebrow or two, especially if one considers the conditions under which HSR has been successful elsewhere in the world. Tom Zoellner at the WSJ looks at the potential for HSR in the US and notes that the most successful routes in operation are those connecting capital and major business center in Japan (Tokyo-Osaka, 246 miles) and France (Paris-Lyon, 289). Besides connecting cities that provide a reliable passenger base, these routes fall in what Zoellner calls the sweet spot for revenue, distance of between 200 and 600 miles. Indeed, as Zollener notes, even the lumbering Amtrak, with trains averaging 68 mph, is able to capture 3/4s of the combined rail and air travel on the 225 mile route between D.C. and New York.

This suggests two points. First, that an extensive HSR system is questionable on the face of itself. We should expect to see 200-600 mile segments selectively placed between major metropolitan areas. Of course, if you have a string on larges cities 200-600 miles from each other, you might expect a longer line to connect them. However, you don't expect to see a huge network that includes an 1100 mile run through Tibet and the Gobi Desert to the far flung city of Urumqui.

Second, the example of the much lower tech US Northeast Corridor (NEC) suggests how much might be accomplished with less than high speed rail. Amtrak not only captures 75% of the non-automobile/bus traffic between DC and New York, but the four track NEC provides rail capacity for daily commuter trains. Where Amtrak has about 11 million passengers on its NEC trains (which includes the New York to Boston segment), the total passengers carried by Amtrak and various commuter rail services that use the NEC amount to 260 million/year. That's about a 22 to 1 ratio of commuters to intercity passengers.

Of course, another alternative to HSR, especially for routes over 600 miles, is airline travel, which China has not neglected. Indeed, Gordon Change at Forbes notes that China's Commercial Aircraft Corporation of China (COMAC) is hoping to start selling its C919 aircraft in 2016 and is hoping to sell over 4600 to Chinese airlines. However, though air travel in China is increasing at the rate of 10% a year, Chang notes that HSR travel has been growing at nearly three times the rate, 28%. He notes that subsidized rail prices are much lower than airline prices and have not seen increase in nearly a decade. So, Change argues that Chinese HSR is dampening demand for air travel and endangering future sales of its C919. However, he doubts that China will be able to operate the extensive network currently envisioned envision, and he notes that the rail operator is already $500 billion in debt.

Indeed, Pettis predicts future difficulties for the economy as a whole if the systemic imbalance between consumption and investment is not adjusted. The money being poured into HSR, and into may other infrastructure and manufacturing investments, may be sparking apparent short term growth, but this apparent growth may be masking the destruction of wealth if these investments are economically unsound. In the long run, any destroyed wealth will take the form of bad debt that will have to be paid down, which will slow future growth (or possibly cause a contraction in GDP). Pettis argues that if China does not take strong action to adjust its policies, it may face a Lost Decade similar to what Brazil experienced in the 1980s (Pettis, 2013, p 81-82).

This leads me to question whether China's investments in HSR, especially the current and future investments aimed at doubling the system, might ultimately be wealth destroying. Will they find themselves with a system that is greatly overbuilt and containing large segments that are untenable? While one might draw a fanciful parallel to the Simpson's monorail episode, more apt comparisons might be the overbuilding of American railroads at the turn of the last century or of the internet during the dot-com bubble. Both these examples involved over investment in infrastructure, one in steel rails and the other in fiber optics, that was ultimately unprofitable.

Of course, both the above examples left us with some infrastructure that, if not worth the cost of building, was nonetheless of enduring value. This is likely to be true of China's HSR as well. Indeed, it may well continue to be the pride of the nation even after its debt goes bad and large segments have to be abandoned or downgraded. After all, the NEC is the legacy of the Pennsylvania Railroad and then, after its merger with the New York Central) the notoriously bankrupt PennCentral.

Indeed, the more unequivocal example wealth destroying investment are likely to be in manufacturing where unprofitable firms are plowed under by their competition and their shuttered factories are of limited enduring value. In that sense, COMAC, if it fails to break up the Boeing-Airbus duopoly in midsized commercial aircraft, may end up looking like a more unmitigated failure than Chinese HSR.

Postscript: BBC Two has a report by Robert Preston that details the scale of Chinese investment and accompanying debt and warns of a future economic crisis.

