Friday, December 10, 2010
Bloomberg news reports that China's trade surplus in November was larger than expected and argues that this underscores the case for higher interest rates. Yet higher interest rates is in fact something which all other things being equal increases a trade surplus since it encourages higher domestic savings while discouraging domestic investments. And when a country has higher savings while lower investments this will mean higher net exports, or in other words a higher trade surplus (or more strictly current account surplus). The effect is theoretically ambiguous for countries with floating exchange rate since the direct effect of higher interest rates are counteracted by the indirect effect of a stronger currency. However, if the exchange rate is fixed yet the central bank is still able to set interest rates more or less independently because of the existence of capital controls, as is the case in China, then higher interest rates have an unambiguous trade surplus increasing effect. So, if Chinese leaders wants to reduce China's trade surplus higher interest rates (or for that matter higher reserve requirements) is definitely not something they should do.