China and America, The Odd Couple

It has become a tedious tradition for Westerners dealing with China to garnish their speeches with wisdom from the Chinese classics. Barack Obama, addressing Chinese and American leaders in July, used not just a banal quotation from Mencius, a Confucian sage, but a punchier one from Yao Ming, a Chinese basketball player: “No matter whether you are new or an old team member, you need time to adjust to one another.” Though it is 30 years since the two countries re-established diplomatic ties severed by the Communist takeover, both sides still badly need to adjust.

The heart of the problem is a profound uncertainty in both countries about where the relationship may lead. In many respects the two countries are in the same bed. Their economies have become interlocked, especially in the past decade. America is the world’s biggest debtor and China its biggest creditor. From climate change to the economic recovery, the world faces problems that demand China and America work in concert.

But before the argument commences, first some number as a slight comparison between those two countries:

China has the world’s largest foreign currency reserves. Though the chart says it is $1.9T, the more recent figure was $2.4 Trilllion at the end of December 2009.

The public debt as a percentage of GDP for the U.S. is more than double that of China at about 38%.

China’s total external debt is just $400B. China is the creditor nation while the U.S. is the debtor nation. Currently the gross external debt of the U.S. is a whopping $13.75 Trillion. According to the U.S. Office of the Treasury the majority of this debt is in the form of long-term bonds and notes.

Clearly the U.S. has long ways to go before it can eliminate the public debts to low levels and be become a creditor nation again.

The services sector forms about 80% major part of the U.S. economy whereas in China it is just 40%. Since the majority of the U.S. manufacturing was off-shored to developing countries, this sector accounts for just 19% of the U.S. economy. In China manufacturing accounts for 49% of the economy. A significant portion of the service sector economy in the U.S. was based in the FIRE (Finance, Insurance and Real Estate) industries, while China's economy is more based to manufacturing.

In the China-USA relation, China is being cast as the villain. One major issue is that China is controlling the exchange rate of the Yuan to USD and holfing it artificially low by buying as many US-Dollars as they need, which is why China is Americas biggest creditor. By buying this currency, China increases the amount of the Yuan on the market but decreases the presence of the USD, making the Yuan very low valued in comparison to the USD, thus being able to export more frequently, due to the buying power of the USD against the Yuan. By tying the Yuan closely to the dollar, China has been forced to hold its interest rates lower than is prudent: higher rates would attract more “hot money” from abroad, putting upward pressure on the currency. The real rate of interest paid on bank deposits is negative and lending rates are far too low for such a fast-growing economy. Cheap money results in excessive bank lending and poor investment decisions, which could lead to an increase in non-performing loans. Excessively low interest rates are also fuelling stockmarket and property bubbles. It is also stealing jobs and causing the United States to run a huge trade deficit. Beijing must therefore be forced to revalue the Yuan.

America's anger at China is clearly growing. It filed a complaint to the World Trade Organisation (WTO) against Chinese export subsidies. After due consideration, the Department of Commerce announced tariffs of 10-20% on glossy paper imported from China, to offset the impact of alleged government subsidies. This reversed a 23-year-old policy of not imposing countervailing duties on a non-market economy. Then, the Bush administration filed two more complaints: one on Chinese pirating of DVDs and CDs, and the other over restrictions on the sale of foreign films and music in China.

Although by themselves these actions are trivial, together they point to an increasing appetite for tougher action against China.

Congressmen complain that the so-called China-US Strategic Economic Dialogue (a series of high-level talks between the two countries) has so far failed to produce results. The recent deterioration in trade relations does not bode well for the next meeting, which is due very soon. Many commentators now reckon that Congress will inevitably pass some kind of China-bashing legislation later this year. A sharp economic slowdown in America as a result of the collapsing housing market would make this even more likely.

The infamous Schumer-Graham bill, which proposed a 27.5% tariff on all Chinese goods to offset the Yuan's alleged undervaluation, was withdrawn. But the two senators behind it are working with others on a new WTO-compatible version that could soon appear. Although the new bill is unlikely to include across-the-board tariffs, it could have sharp teeth.

Meanwhile, the target of all this hostility looms ever larger: China's trade surplus with America increased to $233 billion last year, accounting for almost 30% of America's total deficit. China's total current-account surplus reached an estimated $250 billion, or 9% of GDP, up from only 1% in 2001. In addition to that, in the first four months of 2007, its trade surplus jumped by 88% compared with the same period in 2006. If this trend continues in that manner, it will inevitably lead to an overheating of the Chinese economy, as has be mentioned before.

These are the arguments behind an increasingly protectionist mood in Washington. Yet they are largely flawed. If one regards these issues a bit more accurately one would find that a stronger Chinese currency would not much reduce America's trade deficit. Indeed, the irony is that China, not America, has more to gain from setting the Yuan free. Without a more flexible exchange rate, there is a growing risk that China's sizzling economy will boil over, or overheat, as is comes to be known. An overheating economy is an economy that tried to operate beyond its operational capacity, exchausting resources, labour and capital alike.