Applying Selectorate Theory to Lampton's "How China is Ruled"

In the recent issue of Foreign Affairs, David Lampton  analyzes the current challenges facing Chinese political leaders. He provides insights that are interesting in their own right we can tease some additional insights if we apply Bueno de Mesquita, Smith, Siverson, and Morrow's (BDM et al., 2003) Selectorate Theory to his analysis.

Lampton provides a concise summary of his general argument as follows:

The fact is that China’s central government operates today in an environment fundamentally different, in three key ways, from the one that existed at the beginning of Deng’s tenure. First, individual Chinese leaders have become progressively weaker in relation to both one another and the rest of society. Second, Chinese society, as well as the economy and the bureaucracy, has fractured, multiplying the number of constituencies China’s leaders must respond to, or at least manage. Third, China’s leadership must now confront a population with more resources, in terms of money, talent, and information, than ever before. (Lampton, 2013)

With regard to the first difference between the Deng period and the current one, Lampton draws on Weber to argue that leaders have three sources of power: tradition,  personal qualities (charisma) of the leader, and constitutional/legal norms. In Lampton's view, while Deng benefited from a mix of the Mao tradition and his own charisma, the foundations of legitimacy in China shifted as the selection criteria for leaders began to include age and term limits, performance, and opinion polling in the Communist Party. In his words, this has resulted in the following situation:

China, in other words, has gone from being ruled by strongmen with personal credibility to leaders who are constrained by collective decision-making, term limits and other norms, public opinion, and their own technocratic characters. As one senior Chinese diplomat put it to me in 2002, “Mao and Deng could decide; Jiang and the current leaders must consult.” (Lampton, 2013)

The second change in the Chinese political system that Lampton identifies is the fracturing of  the society, economy, and bureaucracy into a larger set of competing interests. This has required the leadership to focus more on maintaining than transforming the system as they try to manage the competition between these interests, as he describes below:

Since Mao, however, China’s society and bureaucracy have fragmented, making it harder for Beijing to make decisions and implement policies. To deal with the challenge, the Chinese government, particularly since Deng, has developed an authoritarian yet responsive system that explicitly balances major geographic, functional, factional, and policy interests through representation at the highest levels of the CCP. Although the pathways for political self-expression remain limited, and elite decision-making opaque, China’s rulers now try to resolve, rather than crush, conflicts among competing interests, suppressing such conflicts only when they perceive them to be especially big threats. (Lampton, 2013)

Now, if we look at these two changes through the lens of Selectorate Theory, we might argue that the second change has largely driven the first one. What Lampton sees as the fracturing of the society, economy, and the bureaucracy might be interpreted as growth of the size of winning coalition (WC)  needed to rule in the system. Given  that Lampton describes the norms of leader selection as "incomplete, informal, and reversible," we can well imagine a situation in which social, economic, and bureaucratic development has produced the unintended effect of increasing the minimum number of people or interests in the Selectorate (i.e., the Chinese Communist Party or CCP) that a leader needs to include in his winning coalition.

If the WC is growing in size, than we would expect that the essential task of political survival (i.e., the provision of private benefits to members of the WC) would become complex and time consuming for leaders. This would especially be the case if the interests of the members of the WC became more heterogeneous as this would create more conflicts between the private interests of the WCS members and complicate the provision of private benefits to them.

In such a situation, it would not be surprising to see  leaders who are more skilled at managing multiple constituencies and resolving conflicts to bubble to the top of the leadership selection process because these are the people who will be best at amassing a WC from among heterogeneous interests within the Selectorate and will be viewed as a credible supplier of private benefits among those interests. Also, in practice, Leaders will need to spend more time devoting themselves to providing benefits and resolving conflicts within the WC. Just as importantly, conflict resolution is more likely to be visible from the outside and the process of providing private benefits will be more notable. Therefore, the norms of selection and the perceptions of the leaders may be driven by changes in the size and characteristics of the WC.

