Business Case Studies, Executive Interviews, Kai-Alexander Schlevogt on The China Factor

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Executive Interviews: Interview with Kai-Alexander Schlevogt on The China Factor
January 2008 - By Dr. Nagendra V Chowdary

Dr.Kai Alexander Schlevogt
Professor of international strategy
leadership at the National University of Singapore Business School
He serves as a Program Director of the Nestle Global Leadership Program
delivered in association with London Business School.

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    The speed of change surprises most observers. Whereas China did not have much financial clout in international markets even two years ago, global analysts now are watching it carefully. Reverberations in its stock markets can trigger shock waves around the world. China also has the power to create economic havoc in the US. Currently, it purchases large amounts of US government bonds to keep its exchange rate low. This enables the US to enjoy low interest rates. If China were to stop lending to the US, the cost of borrowing there would go up significantly, which would most likely lead to a severe recession.

    China also holds foreign currency reserves of over a trillion USD, most of it in dollars. If it were to shift away from the dollar, the greenback would devalue dramatically.

  • Should the Chinese government allow the Yuan to appreciate to reduce global trade imbalances?
    At least in the short-run, I recommend the Chinese government to keep the Renminbi within a narrow trading band with reference to a basket of the currencies of its major trading partners for political and economic reasons. Let me explain.

    The boom in Chinese net exports increased the demand for Chinese currency to pay for them. Macroeconomists conceptualize this change as an exogenous shift in demand that moves the economy away from equilibrium. Since the Chinese government de facto keeps its currency in a narrow trading band with the US dollar, markets do not clear. The country accumulates a large trade surplus with the US and huge foreign currency reserve, since it has to purchase US dollar denominated government bonds to keep the greenback strong. Neoclassical economists trust in an easy solution to restore equilibrium: They believe that if the exchange rate were fully flexible, the Chinese Yuan would appreciate and net exports decrease until a new equilibrium is reached.

    However, the neoclassical model assumes perfectly competitive markets. With idealized features like unlimited numbers of buyers and sellers, perfect information, no government interference and, to top it all, rationally thinking people, those are a rare species in the real world!

    I will first argue against the theoretical orthodoxy on purely macroeconomic grounds and then move to the political economy. It is possible that a flexible exchange rate, at least in the short-run, will not clear markets and may even lead to new types of imbalances. For example, faced with an appreciating currency, Chinese exporters may simply allow their margins to be squeezed to keep their prices low. How long they can maintain such a strategy depends on their financial "slack" in terms of economic rents and reserves. If the government supports them, they may be able to keep in business indefinitely. Besides, the demand for Chinese exports might not immediately decrease when they become more expensive. The priceelasticity of demand might be relatively low at least in the short run. It might be very difficult for major importers to locate alternative sources that can supply the high volumes they need. Besides, currency speculators may move the Yuan away from the elusive "scientifically" correct level, INTERVIEW 5 which accurately reflects the forces of supply and demand in the real economy and clears the markets. The resulting exchange rate may distort resource allocation, as witnessed in the Asian Financial Crisis, when even the efficient Singapore economy was hit hard.

    Even if markets were to clear eventually, the transition might come at huge costs: High uncertainty and instability. I believe that politics is the most important factor driving economic development and that volatility is expensive. In an increasingly complex and uncertain world, a government needs more national control, not less. The reason for China's success in the past was that it had structures, systems and processes in place that allowed the government to manage events. Thus, it avoided significant damage from the Asian Financial Crisis, whereas the governments in other countries that had put less controls in place suffered dramatically. To continue its success, China must remain in charge of developments.

    Besides, many people spend large sums of money on premiums to insure against risk, which are a good measure of its costs. Alas, one cannot even insure against uncertain events, since in contrast to risk, it is impossible to specify the full range of different outcomes in advance and probabilities cannot be calculated. The political stability resulting from narrow currency trade bands is a certain gain, whereas flexible rates surely introduce uncertainty without assured benefits. Any future changes to the currency regime should only be made after small-scale experiments have yielded positive results. A shock therapy like in Russia can easily lead to national collapse.

    It is also important to mention that contrary to popular opinion, a flexible Yuan most likely is not even in the national interest of the US. To start with, the shift will immediately favor one group and put another groups at a disadvantage. The aggressive call for a freely floating Yuan originated from special interest groups, in this case lobbyists from those industries in the US that are hit hard by Chinese exports. Reacting to the forces at work and incentives in a democratic system, US career politicians resorted to pork barrel tactics. They backed the policy demands of the pressure groups to please voters and donors.

    The policy would never have been recommended by an individual neutral planner intent on maximizing the gains of the nation as a whole. A significant share of Chinese exports comes from foreign companies, including many multinational companies from the US. If the Chinese currency appreciates, they are likely to lose. Besides, imports would become more expensive in the US, possibly fueling inflation.

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