China’s Growth Benefits its Southeast Asian Partners

Benefits to Country X from China Growth

• Y = C + I + G + NX• C – Increases and shifts IS curve rightward• I – Increases and shifts IS curve rightward• G – Can stay unchanged while enjoying benefits of

increased national income• NX – with correct monetary policy, interest rates stay

constant and NX is either neutral or increases• End Result: China growth presents easy opportunity to run

expansionist monetary policy and capture gains from trade, investment, and net exports without additional government spending

Gains in “C” China Growth Increases Country X GDP through Trade

1) Law of Comparative Advantage- Gains from trade on specialization in production 2) Subsidized exports through undervalued RMB, gains

go to Country X purchaser of China exports- Result: Country X gets more in goods and services for

same expenditure – exogenous efficiency gain increasing Y

- Result: Increase in “C” shifts the IS curve of Country X rightward, increasing Y (assuming appropriate monetary policy).

Gains in “I”China Growth Increases Wealth of Country X through Finance

• Investment by China in SE Asian countries (growing more than 95% over four years to US$2.2 billion in 2008).

• Net Investment Income received by SE Asian countries/companies invested in China assets (FDI growing at 12% over four years to US$5.4 billion in 2008).

• Third Party Investment into SE Asian countries to develop industries to support trade with China (e.g.: FDI into natural resource exploitation/food production/energy/etc. for sale to China).

Country X enjoys benefits without having to increase “G”

• Fiscal policy towards macro goals is ineffective in small open capital account economies.

• The subsidy China provides in “C” and “I” allows government to enjoy the beneficial effects of a rightward shift in the IS curve without changing “G” (given appropriate monetary policy).

• By not increasing “G” yet stimulating the economy, country X can run at lower deficit and debt levels: lower government cost of capital.

• While not counted formally in “G”, foreign aid from China to SE Asia increases GDP.

Neutral or Gain in NX for Country X

• Obtaining the NX gains requires expansionist monetary policy to follow the increase in demand for money resulting from shift of IS curve. Low risk of inflation as sequence is that monetary expansion follows corresponding gains in total factor productivity.

• NX to China improves Y in most SE Asian countries– undervalued RMB effect offset by higher growth of China’s market demand for imports.

• Increased China tourism to SE Asia countries

Present Beneficial Opportunity for Monetary Policy Expansion

• Fiscal policy in small open economies is ineffective• In order to take advantage of the benefits posed by the

shift in the IS curve rightward as a result of increases in C, I, and NX, governments of SE Asian countries should pursue monetary expansion policies following the gains to keep interest rates low and reset the equilibrium at point corresponding to the resultant increase in Y.

• This is a case of monetary policy following gains in Y, so low risk of inflation, this is just a corresponding increase in money to match exogenously driven increase in Y.

Effect of Distortions from China’s Restricted Capital Account and Undervalued Currency

• Results in a transfer of assets and returns from China to other trade and finance partners.

• Goods exported from China are cheaper than market price for other importing countries.

Foreign Exchange Reserves Transfers to SE Asia in Lower Global Interest Rates

• As a result of the undervalued RMB, China is accumulating massive foreign exchange reserves, which will certainly erode in value, and is thereby subsidizing low US interest rates.

• Leads to lower global interest rates (exogenous to IS-LM model)

• SE Asian countries are global interest rate takers (no pricing power)

• Leads to lower cost strategies available under which to pursue growth.

Counter Argument

• Claim that China is driving investment away from SE Asia• China is paying a short term subsidy to investors in order

to develop the industrial base to drive future unsubsidized gains (which are not reflected in the IS-LM model as it holds economic structure constant and changes in Y are exogenous – though economic structure is the generative engine for Y).

• IS-LM analysis makes China growth look beneficial for others, but IS-LM cannot model industrial policy and changes in economic structure, so IS-LM may not be able to adequately capture dynamics in play.

Rebuttal

• IS-LM does not address changes in economic structure driving Y so we have no basis to determine whether it will succeed or fail in the future under this framework.

• What the above IS-LM analysis shows us is that China is currently transferring wealth to SE Asian countries, and subsidizing their economic growth, making life harder for China and easier for SE Asian countries than it would otherwise be.

• Current benefits to SE Asia are clear, distribution of future benefits and losses is entirely uncertain.

Four Main Points

• IS Curve Shift from gains from trade improving economies in all China’s trade and investment counterparts in SE Asia.

• SE Asian countries are presented with easy low-risk monetary policy strategies to keep interest rates low and lock-in increases in GDP

• Undervalued RMB is subsidy to SE Asia on trade.• Undervalued RMB is a subsidy to SE Asia on low

global interest rates.

Conclusion

• China is pursuing changes in its economic structure (industrial policy) at the costs of wealth transfers from China to other countries in the form of low interest rates, cheap exports, increases in GDP in trading and investment partners, and easy growth with appropriate monetary policies.

• China’s growth and policies result in a current period gift to its trading and investment partners. It is up to the governments of each of these countries to determine how best to take advantage of this gift to build their competitiveness and growth in the future.