TCS Daily


A Slow Moving Chinese Train Wreck

By Desmond Lachman - August 7, 2007 12:00 AM

As US Treasury Secretary Hank Paulson ends yet another round of Strategic Economic Dialogue talks in Beijing with very little progress to show for his efforts, one cannot help feeling that one is watching a slowly unfolding Greek tragedy. For all the main protagonists of this drama play their parts seemingly oblivious to the very unhappy end towards which their actions are inexorably leading them. And they certainly pay no heed to the growing chorus of Cassandras warning of the grave dangers to the global trade system that lie ahead.

Among the leading protagonists in this drama are Chinese President Hu Jinato and Vice Premier Wu Yi, who represent the Chinese Communist Party in these talks. Filled with hubris, they never seem to tire of reminding Mr. Paulson of China's 5,000-year glorious imperial past. Nor do they tire of making it quite clear that a country of China's historic importance is not about to change its exchange rate policy under pressure from the United States, a relative newcomer on the international stage. Rather, they insist that the Chinese government will set its exchange rate policy exclusively in China's own national economic interest.

The Chinese also make it quite clear by their actions, if not by their words, that they view China's economic interest as that of maintaining an artificially undervalued exchange rate. They do so with a view to allowing China's exports to grow each year by a staggering 30 percent, which they see as the only realistic way that the Chinese economy can absorb the 10 million workers who leave the Chinese countryside for the cities each year.

For his part, Secretary Paulson consistently seems to allow hope to triumph over experience in maintaining his belief that China will revalue its currency on its own accord in an effort to reduce its ballooning trade surplus with the United States. He also never seems to tire of counseling Congress to be patient in its dealings with China on the exchange rate issue.

In adopting his softly-softly approach towards the Chinese, Mr. Paulson seems to ignore the fact that over the past two years China has egregiously failed to deliver on the promises that it made to the United States in June 2005 to become progressively more flexible on the exchange rate issue. Indeed, over the past two years, China has allowed only the minimum of appreciations of its currency against the depreciating US dollar, while on a trade-weighted basis China's currency is as grossly undervalued today as it was in June 2005.

While Mr. Paulson urges patience and while he steadfastly refuses to deem China a currency manipulator, China's trade surplus with the United States continues to grow like Topsy. In the first six months of 2007 alone, China's trade surplus with the United States swelled to a record US$112 billion, which was a full 85 percent greater than China's surplus in the same period of 2006.

True to script, the US Congress is adopting an increasingly confrontational stance towards China with the approach of the 2008 elections growing nearer every day. It does so knowing full well that China bashing is a sure vote getter at a time of increased economic insecurity. As the US economy slows under the weight of its severe housing market slump, external scapegoats like China always come in handy.

Seemingly forgetful of the disastrous consequences for global prosperity of the 1930 Smoot-Hawley Tariff Act, today Congress has before it no fewer than 60 proposals to do something about the Chinese trade surplus. More ominous still, last week the Senate Finance Committee approved a proposal that would require the US Treasury to impose anti-dumping duties on China should China persist in maintaining an undervalued exchange rate. And the Committee did so with a 20 to 1 majority, which should be seen by China as the clearest of warnings that Congress could very well approve veto-proof trade legislation that would be inimical to China's longer-term economic interest.

For its part, the International Monetary Fund, whose supposed role in this looming US-China showdown is that of acting as international umpire, also sticks unswervingly to script by maintaining a deafening silence on the Chinese exchange rate issue. Still smarting from its loss of credibility in Asia for its mishandling of the 1997 Asian currency crisis, the IMF lacks the backbone to declare that China's currency is grossly undervalued and to call upon China to do something about its undervalued currency.

There is of course always the chance that China blinks in time and takes substantive exchange rate action that might avert a breakdown in US-China trade relations. However, all the clues are currently pointing in the direction of China not budging from its present policy script. At a time of increased global financial market volatility, this is a great pity as it is certainly the last thing that the world economy now needs.


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25 Comments

I thought trade was supposed to be free
What part of "free" don't we understand? China is free to set its exchange rate anywhere it wants... while we are free to trade with them or not, as we please. We are no more free to meddle in their own internal fiscal policies than they are in ours.

So long as they are anxious to trade their items of cheap manufacture for our own handsome portraits of former presidents, I think we have a deal with willing partners on both sides.

Trade is never free
and the U.S. like China wants to manage its trade relationships with other nations. It's a universal characteristic of all great powers that they want to manage trade in their interests. The problem with China is that it is the first country the U.S. has encountered that cannot be bullied into adopting a program some U.S. legislators want.