Furthermore, China officially abandoned its decade-long policy of pegging the Yuan to the dollar in July 2005. Since then it has risen by only 8% against the greenback. Because the dollar itself has weakened, the Yuan's trade-weighted exchange rate has barely budged. In real trade-weighted terms it is about 10% cheaper than at the dollar's peak in 2002. As a result, it is not just the usual protectionist suspects that demand action, but many mainstream American economists are now calling on China to revalue by 20% or more. Yet the standard arguments for a revaluation are based partly on a myth.

The 'myth' is that there is overwhelming evidence that the Yuan is grossly undervalued. China's large bilateral trade surplus with America proves nothing. It largely reflects Asia's changing supply chain. Much of what America buys from China today once came from Japan, South Korea and Taiwan. China now imports components from these countries, assembles them and exports the finished goods to America. Knock out these and America's bilateral deficit with China shrinks by more than half. Even so, China's overall current-account surplus is also huge. The surge in its foreign-exchange reserves, to over $1.2 trillion, also suggests that the Yuan is undervalued: without those massive purchases of dollars, the currency would have risen.

However, not all economists agree with those theories and disagree that the Yuan needs to be sharply revalued. At one extreme is Morris Goldstein, of the Peterson Institute for International Economics, who argues that the Yuan is undervalued by 40% or more against the dollar and should immediately be revalued by 10-15%. In the other corner many highly respected economists, including Robert Mundell, an economics Nobel prize-winner, and Ronald McKinnon, of Stanford University, strongly argue against a big appreciation of the Yuan.

Beijing's arguement also deny that the pegged exchange rates do harm to the USA. Many of the arguments used in Beijing for why a revaluation would endanger China's economy are equally suspect. For instance, the common claim that a big jump would seriously harm China's growth and employment contradicts the argument (also favoured by Beijing) that an appreciation would have little effect on China's trade surplus with America.

Or take another popular line of defence: it is often asserted that China cannot afford a more flexible exchange rate until its dodgy banking system is reformed and strengthened.

However, these arguments, not unlike the ones made the USA, are not flawless. Eswar Prasad, an economist at Cornell University, even says these argument has it completely backwards. The distortions caused by today's rigid exchange-rate regime may themselves be the biggest threat to Chinese financial stability. A sound banking system requires an independent monetary policy, which uses interest rates rather than blunt directives, to guide credit. And a country cannot control its monetary policy unless it accepts a more flexible exchange rate.

News that China's real GDP surged by a breathtaking 11.1% in the year to the first quarter and that consumer-price inflation had risen to 3.3% in March (it eased to 3% in April), stoked fears that the economy is out of control. But concerns about overheating in the usual sense of excess demand are exaggerated. China's widening current-account surplus and its strong investment imply excess supply. Excluding food, the inflation rate is only 0.9%. Instead, the real concern is that excess liquidity, as a result of the surge in foreign-exchange reserves and low interest rates, is flooding into shares. Households are withdrawing money from low-yielding bank accounts to bet on the stockmarket. China needs much higher interest rates to cool its asset markets. To regain control over its monetary policy China needs to let the Yuan rise.

A revaluation could also help the government succeed in shifting the balance of growth away from investment and net exports towards consumption. A stronger exchange rate would boost consumers' purchasing power, allowing them to buy more foreign goods. Excess saving in China is as much to blame for global imbalances as inadequate saving in America.

Most of the increase in saving has come from Chinese companies, which are earning record profits. But household saving is also kept high by the poor public provision of health, education and pensions. Partly as a result, consumption accounts for an unusually low share of GDP.

The good news is that the mix of growth is starting to become more balanced: over the past year, investment has slowed while retail sales have quickened, rising by 15.5% in the year to April. In other words, consumer spending is now growing faster than GDP. Dragonomics, a Beijing-based research firm, estimates that consumption rose from 37% to 40% of China's nominal GDP growth in 2006 and is set to rise again.

The stronger growth in Chinese consumer spending has got much less attention in America than the sharp increase in the country's trade surplus. The contribution of net exports to China's growth has increased so far this year. However, the near doubling of its trade surplus in the first four months of the year was probably a one-off, because firms brought forward their shipments so as to avoid an expected reduction in export-tax rebates. Exporters are also thought to be overstating their export revenues in order to dodge capital controls and bring in foreign money to invest in Chinese assets. If so, the trade surplus should stabilise in coming months.

In the long run, stronger domestic consumption could trim China's trade surplus. The government can encourage this by spending more. Its spending on health care and education rose by an average of 50% last year and it is budgeted to rise by more than 60% this year—but from such low levels that it could take years to increase social spending by enough to encourage households to save a lot less. Meanwhile, a stronger Yuan would help to rebalance the mix of China's growth.

World economists say that China has succumbed to hubris. It has mistaken the soft diplomacy of Barack Obama for weakness, mistaken the US credit crisis for decline, and mistaken its own mercantilist bubble for ascendancy. There are echoes of Anglo-German spats before the First World War, when Wilhelmine Berlin so badly misjudged the strategic balance of power and over-played its hand.

Within a month the US Treasury must rule whether China is a "currency manipulator", triggering sanctions under US law. This has been finessed before, but we are in a new world now with America's U6 unemployment at 16.8%.

