The Coming Trade War

Henry C.K. Liu

Part I:   The Coming Trade War and Global Depression
Part II:  Dollar Hegemony Against Sovereign Credit
Part III: Trade in the Age of Overcapacity
Part IV: Scarcity Economics and Overcapacity
Part V: 
Trade Related Aspects of Intellectual Property Rights (TRIPS)

Part VI: Trade Wars Can Lead to Shooting Wars

This article appeared in AToL on  August 20, 2005

Within US policy circles, the rapid rise of China as a major force in the global economy is provoking a reconsideration of whether free trade is still in the US national interest. The prospect that China can be a major economic power is feeding wide-spread paranoia in the US.  The fear is that developing nations led by China and India may out-compete the advanced nations for high-tech jobs while keeping the low-skill, labor-intensive manufacturing jobs they already won. China already is the world's biggest producer and exporter of consumer electronics and it is a matter of time before it becomes a major player in auto exports. Shipbuilding is now dominated by China and aircraft manufacturing will follow. The US Navy is now dependant on Asia, and eventually China, to build its new ships and eventually the economics of trade will force the US Air Force to procure planes made in Asia and assembled in China.

The fear of China by the US dates back to almost two centuries of racial prejudice, ever since Western imperialism invaded Asia beginning in early 19th century.  Notwithstanding that it is natural, ceteris paribus, that the country with the world’s largest population, an ancient culture and long history would again be a big player in the world economy as it modernizes, the fear that China might soon gain advantages of labor, capital and even technology that would allow it to dominate the world economy and gain the strategic advantages that go along with such domination, is enough to push the world’s only superpower to openly contemplate preemptive strikes against it. Furthermore, Chinese culture commands close affinity with the population in Asia, the main concentration of the world’s population and a revived focal point of global geopolitics. Suddenly, socio-economic Darwinism of survival of the fittest, celebrated in the US since its founding, is no longer welcome by US policymakers when the US is no longer the fittest and the survival of US hegemony is at stake.  To many in the US, particularly the militant neo-conservatives, international trends of socio-economic Darwinism now need to be stopped by war.

China has more than 1.3 billion people, a fifth of the world’s population, and a work force of 700 million as against a US work force of 147 million. To avoid being over taken by China in aggregate national income, US wages would have to maintain a gap of five times over Chinese wages. Historically-based technological and economic advantages currently give US workers a nominal wage gap of over 35 to 1 over Chinese workers, or 9 to 1 on purchasing power parity (PPP) basis. This comfortable gap is not based on current productive differentials but rather on unbalanced terms of trade and geopolitical incongruity left by history. Yet until wage parity is attained, free trade will continue to be driven by cross-border wage arbitrage in favor of China.  But with wage parity, the Chinese economy will be five times the size of the US economy, a prospect not welcomed by the US geopolitical calculations. It was the superior US economy that enabled the US to emerge as victor in the two world wars and to prevail in the Cold War.

The US is waking up from its self delusion about free trade to the reality that free trade never leads to balanced trade.  Free trade always works against the weaker trading partner even with the principle of comparative advantage. The British promoted free trade when it’s economy was the strongest in the world.  Friedrich List, in his National System of Political Econ (1841), asserts that political economy as espoused in England, far from being a valid science universally, was merely British national opinion, suited only to English historical conditions. List’s institutional school of economics asserts that the doctrine of free trade was devised to keep England rich and powerful at the expense of its trading partners and it must be fought with protective tariffs and other protective devises of economic nationalism by the weaker countries. Henry Clay’s "American system" was a national system of political economy.

The US was happy to promote free trade when unbalanced trade was in favor of the stronger US economy. Balanced trade between unequal partners requires managed trade at the expense of the stronger partner, which is achieved by the weaker economy resorting to government interference on free trade for more favorable terms of trade.  Such government interference is driven by the politics of trade.  When managed trade is conducted against the weaker partner, it is economic imperialism.  When it is conducted against the stronger partner, it is known as leveling the playing field.  Yet some in the US are engaging in New Speak when they seek the perpetuation of economic imperialism by demanding a leveling of the playing field in trade with weak, less-developed economies.

