Avoiding a US-China currency and trade war
28 November 2011
K I Woo, Senior Advisor of Human Capital Alliance Limited gives us an interesting view from China on the continuing US/China currency debate.
Encouraged by Nobel laureate economist, Paul Krugman and New York Senator Charles Schumer the US media continuously blames China’s currency manipulation as a key reason for America’s seemingly protracted 10 per cent unemployment rate and huge trade deficits.
Although their accusations contain elements of truth, China’s “undervalued” currency is only one of many reasons why the US has suffered protracted high unemployment rates and huge trade deficits with China especially during the current US recession.
Nevertheless, everyone including many Chinese experts are wondering whether a currency and trade war between the US and China will be the only solution that will satisfy US politicians facing imminent elections.
Currency war could launch a trade war
Huang Yiping, Professor of Economics at Peking University’s China Center for Economic Research and Citigroup’s former Chief Economist in Asia recently said that any currency war would include a trade war wherein the US would implement Congress-passed punitive import tariffs against China. “But such measures would (also) have to pass scrutiny the World Trade Organization.”
Although import tariffs would reduce Chinese exports to the US, the gap Huang said would probably be filled by exports from other low-income countries. Many of these import tariffs would lead to unpopular higher consumer prices and could also lead to higher US inflation.
Perhaps more importantly, these import tariffs, “given the differences in comparative advantage between China and the US, it is doubtful that the lost jobs would go to the US.”
For now, Huang said the Chinese government is content with trying its best to avoid a sharp currency adjustment that could significantly damage its export sector.
He believes that the risks of a trade war are manageable. “Both the US and Chinese governments appear to favor multilateral frameworks for resolving the renminbi dispute.”
Moreover, the leadership in most countries believes that economic imbalance issues are ultimately global issues. “A critical question, however, is what specific policy approaches the G20 (they) might adopt dealing with such problems.”
Why renminbi appreciation alone is not relevant?
Another leading Beijing-based think-tank economist argues that appreciating the renminbi (yuan) will not significantly uplift the US economy.
Yao Yang, Director of Peking University’s China Center for Economic Research (CCER) said recently that the renminbi’s appreciation would not be a great help in reducing the U.S. trade deficit and creating jobs.
“As the two countries are the two biggest trade partners in the world, neither China’s nor the U.S.’ economic issues are merely domestic. Instead, it’s global,” Yao said.
China’s trade surplus with the United States in 2007, Yao said stood at 206.6 billion U.S. dollars, and it declined to 143.4 billion dollars in 2009 due to shrinking external demand in the wake of the global financial crisis.
“ However, 44 percent of the surplus was contributed by U.S. companies operating in China, and 20 percent by other foreign companies there.”
Using Apple’s iPhone, as an example, Yao said the product, assembled in China, alone accounted for $US1.9 billion of China’s trade surplus with the United States in 2009.
“Most of China’s trade with the U.S. is compensation trade, which may account for 60 percent of the total (bilateral) trade,” Yao said. “The yuan’s appreciation may somewhat increase China’s trade surplus, contrary to the common sense.”
It means China can import raw materials and equipment at relatively low prices, he added.
Even if China is forced to give up exporting some of its products once the yuan appreciates, Yao said the United States will still have to buy those products, which it usually does not manufacture, from other countries — which neither helps bring down its trade deficit nor create jobs, he said.
Moreover, a CCER’s model showed if the yuan appreciated by 5 percent against the dollar, the U.S. employment rate will rise by only 0.03 percent and even if the yuan appreciates by 20 percent, it only helps to raise U.S. employment by 0.16 percent.
Meanwhile, the model also showed that the increase in the yuan’s value is unlikely to affect the U.S. gross domestic product (GDP) much — if the yuan rises by 5 percent, the U.S. GDP would go up 0.02 percent, while China’s GDP would contract 0.56 percent.
“In general, our research shows that the impact of the yuan’s appreciation on the economies of China and the U.S. is minor. The attempt to fix U.S. economic problems by urging the yuan to appreciate is not effective.”
Attacking root causes of imbalances
Economist Huang said global leaders would do much better attacking economic imbalances by attacking their root causes.
He added that is was rather simplistic for anyone to blame China’s currency policy and an undervalued renminbi as the root cause of US currency problems.
Currency values, he said are important but no one should expect the mere depreciation of the dollar would be sufficient to reverse the US current account deficits and resolve the country’s unemployment problems that have been mired at 10 per cent for the past several years.
