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SPEAKING FREELY
The debate over China's currency
bottom line
By Sam Baker
Speaking Freely is an Asia Times Online
feature that allows guest writers to have their say.
Please click here
if you are interested in
contributing.
The
risk to China's economy and global financial markets is
that politicizing the debate over China's currency
regime both in the United States and China would result
in trade sanctions by the US against China. Such an
outcome would be a huge setback for free trade, for
globalization and ultimately for global growth.
However, there is a silver lining. The threat of
a trade war may bring - and we think it eventually would
bring - both countries to the negotiating table to hash
out a mutually acceptable bilateral deal that addresses
rising domestic political pressures on both sides.
Replay of
history
The relative intractability of American
and Chinese positions regarding their respective views
of the currency issue, and the likelihood that China's
trade surplus with the United States will continue to
grow in the coming months, suggests to us that it is
only a matter of time before bilateral relations are
strained in what looks to be a repeat of the nasty
US-Japan trade spats that played out in the 1980s - if
only we could be assured that developments between the
US and China would parallel the US-Japanese relationship
dynamics of the 1980s.
The world can surely
survive another round of similar saber-rattling and
tough-sounding diplomatic rhetoric, as the dynamics back
then never escalated into a damaging cycle of
tit-for-tat trade protectionism. However, we note a
crucial missing factor in today's circumstances that
mitigated the US-Japan trade skirmishes: namely, a
flexible exchange rate in the US trading partner with
the exploding trade surplus.
Given the lack of a
sufficiently flexible currency regime in China, some
other solution, or set of solutions, will have to
diffuse the inevitable swell of political pressure that
we believe the Chinese trade deficit will bring to bear
on US politics and policy in the coming months.
As highlighted above, we believe the current
debate about whether Chinese policymakers should adjust
the yuan - by how much and when - has been polarized and
politicized to a point of no return in the United
States, with the same increasingly true in China. US
policymakers have more or less boiled the debate down to
the problem of an unfairly undervalued Chinese currency
costing American jobs.
Meanwhile, Chinese
policymakers continue to justify their commitment to a
stable currency regime by pointing out the risk of
altering what has been a key pillar of their successful
economic policy record since the yuan was effectively
pegged to the US dollar in 1994.
Jobs, jobs,
jobs
Since few issues resonate more powerfully
with American voters than does the outlook for jobs,
this is not an issue that will go away easily, nor
should it be dismissed lightly regardless of the long
list of other important issues competing for the
attention of the American public and US policymakers.
Having said all that, we are not suggesting that
a modest expansion of the trading band for the yuan or a
revaluation of the currency is off the negotiating table
in the next 12 months or so. Either is possible.
However, given the political constraints in
China and the gradualist approach to economic policy
making that is the modus operandi of Chinese leaders, we
see almost no chance for either a freely floating
exchange regime or the kind of double digit maxi
revaluation that would be required to neutralize the
increasing politicization in the US of China's exploding
trade surplus or the related currency debate.
If
Chinese policymakers do eventually decide to revalue the
yuan, we believe the adjustment(s) will be in the low
single digits, say no more than 6 percent over the next
year. Such an adjustment, by itself, would not be enough
to sufficiently reverse China's exploding trade surplus
or to diffuse the continued escalation of trade tensions
between the US and China that could lead to a
potentially harmful trade conflict.
The absence
of an easy panacea to trade tensions via a currency
adjustment may provide a favorable backdrop for the
emergence of a natural alignment of incentives on both
the US and Chinese sides to negotiate a meaningful and
mutually beneficial bilateral trade deal based on
comparative economic advantages.
Meantime,
however, with no quick currency fix on the horizon,
American industry and labor have decided to take matters
into their own hands, as evidenced by the National
Association of Manufacturers' plan to file a Section 301
trade sanction complaint with the United States Trade
Representative office (USTR) alleging China's currency
regime is an unfair trade practice. The complaint is
still in the early stages of preparation, but it is
already causing concerns for US policymakers who view it
as a potential wild card that could force provocative
trade sanctions with China.
