Analysis: Glimmer of G20 hope as China adjustment takes shape

It's too early to be sure, but signs that China's current account surplus will keep shrinking as a share of national output could draw some of the venom from the debate on global economic imbalances preoccupying the G20.

Imbalances in general and China's exporting clout in particular remain controversial, even if a brightening global growth outlook has dampened excited talk of currency and trade wars.

Brazil has joined India in complaining about the yuan's exchange rate, which the International Monetary Fund, in a report prepared for a G20 finance ministers' meeting in Paris, says is still substantially undervalued.

But the problem, some economists contend, is at least not getting worse -- thanks partly to another issue that the Group of 20 major economies is grappling with: food-driven inflation.

U.S. Treasury Secretary Timothy Geithner makes little attempt to hide his satisfaction that, because China's inflation is much higher than America's, the yuan's real exchange rate against the dollar is rising at around 10 percent a year. That would translate in time into a major shift in relative competitiveness.

In a nutshell I would say that as long as the U.S. is happy, tensions in the G20 will not increase in any serious way, said Wendy Dobson, co-director of the Institute for International Business at the University of Toronto's Rotman School of Management.

Inflation is a second-best solution as it punishes those on low and fixed incomes, but vested interests stand in the way of the ideal economic outcome, be it in China or the United States.

Real RMB appreciation is substantial and the politics in China of faster nominal appreciation are probably as intense as the U.S. politics of fast deficit reduction, said Dobson, a former associate deputy minister of finance in Canada.

The yuan is also known as the renminbi (RMB).

Each knows what it has to do and each is moving in the right direction but much slower than rest of the world would like, she added.

NOT CONVINCED

The IMF's first deputy managing director, John Lipsky, would certainly like faster action. He warned G20 deputy ministers on Thursday that global imbalances were in fact likely to worsen.

In particular, the IMF has warned of the medium-term risk of a significant rebound in China's current account surplus, which stood at $306 billion, or roughly 5.2 percent of gross domestic product, last year, down from a peak of 10.6 percent in 2007.

To be sure, according to the Bank for International Settlements, the yuan's real exchange rate measured against the currencies of China's main trading partners has actually depreciated since Beijing abandoned a de facto dollar peg last June -- hence the ire of Brazil and others.

That fact will not be lost on a regular IMF fact-finding mission due in Beijing next week.

Moreover, Derek Scissors, a research fellow with the Heritage Foundation in Washington, argues that the current account is an inadequate gauge of the imbalances plaguing China.

Because investors anticipating a stronger yuan find ways of parking money in financial assets, he looks also at China's surplus on its financial and capital account, which rose to $166 billion last year.

Since the People's Bank of China buys most of the foreign exchange flowing into China to control the yuan's rate of climb, the central bank's reserves rose by $470 billion in 2010.

That is a clearly better number to use than the current account. It does show slower growth from a bigger base, both in terms of GDP and reserves themselves. But it also modifies the claim of rebalancing: growth in imbalances has slowed sharply, a necessary first step but not actual rebalancing, Scissors said.

TRICKY ADJUSTMENT

Still, the G20 is leaning heavily toward adopting the current account as a major benchmark, and many economists are forecasting a continued decline in China's surplus.

Macquarie has penciled in 4.4 percent for this year and 3.7 percent for 2012; Nomura's forecasts are 4.1 percent and 3.1 percent, respectively. Geithner last year floated an indicative maximum surplus or deficit of 4 percent.

At this point, China is clearly helping to rebalance the world economy in two ways: its import volume is rising distinctly faster than its by no means sluggish export volume, and its increased overheating means inflationary pressure that raises the real effective exchange rate, Charles Dumas of Lombard Street Research in London said in a report.

Imports leapt 51 percent in January from the same month a year earlier, outstripping a 38 percent rise in exports.

Seasonal factors make the figures impossible to interpret with confidence, but the buoyancy in imports extends beyond commodities. China last year became the world's No. 2 importer.

German exports to China of luxury cars and top-of-the-line manufacturing equipment are booming as China raises the quality of its industrial base, a priority of the five-year plan to be unveiled next month.

As for inflation, the other ingredient in China's rebalancing, a consensus has formed that a higher rate of around 4 percent is the new normal in an era of rising food prices and rapidly accelerating wages for migrant workers.

The ruling Communist Party needed no reminder of the perils of inflation even before the recent spate of revolts in North Africa and the Middle East. Policymakers are on high alert.

But as economists at Bank of America Merrill Lynch point out, inflation also helps the economy adjust: rising wages erode the competitiveness of labor-intensive exporters and boost consumption in a way that fiscal policy cannot.

China's costs and productivity relative to those of viable rivals mean it will remain an unbeatable mass manufacturer of consumer goods, even if the likes of Bangladesh and Cambodia capture lower-volume runs of low-end textiles.

But the message for the world is: get ready for higher prices from China. In the United States, the cost of apparel rose 1.0 percent in January, the U.S. Labor Department said on Thursday.

The trend of adjustment through higher inflation is likely to persist for the next several years, the BoA Merrill economists concluded in a report.