Relations between the US and China have been deteriorating. Although both sides have poked each other in various ways (Obama meeting with the Dalai Lama, China dissing Obama in Copenhagen by standing him up for a meeting, some tit for tat on tariffs), the major, unresolved bone of contention is China’s pegging of its currency, the renminbi, at a level most experts deem to be undervalued. This has widespread ramifications: a continuation of global imbalances (one of the causes of the financial crisis) and preserving Chinese employment at the expense of its trading partners.
The US has strengthened its push for China to Do Something about the renminbi, meaning revalue it, with Obama calling for a “more market-oriented exchange rate”. Some analysts have forecast a rise of 5% this year. But the noise out of Beijing suggests otherwise. From Bloomberg:
Chinese Premier Wen Jiabao rebuffed calls for the yuan to appreciate, risking a further downturn in relations with the U.S. where lawmakers and economists say his stance is hampering a global recovery.
“I don’t think the renminbi is undervalued,” Wen said yesterday at a press conference in Beijing marking the end of China’s annual parliamentary meetings, using another term for the yuan. “We oppose countries pointing fingers at each other and even forcing a country to appreciate its currency.”
Yves here. The reason this issue is coming to the forefront now is twofold. One is that the Obama administration’s falling poll ratings are forcing it to address a central issue that it has neglected, namely, unemployment. The measures so far, a stimulus packages that most economists deem to be inadequate, and extending unemployment benefits, have simply blunted the severity of the problem rather than solved it. A cheaper dollar would bring jobs back to the US (in fact, manufacturers like Caterpillar have already started repatriating jobs. And before readers start arguing in favor of cheap Chinese labor, most firms who have outsourced and offshored have found cost savings to come up well short of expectations. Why? First, labor costs are a relatively small component of most manufactured goods. Even in a supposedly-hopeless-for-advanced-economies field like apparel, some US manufacturers like American Apparrel are paying $12-$13 an hour for workers who make T-shirts and sweatshirts, supposedly commodity items, and still show a profit). Sending work overseas greatly increases administrative costs, which involves much higher paid workers, along with higher shipping and inventory financing costs).
Two is that the Treasury faces an April 15 deadline to decide whether to label China a currency manipulator. That in turn would allow the US to impose retaliatory tariffs. Even normally pro-trade economists like Paul Krugman have pointed out that countries that persistently undervalue their currencies are effectively stealing jobs from their trade partners. While allowing currencies to adjust is the best remedy, taking steps like imposing tariffs to counter the Chinese export subsidy of an artificially cheap RMB is a fallback.
Our initial take was that Team Obama would stage a repeat of its stance last year: saber rattle and do nothing. But there is now bi-partisan pressure on the Obama administration to act. Not only is this move likely to be a winner domestically (and Obama is in desperate need of a win), China’s position is untenable. It has no ready way to retaliate against the US without damaging itself. Stop buying Treasuries at auction? That would drive the RMB up, exactly what they are trying to avoid. Apply tariffs to US goods? Yes, that would hurt specific US exporters, but given China’s massive trade surplus with the US, we come out net ahead on any trade war. Withhold strategic US imports, like chips? That could be disruptive short term, but would lead over time to permanent relocation of production outside China.
Ambrose Evans-Pritchard in the Telegraph contends that China is badly overestimating its power, and will come out the loser if it does not back down:
China has succumbed to hubris. It has mistaken the soft diplomacy of Barack Obama for weakness, mistaken the US credit crisis for decline, and mistaken its own mercantilist bubble for ascendancy. There are echoes of Anglo-German spats before the First World War, when Wilhelmine Berlin so badly misjudged the strategic balance of power and over-played its hand….
Clearly, Beijing is in denial about is own part in the global imbalances behind the credit crisis, specifically by running structural trade surpluses, and driving down long rates through dollar and euro bond purchases. No doubt the West has made a hash of things, but the Chinese view of events is twisted to the point of delusional.
What interests me is Beijing’s willingness to up the ante. It has vowed sanctions against any US firm that takes part in a $6.4bn weapons contract for Taiwan, a threat to ban Boeing from China and a new level of escalation in the Taiwan dispute…
We have talked ourselves into believing that China is already a hyper-power. It may become one: it is not one yet. China is ringed by states – Japan, Korea, Vietnam, India – that are American allies when push comes to shove. It faces a prickly Russia on its 4,000km border, where Chinese migrants are itching for Lebensraum across the Amur. Emerging Asia, Brazil, Egypt and Europe are all irked by China’s yuan-rigged export dumping.
Michael Pettis from Beijing University argues that China’s reserves of $2.4 trillion – arguably $3 trillion – are a sign of weakness, not strength. Only twice before in modern history has a country amassed such a stash equal to 5pc-6pc of global GDP: the US in the 1920s, and Japan in the 1980s. Each time preceeded depression.
The reserves cannot be used internally to support China’s economy. They are dead weight, beyond any level needed for macro-credibility. Indeed, they are the ultimate indictment of China’s dysfunctional strategy, which is to buy $30bn to $40bn of foreign bonds every month to hold down the yuan, refusing to let the economy adjust to trade realities. The result is over-investment in plant, flooding the world with goods at wafer-thin export margins. China’s over-capacity in steel is now greater than Europe’s output.
This is catching up with China, in any case. Professor Victor Shuh from Northerwestern University warns that the 8,000 financing vehicles used by China’s local governments to stretch credit limits have built up debts and commitments of $3.5 trillion, mostly linked to infrastructure. He says the banks may require a bail-out nearing half a trillion dollars.
As America’s creditor – owner of some $1.4bn of US Treasuries, agency bonds, and US instruments – China can exert leverage. But this is not what it seems. If the Politburo deploys its illusiory power, Washington can pull the plug on China’s export economy instantly by shutting markets. Who holds whom to ransom?
Any attempt to retaliate by triggering a US bond crisis would rebound against China, and could be stopped – in extremis – by capital controls. Roosevelt changed the rules in 1933. Such things happen. The China-US relationship is no doubt symbiotic, but a clash would not be “mutual assured destruction”, as often claimed. Washington would win.
Contrary to myth, the slide to protectionism after the 1930 Smoot-Hawley Tariff Act did not cause the Depression. Trade contracted more slowly in the 1930s than this time. The Smoot-Hawley lesson is that tariffs have asymmetrical effects. They devastate surplus countries: then America. Deficit Britain did well by retreating into Imperial Preference.
Barack Obama has never exalted free trade. This orthodoxy is, in any case, under threat in the West. His top economic adviser Larry Summers let drop in Davos that free-trade arguments no longer hold when dealing with “mercantilist” powers. Adam Smith recognized this too, despite efforts by free-trade ultras to appropriate him for their cause.
China’s transformation has been remarkable since Deng Xiaoping unleashed capitalism, but as ex-diplomat George Walden writes in China: a Wolf in the World? you cannot feel at ease with a regime that still covers up Mao’s murderous nihilism. He reminds us too that China has never forgiven the humiliations inflicted by the West when the two civilizations collided in the 19th Century, and intends to exact revenge. Handle with care.
Update 12:45 AM: Team Obama seems to be laying the ground domestically for a serious spat, given the latest PR sighting via the New York Times, “China Uses Rules on Global Trade to Its Advantage.” Looks like the American populace is being “educated” that China plays dirty. Not that I disagree, mind you, but the timing and the placement of the story (front page) is revealing.