One counterpoint I often hear about the renminbi’s role in rebalancing China’s economy is “but hey, look at Japan: It’s had a flexible exchange rate for years and, yet, its growth is still reliant on external demand”.
True. So let’s see what’s going on in Japan, whether there are any differences with China and whether the case for renminbi appreciation still stands from an economic rebalancing perspective.
One reason behind Japan’s lackluster consumption growth has been a stagnant growth in real wages: Real wages have barely moved for more than a decade, even while labor productivity growth has actually been strong. As a result, the labor share of income in Japan has declined steadily—some 5-6% of GDP since the mid 1990s.
The reasons for this were explored in a recent IMF working paper and the verdict was as follows:
First, increased trade openness and competition from foreign, cheaper labor has put downward pressures on real wages in tradable sectors (notably manufacturing). This is not a phenomenon specific to Japan: Other advanced economies have also experienced similar pressures on real wages, especially as companies’ ability to relocate to take advantage of cheaper labor has improved.
Apart from globalization, Japan’s economic structure and labor market regulations seem to have exacerbated the fall in labor’s share of income. Specifically, productivity in the services sector has been low, leaving little room for real wage growth there. Which means that, if I’m a manufacturing worker disgruntled with my stagnant real wage, I don’t really have anywhere better to go: Shifting to the services sector will not raise my purchasing power prospects.
From a policy perspective, and to the extent that rebalancing growth towards domestic demand is an objective, the implications are clear: Steps to increase productivity in the services sector would help lift real wages there, putting pressure on the manufacturing sector to do the same and reward their employees more in line with their productivity.
Turning on to China: First of all, household consumption growth in China is not at all stagnant—on the contrary. However, GDP growth has been much faster, bringing the share of household consumption to GDP down to a stunningly low 35%–a 10 percentage point reduction since the mid 1990s. Much of the reason is to be found in real wage growth: While robust, real wage growth has been slower than that of GDP, leading to a steady decline in labor’s share of income to an estimated 50%.
So while the paces of underlying growth in wages and consumption differ widely between Japan and China, part of the reason behind the lackluster performance of private consumption in both countries has to do with the fact that labor has been awarded a declining share of national income.
But there are important differences: First, in the case of Japan, labor’s share of income is still 60%–above the advanced-economy median of around 57%. So the fast decline in recent years has partly reflected a convergence towards advanced economy levels. In contrast, China’s labor share of income, at 50%, is far lower, and “abnormally” so at that, considering that developing economies tend to be more dependent on labor intensive industries (I’ll come back to that).
More importantly, a key reason behind Japan’s (and other advanced economies’) declining labor share of income is a distinctly external shock: That of globalization, foreign competition and equalization of factor incomes through freer trade and relocation of production abroad (including by Japanese companies in developing Asia).
In contrast, China *is* that shock: It is the place where many companies relocate to take advantage of cheap labor costs (as well as a potentially huge consumer base). This means that the decision not to raise the purchasing power of labor (whether it’s by raising nominal wages or through an appreciation of the renminbi) is an autonomous one—not one that is enforced by the global competitive landscape.
Of course, things are not as simple as that. First, not all industries in China have the same degree of profitability. Arguably, there is little room to raise wages in some low-value-added industries, especially since some companies are deemed to survive only because of the undervalued exchange rate (per the government’s recent stress tests on the sensitivity of some companies to renminbi appreciation).
Secondly, even in larger companies with fat profits (including many state-owned enterprises), profitability has been partly sustained by a slew of (what should be) temporary boons: Subsidized energy prices, land subsidies, low interest rates (partly due to controls on capital outflows) and, of course, the favorable exchange rate. Steps to remove these advantages would limit the scope for strong wages increases going forward, as profitability declines.
The underlying issue though is the developmental objective that these distortionary policies are set to achieve: That of an overarching focus on building capital- and resource-intensive industries. This has limited the growth in the number of employed people or, more relevantly for China, in the number of people who can shift out of farming employment in the context of the country’s ongoing urbanization.
This is where the comparison with Japan becomes very informative: If China wants to avoid Japan’s reliance on external demand, it will need to undertake policies that encourage an efficient and dynamic service sector to flourish.
What’s the role of the exchange rate here? As noted above, the exchange rate is just one of the distortionary policies aimed at promoting the development of the tradable sector; but it’s an important one for realigning production and investment incentives.
Renminbi appreciation would reduce the profitability of capital-intensive, export-oriented companies, limiting the recycling of corporate savings back to industrial capacity building (which is what companies have been doing). It would shift production incentives away from low-value-added, exchange-rate sensitive sectors and towards higher-value-added industries as well as the services sectors. It would raise the purchasing power of consumers by lowering the price of imported goods, freeing up income for services consumption. And it would diminish the current influx of liquidity due to the accumulation of FX reserves, raising the cost of capital and, thus, lenders’ “benchmark” for efficiency and profitability in both the industrial and services sectors.
Clearly, a change in China’s exchange rate policy is not a panacea for rebalancing growth. A multitude of other policies need to be taken in tandem. But its contribution to realigning production incentives, together with the unsustainability of what UBS economist Jon Anderson has called China’s “expropriation” of savings from the rest of the world, make it a critical and an urgent step.
Originally published at Models & Agents and reproduced here with the author’s permission.
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