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Source: www.asiaecon.org |

Foreign Direct Investment and the Current Account Surplus in China


Foreign Direct Investment    An important factor in the tremendous growth in Chinese exports, was the country's pursuit of policies encouraging the establishment of foreign-invested factories. In 2004, nearly half of Chinese exports were produced by foreign-invested firms. Initially, China had major political concerns of relinquishing control of Chinese assets to…


    An important factor in the tremendous growth in Chinese exports, was the country’s pursuit of policies encouraging the establishment of foreign-invested factories. In 2004, nearly half of Chinese exports were produced by foreign-invested firms. Initially, China had major political concerns of relinquishing control of Chinese assets to foreigners, due to the socialist character of the economy. Once they recognized that FDI could transfer useful technical and managerial skills, China encouraged it.

In the 1990’s, the government introduced rules and policies which paved way for immense FDI capital flow into China. The Chinese government allowed foreign investors to establish wholly foreign-owned enterprises with no knowledge-transfer requirements, to receive favorable treatment in additional geographical areas, and to manufacture and sell a wide range of goods in China’s increasingly attractive domestic market. In addition to the liberalized FDI regulations, strict international loan ceilings made foreign investors who are interested in China to lean toward FDI as opposed to securities and loans. As a result, by 2004, China was the world’s largest recipient of FDI with an annual inflow of $64 billion; becoming to account for more than 70% of China’s total capital inflows.

FDI has made enormous leaps in terms of inflows. From 1990 to 1994, FDI inflow has jumped nearly 300% from $3.5 billion in 1990 to $33.8 billion in 1994. FDI inflow as shown yearly positive gains, however, there is a drop from 1998 to 2000. During these years, both domestic and foreign investors came to expect an imminent renminbi revaluation. This caused both domestic and foreign investors to increase their shorter-term renminbi-denominated assets and foreign currency-denominated liabilities to take advantage of the expected renminbi appreciation. Looking at the financial account during these years, the financial account has grown from -$6.3 billion in 1998 to $34.8 billion in 2001, depicting the tremendous capital inflow from non-FDI investments.  

Many economists believe that the high consumer savings rate in China in turn funds FDI into China. Due to the rising private burden of expenditures on house, education and health care, Chinese citizens have to save a large portion of their wealth for unexpected expenses. The average urban household saving rate in china rose by 7 percentage points, to 25% of disposable income from 1995 to 2005. With a very large amount of savings, people in China usually save their money in U.S. bonds, deposits, treasuries, and hedge funds because of the stability in U.S. assets. Some of the savings may go to Chinese banks, but because of the distrust by many of the Chinese government, many opt to put their money in the U.S.
   
In macroeconomic terms, excess savings equates to increased loanable funds. As the capital is being flown into the U.S., while the assets are being imported to China, the U.S. will have more loans to be lent out for investment purposes. With a higher supply of loanable funds, interest rates will fall, and investments will rise. Some of those investment flows will be directed towards domestic projects, and some will go to international projects, most popularly, China. As FDI increases into China, the economy of China will boost from the increased output, consequently increasing income and raising savings once again. The cycle repeats, and in a sense, China is funding their own growth.

Current Account Surplus in China

In addition to such high savings inconsequently funding its current account surplus, China has pegged their currency, what many believe to be undervalued, to the dollar. Initially, after abolishing the dual exchange rate and adopting a fixed exchange rate, China was able to stabilize its economy and reduce inflation to negligible levels. After the Asian crisis, growing capital flows into China put pressure on the exchange rate. To maintain the value amidst pressure on the yuan to appreciate, China’s central bank exchanged incoming dollars for renminbi and used the dollars to purchase dollar assets such as U.S. Treasuries.  
   
As the Chinese economy began to boom, many international countries began to accuse China of currency manipulation. With politicians and manufacturing representatives concerned with protecting their own countries’ and firms’ trade interests, many attributed upward pressure on the renminbi to China’s rapid foreign exchange reserves accumulation and faster labor productivity growth. In further evidence, many pointed to China’s excess exports and inflow of dollars as evidence of an undervalued exchange rate. 
   
The United States, one of the main importers of Chinese goods, became uncomfortable with China’s growing dominance in exports. A strong protectionist movement emerged, arguing that the undervalued peg of China gives an unfair advantage in the U.S. market and hurts domestic employment. Likewise with the EU and Brazil, they began to push for protectionist policies such as tariffs and quotas as well. In addition, many economists believed the Chinese policy of pegging the yuan to the U.S. dollar was straining its own economy. Because of the fixed exchange rate and leaky capital controls, monetary policy renders ineffective in economic stability. If China elects to use monetary contraction to appease inflationary pressures, the higher interest rates would attract further capital inflows, further inflationary pressures, and appreciating pressures on the currency.
   
Despite a myriad of pressures around the world to revalue its currency, China finds some evidence supporting the current peg. In defense of the undervalued peg, several analysts and economists have argued that the large increases in exports were matched by large increases in imports. A proportional increase in imports may imply that the currency is not undervalued, and that domestic currency can import relatively the same amount as the foreign country can import.. In defense of critiques against the inability to use monetary policy, economists argued that China maintained a substantial degree of autonomy over monetary policy. Economists Guonan Ma and Robert N. McCauley estimated the average domestic and foreign three-month, money-market yield and found a yield gap. Although many believe that China has leaky capital controls, this average yield gap shows that capital controls in China effectively segmented both markets, despite a higher domestic yield than foreign. If capital controls were indeed leaky, there would be appreciation pressure on the yuan, consequently needing official reserve transactions to maintain the interest rates. With the ability to maintain an interest rate level above the world, Chinese authorities could use interest rate adjustments to achieve external and internal objectives.

Source: www.asiaecon.org |

 

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