TCS Daily

Protectionist Storm Clouds Gathering

By Desmond Lachman - June 3, 2005 12:00 AM

It is almost two years now since the US Treasury began its intensive engagement with China to hasten that country's move to a more flexible exchange rate policy. Yet, despite that engagement, China has doggedly maintained its exchange rate fixed at the 8.28 yuan to the dollar first set in 1995. This hardly bodes well for China making a meaningful change in its currency to a more realistic level over the next six months. It also does not bode well for China avoiding a major trade policy showdown with the US Congress, which is rapidly running out of patience with China's mercantilist approach to international trade.

China's strong reluctance to move to a more realistic exchange rate is very much grounded in China's export-oriented economic growth strategy. Rapidly increasing exports are viewed not simply as a means of promoting China's modernization but as a means of absorbing the estimated 200 million underemployed workers in the countryside.

Aided by an undervalued exchange rate, China has had considerable success in that strategy. This is reflected in growth rates in excess of 9 percent a year over the past decade and in an export sector that now accounts for fully 36 percent of the Chinese economy. With the export sector now growing at an annual rate of 30 percent, exports account for a full 11 percentage points of China's GDP growth.

While there can be little doubt that China's export miracle has been a major pillar of its enviably rapid pace of economic growth, it has done so in a manner that has added to today's global payment imbalances. Since China's imports do not increase at nearly the same rapid pace as do its exports, China now runs an overall current account surplus of 4 percent of GDP.

Even more of a red flag to the US Congress, China's bilateral-trade surplus with the United States has now ballooned to over US$160 billion a year. This trade surplus accounts for roughly one quarter of the overall US trade deficit. At the same time, China has become a major destination for foreign direct investment, which has boosted China's overall balance of payments surplus to US$200 billion and which has increased its international reserves to over US$650 billion.

China's persistent and growing trade surpluses have prompted Senator Chuck Schumer to garner the support of no fewer than 67 senators for tough action against China in order to curb these trends. Specifically, Senator Schumer is proposing the imposition of a 27.5 percent across the board tariff on Chinese imports at the end of this year unless China revalues its currency within the next six months.

Against this background, it is little wonder that the US Treasury is now adopting a less conciliatory approach to the Chinese exchange rate issue. In last week's six-monthly exchange rate report to Congress, the Treasury declared that "the fixed exchange rate that China maintains is a substantial distortion to world markets, blocking the price mechanism, and impeding adjustment of international balance". It is little wonder too that the US Treasury has now put China on notice to revalue its currency within the next six months or run the risk of being declared a "currency manipulator" in the Treasury's next six-monthly exchange report.

The political escalation of the Chinese exchange rate question raises difficult issues of a face saving nature for the Chinese government. How can a proud ancient nation and a would-be global economic power be dictated to by the United States on a matter of such strategic national importance? How dare foreign countries meddle in China's domestic economic decisions and challenge China's national economic sovereignty?

Beyond the question of how to save face, the Chinese government's basic predicament is that they do not seem to have good policy options on this matter. A small exchange rate move of the order of 5 percent would rightly be seen by the US Congress as a derisory gesture that would do next to nothing to reduce China's outsized bilateral-trade surplus with the United States. It would also do little to quell protectionist pressures against China.

At the same time, a small exchange rate move is likely to encourage further large speculative capital inflows into China of a destabilizing nature. Speculators are more than likely to reason that, having caved once to international pressure by moving the exchange rate, the Chinese government would cave again as international pressure mounted for another change.

A large move of the exchange rate by the 10-15 percent now purportedly being demanded by the US Treasury would also not be an appealing option to the Chinese government. For such a move would run the risk of putting a dent in China's export machine. And this could have serious ramifications for China's overall economic growth performance given that China's whole economic growth strategy is premised on an ever-expanding export sector.

Unappealing as its exchange rate policy options might be, the Chinese government has to realize that it cannot realistically expect the rest of the world to remain China's primary growth engine. Rather, China has to find the means for stimulating domestic demand growth so that such growth could take over from exports as the principal driver of the Chinese economy.

The Chinese government also has to realize that, as a member of an international financial system, China too has to play its part in redressing today's unprecedented large global payment imbalances. For if China resists meaningfully revaluing its exchange rate with a view to reducing its trade surplus, China will unleash strong protectionist pressures abroad . And the Chinese government must know that China will have the most to lose from the world drifting towards protectionism.

The author is Resident Fellow, American Enterprise Institute.



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