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    Greater China
     May 27, 2005
Keep your (made-in-China) shirt on ...
By Brian Wingfield

WASHINGTON - At a breakfast with reporters on Wednesday, Charles Schumer, a Democratic senator from New York, declared that China "does not play by the rules". The country's currency, which is pegged to the US dollar, is undervalued, he said, and Beijing should revalue it immediately. The Chinese government, for the moment, has refused to do so, prompting the senator to flatly state: "China wants the advantages of free trade and not the responsibilities."

Schumer has been one of the most vocal US critics of China's monetary policy, arguing that the undervalued yuan makes Chinese exports exceptionally cheap in world markets. The evidence? Chinese textiles have surged in American markets by as much as 1,500% since global trade rules were changed on January 1. In April, Schumer and Lindsey Graham, a Republican senator from South Carolina, introduced a bill that threatens a 27.5% tariff on all Chinese imports to the US if China does not rethink its monetary policy within six months.

The Schumer-Graham proposal is one of Washington's loudest shots yet in the increasingly tense Sino-American trade relations. The threat, of course, is that a deterioration in these relations could erupt into a full-on trade war, with each side imposing protectionist import restrictions on the other. If the actions of the past few weeks are any indication, the two countries are headed that way. On May 13, the US launched a virtual weeklong assault on China's economic policies. That day the Commerce Department announced that it plans to impose "safeguard" restrictions - permissible under global trade rules - on three categories of clothing and textiles from China, noting that the absence of quotas within the past five months has disrupted American markets.

Four days later, Treasury Secretary John W Snow testified before Congress that China's currency regime has become "highly distortionary". His written report to Congress that day stated: "China is now ready to move to a more flexible exchange rate and should move now." The next day, the Commerce Department slapped safeguard measures on four more categories of Chinese clothing and apparel imports. The emergency quotas will go into effect after Washington and Beijing have had a formal consultation on the matter, to be scheduled sometime next month.

The European Union has also jumped into the fray. In April, the EU began an inquiry into textile dumping by China, and on May 17, Peter Mandelson, the EU's trade chief, publicly called for China to curb its textile exports. Six days later, the Union's member states announced that they would soon hold consultations with Beijing in an effort to stem surging imports of T-shirts and flax yarn. Then, on Wednesday, the EU said that China has until the end of the month to decrease textile exports to Europe or face restrictive quotas within the next few weeks.

In spite of the twin assaults on its economic policies, the Chinese government has not really fired back. Instead, Beijing has used a deft blend of rhetoric and action to keep its critics at bay, at times playing the victim to arm-twisting foreigners (as when, for example, Chinese minister of commerce Bo Xilai complained at a Paris meeting in early May, "China needs to export 800 million shirts in order to buy one Airbus A380"). Regarding the currency issue, Chinese Prime Minister Wen Jiabao remarked on May 16 that his government "will take the initiative to advance the reform of the exchange rate without any pressure from outside". However, just a few days later, China began to allow its banks to begin a new foreign exchange trading system that deals in eight currency pairs. This long-planned move has been seen by some observers as a step toward currency revaluation.

On the trade issue, Beijing has taken a similar stance. Commerce Minister Bo said that under a World Trade Organization agreement, the US and EU have had years to phase out their quotas, but waited until only recently to remove them. "[This delay] caused the short-term rapid growth of China's textile exports in the first several months of this year," he said. Yet, last Friday, the Chinese government announced that it would raise export tariffs by as much as 400% on 74 types of textile products beginning June 1. Beijing said it made the move "independently and voluntarily", but it was largely seen as an act of appeasement to Washington and Brussels. On Monday, however, the Ministry of Commerce said it might retract some of those newly announced tariffs should the Americans and Europeans follow through with their threats to impose safeguard quotas.

Several questions beg to be answered: Is China really abusing its competitive advantage, or is it being victimized by the US and the EU? Is a trade war imminent? Should China revalue the yuan, and if so, how should it do this? Perhaps most importantly, who wins and who loses from all of this?

On the surface, it seems the trade problem is really just a symptom of a much larger concern - China's undervalued currency. However, there are two separate - but linked - issues here: monetary and trade policy. The fact that they have each reached boiling point is perhaps the reason for the recent saber-rattling, and a closer look at both of them helps reveal the answers to the questions at hand.