All actions have consequences. China's artificially low exchange rate serves to depress the living standards of the population by paying them in a currency that is artificially devalued.

At least this author understands that protectionist measures such as tariff barriers would be an economic disaster. He can wail about China's policy, but at least he recognizes that the remedies some in Congress are proposing are a chalice full of hemlock.

Are you worried for your socialist buddies?
I don't understand why we should care what China does with its money.

If China wants to buy raw materials on the world market using its 'cheap' currency and sell the finished product to the world cheaply, who is losing but China?

The way to stop China
If the U.S. wants to curtail the trade deficit, they should ask the Fed to hike rates and raise the value of the dollar. Although China is pegged to the dollar, at a certain point imports from other countries become cheaper. Of course the trade deficit with other nations will increase, but not too much because the economy will be in recession.

The other option is to out compete the Chinese, by cutting taxes and regulations. Unfortunately, voters don't want to compete, they are looking for a free lunch.

Don't Trade with Countries that Point Nuclear Weapons at You
Is it smart to trade with a nation that points nuclear tipped missiles at us, and has twice threatened us with these weapons?

China takes their trading profits, builds nuclear missiles and points them at us. Do you really want to keep funding this?

Many people complain about what tariffs will do to our economy. Well, what will nuclear war do to our economy?

The dangerous game
I think the hope is the 1 billion people who prefer to trade with the west will somehow influence those handful of leaders who have their fingers on the buttons.

Pop Quiz: Name the Number One Trading Parter of America at the outbreak of WWI.
Answer: The Empire of Germany
(and everyone back then thought that WWI couldn't happend because the world's powers were too 'economically integrated' as well)

That'll show 'em
You offer your cure: "If the U.S. wants to curtail the trade deficit, they should ask the Fed to hike rates and raise the value of the dollar. Although China is pegged to the dollar, at a certain point imports from other countries become cheaper. Of course the trade deficit with other nations will increase, but not too much because the economy will be in recession."

Isn't that a little extreme, bringing on a recession in our own country to spite the Chinese for, what? selling us cheap stuff we want to buy?

I have to concur, it would have a damaging effect on them. Our industrial base would contract, many jobs would cease to be and we just wouldn't have enough cash on hand to afford to buy as many of those Chinese baubles.

Then when our pay scale collapsed to below-Chinese levels, we would again become competitive in the global marketplace. It's a master plan!

You're kidding, aren't you? This comment is intended to be ironic, and I'm just missing the humor. Right?

Wait a second. If we raise the value of the dollar... and China's cash assets are denominated in dollars... haven't we just made them a whole lot richer?

I think there was a bit more to WWI than that.
You point is way too simplistic.

Could have fooled me
Wait a second. I'm coming up with a different answer:

* Value of U.S. Exports for 1914:
1914 - $ 824.8 million to Allies

1914 - $ 169.3 million to Central Powers
—University of Albany History 101 Syllabus (Spring 1997), a link from the EDSITEment resource History Matters

http://edsitement.neh.gov/view_lesson_plan.asp?id=474

China's artificial exchange rate hurt the poor countries
It is unfortunate that the effect of an undervalued Chinese currency is discussed only from the angle of its trade surplus with the USA. The Chinese exports compete with goods that many of the poor countries in the world are also able to produce. Because these countries do not have the institutional stranglehold on their domestic economy, they are not able to manipulate their currencies. In effect, China is giving a huge subsidy to its exporters by not allowing the currency to find its natural level.

If China wants to take the benefit of international trade, it should follow the rules fully. Also, it has been established that it is in the interest of every country that it allows the currency to find the natural level. China is stuck in relatively low level technology items, because an undervalued currency encourages production of only those goods with a high local content. This discourages entreprenuers to move up the technological scale where there can be a good import content. They find it more profitable to be in their present business.

Ashok Chowgule, Goa, India

This is silly
Everyone knew that war among the European powers was imminent, had known it since the end of the Franco-Prussian War in 1870. Try reading Barbara Tuchman's The Proud Tower and the Guns of August. Lays out the entire inevitability of WW1.

More utter silliness
Nations trade with each other all the time, irrespective of how they may disagree on some issues. Pointing missiles at us? Exactly when? And were we pointing back? If they don't hold it against us, why should we hold it against them? You claim that they use profits to build missiles. Well, do we do the same thing? Are you building a case for other nations to morally refuse to trade with us?

More to the point, no one would accuse Winston Churchill of being a softie. On this kind of issue he noted "jaw, jaw, jaw is always better than war, war, war".