China and the US and much of the world should be addressing structural imbalances that are the root cause of the current economic disputes.
“Therefore, it is better to adopt more comprehensive policy approaches to deal with the problems,” he said.
Addressing China’s structural imbalances
During the past 30 years, Huang said China has adopted an asymmetric market liberalisation approach which has contributed greatly to current economic imbalances both within China and globally, especially with the US.
“While product markets are almost completely liberalised, factor markets remain heavily distorted.”
These product factor distortions he said have artificially lowered China’s production costs that have in effect subsidized producers, exporters and investors and are behind China’s structural imbalance problems.
“Therefore, completion of factor market liberalisation should be a critical part of the reform program necessary to rebalance the Chinese economy.”
Exchange rate must also appreciate more quickly
Although China’s exchange rate policies that have kept the renminbi relatively weak are undoubtedly also a key production factor distortion, Huang said that China is also moving toward its liberalization.
“Increasing exchange rate flexibility is consistent with China’s announced policy goals. China has to do our part by introducing a more flexible exchange rate and reducing the current account surplus,” he said.
Huang said that China’s faster appreciation of the renminbi could also be part of its efforts to prevent China from becoming the victim of the Fed quantitative easing policy (QE2).
“When the dollar liquidity flows outside the US, China will be one of the favorite destinations because of its strong growth, high interest rates and expectations of currency appreciation. If it doesn’t adjust its current policy, China could be the next big bubble,” he said.
In order to avoid that unhappy outcome, Huang said the Central Bank will let the renminbi rise steadily. “That might attract more hot money inflows, but it is better than a one-step adjustment.”
The central bank he said must raise interest rates more swiftly. Although this policy may encourage more capital inflows because of the wider interest rate differential between China and the rest of the world.
Therefore, the Chinese authorities, he said should also consider temporary measures to control capital accounts. An exchange rate adjustment will take some time and more restrictive capital controls may provide a better environment for that adjustment.
“More importantly, capital account controls can help stop US dollar liquidity at the border. But of course, such controls should be temporary and for the adjustment period only. Once a large part of the adjustment is done, we should abolish those controls and re-accelerate capital account liberalisation.”
How China’s production factor distortions caused economic balances
China’s large current account surplus, Huang said is caused mainly by broad distortions of the factor markets, which generally decreased costs of production and artificially improved competitiveness of China exports.
“Exchange rate misalignment is only a part of that broad distortion picture. Relying exclusively on currency adjustment to correct the overall external imbalance requires an outsized appreciation, which is difficult for China to accommodate at this stage, both politically and economically.”
The exceedingly low savings ratio in the US before the subprime crisis, he said was similarly by a number of structural factors.
“Simply depreciating the US dollar by a significant margin is unlikely to be sufficient to substantially lift the savings ratio.
Fortunately, global rebalancing is already occurring. “In the US the current account deficit as a share of GDP has already halved from its pre-crisis peak, while in China the surplus as a share of GDP has already shrank by two-thirds.”
China’s recent external balance readjustments, Huang said were to a certain extent – a result of changes in domestic factor markets. “Factor costs have been on the rise despite the global financial crisis.”
During the past year, the Chinese government began to reduce price distortions for most resource products in order to improve economic efficiency, and the impending labor shortage pushed up wages by close to 20 per cent. Global electronics firm Foxconn Plc in Guangdong province was a prime example of a Chinese based company that raised its salaries by about 20 per cent for its 500,000 employees.
Government rebalancing policy initiatives
Political leaders such as Premier, Wen Jia Bao repeatedly emphasized in 2010 that structural balances are detrimental to China’s sustainable local and international development. (footnote)
China’s existing growth pattern has been described as “unstable, unbalanced and unsustainable.
Economist Huang said that one of the most widely identified imbalance problems is the rising share of investment in GDP, which increases the risk of excess capacity and low returns. A persistent current account surplus, he said also means that China, as a low-income economy, has been exporting capital despite domestic investment needs.
Most of the current account surplus is held as foreign exchange reserves, which have relatively low returns and are vulnerable to exchange rate risk. “In addition, the surpluses indicate the degree to which Chinese growth is dependent on external demand.”
Income inequality has also drastically increased. Other growth quality problems include inefficient resource use, serious pollution, and corruption among local government officials. If these problems persist, China’s strong economic growth will be unsustainable.
Changing the growth model is one of the top policy priorities under Wen’s government, which has already undertaken a range of policy measures to adjust China’s economic structure.