The back story: Exchange rate
The monetary story began in 1995, the year the yuan was first pegged to the dollar at a rate of 8.28 to one. This fixed rate - established before China became a global economic powerhouse and before it joined the World Trade Organization (WTO) - was intended to give the country monetary stability. To maintain this exchange rate, China accumulated foreign exchange reserves, mainly US Treasury bills. But in 10 years, much has changed. China's economy has grown substantially - a whopping 9.1% in 2004 alone. According to US Treasury figures, its balance of payments surplus soared 76% from 2003 to 2004, and its current account surplus increased to US$68.7 billion. In the second half of 2004 alone, China's foreign exchange reserves grew to $610 billion. In the first quarter of 2005, China's real gross domestic product (GDP) increased at a 9.5% annualized rate, a torrid growth fueled by exports and massive capital inflows. In addition, the US dollar has depreciated in world markets in recent years, taking the yuan with it. This has caused both American and Chinese goods to be more competitive in world markets. Speculative capital continues to flow into China; commodity and energy shortages can be found all over the country; and speculative purchases of real estate and even artwork have become common in Chinese cities. All of this seems to indicate that the Chinese economy is overheating.

At the same time, the United States has contributed to China's growth. Simply put, American consumers buy a lot of Chinese goods. The US Treasury estimates that China's surplus on trade in goods with the US increased by $23.3 billion in 2004. In the first four months of 2005, America's trade deficit with China was measured at $21 billion.

In short, within the past decade, China has become a global economic power, and its actions are starting to affect the world. Many economists believe that once a country's economic development reaches a certain stage, it is time to throw away the training wheels and join free-market economies that allow their currencies to float. According to Senator Schumer, that time has already arrived. "If China doesn't float, it throws the whole international trade system out of whack."

China at least acknowledges this concern. In March, Prime Minister Wen said his country would eventually "create a market-based, managed and floating exchange rate," according the Treasury Department's report. So far, however, Beijing has not taken much action.

Treasury Secretary Snow believes that China must move quickly. The present currency regime, he said, "poses risks to the health of the Chinese economy, such as sowing the seeds for excess liquidity creation, asset price inflation, large speculative capital flows, and overinvestment. It also poses risks to its neighbors, since their ability to follow more independent and anti-inflationary monetary policies is constrained by competitiveness considerations relative to China."

Thus, because its currency is undervalued, Chinese goods become artificially inexpensive in world markets. All of which brings us to the trade issue.

The back story: Trade
This part of the tale begins in 2001, when China joined the WTO, a global league of free-trading economies. According to the terms of the accession agreement, other WTO members were permitted to "safeguard" their textile industries by imposing emergency quotas that limit growth in Chinese textile imports to 7.5% annually. This agreement will last until 2008, when quotas on Chinese goods will become prohibited under WTO trade rules.

Compounding this situation, the Multi-Fiber Agreement, a decades-old quota program on textiles, was set to end on January 1, 2005. WTO members had been given several years to phase out their quotas, but most waited until the end in order to protect their domestic manufacturing industries, according to Laura Baughman, director of the Trade Partnership Worldwide, an international trade consulting firm based in Washington.

Naturally, when the quota system expired in January, Chinese textiles and clothing began to flood into Europe and the United States. According to figures from the US Office of Textiles and Apparel, Chinese imports of cotton trousers surged by more than 1,500%. Imports of shirts increased by 1,300% during the first four months of 2005. Increases of similar magnitude were found in many other textile categories, and the EU has experienced the same phenomenon. As a result, the US and EU have both argued that they have little choice but to impose the safeguard quotas allowed under WTO rules.

Experts ponder the outlook
Despite the charged rhetoric of recent weeks, there is probably little likelihood that China's economic relations with the world will deteriorate into a trade war as such. For one, the trade situation is not bilateral; the US and EU have both taken issue with China's surging textile exports. By agreeing to raise tariffs on 74 types of textile exports, China has already shown that it is willing to cooperate with the international community. Furthermore, as Baughman notes, the safeguard restrictions are perfectly legal under WTO rules. In 1995, all WTO members began a 10-year phase-out period of the textile quotas in place under the Multi-Fiber Agreement. When China joined the organization in 2001, it too agreed to drop the quotas by 2005. The imposition of the safeguard measures is not necessarily a case of China being victimized by the US and the EU; however, there is no doubt that those economies are taking maximum advantage of the opportunity afforded to them by WTO rules in order to preserve their textile manufacturing industries, even at the expense of their own consumers and retailers.

Having said that, the tariff bill proposed by senators Schumer and Graham is a different story, says Baughman. Under global trade rules, one WTO member cannot unilaterally raise tariffs against another member without subjecting all members to the same tariff. Such action on the part of the US Congress would undoubtedly provoke China into filing a case against the US with the WTO, which raises the question: if such an action would be illegal, then why threaten China with it at all? "This is for the folks back home," says Baughman, noting that the threat is simply a move by politicians to show their constituents that they are protecting domestic jobs.

However, the safeguard quotas could have several negative effects. On the American and European sides, producers will have an incentive to charge customers more for textiles, since the supply will diminish. In addition, Baughman points out, importers will simply shift their sourcing to other low cost manufacturing country, such as Bangladesh or India. On the Chinese side, an increase in export tariffs would hurt textile producers, while at the same time actually raising revenue for the Chinese government (a tariff is simply a tax on goods, after all).

