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Capitalism with Special Chinese Characteristics: The runaway train of China’s economy is a special case of what economists label “Dutch Disease” (Gustav Ranis, 19 June 2007, YaleGlobal)

The basic cause of these anomalies in a country that continues to call itself communist – and is currently engaged in an effort to enhance “social harmony” in the context of 10-percent-plus growth rates – is a particular type of Dutch Disease. The economic ailment acquired its name from the1960s natural-gas boom in the Netherlands and is generally defined as the impact of a raw-material export spurt, possibly along with related foreign-capital inflows, on strengthening the exchange rate.

Such an appreciation of the currency implies a shift away from labor-intensive export sectors that are becoming less competitive internationally and toward domestic non-traded goods, also enhancing inflationary pressures.

China has thus far resisted letting its exchange rate appreciate much – despite international pressure – and instead continues to accumulate foreign-exchange reserves resulting from her mounting trade surpluses. As a consequence, China has managed to postpone most of the negative impact of the garden-variety “Dutch Disease.”

But another version of that disease could be more relevant in China’s case, one defined as the massive inflow of foreign exchange, from whatever source, adversely affecting decision-making throughout the body politic. The Chinese version of this phenomenon results from the continuing large-scale export surpluses caused by massive labor-intensive exports, associated with the maintenance of an undervalued exchange rate, and accompanied by large-scale foreign direct investment flows as well as some speculative portfolio capital. As labor surpluses in the coastal provinces are gradually exhausted, these “vent for surplus” activities move into the interior, continuing to fuel the overall investment boom.

China’s cumulative export surpluses since the late 1980s have amounted to $386 billion and inflows of FDI to $994 billion. With foreign-exchange reserves well above the $1 trillion mark, the Chinese government finds itself unable to cool down the boom – investments currently still run at 40 percent of GDP – all of which has led to lower levels of efficiency, i.e., falling rates of return and rising industrial capital-output ratios.

With saving rates nearing 50 percent and consumption continuing to lag as families worry about the need to finance their own health care and pensions down the road, we witness Beijing’s inability to rein in local governments’ continuing investment binges.

Households have two choices: put their money into government banks which continue to lend to local bodies – regardless of what the central government’s monetary and fiscal authorities have to say on the subject – or chase stocks or real estate in highly volatile asset markets.

In other words, this version of Dutch Disease is not caused by a natural-resource bonanza but massive labor-intensive exports plus large-scale capital imports, which affect not the exchange rate but the decision-making process. With enough resources around to buy off any and all stakeholders, incentives to push for reforms or pressure for care in lending and rational decision-making are reduced. Foreign investors remain anxious to maintain a competitive foothold in a market that continues to promise large future returns, and domestic financial institutions at the center are not sufficiently mature to impose their will on local bodies. No one feels obliged to blow the whistle as long as the bonanza lasts.

Properly understood, cheap labor is just another commodity, making this a classic case of the Dutch Disease. The important thing is that rudimentary assembly work is the only ingredient that China adds to the economic equation, making the labor little different than a raw material.

Posted by Orrin Judd at June 20, 2007 6:44 AM