As poor nations press the WTO to stop unfair US farm subsidy, US cotton growers try to defuse the mounting pressure by offering help to growers in poor nations. The US government spends $4.5 billion annually in subsidy on a cotton crop with a market price of $5.9 billion, which otherwise must be priced more than double in the world market. This subsidy enables US growers to profitably export three quarters of their output and control 40% of world trade in cotton. What the US lost in textile manufacturing, it gains back in subsidized cotton export, high returns on investment in overseas textile mills and low consumer prices in cotton goods. Thus the current tariff war against Chinese textile is merely the US wanting its cake and eating it too. While $4.5 billion is a merely pittance in the $2.4 trillion 2005 US fiscal budget, the subsidy has the effect of ruining the economy of the world’s poorest nations.

The National Cotton Council, a powerful trade group in US domestic politics, while basking in the happy situation of seeing US cotton export increase by 350% between 1999 and 2004, from 4 million 480-pound bales to 14 million bales, explains that the goal of helping African growers is “not to make Africa a big cotton producer,” only to make the miserable lives of poor Africans “a little better.”  It is a strategy of protecting managed trade with welfare trade.  On the other hand, simply doubling the market price of cotton will not help African growers, whose competitive disadvantages go beyond market price, and cannot be eliminated without fundamental changes in the terms of global agriculture trade.

While China’s economy has grown by over 9% annually for the last couple of decades and its GDP had soared from $147 billion in 1978 to $1.6 trillion in 2004, the US GDP, $11.75 trillion in 2004, was still far ahead by 7.4 times over that of China.  Because of the difference in population size, US 2005 per capita GDP is $41,917 while that of China is only $1,411, a gap of almost 30 times. The US ranks 8th in the world in per capita GDP while China ranks 111th.  In 2004, US per capita income was $35,400 while that of China was $960, a 36.8 times gap.  The per capita income gap between the two economies, while closing at a dramatic rate, is still substantial. Despite such wide per capita income disparity, the US is apprehensive because it is this disparity that drains jobs from the US. While the narrowing of the wage disparity will slow the job drain to China, the resultant rise in Chinese aggregate national wealth will threaten US economic dominance in the world. In a neo-liberal free trade regime, the US has a choice of losing jobs or losing economic dominance and geopolitical power to China.  That is the key dilemma in US economic policy towards China.

There is an economic basis behind US antagonistic militancy towards China. The US won both previous world wars primarily by its war-time productive power.  This fact has not been forgotten by US policy-planners. While US manufacturing base has been seriously eroded by neo-liberal global trade in the last two decades, the prospect of a shooting war with China will relocate much of the lost manufacturing back to the US in short order.  In 1942, only weeks after Japanese attack on Pearl Harbor, President Roosevelt called for an annual production of 60,000 military planes, a near impossible demand considering that prewar annual production was only 6,000. But in 1943, some 86,000 planes were produced, exceeding the president’s call by a third. In World War II, the US produced 31,000 B17 and B24 long-range bombers to support strategic bombing, reaching a peak production rate of 50 per day.  In 1941, 55,000 individual work hours were needed to turn out a B-17, and by 1944, this had dropped to 19,000 hours. Strategic bombing crippled German war production from ball bearings production to oil refineries for critically needed gasoline. The shortage of gasoline stalled German resistance in both the Eastern and Western fronts and crippled the Luftwaffe. Also, the time it took for an aircraft carrier to be built in the US dropped from 36 months in 1941, to 15 months in 1945. In all, 300,000 military planes were produced in four years of war. Because of the production prowess of the US, Germany and Japan simply could not produce enough weaponry fast enough to keep up with battle attrition the way the Allies could. It was only a matter of time before the Axis powers would be defeated.  A market economy is a feeble weakling compared to a war command economy. That a war in Asia will relocate manufacturing jobs back to the US in large scale to get the US economy moving again must have occurred to the neo-con warriors who have been controlling US policy since 2000.  The hawks in this group are betting on the gamble that China’s nuclear deterrence against attacks from the US can be neutralized by US strategic defense initiative (SDI), and that the US mainland will again be safe from attack.

Notwithstanding irrational paranoia from US militarists, the fear of China by the US is not fundamentally based on military threat, albeit it has a military dimension. Henry Kissinger, arguably the greatest living master of geo-realpolitik, wrote on June 13 in the Washington Post: “Military imperialism is not the Chinese style. Clausewitz, the leading Western strategic theoretician, addresses the preparation and conduct of a central battle. Sun Tzu, his Chinese counterpart, focuses on the psychological weakening of the adversary. China seeks its objectives by careful study, patience and the accumulation of nuances -- only rarely does China risk a winner-take-all showdown.”