One way trade
tension would naturally go away is if the US job market
improved dramatically. We note that US-Japan trade
tensions began in the early 1980s during a period of
extreme job insecurity in the United States, where the
national unemployment rate stuck at post WWII highs near
10 percent. A declining trend in unemployment combined
with the sharp revaluation of the Japanese yen in the
mid 1980s bought time for US policymakers until a
confluence of factors including a sharp decline in the
overall US trade deficit caused the Japanese trade
surplus to disappear as a key domestic issue.
Durable factors drive trade
tensions
Despite a recession in 1991, and despite
the coincident reversal of a previously positive trend
in both unemployment and in the US trade surplus in the
early 1990s, it took well over 10 years, until June of
this year, before the right combination of factors
-including and especially weak labor markets - created
enough pressure on US policymakers to take notice of an
exploding bilateral trade deficit.
This time
around it is interesting to note that unemployment is at
a lower absolute level compared to the early 1980s, and
the US trade deficit is a smaller percentage of US GDP
than the trade deficit with Japan ever was, even at its
height in the mid-1980s. But workers' expectations are
different and probably higher now, and the overall US
trade deficit is higher than the peak level of the
1980s. We are also seeing an unusually protracted lag in
the job market recovery compared to previous US business
cycles.
Meanwhile, the Commerce Department's
latest trade report shows the US trade deficit with
China continuing its ascent in July, hitting an
all-time-high of US$11.3 billion while America's overall
trade gap widened modestly. The worse than expected
August jobs report combined with China's increasing
share of America's growing trade deficit merely adds
fuel to a debate that is already highly charged and
politicized in both the US and China.
Given the
lack of evidence suggesting an imminent recovery in the
outlook for the US job market, and because we cannot
discount the possibility of another setback to the
economy in the foreseeable future, such as could happen
with another major terror attack, we expect the heating
up of political pressures related to China's still
exploding trade surplus with the US to continue,
especially as we head into 2004 presidential election
campaign season.
Jobs are an emotional issue
that resonates as deeply with voters as any other issue.
There is also no easier scapegoat than inexpensive
imports to explain a weak job market. Cheaper imports do
risk replacing domestic suppliers and jobs, if only
temporarily, before other industries and businesses can
pick up the slack. But that means that Chinese imports
will continue to cost American manufacturing in the
months to come during a particularly sensitive time in
the US political cycle.
If American jobs are
perceived to remain in the balance as a result of
China's refusal to revalue their currency, we may see an
unstoppable swell of pressure from US manufacturing
and/or labor on US policymakers for protection in the
form of trade sanctions and import tariffs against
Chinese goods.
A key development along these
lines is offered in the front page headline story of the
September 18, 2003 edition of the Wall Street Journal
titled: "US Manufacturers Target China for Trade
Sanctions." The article describes the unwavering
intention of a coalition of 80 or so major US business
and labor groups led by the National Association of
Manufacturers (NAM) to file a Section 301 trade
complaint with the US Trade Representative's office
alleging China's (effective) peg to the US dollar is an
unfair trade practice. In a worst-case scenario the
complaint could initiate a World Trade Organization
(WTO) review that would trigger automatic trade
sanctions if a negotiated settlement cannot be reached.
Let us forget for a minute that the basis of
this complaint has little to do with generally accepted
principles of international economics on free trade, let
alone with WTO rules. However, no matter how dubious the
justification for the complaint is, we believe NAM has
interpreted correctly that China is unlikely to revalue
the currency either soon enough or dramatically enough
to address the US industry's concerns over the threat of
Chinese imports stealing US jobs.
Heavy lobbying
by the US textile industry to disallow the abolishment
of quota restrictions as currently indicated in China's
WTO accession agreement is another clear indication of
the rising impatience and activism of industry and labor
related to the realization that no matter what the Bush
administration does, it is unlikely to be able to push
China enough to make a "meaningful" difference on the
currency.
An equivalent appreciation of the
Chinese yuan versus the dollar compared to the
adjustment the yen made in just 24 months from 1985 to
1987 would bring the Chinese yuan/US dollar exchange
rate to 5/US$1, or roughly 40 percent stronger than
the current 8.28/US$1. At best, we could see a single
digit adjustment in the yuan over the next 12 months.