The currency issue, on the other hand, has been brewing for much longer than the trade problem, and its effects are not just speculative, they are already somewhat visible: China's goods are artificially cheap, and its Asian trading partners are not free to let their currency appreciate freely because they fear they will be undercut by cheap Chinese goods. China, for the most part, has benefited as its economy booms - although Beijing has had increasing reason to worry about the negative side effects of excessive growth recently, and the country's massive accumulation of dollar reserves is hardly beneficial if its side effect is to further weaken the dollar.

Morris Goldstein, a senior fellow at the Institute for International Economics in Washington, says China should allow the yuan to appreciate relatively soon because there are two primary risks to not taking action. First is the risk of instability if people expect exchange rates to do nothing as capital continues to flow into the country and it runs a current account surplus. Second, he says, "people will regard the Chinese as not playing by the rules".

China effectively has three options. First, it can continue with the status quo. However, this would still disrupt the monetary policies of its neighbors and could cause China to face retaliatory action by the US. This could also cause unstable capital inflows on the part of currency speculators, who hope to make quick buck when the yuan finally does appreciate.

Second, China can let the yuan float freely now. Doing so runs the risk of overvaluing the currency and drastically cutting exports, which many regions of China have become economically dependent upon. It would also likely cause significant instability in the country's financial system, which could have a profound effect on the global financial markets, including US markets. A sudden appreciation of the yuan would effectively cause its dollar reserves to depreciate, which could in turn cause US interest rates to rise. This could bring an end to the current housing boom in the United States, and it would undoubtedly affect the debt levels of US credit card holders, which are currently sky-high.

The third option is to let the yuan adjust gradually. Goldstein and his colleague Nicholas Lardy have suggested a two-step process. The first part would involve an initial revaluation of the yuan by 15-25%. The second would be a "managed float". that is, a re-pegging of the yuan to a basket of currencies (such as the dollar, the yen and the euro) with a relatively wide fluctuation band. Goldstein also says that "the more multilateral pressure that goes on China, the better", noting that the Europeans, Asians and notably the International Monetary Fund should help China effectively manage its revaluation.

The IMF declined to comment for this article, pointing reporters to its website, which states: "Our position has been quite clear. We have for some time believed that it is in the interest of China to adopt a more flexible exchange rate system, and the reasons are well known. More flexibility would allow for an autonomous monetary policy and cushion against shocks. Such a move toward flexibility is best taken from a position of strength, and the current conditions would be favorable for such a step. We keep in close contact with the authorities, providing them advice as they request [it]. We have a very active technical assistance effort with the Chinese and continue to be impressed by the growth in [China's] economy."

So where does this leave us? In relative stability, one can only hope. China has become far too integrated in the world economy for it to be shut out - or for it to shut anyone else out, for that matter. The country's trade relations with the US and the EU have effectively reached a tipping point, and in all likelihood, safeguard quotas will be imposed. However, they must be renewed each year, and the possibility remains that this will not happen if China makes good on its efforts to control its textile exports. At any rate, the Asian giant only needs to hold out until 2008, at which point the quotas will be gone for good.

Because of the trade issue, now seems as good a time as any to address China's monetary concerns, and the US rhetoric - including the Schumer-Graham bill - is quite possibly an effort on the part of the United States to nudge China to allow the yuan to appreciate now rather than later. Nonetheless, any effort to revalue will require the support of the international community. China is the greatest economic success story of the past decade. In a mere 10 years, it has grown from a truly developing economy to one that is able to have a significant effect on the world's largest trading blocs.

Speaking in Beijing in September of 2004, John Williamson, a senior fellow at the Institute for International Economics, perhaps summarized China's situation most succinctly. When describing the possible revaluation of the yuan, he noted that China has not yet experienced a growth crisis. "This does not mean that China's current policies deserve to be perpetuated," he said, "but it does imply that any change needs to be evaluated carefully to make sure that it will not risk undermining China's success."

Brian Wingfield is a freelance reporter based in Washington, DC.

(Copyright 2005 Asia Times Online Ltd. All rights reserved. Please contact us for information on sales, syndication and republishing.)

Fresh US salvo in trade spat with China (May 20, '05)

US begging for dollar devaluation
(May 13, '05)

Export flood fuels revaluation debate
(May 11, '05)

Revaluation not imminent: vice finance minister (May 11, '05)

Globalization ideologues have no clothes (May 7, '05)

US walks China trade tightrope
(Apr 29, '05)

The case for China to pull the peg
(Nov 20, '04)

China, US textiles, quotas and votes (Oct 29, '04)


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