US fear of China is a reaction to the destabilizing effect on existing, established geo-economics from the natural rise in economic power of a modernizing nation with a large population. It was this natural advantage of a large population that permitted the US and the USSR to exploit geopolitical opportunities to capitulate themselves into superpowers status after WWII. The British Empire was first and foremost a quest for population, and the wealth associated with it, albeit without the benefit of equality, the lack of which became the central weakness that deprived the empire of longevity. The lack of equality within the USSR was the main cause of its dissolution, not perverted communist doctrine. The large aggregate population of the EU is now driving its new economic aspirations. Japan will never be a contender for superpower status because of its small population and its exclusionary national culture.

Immigration is the fountainhead of economic development and sustained prosperity.  The developmental history of the US is one of immigration. The US owed its economic rise to immigration. Throughout Chinese history, immigration from distant lands and foreign cultures enriched Chinese civilization and contributed to long periods of prosperity. Germany benefited greatly from the immigration of Jews and lost much from Nazi prosecution of its Jewish citizens.  The current anti-immigration phobia in the US and in the EU will put self-inflicted roadblocks in the path of these economies toward a new age of prosperity.

But the history of the US in its process in becoming an economic superpower is instructive.  As a prosperous, internationally-engaged US evolved into a huge open market for the world’s developing economies, so will a prosperous, internationally engaged China. China, similar to historical US experience, will go through several series of historic policy debates over the choice between isolationism and international engagement as its economy develops. Developing countries should not misconstrue isolationism as an effective strategy of anti-imperialism. Quarantine is a strategy that deprives the subject of any chance of developing effective immunity against invading viruses that eventually exposes it to more serious vulnerability.  Yet US policy on China will impact the outcome of China’s policy debates with serious consequences.  Hostility breeds counter hostility and protectionism breeds counter protectionism. Isolation between hostile nations leads inevitably to war.

Kissinger went on in the same article: “With respect to the overall balance, China’s large and educated population, its vast markets, its growing role in the world economy and global financial system foreshadow an increasing capacity to pose an array of incentives and risks, the currency of international influence. Short of seeking to destroy China as a functioning entity, however, this capacity is inherent in the global economic and financial processes that the United States has been preeminent in fostering.”

A China forced defensively by hostile US policy into isolationism, a recurring tendency throughout its long history, ironically would lead to regional decline and instability that would quickly turn global in this interconnected world. 
The decline of China that began in early 19th century was traceable in part to Chinese self-imposed isolationism, in contrast to Japan’s forced opening to the then more technologically advanced West that led to the Meiji Reformation. The modern history of China might have been totally different if Chinese isolationism had not prevailed in Chinese politics in the early 1800s, and modernization had been allowed to proceed with needed stimulation from mutually beneficial contacts with the West before Western imperialism had a chance to take shape.

An internationally-engaged China will be a positive force for world peace and prosperity. As the enormous China market becomes reality from rising income, it will impact traditional international economic relations to restructure residual prejudicial racial enmity and Cold War geopolitical alliances and give rise to a new mode of world order free of residual racial phobia and obsolete ideological conflicts. 

US hostility and pre-emptive strategy toward a peacefully-rising China may be forced to fall back on ineffective US unilateralism, devoid of willing partners even from among its residual Cold War allies.  Trade protectionism will lead to US isolationism, a movement with a significant past in US history. Yet, as a superpower, the US cannot isolate itself from the rest of the world without severe penalties. Or to put it another way, the cost of US isolationism is the forfeiture of US superpower status.

Kissinger observed correctly in the same recent article that “in a US confrontation with China, the vast majority of nations will seek to avoid choosing sides.” Already, normally dependable US allies such as the UK, the EU (particularly France and Germany), Japan, Australia and even Israel, are experiencing rising conflicts with US policy on China.  These nations are beginning to see US demands for unquestioning support of its hostile policy on China as not being congruent with their separate national interests. Everywhere else in the world, from Asia to Latin America, from the Middle East to Africa, sympathy for China’s effort to regain its natural prominence in the world and positive response to its effective development strategy are mounting while appreciation for unilateral US security and economic policies is falling.  While the US is still a juggernaut in its coercive ability to commandeer much of the world’s wealth, its ability to produce wealth appears to have visibly declined. It is becoming increasingly obvious to some in Washington that a military option is the answer to arresting US economic decline that threatens US superpower status.