Thus, the potential ameliorating impact of a currency
adjustment on trade tensions between China and the US is
just not available. This is in sharp contrast to the
1980s when the success of US policymakers in pressing
for a revaluation of the Japanese yen more or less
satisfied American industry and labor groups, keeping
them safely on the sidelines with respect to at least
the currency issue.
Unprecedented move
signals new policy risks
The NAM Section 301
complaint will be the first ever filed to settle a
currency dispute, and therefore it has already injected
a significantly higher amount of risk and uncertainty
into the resolution of Sino-US trade tensions than those
that entered the complex US-Japan trade story in the
1980s. US policymakers on the front lines of this issue
no doubt understand the downside of potentially losing
the initiative to manage the China currency issue as a
result of the likely filing of the NAM complaint.
Grant Aldonas, the US Commerce
Department under secretary for international trade,
explained to media after a meeting with NAM on
September 17 that the kind of congressional action implicit in
the filing of a Section 301 trade complaint is "a
relatively blunt instrument" saying that "he prefers a
negotiated resolution instead". Unfortunately, the risk
rises every day that political considerations may trump
such well-intentioned policy related preferences.
Whether or not, and to what extent, the Bush
administration decides to extend steel tariffs may
provide a relevant barometer for how the China trade
deficit issue plays out in Washington. If politics win
the day on the steel tariff issue, ie, tariffs are
extended - even with plenty of exceptions - then we see
the chances of provocative trade sanctions of one form
or another going from unlikely to possible. If political
considerations win the day on steel, then why should we
expect rational free trade policy to win the day on
China?
In an effort to gain the upper hand in
this continuing argument, policymakers and pundits
lining up on either side of the debate have continued
upping the ante regarding the economic consequences
should Chinese policymakers make the "wrong" choice on
the currency. Both sides warn that if Chinese
policymakers make the wrong choice about whether or not
to adjust the currency, then the near-term economic
repercussions could be fatal, not only for China, but
also for the world. The result is a debate that has
erroneously been focused on a set of false choices
between two exaggerated scenarios.
Why China
is safe, either way
China has plenty of
international reserves to defend a modest move away from
the current pegged rate. Meanwhile, Chinese policymakers
are no longer facing the challenge presented by capital
flight that caused great consternation in the wake of
the Asian crisis. In fact, currency repatriation has
replaced capital flight as underscored by a balance of
payment accounts last year that indicate an
unprecedented positive number for the errors and
omissions account. These inflows are no doubt related to
Chinese investors seeing higher returns domestically
than in foreign currency options - and they no doubt
provide ample evidence that uncontrolled capital flight
is highly unlikely.
An informal poll
we conducted in a meeting with 25 executives from
Huarong Asset Management attending training sessions in the
US underscores this conclusion. Granted this is
quite unscientific, but we believe compelling as well, so
we include the results here. Only six of the 25 said they
would be interested in moving some of their local
currency savings into foreign currency instruments if
freely allowed.
At the same time, we see no
reason why China cannot safely delay a move to a
flexible exchange rate regime in six or 12 months or
even longer. China's transition to a flexible exchange
regime is a story that will play out in five to 10 years
time, with plenty of latitude available to Chinese
economic policymakers regarding the start time. Despite
some signs of sectorial and regional overheating in the
economy, we believe the overall macro situation is
robust enough, including tame inflation, for China to
continue a pegged exchange regime for at least a year.
We come back to our conclusion that a key risk
to China's economy or global trade and growth is not
China's currency regime. Rather it is that American
policymakers will succumb to using the Chinese currency
issue as a politically expedient punching bag for the
weak job recovery here in the US, especially as we head
into the presidential election cycle for 2004.
Until proven otherwise - by a decision to extend
steel tariffs, for example - our central scenario still
assumes the Bush administration ultimately understands
the risk of playing politics with China's trade deficit.
US Commerce Department Undersecretary Grant Aldonis's
preference for a "negotiated settlement" suggests such
awareness. However, the window of opportunity for the US
and China to begin negotiations is not unlimited, as the
Section 301 complaint, the textile issue and the
possibility of policy intervention by Congress continues
to intensify and percolate along in the background.
A combination of proactive and subtle bilateral
diplomacy as well as equally brave domestic politicking
and policy-making in both the US and China would defuse
the politicization of the China currency debate here in
the US and provide tangible economic benefits for China
and in turn for the US and the global economy.
