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    Greater China
     Jul 14, 2005
Washington ignorant of China's importance to US
By Jephraim P Gundzik

The increasing politicization of economic relations between Washington and Beijing poses a significant threat to the US economy. A series of protectionist measures against imports of Chinese goods and capital have been imposed by the Bush administration or are being threatened by Congress. But rather than supporting the economy, as intended, such measures are likely to push US inflation and interest rates higher and economic growth lower.

Embracing protectionism
For most of the past 25 years, the US has championed free trade globally as the best means to support strong economic growth worldwide. In this span Washington has ratified numerous bilateral and multilateral free trade deals. It has also supported global free trade through the General Agreement on Tariffs and Trade (GATT) and its successor, the World Trade Organization (WTO). However, in the past two years, US support for free trade has waned.

Washington's unwillingness to open the US to agricultural import competition has effectively destroyed the Bush administration's dream of creating a Free Trade Area of the Americas (FTAA). It has also impeded progress in the achingly slow Doha Round of WTO Negotiations. In the last year, this passive protectionism has been replaced with active attempts to protect the US from Chinese goods and capital imports.

Under WTO agreements in place since 1995, global trade in clothing and textiles became quota-free on January 1, 2005. This prompted a surge of clothing and textile imports to both the EU and US from China, which is the low-cost producer for many categories of textile items. While Brussels chose to negotiate an agreement with Beijing over limiting clothing and textile imports, Washington slapped new quotas on several categories of clothing and textile imports from China in May 2005.

The Bush administration has been applying increasing pressure on Beijing to revalue the yuan over the past two years. The US Senate joined the administration in applying pressure on Beijing for an exchange rate adjustment. In April 2005, the Senate voted 67-33 in favor of considering legislation that would threaten Beijing with a 27.5% tariff on all Chinese exports to the US unless the yuan was allowed to float.

A second Senate vote on the tariff legislation was scheduled for July 27. In early July, the sponsors of this legislation, US Senators Lindsey Graham and Charles Schumer delayed the second vote in order to give Beijing more time to revalue the yuan. However, should Beijing continue to avoid a yuan revaluation, as expected, a vote on this tariff legislation will return to the Senate's agenda.

Officials in Beijing have repeatedly expressed that the timing of a yuan revaluation will not be decided in Washington. European and Asian central bankers, as well as many US commentators, support Beijing's position. Meanwhile, China responded angrily to the new US import quotas on clothing and textiles, accusing the Bush administration of violating WTO rules.

Tempers in Beijing became further elevated when, in July 2005, the US House of Representatives approved a resolution by a 398-15 margin urging the Bush administration to block the purchase of California-based Unocal Corporation by the China National Offshore Oil Corporation (CNOOC). The House resolution describes the proposed Unocal-CNOOC transaction as a threat to US national security. In a written statement, China's Foreign Ministry responded to the resolution demanding that "the US Congress correct its mistaken ways of politicizing economic and trade issues and stop interfering in the normal commercial exchanges between enterprises of the two countries".

China's goods fundamental to low US inflation
China is the second-largest source of US imports: in 2004, the US imported a record $200 billion in goods from China. At only 14% of total US imports, China appears to be only a small supplier to the vast US market. However, the majority of US imports from China are consumer goods, and Chinese firms dominate this category of imports. In 2004 China accounted for 81%, 68%, 42%, 22% and about 20% of total US imports of sporting goods, footwear, furniture, electronic equipment and clothing, respectively.

As a key supplier of consumer goods, Chinese imports directly account for about 10% of total personal consumption expenditure on clothing and footwear and 6% of expenditure on furniture and household equipment in the US. Clothing, footwear, furniture and household equipment make up 10% of total personal consumption expenditure, excluding food and energy, in the US. Overall, imports from China make up about 2% of total personal consumption expenditure, excluding food and energy.

This low percentage of personal consumption expenditure may appear to be an underwhelming statistic; however it plays an important role in determining the evolution of the US Federal Reserve's preferred inflation indicator, the core personal consumption expenditure (PCE) deflator, which excludes food and energy. Unlike the consumer price index (CPI), the weightings of goods used in the PCE deflator are adjusted to reflect changes in consumption patterns. In other words, the PCE deflator is derived from the weightings of actual personal consumption expenditure in US national accounts data.

In a straightforward calculation, because Chinese goods account for 2% of total personal consumption expenditure, excluding food and energy, Chinese goods also account for 2% of the core PCE deflator. However, China is the price leader in US consumer goods. As a result, the price of Chinese goods is a strong determinant of the price of similar goods in the US market; this is due to the nature of price competition.

