HONG KONG - A rise in the yuan would make Chinese exports less competitive and cut the cost of imports, providing incentives for capital and labour to be redeployed towards the domestic sectors of the economy.
But the exchange rate is just one of myriad variables that determine a country's current account balance, which, by definition, reflects the difference between domestic savings and investment.
In China's case, savings dwarf its already massive investment, resulting in a large current account surplus that is the object of fierce criticism by U.S. lawmakers who say it goes to the heart of imbalances in the global economy.
Yet Anoop Singh, director of the International Monetary Fund's Asia and Pacific Department, cautioned against expecting an overnight solution. Reducing China's savings called for a battery of policies over the medium term, he told a news conference in Shanghai on Thursday.
This will require a mix and a range of policies. It is very important that this package of measures is not viewed as based on one policy, which is the exchange rate, Singh said.
Here are some questions that Chinese rebalancing raises.
WHY DOES CHINA SAVE SO MUCH?
China's gross aggregate savings rate now tops 50 percent of gross domestic product, by far the highest of any big economy.
From 1997-2007, the savings rate of enterprises rose by 11.1 percentage points and the government's savings rate rose by 4 percentage points; but the household savings rate fell 1.8 percentage points, Citigroup economists Willem Buiter and Minggao Shen noted in a report.
For a related analysis [ID:nSGE61F01U]
Still, household savings are high. Because China has a flimsy social safety net and underfunded public services, people salt money away for their old age and to pay for medical bills and school fees.
WHY HAVE FIRMS BENEFITED AT THE EXPENSE OF THE WORKERS?
The most significant imbalance in China is a low and declining share of household disposable income. Growth in incomes has been fast but has not kept pace with the overall expansion of the economy.
The wage share in total income fell to 39.7 percent in 2007 from 52.8 percent a decade earlier, according to Louis Kuijs, a World Bank economist in Beijing.
Two major factors have driven this development.
First, rapid growth of the labour force has kept a lid on wages as tens of millions of farmers have left the land for urban jobs.
Second, contrary to conventional wisdom, Chinese manufacturing is very capital-intensive. So the marginal demand for labour has been relatively low except in a few export-oriented sectors such as textiles and shoes.
The first part of this equation is changing. Labour shortages are widespread in coastal regions because migrant workers are finding more jobs nearer home as growth spreads inland.
And now that their families have escaped poverty, young migrants are no longer as willing to make the same sacrifices as their parents, working for a pittance in poor conditions far from home.
The result is that labour costs are rising fast. The minimum wage in Guangdong, which accounts for nearly a third of China's exports, will rise over 20 percent next week. [ID:nTOE62H010]
However, the reasons why China has a capital-heavy economic model remain. Chief among these is the low cost of borrowing.
For favoured firms that have access to bank credit, the benchmark rate for one-year loans is 5.31 percent, half the current real GDP growth rate.
To attract tax-generating industries, local authorities also offer tax breaks and cheap land. Water and power tariffs are low by international standards and the cost of complying with environmental and health and safety standards is not onerous.
HOW DOES THE FINANCIAL SYSTEM AMPLIFY THE IMBALANCES?
Chinese firms, especially state-owned enterprises, have a strong bias to retain earnings to finance fixed and inventory investment plus working-capital needs, Buiter and Shen said.
This is partly because of constant worries that regulators might impose credit quotas without warning. Underdeveloped commercial paper and bond markets are also a factor.
So, although state financing and bank loans for capital spending surged by more than 50 percent in 2009, other sources, including retained earnings, still provided three-quarters of all financing for investment, the IMF said in Thursday's report.
State-owned companies are abetted in their eagerness to save -- and to channel their profits back into ever-more investment -- because the central government requires them to hand over no more than 10 percent of their profits as dividends.
As a result, the state is deprived of revenues that it could spend on more generous transfer payments to households. These would have a powerful effect on consumption: the IMF calculates that every yuan spent by the government on health frees urban families to spend two extra yuan on consumption.
Private companies retain their profits to finance expansion because only a few have access to bank loans.
Banks are nearly all state-owned and have scant incentive to take the risk of allocating part of their credit quota to borrowers not implicitly or explicitly backed by the government.
WILL THINGS CHANGE?
They already have in some respects.
China's working-age population will peak around 2016, reinforcing the unfolding trend towards higher real wages and raising the labour share of income. That in turn should boost household consumption, which fell to just 35.8 percent of GDP in 2008, a record low for a major economy in peacetime.
Rising per capita incomes should also reduce the need to save so much for a rainy day, especially if the government keeps strengthening the social safety net.
Spending on healthcare rose 163 percent between 2005 and 2008. Outlays on education and social security rose 125 percent and 83 percent, respectively, over the same period, noted Andy Rothman, a macro strategist for CLSA in Shanghai.
Measures in train to make it easier for farmers to settle in cities with their families will also accelerate the development of an urban-based service economy, boosting consumption.
Other aspects of the economy will be slow to change. China still has huge infrastructure needs, so investment will continue to account for a large share of GDP growth.
Learning the lessons of the financial crisis, China is likely to be slow to liberalise its banking system. That will restrict the availability of personal credit and force people to save for big purchases. And pension systems cannot be built overnight.
In short, the process will be gradual. (Reporting by Alan Wheatley; Editing by Ken Wills and Tomasz Janowski)