China has an historic opportunity to use the
building wave of international attention on their
currency regime as a way to provide the needed domestic
political cover to offer the US a comprehensive
market-opening deal. We envision an optimal deal
focusing on openings in China's service sectors,
including and especially in financial services, beyond
what is specified in the current WTO negotiated
timetable, in exchange for the US dropping pressure on
China to revalue the yuan.
We emphasize
services, especially financial services - because this
is where US industry excels and holds its strongest
global comparative advantage, and where, at the same
time, China is in most urgent need of foreign expertise
and capital.
Tiny steps toward a
settlement
We are encouraged that Chinese
policymakers's pronouncements in the wake of growing
international pressure to revalue the yuan are beginning
to reflect an increased sophistication that is starting
to shape domestic policy and foreign diplomacy in
general.
For example, policymakers attempted to
diffuse attention on the currency issue during Treasury
Secretary John Snow's visit to Beijing during the first week
of September by pre-empting the visit with reports that
several policy initiatives were in the works to reduce
China's trade surplus, including:
Easing controls on foreign currency
holdings by companies, a move designed to encourage
imports.
Reducing some export subsidies to blunt
the competitive advantage of sensitive Chinese products
like textiles and furniture.
Raising the cap on the amount of
foreign currency that Chinese business executives and
tourists may take with them when they travel abroad.
We admire the spirit of this "goodies bag"
offered to Secretary Snow. We also appreciate the fact
it was proactively initiated as it suggests an increased
awareness by Chinese policymakers of the political
implications and stresses impacting US policymakers
related to the enormous Chinese trade surplus with the
US. However, the measures are not nearly the right ones
needed to address the key political stress point of
China's trade surplus with the US: ie, jobs.
China needs to offer the US a comprehensive
package that explicitly offsets the near-term loss of US
jobs to Chinese imports with enhanced openings and
opportunities for US businesses in the Chinese market.
China's unproductive and inefficient service sector,
especially financial services, provides the perfect
win/win solution for both sides.
Building a
workable deal
Let's say China proposes a
comprehensive offer to the US that opens its financial
sector and other select service industries faster and
more aggressively (including ownership limits in
domestic Chinese firms) than outlined by its WTO
commitments. US policymakers could use the market
openings as a meaningful and easily understandable
alternative to the currency issue as a way to diffuse
political pressure over China's trade deficit. It's a
fair trade: market access for market access, or in other
words, jobs for jobs.
Such a diplomatic coup
could at once neutralize the currency debate in the US
while providing a valuable injection of US expertise,
capital and technology into a sector of China's economy
that continues to be an enormous drag on growth. Opening
its financial sector to US firms would mean more
efficiently allocated capital, fewer new NPLs and, among
many other benefits, an additional 3-4 percentage points
in potential annual GDP growth resulting from
improvements in financial intermediation.
Conventional wisdom says Chinese policymakers
negotiated hard to limit financial-sector market
openings for fear foreign competitors would dominate
China's financial sector, leading to massive capital
flight and a collapse of the domestic banking industry.
The reality is that the decision to limit foreign
competition in the financial sector was much more a
political consideration than a macroeconomic policy
concern.
Chinese policymakers understand the
constraints faced by foreign banks aiming to gain market
shares quickly in China, notwithstanding the enormous
inefficiencies of the domestic banking system. A dearth
of qualified companies to lend to is one huge constraint
for foreign banks. Lending on a commercial cash-flow
basis to a typical Chinese company is not easy given the
lack of sophistication in the financial reporting of
most private Chinese firms, as only a few are listed.
Collecting deposits would be another challenge
for foreign entrants given the size of the country and
the enormity of the branch network required. Electronic
banking would be an option for banks looking to avoid
building a big retail network in China, but that is not
an overnight option either as only a small percentage of
the population is "connected". The bigger risk for
China's economy is that financial intermediation remains
undeniably inefficient in allocating China's vast
domestic savings.
China's big four banks,
however, wield enormous political power, for one because
they each provide hundreds of thousands of jobs. More
importantly, however, the banks remain politically
protected by a diehard group of local Communist Party
leaders who do not want to see what amounts to personal
spending accounts taken away.