Of course, the third difference between the current political situation and the one faced by Deng remains to be considered. Here, Lampton argues that the people, in the form of individuals and local governments, are gaining in resources, in terms of capital, human capital and information, vis-a-vis the national leaders. This has driven the government to become sensitive to public opinion and active monitor it through opinion polling. So, where, Mao sought to define public opinion and Deng only followed it where it accorded with his view, Lampton describes the current attitude as follows:

Today, in contrast, almost all Chinese leaders openly speak about the importance of public opinion, with the goal being to preempt problems. In August 2013, for instance, the state-run newspaper China Daily reminded readers that the National Development and Reform Commission had issued regulations requiring local officials to conduct risk assessments to determine the likelihood of popular disturbances in reaction to major construction projects and stated that such undertakings should be shut down temporarily if they generated “medium-level” opposition among citizens.(Lampton, 2013)

On the face of it, this concern with public opinion (to the extent that it is genuine) runs counter to the central story of Selectorate Theory. According to the theory, Leaders of nations with small Winning Coalitions will focus on providing private benefits to the members of the WC and generally disregard considerations of public benefit. They certainly will not compromise the provision of private benefits to WC members that one one expect to occur in a major construction project for the sake of people who are not in the WC. In, general, Leaders are not expected to be concerned with public benefits unless they are in a system with a WC so large that providing private benefits to the members of the WC is more expensive or difficult than providing public benefits to the society as a whole. So, unless the concern with public opinion is viewed as symbolic window dressing, it would appear that Chinese leadership is violating one of the rules of the Dictator's Handbook (BDM and Smith, 2011). Rule 5 to be precise.

While this might be the case, there might be something else going on. Consider that, according to Selectorate Theory,  the endurance of leaders in Soviet style systems is based not only on having a small WC but also having a large Selectorate (i.e., the party). The size of the Selectorate is important because, even if members of the Selectorate aren't in the WC, they have nonetheless a chance of being in one and, therefore, are more likely to support the system in place.  The CCP had a membership of 82.6 million in 2012 and added 17 million members between 2001 and 2012. (China Daily, Nov, 5 2012) While that accounts for only 6% of the country's population, the party has expanded 25% in size since 2001 and thus is including a larger portion of the population that has a shot of being in a WC. Of course, if the WC is growing,  that only increases their hopes of being included.

However, the 82.6 million people's shot at being in a WC that will provide them with private benefits if the current system is successfully challenged by the 1.27 billion or so people in China who are not in the CCP. Therefore, one can imagine there being broad support for a rule that constrains the provision of private benefits to members of the WC when it causes noticeable public opposition. Of course, in practice, implementing the rule in a particular case would be problematic as it involves denying a private benefit to a member of the WC who might value receiving that benefit more than promoting the overall system's long term survival (especially if one considers that the delay or cancellation of any one project will make a very small difference in the system's long term prospects). So, there may be as much tension between elements of the CCP involved here as between the CCP and the population.


References:

Bueno de Mesquita, Bruce, Alastair Smith, Randolph Siverson, and James D. Morrow. (2003) The Logic of Political Survival. Cambridge, MA: The MIT Press.

Bueno de Mesquita, Bruce, Alastair Smith. (2011) The Dictator’s Handbook: Why bad Behavior Is Almost Always Good Politics. New York, NY: Public Affairs.

Lampton, David M. How China Is Ruled. (2013, December 16). Foreign Affairs. Retrieved February 3, 2014, from http://www.foreignaffairs.com/articles/140344/david-m-lampton/how-china-is-ruled?nocache=1

The Renminbi and the Role of the Dollar: Greenback vs Redback

The last post talked about currency manipulation and the renminbi, but what about the idea of the renminbi as a challenger to the dollar's role as global reserves currency. In other words, is the redback (as the renminbi is sometimes called) a threat to the greenback's global dominance.

The Economist gave the standard arguments (albeit in the kind of depth somewhat unique to the Economist) one normally hears back in 2011. Specifically, that being the issuer of the world's reserve currency was a boon to the US (often called the exorbitant privilege) and that China was fed up with relying on the dollar. However, it also discussed the traditional counter-argument that being the issuer of the reserve currency is a curse because it puts a nation in the Triffen dilemma. That is, it encourages the issuer to put more money in circulation, which in turn undermines confidence in its currency. (Of course, the Triffen dilemma applied to the Bretton Woods System in which the US had to maintain a fixed exchange rate with gold while everyone else was able to adjust the value of their currency to the dollar, but I'll let that slide.)

Barry Eichenberger laid out the in-depth argument for the demise of the dollar as the reserve currency in "Why the Dollar's Reign Is Near an End" He argues that the US dollar's role as reserve currency is founded on 3 pillars: the depth of US dollar securities in the market, the fact the dollar is the world's safe haven, and the lack of viable alternatives. However, the rise of the Euro and the Yuan will provide rivals for the dollar while economic crises and rising debt in the US will undermine the perception of dollar as a safe haven. This will lead to multiple reserve currencies being adopted instead of reliance upon the dollar alone.

