As the Singapore economy rebounded spectacularly this week ,the government moved to limit inflationary pressures. This was after year-on-year economic growth reached 13.1% in the first quarter of 2010.  This strong performance was related to the increased demand for electronic components and growth in the pharmaceutical industry.

The Singapore government operates a managed exchange rate regime. The Singapore dollar is pegged to a trade-weighted index of five currencies. The exact make-up of the index is kept secret, but the rate is allowed to fluctuate within a four percent target range. This ambiguity leads to less speculation by currency traders, and what is known as a basket, band and crawl method of currency management. Overtime, this has allowed the government to steadily appreciate the currency as demand for exports surged. Since 1980’s the value of the Singapore dollar versus the US Dollar has appreciated by nearly 80%.

This exchange rate mechanism is also how the government controls the rate of inflation in the small city-state. Because Singapore’s net exports make up over 100% of GDP, a subtle appreciation of the exchange rate leads to less imported inflation and less demand for exports. The effect of a 1.3% appreciation of the currency band this week, is expected to reduce inflationary pressure over the next 12 months.

The approach is something that the Chinese government is maybe looking towards. The Yuan is pegged directly to the US Dollar and has been since mid-2007. China has been able to maintain this peg by selling vast amounts of yuan to purchase US Treasury Bonds, and to thereby create large foreign currency reserves. As widely reported, the Chinese government has been under pressure to appreciate the yuan by anything up to 60% compared to the US dollar. How the government achieves this shift is complicated but may lead to a significant loss of export competitiveness and imported inflation.

However as Wei Gu from Reuters reports,

“This (Singapore) approach is not open to China, whose inflationary pressures are home-grown, and whose exchange rate looks more undervalued. Nevertheless, Beijing can learn from Singapore’s model, which offers a better balance between stability and flexibility”

Of course, there are huge differences between a city-state and the world’s third-largest economy. Singapore, whose foreign trade is three times its GDP, has to allow enough freedom in its exchange rate to achieve domestic price stability. China, where foreign trade accounts for 50 percent of GDP, that incentive is much smaller.

Moreover, China could not adopt Singapore’s approach without a one-time appreciation in its currency. Otherwise it would be hard to create a two-way trade: China currently restricts the yuan’s movement against the dollar to just 0.5 percent every day. Nevertheless, as China considers making its exchange rate more flexible without abandoning stability, the Singaporean model is worth studying.”

Discussion Questions:

1. What are the advantages and disadvantages of a floating exchange rate?
2. What are the advantages and disadvantages of a fixed exchange rate?
3. What is the common tool used by many governments to control inflation. Why can’t all countries use the Singapore approach?
4. Can a country use both Monetary Policy and a managed exchange rate to control inflation? Do trade-offs exist?
5. Evaluate the effects on the Chinese economy of an appreciation of the yuan.

When teaching international trade to high school economics students, one of the challenges is understanding the pros and cons of trade surpluses and deficits. A country’s balance of trade refers to the net flow of revenues and expenditures goods and services between the country and its trading partners. In technical terms, this is known as the current account on a nation’s balance of payments. A country that spends more on imports than it earns from the sale of exports has a current account deficit. A nation that earns more from the sale of its goods and services to the rest of the world than it spends on imports has a current account surplus.

A common impressions among students is that a trade surplus is good and a trade deficit is bad. One challenge I face in teaching this topic is separating economic terms such as “suplus” and “deficit” from non-economic, normative concepts such as “good” and “bad”. In fact, a trade surplus is not always a good thing. To illustrate, I will look at the current account balances between China and the United States. In 2007, the US ran a trade deficit with China of $258 billion. While the US imported $321 billion of Chinese goods and services, it only earned $63 billion from the sale of exports to China. To most students, it would appear that China is “winning” in the game of trade, since it has such an enormous trade surplus with the United States. This, however, is not necessarily the case.