Eleven of the 16 countries surveyed in June 2005 by the US-based Pew Research Center: Britain, France, Germany, Spain, the Netherlands, Russia, Turkey, Pakistan, Lebanon, Jordan and Indonesia, had a more favorable view of China than of the US. The survey on global attitude finds that while China is well-regarded in both Europe and Asia, its burgeoning economic power elicits mixed reactions. Majorities or pluralities in France and Spain believe that China's growing economy has a negative impact on their own economies. Respondents in the Netherlands and Great Britain, traditionally free trade nations, have much more positive reactions to China's economic growth. Public opinion in the US on this issue is divided; ­ 49% view China’s economic emergence as a good thing, while 40% say it has a negative impact on the US. Whatever their views on China's increasing economic power, European publics are opposed to the idea of China becoming a military rival to the US, despite their deep reservations over US policies and hegemony. Solid majorities in every European nation ­ except Turkey regard China’s emergence as a military superpower as undesirable. In Turkey and most other predominantly Muslim countries, where antagonism toward the US runs much deeper at this time in history, most people think a Chinese challenge to US military power would be a good thing.

Nonetheless, there is considerable support across every country surveyed, other than the US, for some other country or group of countries to rival the US militarily. In France, 85% of respondents believe it would be good if the EU or another country emerged as a military rival to the US. Most Western Europeans want their countries to take a more independent approach from the US on diplomatic and security affairs than it has in the past. The European desire for greater autonomy from the US is increasingly shared by the Canadian public; 57% of Canadians favor Canada taking a more independent approach from the US, up from 43% two years ago. The US public, by contrast, increasingly favors closer ties with US allies in Western Europe, a continuation of traditional US Eurocentric attitude, while the center of world affairs is shifting toward Asia.

China’s Dilemma: Growth and Equality

Chinese President Hu Jintao laid out China’s economic goals through 2020 in a May 16, 2005 address in Beijing. He vowed to quadruple to $4 trillion the nation’s 2000 GDP of $1 trillion.  This would still be only about one-third the size of the US economy in 2005, which itself will surely grow significantly by 2020.  Even if China’s economy quadruples, the average Chinese will remain poor. If China succeeds in her goal, per capita income would rise only to $3,000. In contrast, US per capita income was $40,100 in 2004. Thus all the talk of China overtaking the US in the near future is misleading.

Yet China is paying a heavy social price for fast GDP growth. A recent survey by China’s National Bureau of Statistics found that earners in the highest-income bracket in cities earned 11.8 times more than those at the low end of the scale in the first quarter of 2005.  The figures were 4.16 times in 1996 and 5.7 times in 2000. Statistics from the Ministry of Labor and Social Security also indicate that the richest 10% of households own 45% of private urban wealth. The poorest 10% of urban households have less than 1.4% of the private wealth in Chinese cities. Urban poverty has been increasing since the mid-1990s although the Chinese Government has been more successful in reducing rural poverty. Urban poverty is concentrated in three groups: the disabled and elderly without family, the unemployed and migrant workers. Given the absence of a sound social security system in the country’s move toward socialist market economy, the rich-poor gap among Chinese urbanites may become threatening to social stability. Popular resentment towards the rich is approaching seismic dimensions, unlike in the US where the rich enjoy the enviable status of adored celebrities. The business newspaper, China Daily, identified “government policies as mainly to blame for their failure to ensure equal opportunity and fair wealth distribution and to give enough help on a timely basis to the urban needy.”

To the government’s credit, Premier Wen Jiabao in a press conference on March 14, 2005 referred to Nobel laureate economist Theodore Schultz (1979) who maintained that rural poverty in poor countries persists because government policy in those countries is biased in favor of urban residents at the expense of rural dwellers. Schultz visits to farms and interviews of farmers led to new ideas, such as human capital (Investment in Human Capital, American Economic Review 51 - March 1961). “So if we knew the economics of the poor, we would know much of the economics that really matter. Most of the world's poor people earn their living from agriculture. So if we knew the economics of agriculture, we would know much of the economics of being poor,” said the premier.  Yet free trade prevents government subsidy to agriculture. China Daily suggested that the government should also be concerned with the urban poor.  This disparity of wealth naturally accompanies market liberalization and deregulation in all economies. For the Chinese economy to remain a socialist market economy, income and wealth disparity is the biggest obstacle that must be tackled as a top priority.  Socialism does not reject wealth, only the mal-distribution of it.