Michael Pettis disagreed with the view that the RMB could play the role of reserve currency. His original blog post was lost when it was hacked by Business Insider summarized his argument. First, unless China starts running a current account deficit, there will be no way for the world to acquire renminbi. Second, people are suspicious of China's financial system which is in need of significant liberalization and reform. Third, major countries such as Russia, India, South Korea, and Vietnam are also suspicious of China for political and security reasons. Finally, Pettis argues that the international trade in RMB is overstated as most of the trade is in the form of swaps between the People's Bank of China (PBoC) and other central banks as opposed to private financial transactions.

Pettis also argued that having the dollar as reserve currency represents an Exorbitant Burden in a Foreign Policy article. He argues that having the dollar as reserve currency contributes to the US current account deficit and that the US would be better off if another reserve currency was in place. Pettis argues that developing the IMF;s Special Drawing Rights (SDRs) into a truly international currency would be the best alternative.

The Renminbi and Charges of Currency Manipulation

The Chinese renminbi (literally "the people's currency" which is abbreviated RMB and denominated in yuan) is now trading at a rate of 6.06 yuan to the dollar and is trending towards breaking through the 6 to 1 mark in the near future. So  the renminbi has appreciated by about 32% since China stopped pegging its currency at 8 yuan to the dollar in 2005.

However, in 2012, arguments that China was manipulating its currency and costing the US jobs were a central part of Mitt Romney's failed presidential campaign (though, perhaps, far from the cause of his failure). Here are three points of view on this, mostly circa 2012.

The Case Against China: Peter Navarro laid out the argument for China as currency manipulator in China’s Currency Manipulation: A Policy Debate in a 2012 World Affairs article. Navarro makes the claim that:

Most economists estimate the Chinese yuan is grossly undervalued by anywhere from twenty-five to forty percent—and only propagandists like the China Daily and hired guns for China profiteers like Goldman Sachs and Morgan Stanley claim otherwise.

As will be seen below, this claim may be greatly exaggerated or at least out of date by 2012. However, the rapid appreciation of the renminbi vs the dollar since China abandoned its peg in 2005 ( interrupted only by a 2-year plateau during the US recession), suggests that the currency was undervalued for much of the first decade of this century. Navarro argues that this undervaluation had a negative effect on the US economy:

China’s unfair trade practices have indeed taken a very heavy toll on the American economy. Consider that for the second half of the twentieth century, the US gross domestic product grew at a healthy rate of about 3.5 percent annually. Since China joined the WTO in 2001, however, that rate has fallen to an average of only 1.6 percent. While the loss of almost two percentage points of GDP growth a year may not seem like much, it translates into a failure to create two million jobs a year and cumulatively more than twenty million jobs lost to slow growth since 2001. Not coincidentally, that’s almost the exact number of jobs America now needs to get its people fully back to work.

Note, however, that the evidence here is based on a simplistic before and after China joined the WTO comparison and ignores the fact that the decade following China's entry into the WTO included the largest recession in the US since the Great Depression. In fact, if we actually look at the actual Federal Reserve data in the form of  the below graph of the annual percent change from one year ago of US real GDP, we see a less clear cut story.

The graph shows that, prior to the 1990s the US economy rode a roller coaster (albeit with a high ride in the 1960s) before enjoying fairly stable growth in the 2.5-5% range during the 90s. Since 2001, things have not been as good but the two recessions in that time have obvious effects. Indeed, the full magnitude of the Great Recession is on full display here as the graph dips lower in 2009 than at any other time.

Note, the US economy got back into the 2.5-5% growth band between the recessions, precisely when China's currency manipulation was at its peak. Unfortunately the economy has achieved growth rates comfortable within that range despite the fact the renminbi has resumed appreciating against the dollar.

The Case Against China Currency Critics: Edward Lazear argues that Chinese 'Currency Manipulation' Is Not the Problem in a 2013 WSJ Op-Ed. [If thwarted by the WSJ's paywall, summaries of Lazear's Op-ed can be found here and here.]

Lazear compares the yuan-dollar exchange rate with China's exports to the US and Europe from 1995 to 2011. He notes that Chinese exports have steadily increased throughout this period except for a downturn during the Great Recession. However, during this period, the renminbi dropped in value as it rode the US dollars depreciation until the 8 to 1 peg was removed in 2005. As noted above, the reminbi has increased in value since then but imports have continued to trend upwards.