One way of looking at trade balances is that a nation with a substantial current account surplus is actually consuming less of its own output due to the high demand from abroad. As mentioned above, in 2007 Americans spent $321 billion on Chinese goods and services. China only produced $3.2 trillion of goods and services that year, meaning Americans actually consumed over 10% of the stuff produced in China! This represents Chinese output that is NOT being consumed by the Chinese. Additionally, since China imported far less from abroad than it sold, Chinese output being consumed abroad is far from made up for by Chinese consumption of foreign output. While this may sound like a good deal from the perspective of producers, who have a larger market due to trade, from the perspective of Chinese households it means they are consuming less than they are producing as a nation!

One of the goals of macroeconomics is to increase the standards of living of the nation’s people through an increase in the consumption of goods and services. In this regard trade deficit countries are actually better off than trade surplus countries, since they are actually consuming MORE than they are producing as a nation! A trade deficit country gets more than it gives, in a way, which sounds pretty good when if you consider total consumption to be an end in itself. A trade surplus country, on hte other hand, gives the rest of the world more than it gets in return (in terms of goods and services, that is).

Another consequence of running a large trade surplus is the build up of foreign exchange reserves. China, for instance, held over $1.3 trillion USD in its central bank in 2007, representing an enormous level of savings for the Chinese people, since these are dollars earned by the people of China (from their export sales to America), but not spent. These reserves represent a form of forced savings on the people of the nation.

The average Chinese consumer is also made worse off because the governments’ US dollar reserves are held intentionally to keep the value of the dollar high, thereby keeping the price of American and other nation’s imports prohibitively high for Chinese consumers. In this regard, China’s 50% national savings rate is a form of financial tyranny by the government perpetrated against the Chinese people, who, as consumers, would be much better off if the RMB were allowed to appreciate and imported goods and services could be more easily and affordably attained by Chinese households. Employment in the export sector might suffer but falls in exports would likely be made up for with gains in domestic consumption, meaning the overall effect on employment is likely to be mild upon a reductions in China’s trade surplus.

Furthermore, in order to maintain China’s trade surplus the Chinese government must keep the RMB weak. As already mentioned, one way it does this is by holding its US dollar reserves to keep the supply of dollars on foreign exchange markets low and its value high. Another way the Chinese central bank manipulates its currency is by constantly changing the level of interest rates to limit or encourage foreign capital flows into or out of the country, since such flows affect the Chinese currency’s value. If the Chinese central bank and government were to adopt a flexible exchange rate policy, which would help reduce the country’s trade surplus with the United States, this would allow the central bank to use monetary policy in the way it is meant to be used: to stimulate or contract the level of domestic consumption and investment. This week US Fed chairman Ben Bernanke spoke to the US Senate about China’s exchange rate controls, and made a similar point:

“Most economists agree the Chinese currency is undervalued and has been used to promote a more export-oriented economy. I think it would be good for the Chinese to allow more flexibility in their exchange rate.”

Letting its currency, the renminbi, appreciate would give China’s central bank more flexibility in monetary policy and help stimulate domestic demand and consumption, Mr. Bernanke said

China’s trade surplus does not necessarily benefit the country as a whole. Surpluses do keep export sector employment high, but result in a lower overall level of consumption among Chinese households and impose a higher than necessary level of savings on the nation. More balanced trade would increase the level of imported goods and services in China, increase real incomes as the value of the nation’s currency rises, and also allow for more inflows of foreign capital from abroad, further stimulating growth in China’s domestic economy.

Discussion Questions:

1. What are the advantages and disadvantages for the United States of its large current account deficit?
2. What are the advantages and disadvantages for China of its large current account surplus?
3. What benefits would China experience if its currency, the RMB, appreciated against the dollar? What negative consequences would this have for China?
4. Why does China’s large holdings of US dollars and US government debt represent a form of “forced saving” imposed by the Chinese government on the people of China?
5. Would you rather live in a country with a current account surplus or a current account deficit? Why?