For instance, it has taken various steps to stimulate consumption, contain investment growth, reduce overcapacity in certain industries, and reduce external account surpluses.
The fundamental cause of structural imbalance lies in the unique pattern of market liberalisation during the reform period when product markets were completely liberalized but distortions remained in the factor markets.
Such distortions Huang said artificially increased profits for manufacturing production, turning China into a global manufacturing centre through the supply of cheap labour and cheap capital and resources.
Cost distortions have also contributed to oversized investment and exports. This is probably why growth has been so strong in China, but exports and investment have been even stronger.
To alleviate the existing structural risks, Huang said the authorities need to change their policy course.
Attacking root cause – factor-market distortions
Huang suggests that China must attack the root cause of the imbalances and inefficiency problems by eliminating is factor-market distortions.
“The fundamental solution to deal with the imbalance problem is to implement a comprehensive package of factor-market reforms.”
The comprehensive package, Huang said essentially calls for an end to the asymmetrical approach to market liberalisation. “Steady liberalisation of factor markets and the elimination of cost distortions should be top priorities for the next stage of reform.”
Labor-markets should be gradually fundamentally fundamental way to stimulate consumption. The government, he said has implemented new urbanization policies that will allow more rural migrants to officially work in urban areas and also intends to extend the social welfare systems to all rural residents.
Huang added that another positive breakthrough could be the introduction of market-based interest and exchange rates. The China Interbank Offered Rate, he said was a good starting point for a government trying to form a market-based term structure for interest rates.
“But the financial system needs to cater better for the needs of the private sector, which will be the backbone of the Chinese economy. This means market-based interest rates. It also means that the exchange rates should be more flexible.
Land-ownership rules must also be reformed to reduce distortions to land use. The current collective ownership, Huang said said is vague, creating room for corruption and hinders the modernisation of the rural economy.
“In the cities, the government should stay out of the direct negotiation of land prices and private property development.”
Abolishing other cost distortions
The state sector in China that executes much of the policies handed down by the Central Government. Huang said the state sector should be reformed so that is shares more profits with households.
One option, he said is for the State to collect more taxes from state-owned enterprises and then redistribute the gains to broader society. In broader terms, the state sector should gradually give up much of its monopoly power or be privatised.
Huang admitted that the complete liberalisation of factor markets and the elimination of cost distortions are likely to take years to complete. “When completed, they will signal China’s full transition to a market economy and will help lock China’s growth onto a more sustainable path.”
Undoubtedly, China’s recent factor price adjustments as suggested by economist Yao and Huang are an important means to change the renminbi’s real effective exchange rate and impact China’s current trade composition.
“A rapid rise in wages, for instance, not only directly benefits consumption but also forces industries to move toward inland provinces, another positive factor for promoting domestic demand,” Huang said.
US doesn’t cite China for manipulating currency
China’s seemingly pragmatic policies to avoid currency and trade wars with the US seem to be working, at least for now.
In February 2011, the Obama administration declined to cite China for manipulating its currency to gain trade advantages against the United States. (footnote AP)
“Treasury’s finding came in a report it must submit to Congress every six months as to whether other countries are manipulating their currencies. American manufacturers have been pushing for China to be cited. That could result in penalty tariffs being imposed on Chinese imports.”
In refusing to cite China, Treasury said Chinese President Hu Jintao had assured President Barack Obama in Washington that China would intensify its efforts to “further enhance exchange rate stability.”
The future – Henry Kissinger
In a recent interview US television interview with Charlie Rose, US statesman, Henry Kissinger said
“We have to [work] together, which is not the operating style of our societies. If both countries recognize—which I think they are beginning to do—what their real task is, that it isn’t just to stop the immediate day-to-day tensions but to have some vision. … Now, how well they can do it, how quickly, that remains to be seen.
Kissinger also said that each side has its own view.
The Americans, Kissinger said argue that “the Chinese can’t be trusted, that the Chinese really want world domination, that they are taking advantage of us in the transfer of technology and also that the Chinese in the last year have conducted themselves in a more assertive way than we have been accustomed to.”
On the other hand, Kissinger said China believes that it has suffered more than a century of humiliation and that it’s now their turn to demonstrate at least equality.
However, Kissinger concluded that based on Hu Jintao’s recent speeches, China’s governing group during his recent speeches that long-term cooperation is important. “It’s also the evolution that the Obama Administration has undergone.”