More importantly, the trend in exports to Europe does not differ from the trend in exports to the US, indeed they are nearly identical. This holds even during the period in which the exchange rate was pegged at 8 yuan to the dollar and the renminbi was depreciating against the Euro but not against the dollar. In this period, exports to Europe increased by 35% while exports to the US increased by 32%. Lazear argues that the differences in the exchange rate might explain the difference between 35% and 32% growth but the bulk of the growth in both categories is determined by other factors.

Lazear concludes that, while China certainly was manipulating its currency, this manipulation was not the source of its export growth or disappointing job and wage growth in the US.


The Case Against Currency Manipulation, but China Not-So-Much Anymore: In 2012, Joseph Gagnon examined currency manipulation across nations in a policy brief for the Peterson Institute, Combating Widespread Currency Manipulation (PB12-19).  Gagnon defines a currency manipulation as follows:

Currency manipulation occurs when a government 

buys or sells foreign currency to push the exchange 

rate of its currency away from its equilibrium value or 

to prevent the exchange rate from moving toward its 

equilibrium value. (Gagnon, 2012, p. 1)

In his brief, Gagnon finds that 20 nations engage in "egregious" currency manipulation in one of four generala categories:

(1) longstanding advanced economies such as Japan and Switzerland;
(2) newly industrialized economies such as Israel, Singapore, and Taiwan; 
(3) developing Asian economies such as China, Malaysia, and Thailand; and
(4) oil exporters such as Algeria, Russia, and Saudi Arabia. (Gagnon, 2012, p 2)

Most of this manipulation takes to form of purchases of foreign currency aimed at lowering the value of the home currency in order to run a current account surplus (i.e., a trade surplus). Gagnon estimates that the total effect of these 20 nations may be as larges a $1.5 trillion per year and that this may have pushed the US current account down an average of 4% of US GDP.

Gagnon provides a table showing the nations he identified as the most egregious manipulators, along with several indicators of manipulation. The list below shows these nations rank ordered by the first indicator in Gagnon's table, 2011 Foreign Reserves as % of GDP.

Nation                     2011 Foreign Reserves as % of GDP
Libya                        271
Hong Kong               121
Algeria                        97
Saudi Arabia               94
Singapore                   93
Taiwan                       83
Thailand                     49
Malaysia                    48
China                        45
Switzerland                44
Bolivia                       40
Philippines                 32
Israel                         31
Angola                      28
Korea                       27
Russia                       25
Denmark                   24
Japan                        21
Azerbaijan                17
Argentina                    9
Source: Gagnon, 2012, Table 1

It is interesting to note the broad range of nations and the large number of Asian nations that show up on it. It should also be pointed out that China, in ninth position, is middle of the pack, between Malaysia and Switzerland. It should also be pointed out that foreign reserves can accumulate over time and reflect past as well as current policy.

While China is in the middle of the pack in the above list (which is scaled to GDP), it stands at the top when the absolute size of foreign reserves are measured. In a blog post, Gagnon provided this ranking of currency manipulators and China stands head and shoulders above everyone else (with only Japan coming close).

However, though China tops the list because of the size of its reserves, Gagnon notes "...although China tops this list, its reserves have been relatively stable over the past 12 months [July 2011-July 2012], suggesting a marked change in its behavior." So, while China may be holding larges reserves of dollars acquired from past manipulation, it is no longer adding much to this pile, which suggests that it has changed its ways. More specifically, that the renminbi had appreciated enough by mid 2011 to approach its equilibrium value.

Indeed, in September 2012 Ganon was joined by C Fred Berstein in an Op-Ed to the Financial Times in which they argued argued for measures against nations practicing currency manipulation but noted that China "...has not been the major perpetrator of late." They identified the major culprits as follows:

Three distinct groups are now involved. First are other Asian countries, including Japan, Singapore, Taiwan, Korea, Hong Kong, Thailand, and Malaysia. Second are major oil exporters including the United Arab Emirates, Russia, Norway, Saudi Arabia, Kuwait, and Algeria. Third are rich countries near to the euro area, most notably Switzerland but also Denmark and Israel.

So, if the US were to let nationality blind currency manipulation seeking missiles, they would by pass China for a mixed bag of nations, which would include many staunch allies and trading partners.