US Rethinks China Trade Policy

For a decade now, debate in US policy circles has swirled over whether China - a “socialist market economy” according to its constitution - is a strategic partner, a strategic competitor or a rising military rival. What makes China unacceptable to the US is that it is a communist country, albeit the neo-communism being put in place in China is increasingly free of authoritarian effects of a garrison mentality that has resulted from US hostility and containment during the Cold War.  Neo-communism in China is largely a strategic response to and the resultant consequence of expanding global neo-liberalism. Yet while the policy debate between orthodox communism and neo-communism has yet to be definitively settled in China, free trade and market fundamentalism are under reconsideration in US policy circles. If neo-liberalism should fail and the global trading system freezes, the future of Chinese neo-communism will also be put in jeopardy.  Thus US isolationism is the unwitting ally of Chinese orthodox communism.

Paul Samuelson, a Nobel laureate economist, famed author of the standard economics textbook and an ardent supporter of free trade, in an article in the Journal of Economic Perspectives (2004) suggested that China’s growing economic might calls into question whether free trade is a win-win game for the US.  Samuelson said open trade helped the US economy grow since World War II, but that competition from abroad drove down wages in lower-skill jobs. Over time, China and India could displace US high-tech jobs as well and more US wages could be forced further down to sustain competitiveness. Even though US consumers get cheaper Chinese-made goods, many US citizens could be net losers from such trade, Samuelson wrote. Consumer gains from lower prices are offset by worker income losses. If globalization causes enough US citizens to suffer lower wages, the US as a whole loses. “It is going to become so big a problem that some slowing down is going to be politically popular - and has some merits,” says Samuelson, who estimates that from World War II to the early 1980s, increased trade with a revived Europe and the Pacific Basin accounted for 30% of the rise in the standard of living in the US, as a result of the law of comparative advantage.

But Samuelson expects the US to gain less from trade, outsourcing, investment, and other aspects of globalization in the coming 30 years, possibly even lose out on a net basis. In such case, a minority of the US population would gain, but more would suffer lower living standards. “The general dogma that anything that expands globalization is good for everyone isn't right,” Samuelson says. And as all political scientists know, when the majority loses, the politics turns ugly in a democracy.  Even for free-trade guru Samuelson, free trade in a global market economy is only desirable if its serves US national interest. When it does not, free trade needs to be replaced by managed trade, directed by a domestic command economy.

One difference between free trade then, when it was good for the US, and now is that greater inequality has become institutionalized in the US, Samuelson argues. Neither the political establishment nor the electorate is any longer willing to spread around the benefits of freer trade to help those in the US hurt by globalization, as they did in the aftermath of the Great Depression after World War II, through a progressive tax structure, government social spending, and transfer payments. Those harmed are usually at the lower end of the income and wealth ladder. This is true of individuals within the US as well as those in other trading nations. Free trade has worsened the fair distribution of income for the working class and emasculated the ability trade unions to command pricing power for labor, while the more educated professional classes, particularly those in management and finance, have gotten most of the financial gain.  Warren Buffet, one of the most successful investing capitalists in the world, has also been saying that the current US tax regime favors the rich unfairly. Inequality of wealth and disparity of income during the 1920s, coupled with easy credit to fuel a speculative debt bubble, led to the 1929 stock market crash. But it was the resultant pain that disproportionately fell on the unemployed and the working poor that led to the politics of protectionism that prolonged the Great Depression. A repeat of similar economic-political dynamics seems to be evolving in the first decade of the 21st century in the US.

Political philosophers in the past worried that in a democracy, lower-income classes would elect politicians who would confiscate much of the riches of the wealthy. Proponents of democracy then guard against this tendency by promoting the concept of minority rights. The US version of representative democracy has turned that worry on its head. The cost of getting a representative elected in a US election has escalated so much that the rich minority has been able to protect and enhance its interests through campaign contributions to sympathetic if not captured politicians.

Trade was kept from emerging as an important issue in the 2004 presidential campaign. The Bush administration had taken protective measures during its first term in areas where key political constituencies faced competitive pressures, such as steel, agriculture, and lumber, but the president remained solidly a free trader. The AFL-CIO has been pushing for trade with the poor nations to be “fair,” by forcing them to adopt of international labor and environmental standards. Fair trade has become the slogan for both labor and conservatives, but the practical effect of fair trade as defined by US labor would be no trade, as the poor country are not allowed any pricing power, particularly in wages and environmental protection, by the unfair and unequal terms of trade set by their more powerful trading partners in the on-going trade regime.

