Once more Andy Xie argues the point, and once more I feel he is right: fixing deflation in Japan is not about making things worse in China:
Japan is obsessed with China for the wrong reason, in our view. Its leaders are increasingly looking at China’s economic growth and Japan’s economic decline as a fairness issue, i.e., “the renminbi is too cheap”. Japan’s Ministry of Finance has tried repeatedly to internationalize its concern by presenting the renminbi’s value as an issue at G-7 meetings. The rallying cry is, “China is exporting deflation”. Is blaming China fair or helpful to Japan? We think not. China’s economy is growing just as Japan’s was three decades ago. Growth is rapid because of the low base. Wages are low because Chinese workers have little wealth and, hence, put a low value on leisure. This is quite consistent with what Solow’s growth model tells us. Poor people cannot be blamed for working long hours. Would raising the value of the renminbi against the dollar make a significant difference to Japan? It would make a sustainable difference only if the Japanese investment that is now shifting to China were to stay in Japan. But the cost difference between China and Japan is so huge that no conceivable change in the renminbi’s value could reverse the investment flow. The yen/dollar rate has fluctuated between ¥100 and ¥130 with no visible impact on Japanese investment in China.
Economic theory tells us that, if one economy has an undervalued currency, it will suffer increased inflation. The inflationary process of revaluing a currency causes real interest rates to stay low, which may trigger an investment bubble. This is what happened in East Asia before the 1998 crisis. This is why economists usually advise against fixed exchange rate policies. Advising another country to abandon a currency peg makes sense when that country is suffering from high inflation and rising foreign exchange reserves at the same time. But inflation is the last thing that we are likely to find in China. Its price level has been declining for five years. One factor was China’s adjustment to the devaluations in other Asian economies in 1998 through a decline in domestic prices. Its current deflationary problem mostly originates from its labor market. Its effective labor force is growing rapidly, with the quality of new entrants into the labor market also improving. The economy is not growing fast enough to offset this pressure. As a result, wages are rising only slowly, causing deflationary pressure.On the basis of Japan’s prescription for China – raising the value of the currency – the economy would grow more slowly and labor market conditions would worsen. Why should China commit to such a hara-kiri currency policy? Further, a renminbi appreciation could not stick in real terms, as discussed above. The adjustment in 1998 demonstrates that wages in China can fall and large numbers of workers can be laid off. If the renminbi appreciates, China’s deflation would worsen and restore its competitiveness. The exchange rate does not determine competitiveness for an economy with a flexible labor market.
Source: Andy Xie, Morgan Stanley Global Economic Forum
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