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China, Trying to Avoid Japan's Mistakes, Is Actually Following Same Path

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Many have become obsessed with avoiding the "mistakes" made by the Japanese at the time of the Plaza Accords in 1985. But the Chinese are deriving the wrong lesson from that experience.

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Chinese officials face a major dilemma. The economy has been overheating and inflation is picking up. Real interest rates are far too low, by any standard. As a result, overinvestment in construction, manufacturing, and infrastructure are exacerbating massive overcapacity. Chinese officials understand that this accumulation of overcapacity is becoming a major threat.

The Chinese central bank has been badly behind the curve and needs to raise interest rates far beyond the 25bp hike recently announced to begin to address the gross imbalances between investment and consumption. But there are two problems that the Chinese officials face.

The first problem is that many politically powerful Chinese industrial sectors have become addicted to cheap credit and literally can't survive without it. The property sector and various provincial governments with their related investment corporations are particularly vulnerable to even minimal increases in interest rates. Low real interest's rates are the equivalent of a state subsidy to the sectors that receive such credit. This subsidy of industrial concerns is paid for by the household sector, which is characterized by a high rate of savings. In effect, household income, wealth, and consumption are suppressed by negative real interest rates for the benefit of manufacturing concerns. As in all nations, the political power of powerful economic interest group lobbies are greater than that of average citizens, although the latter far outnumber the former.

Second, raising interest rates tends to attract hot money inflows, which force the central bank to accumulate more foreign currency reserves if it wants to keep the yuan undervalued. Obviously, China would prefer not to increase reserve accumulation and give more ammunition to those that accuse the regime of currency manipulation.

A seemingly obvious way to alleviate the interrelated problems of overheating and currency undervaluation would be a substantial one-off revaluation of the yuan. However, I believe that China has performed "stress tests" on a wide array of industries and has concluded that a substantial and swift revaluation could have a devastating impact on a large number of politically sensitive labor intensive industries such as textiles and other manufacturing concerns. In other words, many industries (and jobs) in China are dependent upon an artificially undervalued currency -- much like industries in many countries become dependent on import tariffs and subsidies.

Thus, many Chinese officials may currently be feeling "darned if they do, darned if they don't" with regards to FX and interest rate policy.

After enjoying an unprecedented run of economic success for over two decades, China is finally facing some very tough choices. Foreign pressure may increase the speed with which it must confront these choices. Paralysis, or insufficient action, will have negative consequences, although they may come further down the road.

I believe timely action in China is being hindered by psychological syndrome that one might call "Plaza Accord Syndrome." Many in the Chinese elite seem to have become obsessed with the notion that they must avoid the "mistakes" made by the Japanese at the time of the Plaza Accords in 1985. It has become conventional wisdom in China that it was a monumental mistake for the Japanese to have "caved in" to Western pressure to revalue the yen and that it was this error that brought about Japan's "lost decade" and subsequent stagnation.

Ironically, the Chinese seem to have derived exactly the wrong lesson from the Japanese experience. The real mistake that the Japanese made in the 1980s was to have artificially undervalued their currency far too much for far too long and to have kept real interest rates far too low for far too long. These artificial imbalances that the Japanese created were responsible for the gross imbalances at the root of their subsequent predicament, not the Plaza Accord.

The Chinese, who seem obsessed with not repeating the mistakes of the Japanese, so far, appear to be unwittingly and inexorably following down the Nipponese path.

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