Because of price competition, the impact of Chinese goods on the core PCE deflator extends far beyond its 2% weighting. Just how far would be an interesting subject for Washington to examine. Nonetheless, some examples of how different weightings could impact the core PCE deflator are enlightening. At its nominal weighting of 2%, a 20% increase in the price of Chinese imports would push the PCE deflator up by 0.4%. As price competition extends the influence of Chinese prices, a 4% and 6% weighting and the same 20% increase in the price of Chinese goods would push the PCE deflator up by 0.8% and 1.2%, respectively. Conversely, declining prices for Chinese goods push the US core PCE deflator lower.

This is precisely what occurred in the first quarter of 2005 as US imports of Chinese clothing surged higher, prompting the Bush administration to reimpose import quotas on these goods. The PCE deflator for both women's and men's clothing declined by 0.6% in the first quarter of 2005 compared to the same period in 2004. This helped to hold the overall increase in the core PCE deflator to 1.7% in the first quarter of 2005 as compared to the first quarter of 2004.

The imposition of quotas on imports of Chinese clothing in June 2005 will push the core PCE deflator back up in the second half of this year. An across-the-board tariff on all Chinese imports as proposed by the US Senate, or a revaluation of the yuan, would also push the core PCE deflator higher. How high US inflation goes depends on the magnitude of the tariff or revaluation.

Though other countries could provide cheaper goods to the US than China, no other country in the world has China's industrial capacity. Capacity constraints in other countries, and even in the US, for the production of goods similar to goods now being produced by China would force prices of these goods higher as well. The facts are plain - China's imports are containing US inflation, and any move to increase the cost of these imports will push US inflation higher.

China's capital fundamental to low US interest rates
In February 2005, Federal Reserve Chairman Alan Greenspan, in Congressional testimony, called the decline of long-term US interest rates in the face of rising short-term interest rates a "conundrum". Actually, there is no mystery here. China has played an increasingly important role in US interest rate developments in the past few years, including the decline of long-term US interest rates in 2004.

Because US imports from China have contained the growth of inflation, they have also been a factor in lowering US interest rates. An equally important factor in lowering rates has been the recycling of China's massive foreign exchange reserves - a byproduct of China's oft-vilified trade surplus with the US - into US Treasury securities.

According to Federal Reserve and US Treasury data, about 47% of total marketable Treasury securities were held by foreign investors at the end of 2004. Stripping out Treasury securities held by the Federal Reserve and state and local government in the US leaves foreigners accounting for 61% of all privately held US Treasury securities. In December 2004, China's holdings of Treasury securities amounted to $223 billion, equivalent to 7% of the total amount of privately held US Treasury securities.

At the end of 2004, 80% of the Treasury securities held by foreign investors were in the form of treasury notes and bonds, ie long-term treasuries. Undoubtedly, China's holdings of Treasuries do not vary much from this maturity mix. China's purchases of US Treasuries, along with purchases by other countries, have pushed long-term US interest rates lower.

Washington's self-destructive intervention
Taken to its logical conclusion, the politicization of economic relations between Washington and Beijing poses a significant threat to the US economy. Efforts to push the price of China's imports higher with quotas and tariffs will push US inflation higher. Any revaluation of the yuan would have the same effect on US inflation.

More problematic for the US economy are the implications of administrative controls on Chinese capital inflows and yuan revaluation on long-term US interest rates. By threatening China's proposed investment in Unocal with US government intervention on national security grounds, the US Congress is simultaneously undermining US shareholder rights and preventing China from realizing higher investment returns than are available to it in Treasury securities.

The threat of government intervention destroys the right of Unocal shareholders to maximize the value of their investment by accepting the clearly superior bid that CNOOC is offering. This threat, whether it is realized or not, reduces the value of CNOOC's offer by creating the perception that this offer will be subject to close government scrutiny and may ultimately fail under this scrutiny.

From Beijing's perspective, Washington's interference in the CNOOC-Unocal transaction raises the probability that similar interference could prohibit other Chinese fixed investments in the US. Such fixed investments, offering higher returns than US Treasuries, could give China a way to keep its capital in the US without taking a huge hit when the yuan is eventually revalued. Rather than embracing protectionism and placing future US economic growth at risk, policymakers in Washington must accept that China, Chinese imports and the fixed value of the yuan are integral to the health of the US economy.

Jephraim P Gundzik is president of Condor Advisers, Inc. Condor Advisers provides emerging markets investment risk analysis to individuals and institutions globally. Please visit for further information.

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

Why not just nationalize Unocal? (Jul 8, '05)

US urged to stay out of CNOOC-Unocal bid (Jul 1, '05)

Now the hard part as CNOOC chases Unocal (Jun 28, '05)

Keep your (made-in-China) shirt on (May 27, '05)

Revaluation: a dangerous distraction? (May 21, '05)

Time not ripe for revaluation (May 14, '05)

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

It's not the yuan, silly (Apr 14, '05)

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


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