History rhymes: Comparing China today with 1920s Japan
China faces two main options in dealing with its economic distortions
The Chinese currency has been depreciating since January 2014, and the balance of payments has weakened. There has been a substantial decline in the current account surplus relative to gross domestic product (GDP) since 2010 and, more recently, persistent private sector capital outflows.
The question is: How long will the Chinese yuan continue to depreciate and how much will China’s exchange reserves decline? In this context, it is useful to consider some interesting parallels between the economic experience of Japan in the 1920s and the recent experience of China, which seem to suggest that China’s currency and external account problems could continue for several more years.
Large external surpluses and distortion in the economy
During the First World War, Japan experienced large surpluses on its external accounts that, via monetary expansion, drove up Japanese prices, making the country’s exports uncompetitive compared with other leading economies such as the US and UK.
Similarly, following China’s devaluation of the renminbi in 1994, and the adoption of a fixed rate against the US dollar, China gradually built up huge external surpluses, which continued even after the 2005–2014 appreciation of the currency.
For Japan in the 1920s, the result of the overvaluation was a decade of financial crises, slow growth, agricultural depression and deflation. Only in December 1931, when authorities finally abandoned the pre-war fixed parity with gold and devalued the yen, did Japan’s external accounts return to equilibrium.
Back in China, while the country is not committed to any particular exchange rate, two problems exist:
- First, China allowed its external surpluses to grow for so long that large distortions in the economy were created — principally, massive excess capacity in many basic industries and heavy indebtedness that will take a long time to eliminate.
- Second, there are distinct limits to China’s willingness to allow the renminbi to depreciate.
Together, these factors suggest that China’s problem of external disequilibrium will take much longer than just a year or two to resolve.
China today is faced with essentially the same set of choices as Japan in the 1920s.
- One option is to maintain the current US dollar fixed rate (or a stable renminbi against a basket of currencies), preserving the status quo in its domestic economy — i.e., state ownership of large-scale enterprises, state direction of credit, extensive capital and financial controls. This would imply a long, slow disinflation (relative to foreign economies) with a persistent decline in foreign reserves.
- The second option is to move much more quickly to external equilibrium, allowing the renminbi to fall in line with market forces, to lift a whole range of controls while restructuring the state-owned sector, and thereby ending the distortions that have built up over the past two decades. Such a strategy would enable China to emerge as a far more market-oriented economy, able to adjust to external challenges more rapidly in the future.
In practice, China appears to be adopting a middle road closer to the first option than the second. This middle road will inevitably imply conflicts between means and ends, but to the Chinese authorities it will nevertheless be preferable to the second option.
Blog header image: canonzoom/Shutterstock.com
Renminbi is the currency of the People’s Republic of China. Yuan is a denomination of the renminbi.
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Based in London, John is Chief Economist of Invesco Ltd. with responsibility for providing economic analysis and forecasts to Invesco portfolio managers and clients.
John started his career in 1970 as a visiting research fellow at the Bank of Japan. He joined our company four years later in 1974 as Chief Economist, based initially in Hong Kong and later in San Francisco. As editor of Asian Monetary Monitor in 1983, he proposed a currency board scheme for stabilizing the Hong Kong dollar. John was a director of the Hong Kong Futures Exchange Clearing Corporation for four years until 1991, and in 1992 became a council member of the Stock Exchange of Hong Kong, a position he held for twelve months. In that same year, he was an economic adviser to the Hong Kong Government. He has been a member of the Committee on Currency Board Operations of the Hong Kong Monetary Authority since 1998. He is also a member of the Shadow Monetary Policy Committee in England, and he serves on the board of the Hong Kong Association in London.
John holds an MA from the University of Edinburgh, and an Honorary PhD, also from the University of Edinburgh.