Question

Because of China's sustained export success, many people in the West call for China's fixed exchange rate against the dollar to be revalued or for its currency to be floated in the expectation that it will then appreciate. (a) At its current stage of development, should China be running a deficit or surplus on the financial account of its balance of payments? (b) Given that its trade surplus in 2006 exceeded \(\$ 170\) billion, was China running a balance of payments surplus or deficit? (c) With such large monetary inflows, what was happening to China's foreign exchange reserves and the Chinese money supply? Must this be inflationary, or could the demand for money increase just as quickly?

Short answer

China should run a financial account surplus. With a $170 billion trade surplus, it had a balance of payments surplus. These inflows increase foreign reserves and money supply, which could be inflationary unless money demand rises equally.

Step-by-step solution

Understanding Financial Account

China, at its current stage of development, is typically expected to attract significant foreign investments. This means it should ideally be running a surplus on the financial account of its balance of payments, as foreign investors pour money into the country to capitalize on its growing economy.

Analyzing Trade Surplus and Balance of Payments

Given that China's trade surplus in 2006 was over $170 billion, this surplus implies that China exported much more than it imported. The trade component contributes positively to the balance of payments. Alongside a surplus in the financial account, this translates to an overall balance of payments surplus.

Impact on Foreign Exchange Reserves and Money Supply

China's substantial trade surplus and financial account surplus lead to large inflows of foreign currency, increasing its foreign exchange reserves. This accumulation can cause the domestic money supply to increase as the central bank often buys foreign currency to maintain the currency peg, injecting yuan into the economy in return.

Assessing Inflationary Pressures

An increase in the money supply without a corresponding increase in money demand can result in inflation. However, if the demand for money rises as quickly as the supply—due to China's rapid economic growth and increasing transactions—the inflationary pressure can be mitigated.

Key concepts

Financial Account

The financial account is a key part of a country's balance of payments. It records the flow of money related to investments across borders. In China's context, at its stage of development characterized by rapid growth and industrialization, the country is likely a magnet for foreign investors. These investors seek to take advantage of China's growing markets and abundant production capabilities. Thus, China should ideally run a surplus in this account, meaning more money is coming in than going out. This influx signifies positive investor confidence and strengthens economic expansion.

Trade Surplus

A trade surplus occurs when a country exports more than it imports. This means the value of goods and services sold to the rest of the world exceeds the value of those bought from the world. For China, its trade surplus in 2006, which exceeded $170 billion, demonstrates its success in international markets. Such a surplus contributes positively to the country's balance of payments, indicating a strong export-driven economy.

• This trade strength can result in greater production and employment at home.
• It also reflects the global demand for Chinese products.

Furthermore, a consistent trade surplus can affect currency valuation and lead to calls for exchange rate adjustments.

Foreign Exchange Reserves

Foreign exchange reserves are funds held by a country's central bank in different currencies. They are used to back liabilities and influence monetary policy. Given China's large trade and financial surplus, the country accumulates significant reserves.
As trade and investment inflows increase, the central bank usually acquires foreign currency to stabilize the local currency rate. These reserves act as a buffer against global financial fluctuations and provide stability.

• They help in maintaining the country's currency value against others.
• Can be used to pay off international debt or influence monetary policy.

Managing such reserves effectively can safeguard against unforeseen economic shifts.

Money Supply

The money supply encompasses all the currency and other liquid instruments in a nation's economy. In China, a surplus in trade and financial accounts implies a higher inflow of foreign currency, which when exchanged increases the domestic money supply.

• An increase in money supply may lead to more spending and investment domestically.
• The central bank must ensure that this increase aligns with economic growth to prevent inflation.

Regular monitoring helps in adjusting monetary policies to sustain economic equilibrium.

Inflationary Pressure

Inflationary pressure arises when the money supply surpasses the economic demand for money. However, in a rapidly growing economy like China, where production, consumption, and investment rates are high, the demand for money might also increase correspondingly. This can potentially neutralize inflationary pressures.
Yet, vigilance is key, as unchecked inflation can erode purchasing power and destabilize the economy.

• Managing inflation involves balancing monetary supply with demand.
• Robust economic policies can help maintain stable prices and economic growth.

Thus, while large inflows of money can create inflation risks, effective policy measures can mitigate these effects and encourage healthy economic development.