The labor movement in the US has been the main victim of neo-liberal global trade.  Union membership has fallen from 31.8% of the workforce in 1948 to 12.5% in 2004.  Unions have been increasingly ineffective in protecting worker interests as US domestic politics turns conservative in favor of management.  Yet US labor had been in the forefront in the support for US global anti-communist policy and was among the most fervent supporters of every unpopular war, from Vietnam to Iraq, wars waged to lay the ground for a world of neo-liberalism that eventually came to undermine the economic interests of US labor.  Traditionally, union pay and benefits helped lift even non-union worker pay as employers had to match or better union pay scale to keep employees from joining unions. While union membership of government workers increased from 25% in 1975 to 36% in 2004, the total number of government workers has been declining as a direct result of anti-big-government trends since the Reagan era.

Membership in the private sector where most of the jobs are, union membership has dropped from 21.5% in 1975 to 8% in 2004. The industries that have the largest declines are: manufacturing (from 36% in 1975 to 13% in 2004); transportation (from 47% in 1975 to 27% in 2004); and construction (from 35% in 1975 to 16% in 2004).  Manufacturing workers unions suffer from both sector-wide aggregate job loss and a drastic drop in membership percentage of the remaining work force, as the first waves of outsourcing were concentrated in union plants where labor cost was highest. While wage arbitrage has been the driving force behind the decline of labor unions, the US bankruptcy regime had been the legal venue for the wholesale abrogation of labor contracts and employee pension obligations.

The growing disparity of income in the US translates into low pay for place-related service jobs that cannot be outsourced.  Yet the disproportionate concentration of women, minorities, new immigrants, both legal and illegal, in these jobs presents opportunities for union organization.  The emergence of large employers such as Wal-Mart, Home Depot, FedEx, major national cleaning and telecommunication companies, and labor-intensive food packaging companies such as Tyson, presents identifiable organizing targets.  There is a trend in union strategy to shift from improving the pricing power of labor in vibrant sectors of the economy, to resistance against inhumane oppression in a structurally unfair economy. This trend will move the labor movement increasing out of progressive economics into radical political confrontation.  The first signs of such a shift came from the withdrawal from the AFL-CIO by the service workers union and the Teamsters on July 16, at the opening of its annual convention in Chicago, followed by the United Food and Commercial workers and United Here which represents hotel, restaurant and apparel workers.  These dissident unions aim to cooperate with other unions of laborers, farm workers and carpenters to develop multi-union drives against Cintas, the big nation-wide laundry company, as well as Wal-Mart and FedEx.

In the 2004 presidential campaign, Democratic challenger John Kerry was careful not to disappoint US organized labor, traditionally a key political constituent. But labor is a captured constituent for the Democrats, with no alternative champions in US politics.  In a tight race, the strategy was to woe the undecided who otherwise would vote for the opponent. The opposing presidential candidates of both political parties proclaimed support for trade liberalization, while they make protectionist concessions separately to their traditional constituents for purely tactical reasons of election politics rather than as strategic reforms in national trade policy, with Bush favoring big business such as steel and Kerry opposing outsourcing. Samuelson of course warns that just because free trade sometimes hurts does not mean that trade barriers in the form of tariffs can help. Most efforts at protectionism are self-defeating, Samuelson says. Nonetheless, a slowdown in globalization might be “more comfortable,” allows the guru of free trade.

Many politicians whose own fates are dependent on voter sentiments, are less sanguine. Liberal Senator Charles Schumer (D - New York), and Conservative Senator Lindsey Graham (R - South Carolina), with broad-based bi-partisan support reflective of popular sentiment, introduced the China Currency Bill (S. 295) in April 2005, calling for 27.5% tariffs on all Chinese products sold in the US if China does not revalue its currency by 27.5% within 180 days of the passage of the bill.  The bill was “attached” as an amendment to the Foreign Affairs Authorization Act (S. 600) -- the umbrella legislative authority for the $34 billion foreign aid program.  The pro-free-trade Senate leadership attempted to have the amendment struck down, but was defeated by an overwhelming margin of 67-33.
After that, Senator Schumer agreed to withdraw his amendment only with the quid pro quo compromise of being allowed to hold a full-blown Senate Finance Committee hearing on the Chinese currency issue and the guarantee of a vote on S. 295 before the end of this summer. Similar bi-partisan legislation was also introduced in the US House of Representatives by Reps. Duncan Hunter (R - CA) and Tim Ryan (D - OH).

