TCS Daily

Exchange Rates Must Be on Mr. Bush's China Agenda

By Desmond Lachman - October 20, 2005 12:00 AM

At the start of the year, Paul Volcker, the former Federal Reserve Board Chairman who is not known for being an alarmist, issued an ominous warning. He warned that, in the absence of early remedial policy action, there was a 75 percent probability of a full-blown global exchange rate crisis within the next five years.

When he visits China next month, President Bush would do well to take Mr. Volcker's warning to heart and to place the issue of global payment imbalances firmly on the policy agenda. For given its ever-growing importance in world trade, China has to be part of any successful solution to today's global payment imbalance problem.

Sadly, since Mr. Volcker issued his warning some six months ago, global payment imbalances have only worsened. More disturbing still is the fact that they show every sign of further deteriorating. Indeed, the US external current account deficit is now running at an unprecedented 6.5 percent of GDP. And under the weight of a rising oil import bill and relatively rapid economic growth, this deficit could very well rise further to 7.5 percent of GDP by 2006.

As an important counterpart to the United States' growing payment imbalance, China's external current account surplus is set to almost double to 7 percent of GDP in 2005. Here too the outlook is for a further worsening in the period ahead. Mainly in reflection of slowing domestic demand, the Chinese current account surplus could very well approach 10 percent of GDP in 2006. In US dollar terms, China's current account surplus is now set to exceed the US$150 billion surplus presently being registered by Japan, which would make China the largest surplus country in the world.

Before beating up on China for its resistance to a more flexible exchange rate policy, Mr. Bush would do well to recognize that, while certainly a necessary condition for an improved United States payment position, a cheaper US dollar is only part of such a solution. Rather, Mr. Bush should recognize that what is equally important for any strengthening in the United States' external finances must be an improvement in its savings and investment balance.

In his talks with the Chinese, President Bush should own up to the idea that, not only are US households literally not saving, but that US government expenditures are out of control. He should also accept that the US government simply cannot expect to balance its budget if it insists on spending US$200 billion on a war in Iraq and US$150 billion on Katrina reconstruction, while at the same time engaging in a tax reduction program.

While recognizing that the United States must do more to improve its domestic savings performance, President Bush should not let China off the hook on the exchange rate issue. Rather, he should press hard that China should desist from foreign exchange market intervention and should allow its exchange rate to be determined more by market forces.

For a weaker dollar is needed if the United States is to shift more of its production towards exports and more of its demand away from imports as part of the solution to its balance of payments problem. And Chinese currency intervention has become a major obstacle towards a weaker dollar. It does so not only by keeping the Chinese currency from strengthening but it also inhibits other Asian currencies from strengthening for fear of losing market share to China.

In addressing the Chinese exchange rate issue, President Bush should not be taken in by the facile argument that the present trade setup with China is in the United States' long-term interest. For while it is true that at present China sends goods to the United States in exchange for pieces of US Treasury paper of dubious value, this situation certainly cannot go on forever.

At some point, the Chinese will find that the benefits that they derive from a cheap currency in terms of increased export jobs will be outweighed by the costs of accumulating ever-increasing amounts of United States Treasury paper and by the costs of foregoing ever-increasing amounts of domestic consumption. The longer that the present situation goes on, the larger will these imbalances become and the more painful and abrupt the eventual adjustment is likely to be. In this connection, it is sobering to recall that China's international reserves already exceed US$750 billion and they are growing at an annual rate of US$250 billion.

Should this line of reasoning fail to convince the Chinese that it is in their own interest to be more flexible on their currency, President Bush might remind them that Senator Chuck Schumer remains very much around. More to the point, he might remind them that Senator Schumer has strong support in the US Senate for his idea of a 27.5 percent import tariff on all Chinese imports should China fail to show soon real progress in addressing its large trade surplus. And while high import tariffs on China would hardly be in the United States' long-term interest, it would be the more export oriented and vulnerable Chinese economy that would be the real loser.

The author is Resident Fellow, American Enterprise Institute.


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