An adjustment of
the currency, however, would be a tougher domestic
political pill to swallow as it would impact millions of
Chinese farmers and peasants in the rural/agriculture
sector. A stronger currency would mean cheaper imported
prices on wheat and other land-intensive agricultural
products, putting additional downward pressure on
already strained rural incomes. The export sector
provides another strong lobby against a revaluation of
the yuan. We believe Chinese policymakers will
ultimately understand that a negotiated settlement
opening the Chinese service sector to US firms provides
an imperfect but still superior solution to trade
tensions with the US given the alternative of a
significant revaluation of the currency.
Meanwhile, from a macroeconomic policy point of
view, the Chinese government understands that opening
China's financial sector is a winning strategy for the
domestic economy in the long run. Just as US
policymakers understand that the actual job loss in the
US to Chinese imports is minor from a macroeconomic
policy perspective, Chinese policymakers understand the
same is true for job losses faced by even hundreds of
thousands of Chinese bankers.
China's economy
would be much better off with a swift infusion of US
expertise, capital and technology in the financial
sector. In fact, the macroeconomic benefits would be
enormous. What Chinese policymakers have lacked up to
this point, however, is the political cover required to
make such a move feasible - something the full weight of
international pressure could provide.
Why
China could pull it off
Both China's domestic
policy and foreign policy have become increasingly
sophisticated, reflecting the government's aim to join
the ranks of the world's great powers. Chinese
policymakers have their sights set on becoming one of
the few players America consults or at least listens to
on important global matters. We believe the SARS (severe
acute respiratory syndrome) crisis was a wake-up call
for a Chinese government increasingly tuned into
regional and global responsibilities, rather than the
nail in the coffin for a brittle and ultimately doomed
regime.
Nowhere is the enhanced sophistication of
China's foreign policy more evident than with respect to
Sino-US relations. China's endorsement of US military action
in Afghanistan was a sharp departure from China's previously
knee-jerk condemnation of any and all use of force
by the US military. Prior to September 11, the projection
of US military power no matter what reason or where in
the world was anathema to Chinese leaders.
With this
decision, China clearly broke with its previous identification
as a leader of the developing world. It is
interesting to note that only three years ago Jiang Zemin
declined an invitation to be a spectator at the annual
Group of Eight summit being held in Germany on the grounds
that China's participation in the meeting would reflect
poorly on the country's identification as a leader to
the developing world, and that Chinese policymakers
could better spend their time focusing on their own
domestic economic challenges. This is in sharp contrast
to the eagerly accepted invitation by the newly
installed president and head of the Communist Party in
China, Hu Jintao, for this year's G8 summit. The
important role China is playing as a broker in resolving
the nuclear crisis on the Korean peninsula highlights
China's growing importance in regional and global
geopolitics, as well as the growing respect being paid
the country by the US.
The improved relations
are a starting point, but for a successful settlement
scenario to play out, US policymakers must begin
pre-selling the value of alternate approaches to an
exchange rate adjustment. The crux of the challenge for
the Bush administration is to articulate a vision for
getting American workers and the American economy beyond
the short-term challenges and dislocations posed by a
combination of difficult challenges: inexpensive
imports, relatively low economic growth and surging
productivity. US policymakers must address the
short-term dislocations and difficulties faced by
workers in industries vulnerable to Chinese imports and
from cheaper imports in general in more creative ways.
This is a significant mandate and one that is a great
deal more challenging to engineer and understand than
your typical trade sanction, which is easily implemented
and understood by a public clamoring for quick fixes.
Lessons from history
In the 1980s,
policies aimed at providing additional direct subsidies
to laid-off workers in select industries failed because
the subsidies were not accompanied by job training. The
latest research shows the best-intentioned job training
is not nearly as effective as on-the-job training. Many
workers who lose jobs, however, are forced to start from
square one in another industry. This invariably entails
not only getting over a badly bruised ego, but more
importantly, in many cases, a steep pay cut.
