China in Transition

Time to Abandon Mercantilism

Chi Hung KWAN
Consulting Fellow, RIETI

China's effort to integrate itself into the global economy has up until now followed a strategy of boosting exports on one hand and suppressing imports on the other. While this was dictated by the circumstances that the nation lacked both international competitiveness and foreign currency, given the huge improvement in its balance of payments, the time has come to abandon such a mercantilist way of thinking.

Mercantilism was originally a policy embraced by Western European nations such as Britain from the latter half of the 16th century to the 18th century. Mercantilists believed that a nation's strength could be measured by the amount of gold and silver it amassed through a trade surplus, and so they actively expanded exports. Unlike the European countries of that era, China does not possess any technology of its own, and so it actively invites foreign investment to supplement its technological weakness. While China's market-opening strategy, which combines the inflow of foreign investment with export promotion, has led to high economic growth, it also has such negative effects as the suppression of the development of domestic firms, the deterioration of its terms of trade over a long period, and increased friction with countries like Japan, the United States and Europe as a result of its surging trade surplus.

Reflecting this influx of direct investment and rise in trade surplus, China's foreign exchange reserves totaled $383.9 billion in September 2003, ranking it second in the world behind Japan. This is said to be the symbol of the success of its mercantilist market-opening strategy. While it is true that foreign exchange reserves are necessary to prevent a currency from speculative attacks, they are certainly not something that it is better to have more of. If a country holds more foreign exchange reserves than are necessary, if anything, various problems arise. First, the returns on investments of foreign currency reserves into U.S. Treasury Bonds are much lower than those for domestic investment, and under the current circumstances China's funds are not being efficiently used. In addition, the rise in foreign currency reserves is leading to a surge in money supply, and is exacerbating the bubble in the real estate market. Furthermore, the growth in exports that is fueling the steep rise in foreign exchange reserves threatens to aggravate trade frictions. In fact, the U.S. is demanding the yuan be appreciated because of China's "unfair manipulation" of its exchange rate, and Congress is also considering legislation that would slap a special tariff of 27% on imports from China.

The aim of economic development, in the first place, is to improve the people's standard of living, and the introduction of foreign investment, promotion of exports and accumulation of foreign currency reserves are only means to achieve this end. Should China continue to keep the yuan's exchange rate at a comparatively low level and keep building up its foreign exchange reserves, the purchasing power of its people will remain low and resources will become further concentrated under government control.

Chinese authorities should fully recognize the limits of the mercantilist policies they have so far pursued and review their economic growth strategy by focusing on the following four points. Firstly, the "supernational treatment" given to foreign firms, such as preferential tax breaks, should be corrected so that domestic firms, especially privately-owned companies, are given the right to compete on an equal footing. This would also be in line with the World Trade Organization's principle of nondiscrimination. Secondly, in order to prevent a further worsening of trade frictions and its terms of trade, China should strive to switch from export-driven growth to growth led by domestic demand. To do so, it becomes imperative to tackle such problems as the regional disparity, which is a cause of the lack in domestic demand, the credit crunch brought about by the banks' non-performing loan woes, and the insecurity brought about by inadequate pension and unemployment insurance systems. Thirdly, the precious savings of the people should not be lent to the U.S. and other industrialized nations in the form of holding foreign currency reserves but instead be invested more efficiently in human and physical capital at home. Finally, the government should aim to boost domestic demand, reduce trade frictions and correct imbalances both at home and abroad through a gradual appreciation of the yuan, which has become comparatively undervalued.

By implementing such policies, not only will the fruits of China's economic growth be spread among the people, but China will be held in higher esteem by the international community as a major power that fulfills its responsibilities.

October 31, 2003
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October 31, 2003