What part about
"the Smoot-Hawley Tariff Act was a disaster" do you not understand? Surely one global depression lasting a decade is enough of a lesson for everyone to understand that punitive protectionist measures are always an abject policy failure.

Indeed it does
China's low currency valuation indeed impacts on the competitiveness of other nations. It is indeed a subsidy of exporters. However, it boosts China's urban employment (rather necessary since they've got annual internal migration of 10 million/year) at the cost of lowered real wages in China. However, it also makes imports greatly more expensive. Over time that may be very costly to China, as it increases its import of raw materials and fossil fuels. The increase in cost of imported raw materials will over time weaken the advantage of China's low currency exchange policy.

Socialist Buddies
I sincerely hope you are capable of distinguishing between socialism and communist/capitalist hodgepodge in China.

We are basically financing the industrialization and modernization of China.

I also wonder how much of its raw materials China needs to purchase on the world market.

I wonder what leverage on the world market China will enjoy if current trends continue for another decade; and how the world market will react when Chinese currency is no longer undervalued.

What if we simply allowed the value of our currency to slip a little farther south?
Wouldn't this pressure China to adjust the relationship between it's currency and the dollar?

They may be dumb, but they're not stupid.
They aren't going to launch any nukes at us. They know that they will cease to exist if they do that.

They might bluster, but they'll never push the button.

Yup yup yup
The assassination of Ferdinand was merely a single match thrown upon poweder kegs covered in gasoline. And if it hadn't been that, there would have been another excuse found to go to war within the year.

The yuan is merely pegged to the dollar...what's artificial about that?...
The problems for the Chinese monetary authority would really start if they were to let the speculators at FOREX go crazy with their currency, at this time.

In the US we have purposefully allowed the dollar to stay flat against the strengthening yen and the euro. The Chinese have simply stayed flat with us. And they enforce that policy by buying dollars at FOREX (rather than by dumping their dollars as some of you seem to think.) It is actually the robust, predictable, buying power of the yuan that allows them to do that! Let FOREX create volatility in the yuan and China's fundamental strengths (and her economy) are at the mercy of speculative traders. No, no...no.

We manage our currency. Every Central Bank must manage its currency. That is the job of the monetary authority(forchrisake).

Would we not (should we not?) intervene in the currency market if we believed that the dollar was being traded by foreigners in such a manner that our own economy was being harmed? The yuan is openly pegged to the dollar. There is nothing artificial about that at all. You want the yuan to strenthen, then strengthen the dollar. Pretty simple.

The Chinese have decided to reflect all the revaluing (upward) of their income-producing assets (including labor rates) as inflation...and they have done a terrific job with that approach. If some of that pressure was relieved by allowing their currency to strengthen then the value of their domestic assets (including their wages) would not have risen along with their economic successes.

This inflation is genuinely Keynesian and it is healthy for China. We don't have anything to sell the Chinese anyway (to correct the balance of payments if the dollar was weaker against the yuan) because anything we have that we would allow them to own (consumer goods as opposed to weapons systems)...they already produce for us over there today. And then they make really good copies (of our brands) for their own consumption.

Don't you worry, though. When the Chinese are ready to start buying American, income-producing assets (in earnest) then they will indeed let their currency strengthen against the dollar, they will come over here and they will buy anything they want with cheap dollars.

If we won't let them do that directly then they will buy into global financial institutions that are perfectly able to own anything they want over here. That nightmare has already started and is coming to a company near you...sooner than you might think.

Then the members of Congress will be crying like little girls.

And the reason it was so brutal
was they went to war with what they had.

New machine guns and old tactics.

When you say
"Would we not (should we not?) intervene in the currency market if we believed that the dollar was being traded by foreigners in such a manner that our own economy was being harmed?"

This was tried in the 1970s, the so-called "dirty float". It was a fiscal disaster.

Trade war!
Now we see the logical consequence of the threat of erecting trade barriers. As of yesterday China has promised to retaliate in kind by cashing in their trillion dollars in T-bills. Who could have seen this coming?

Oh! For a president who had kept awake during his college history classes.

Isn't there a flaw in that approach?
Could you explain the logic to me by which a country growing rich through trade decides to start a nuclear war with its trading partner? I'm having trouble walking through the details.

Speaking of bluster...
Didn't Obama recently get himself into a patch of dog poo by saying he wouldn't introduce nukes to the battlefield in Afghanistan? Isn't the theme of our foreign policy now the self-awarded right to nuke anyone we consider to be an enemy, unilaterally?

When I try to think back to similar positions taken by China, nothing comes to mind.

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