Paul Krugman, this year's Nobel economist has the opinion that it's going to be really hard for the USA to fudge on the obvious fact that China is manipulating and that without a credible threat, they are not going to get anywhere.

China's premier Wen Jiabao is defiant. He does not think the Yuan is undervalued. He opposes countries pointing fingers at each other and even forcing a country to appreciate its currency. Once again he demanded that the US takes "concrete steps to reassure investors" over the safety of US assets.

Some say China has got more arrogant and tough. Some put forward the theory of China's so-called 'triumphalism', while others are convinced that the US, with its strong military power, has pursued hegemony in the world, trampling upon the sovereignty of other countries and trespassing their human rights. At a time when the world is suffering a serious human rights disaster caused by the US subprime crisis-induced global financial crisis, the US government revels in accusing other countries.

I let others discuss the rights and wrongs of this, itself a response to the US report card on China. Clearly, Beijing is in denial about is own part in the global imbalances behind the credit crisis, specifically by running structural trade surpluses, and driving down long rates through dollar and euro bond purchases. No doubt the West has made a hash of things, but the Chinese view of events is twisted to the point of delusional.

In Copenhagen, Wen Jiabao sent an underling to negotiate with Obama in what was intended to be - and taken to be - a humiliation. The US President put his foot down, saying that he does “not want to mess around with this anymore“. That sums up White House feelings towards China today.

We have talked ourselves into believing that China is already a hyper-power. It may become one: it is not one yet. China is ringed by states - Japan, Korea, Vietnam, India - that are American allies when push comes to shove. It faces a prickly Russia on its 4,000km border, where Chinese migrants are itching for Lebensraum across the Amur. Emerging Asia, Brazil, Egypt and Europe are all irked by China's Yuan-rigged export dumping.

Michael Pettis from Beijing University argues that China's reserves of $2.4 trillion - arguably $3 trillion - are a sign of weakness, not strength. Only twice before in modern history has a country amassed such a stash equal to 5%-6% of global GDP: the US in the 1920s, and Japan in the 1980s. Each time preceeded depression.

The reserves cannot be used internally to support China's economy. They are dead weight, beyond any level needed for macro-credibility. Indeed, they are the ultimate indictment of China's dysfunctional strategy, which is to buy $30bn to $40bn of foreign bonds every month to hold down the Yuan, refusing to let the economy adjust to trade realities. The result is over-investment in plant, flooding the world with goods at wafer-thin export margins. China's over-capacity in steel is now greater than Europe's output.

This is catching up with China, in any case. Professor Victor Shuh from Northerwestern University warns that the 8,000 financing vehicles used by China's local governments to stretch credit limits have built up debts and commitments of $3.5 trillion, mostly linked to infrastructure. He says the banks may require a bail-out nearing half a trillion dollars.

As America's creditor - owner of some $1.4 trillion of US Treasuries, agency bonds, and US instruments - China can exert leverage. But this is not what it seems. If the Politburo deploys its illusiory power, Washington can pull the plug on China's export economy instantly by shutting markets. Who holds whom to ransom?

Any attempt to retaliate by triggering a US bond crisis would rebound against China, and could be stopped - in extremis - by capital controls. Roosevelt changed the rules in 1933. Such things happen. The China-US relationship is no doubt symbiotic, but a clash would not be "mutual assured destruction", as often claimed. Washington would win.

Barack Obama has never exalted free trade. This orthodoxy is, in any case, under threat in the West. His top economic adviser Larry Summers let drop in Davos that free-trade arguments no longer hold when dealing with "mercantilist" powers. Adam Smith recognized this too, despite efforts by free-trade ultras to appropriate him for their cause.

China's trasformation has been remarkable since Deng Xiaoping unleashed capitalism, but as ex-diplomat George Walden writes in China: a Wolf in the World? you cannot feel at ease with a regime that still covers up Mao's murderous nihilism. He reminds us too that China has never forgiven the humilations inflicted by the West when the two civilizations collided in the 19th Century, and intends to exact revenge. Handle with care.

So as one can see, the argument of whether it is beneficial or hazardous to peg the Yuan is largely depending on the point of view. While one can say that the arguments of one party, say the USA, are correct, another can and will counter-proof them. And while both parties are right in a way, it is not quite possible to make out who is right of wrong in this argument, as it is more complicated than a simple matter of black and white. Nevertheless, if one is solely to focus on the fact, it is true that China's interference with the exchange rate is driving the USA into a greater trade deficit and even may have helped the global crisis, as it partly originated in and was exacerbated by the USA and their currency. It is also fact that China's economy is overheating and a revaluation could save the economy from spiralling out of all control. But the USA will hardly benefit from that, as they formed a dependence to China's export and thus will continue to import, no matter the exchange rate. This is not a problem that can be handled in the short-run. It took decades to reach this point and it will take no less to correct it.

The struggle itself, however, is less the economic state but rather the inherited rivalry between those two countries. Like a couple, they argue on and on, but in the end, they come together again with apologies just in time to be begin a new argument. An odd couple indeed.

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