TCS Daily

China Should Not Cast Stones

By Desmond Lachman - December 3, 2004 12:00 AM

All is not well in the world of international financial diplomacy. Perhaps the most striking example of the malaise was last week's harangue by the Bank of China that the United States should not blame others for its ballooning trade deficit but should put its own fiscal house in order. While there is partial truth to the Chinese charge, the Bank of China does not do the world a service by refusing to acknowledge the fundamental role that China and other Asian countries must play in addressing today's dangerous global payment imbalances.

Last week, Alan Greenspan strongly intoned that any serious solution of the US balance of payments problem must involve a substantial reduction in the budget deficit as part of a strategy to boost the abysmally low level of US savings. This is needed in order to make room for the desired reduction in the US external current account deficit from its present unprecedented level of 5 ¾ percentage points of GDP to a more sustainable 2-3 percentage points of GDP. In that context, an approximate halving of the budget deficit would appear to be an appropriate medium-term policy target for the United States.

While US budget reduction is a necessary condition for addressing today's global payment imbalances, it is hardly a sufficient condition. Rather, beyond US fiscal consolidation, what is also required is a further effective depreciation of the dollar on the order of 15-20 percent. Such depreciation would seem to be a sine qua non both to encourage US exports and to switch US demand away from imports as part of the US external rebalancing process.

It is difficult to see how a further 15-20 percent effective depreciation of the US dollar can occur if the Asian countries as a whole refuse to allow their currencies to appreciate. In particular, it would seem unreasonable to expect Europe to continue bearing practically the full brunt of the adjustment process. In this regard, singularly unhelpful is the Bank of China's assertion that an appreciation of the Chinese renminbi will not solve the US balance of payments problem since the cost of labor in China is only 3 percent that in the United States.

The Bank of China chooses to overlook the fact that China is presently running a very large basic balance of payments surplus as reflected in China's staggering accumulation of international reserves to now more than US$500 billion. Moreover, the Bank of China overlooks the fact that no matter how low relative labor costs might be in China, exchange depreciations work at the margin. By altering the relative price of traded and non-traded goods, a sufficiently large move in the renminbi would almost certainly contribute to reducing China's basic balance of payments surplus.

An equally important oversight on the part of the Bank of China is the fact that the rest of Asia, which in aggregate is more important than China in world trade, fears Chinese competition. In the absence of a Chinese exchange rate move, these countries will remain loath to allow their currencies to appreciate for fear of losing market share. The un-pegging of the renminbi would allow these countries to appreciate, which would go a long way to reducing present global payment imbalances.

A sad irony of China's resistance to alter its present exchange rate arrangement under international pressure is that such action would appear to be in both China's short-term and long-term economic interest. China's fixed exchange rate regime is already resulting in domestic inflationary pressure and is making it difficult to address such pressure with conventional monetary policy instruments. For any increase in domestic interest rates under a fixed rate system, only attracts further capital inflows by cheapening the cost of speculating on an eventual renminbi appreciation.

More menacing perhaps are the strong protectionist pressures building in the US Congress against China on the grounds that China is artificially maintaining a cheap currency. These pressures will almost certainly ratchet up at the beginning of 2005 with the expiration of the multi-fiber textile arrangement, which will allow China to compete more fiercely in the international textile market.

Rather than casting stones at the United States, China would seem better served in seeking common ground with the United States to solve today's global payment imbalances. A more constructive role for China to play would be to offer greater exchange rate flexibility in return for concrete commitments on the part of the United States to address its budget deficit problem.

The author is Resident Fellow, American Enterprise Institute.


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