China can't move further on the yuan
By Qu Hongbin International Herald Tribune


HONG KONG John Snow, the U.S. treasury secretary, visits Beijing this week to talk about what China can do to help cut a U.S. current-account deficit of more than 6 percent of gross domestic product - a record high, and one that is commonly agreed to be unsustainable. For months, the United States pressed China to revalue its currency, the yuan, and China finally responded on July 21 by moving to a managed float system with reference to a trade-weighted basket of currencies.

This has involved, so far, a revaluation of about 2.4 percent against the U.S. dollar. When he arrived in Shanghai on Tuesday, Snow called for more. But China can't deliver, whether it wants to or not.

The revaluation of the yuan has prompted much discussion of the economic fundamentals of China's currency - and much misunderstanding. One of the most serious is the notion that the Chinese economy has become too dependent on exports for growth and needs to shift to a new development strategy.

The total value of Chinese exports is huge, topping $590 billion in 2004, and set to be even higher this year. China is one of the world's biggest exporters and there's no sign of any pause for breath. That has many in the United States worried that China is using a cheap currency to undermine U.S. competitiveness, while increasing U.S. indebtedness and its current-account deficit. This view assumes that China's exports come from China. But it's not so simple.

In fact, up to half of China's exports are made up of intermediate and semi-finished products imported from other countries to be processed and shipped out again. If the double accounting of the import content is stripped out, the ratio of China's exports to its gross domestic product tumbles to about 18 percent instead of the 36 percent seen in the crude data.

With its massive labor pool, its open-door policy to foreign investors and its improving infrastructure, China has emerged over the last decade as an ideal location for assembly and processing and other labor-intensive stages of global production.

As a result, the total value of processed exports has risen rapidly in the last decade, reaching $350 billion, or about 60 percent of China's total exports last year. However, official figures suggest that the value of imported components is as much as 80 percent of the total value of the processed exports.

A Japanese-owned factory in China making notebook computers, for instance, will buy Intel chips from the United States, screens from South Korea and other components from its parent in Japan for final assembly and processing. The finished product has a total value of perhaps $1,000, which is recorded as an export from China to the United States. But the imported parts and components may represent up to 80 percent of the computer's value. This distorts China's export value immensely. Looked at from a value-added point of view, China's level of exports wouldn't be at all exceptional.

How China trades with the rest of the world can only be determined by its comparative advantage - its abundant labor supply. With at least 200 million surplus rural workers hitting the urban job market, China can only continue to engage in labor-intensive production and trade. While it dominates the textile and footwear export markets, China is well positioned to participate in the labor-intensive stages of production for almost all industries. Imagine what a cheap but well-made Chinese car would do to the U.S. auto market.

The bottom line is that China is effectively exporting labor services: The goods processed with imported materials are no more than vehicles to carry the services of Chinese labor to the world market. The value added in China - about 20 percent once double accounting has been stripped out - represents the cost of labor.

Maintaining this channel to expand the export of labor services is crucial to sustaining China's development, which centers on shifting rural surplus labor into industrial and tertiary sectors. Given the sheer size of its surplus labor force, China has no choice but to expand the export of its labor services to create jobs.

There's only one conclusion: Continuing to bolster labor-intensive production and exports is the only viable means for China to absorb its surplus labor and improve rural living standards. To do so, China must keep the yuan's effective exchange rate competitive for the foreseeable future.

(Qu Hongbin is the chief China economist for the Hongkong and Shanghai Banking Corporation.)

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