NCPA - National Center for Policy Analysis


January 3, 2006

Many charge that China's rapid rise in the foreign exchange reserve is a consequence of its mercantilist policy, exporting like mad by relying on a deliberately undervalued currency, cheap labor, and foreign investors, particularly from the United States. A new paper from the National Bureau of Economic Research argues that this is not the case.

The authors argue that the focus on an undervalued currency is off the mark:

  • During the 1980s and 1990s, China's currency was more likely to be overvalued than undervalued.
  • As recently as 1997 and 1998, China chose not to devalue its currency even though such a move would have aided exports.

The authors also note that most of China's foreign direct investment (FDI) is not coming from the United States or nations with a current account deficit with China. The main contributors of China's FDI come from advanced Asian economies such as Japan, Korea and Singapore. Europe and the United States combined account for only about 30 percent of China's FDI at most.

The real reason for the large FDI inflows is the favorable capital controls China is offering to foreign investors. For example:

  • Foreign firms investing in China do not have to pay corporate income tax on their first two years of profits and in subsequent years pay only half the corporate income tax rate of Chinese companies.
  • Overall, the authors argue, China offers more incentives to attract FDI than most countries in the world.

Source: Mathew Davis, "Is China Mercantilist?" NBER Digest, December 2005; based upon: Eswar Prasad and Shang-Jin Wei, "The Chinese Approach to Capital Inflows: Patterns and Possible Explanations," National Bureau of Economic Research, Working Paper No. 11306, May 2005.

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