Newly designed federal government initiatives
have already been implemented that are aimed at
temporarily subsidizing workers' incomes when they are
forced to start over in a new job or industry for less
pay as a result of foreign competition. This allows
workers to get the kind of on-the-job- training that has
proven to be far more effective than training programs
in giving workers the chance to change industries and
careers. The latest buzzword in this area is worker
re-training accounts, which could be saved tax free and
matched by employers in vulnerable industries. These
initiatives are not as easy to sell as a currency
adjustment, and therefore they need more aggressive
marketing by the Bush administration.
Cheap
imports and China's trade surplus
The idea of a
"hollowing out" effect being a risk for the US economy
has come back in vogue despite history's clear lesson on
the subject. The much-feared hollowing out of the US
economy that pundits warned about in the 1980s as cheap
imports from Japan, Taiwan and Korea flooded the
American economy actually played a key role in building
the foundation for an unprecedented economic expansion
for the US economy in the 1990s. Since the mid 1980s,
manufacturing's share of the US economy has remained
constant while its share of employment has been cut in
half. This data underscores the idea that cheaper
imports do cause job losses in the short term but
ultimately lead to higher productivity and higher
standards of living over time.
Meantime, China's
huge trade surplus is really an aggregation of what was
previously a bunch of smaller trade surpluses. China has
gained more of the US export market share as its Asian
neighbors have lost their market share over the past
decade. At the same time, Asian regional trade to China
has surged, meaning that China has become the assembler
for Asian suppliers that used to ship directly to the
US. China's enormous and still growing trade surplus
with the US has become a lightening rod for attention as
the source of manufacturing job losses, but this is a
blatant politicization of the facts.
US
businesses, workers and, by extension, the US economy
has
been adjusting to the effects of globalization for
decades now. In the 1980s the deluge of cheaper
and higher quality Japanese imports, sparked a debate on the
hollowing out of the US economy and job losses.
Remember, also, Ross Perot's infamous line in his bid
for the White House in 1987 about the "loud
sucking sound" we would hear from jobs leaving the US
for Mexico if the US signed on to the North American
Free Trade Agreement (NAFTA). It is important to note that this
type of anti-globalization rhetoric left mainstream politics
as the United States enjoyed an unparalleled
economic expansion in the 1990s.
We observe with
great concern the dramatic manner in which the Chinese
currency issue has taken over front-page headlines in
the course of only the last few months, since Treasury
Secretary Snow kicked off the debate in June with
comments suggesting China should let its currency
reflect fundamentals. Secretary Snow has continued
hammering this theme, while a seemingly endless stream
of policymakers and pundits continues hashing out the
various sides of the argument in editorials not only in
leading financial newspapers, but also, and even more
ominously, in local papers, as this reflects a
potentially potent grass-roots movement in the US.
A political/diplomatic solution is required for
what we believe at heart is a political problem - and
one that has extremely dangerous implications for global
markets. On the US side, the government must do a better
job explaining why the short term dislocations caused by
less expensive imports are a tough but worthwhile price
to pay for the gains to American living standards. At
the least, the Bush administration must not waffle on
putting a clear cut end to experiments with absolutely
unforgivable protectionist measures like steel tariffs,
not to mention continued rhetoric suggesting a link
between an undervalued Chinese currency and American
jobs. This is shameless populist pandering and is a
grave risk for global markets.
The well-cooked
Chinese word for crisis is a combination of the symbols
for danger and opportunity. This is particularly apropos
to the situation the world faces now regarding US-China
trade tensions.
At the end of the day, what
matters most to the health of global trade and growth is
that the US and China find a way to turn what appears to
be a potentially looming crisis in bilateral trade
relations into an opportunity to resolve China's
currency issue in a market friendly and globalization
friendly manner. An optimal answer, as we've elaborated
above, is for China to develop a comprehensive service
sector opening package for US firms in exchange for
continued unimpeded access to US export markets. The
result would have a profoundly long-term positive impact
on the economies of all the players involved, including
China, the US and the global community in general.
Sam Baker is director of the Asia
Group at Trans-National Research, a US-based independent
research firm specializing in political and economic
analysis of emerging markets. He leads research groups
of senior institutional investor clients to Asia several
times a year.
(Copyright 2003 Trans-National
Research.)
Speaking Freely is an Asia
Times Online feature that allows guest writers to have
their say. Please click here if you are interested in
contributing.
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