In the past decade, Chinese exports have increased 6.5 times, from US$91.7 billion in 1993 to US$593.4 billion in 2004.  Yet 62% of that increase has been driven by foreign direct investment as offshore Chinese outposts of foreign companies and investors from the US, Europe, Japan and elsewhere in Asia. For every dollar China retains as a trade surplus, another $4 goes to returns on foreign investment.  And even that dollar goes to the Chinese central bank to buy US Treasuries to finance the US debt economy, and cannot be spent inside China. This is why economists say Chinese GDP growth is supporting the global economy, which is dominated by the dollar economy.

China is significant not only because it is the most populous nation with the fastest growing economy, but also because it is one of the poorest and thus has much prospect and room for basic growth. Blessed with a long history of a rich culture, the economic revival of China can proceed at lightning speed and bring with it a new world of plentitude. The whole world now wants to trade and interact with the Chinese economy because under the current trade regime, trade with China benefits the foreign trading partners more than its does China itself.

It does not matter what the exchange rate of the Chinese currency is; China is totally free to set the exchange rate as long as trade is ultimately denominated in Chinese currency and Chinese prices are competitively adjusted according to the exchange value of the Chinese currency, even if the dollar remains the world’s main reserve currency for global trade. The question of the exchange value of the Chinese yuan in relation to the US dollar is a minor technical issue within the peculiar regime of dollar hegemony. It has no fundamental macroeconomic significance.  The day will come when this technical issue will become mute, when the Chinese yuan will naturally become a reserve currency for trade, reflecting the reality of changing global trade patterns.

As the attempt of a Chinese state owned oil company to merge with US-based Unocal Corporation fanned protectionist passions in the US Congress, Federal Reserve Chairman Alan Greenspan warned senators in public testimony not to let their misguided frustrations with China’s economic policies breed reactions that would do the US economy more harm than good. What is not generally recognized is the fact that Chinese monetary and trade policies are defensively driven by US policy. Proposed tariffs against Chinese goods and other forms of protectionism would significantly lower US living standards and would not save jobs in the US, Greenspan told members of the Senate Finance Committee.

Greenspan testified that he was “aware of no credible evidence” that revaluing the Chinese currency “would significantly increase manufacturing activity and jobs” in the US.  Many of the goods sold in the U.S. with a “Made in China” label are merely assembled in China from parts made elsewhere in Asia. If the yuan, and therefore Chinese labor, were more expensive in dollar terms, those goods would be assembled elsewhere in Asia, at no net benefit to the US, Greenspan said.  He said that Senator Schumer’s proposed tariffs on Chinese goods “would significantly lower US imports from China but would comparably raise US imports from other low-cost sources of supply in Asia and perhaps Latin America as well. Few, if any, jobs in the US would be protected. In this respect, CAFTA (Central America Free Trade Agreement) is linked to the China trade issue.

Greenspan credited the relatively free flow of goods and services across national borders with enabling the global prosperity of the last six decades. “A return to protectionism would threaten the continuation of much of the extraordinary growth in living standards worldwide, but especially in the United States, that is due importantly to the post-World War II opening of global markets,” he said.  For lawmakers worried about US job losses, Greenspan recommended that they bolster job retraining programs and improve education in middle and high schools.  Nevertheless, Congress introduced political obstacles that successfully blocked the proposed CNOOC/Unocal merger, forcing CNOOC to withdraw on August 4.

US False Hope on Yuan Revaluation

The People’s Bank of China announced on July 20 that effective immediately the Renminbi (RMB) exchange rate will go up by 2.1% to 8.11 yuan to the dollar and that China will drop the dollar peg to its currency. Instead, China will move to a “managed float” of the RMB, pegging the currency’s exchange value to a basket of currencies. In an effort to limit the amount of volatility, China will not allow the currency to fluctuate by more than .3% in any one trading day. Linking the yuan to a basket of currencies means China’s currency is relatively free from market forces acting on the dollar, shifting to market forces acting on a basket of currencies of China’s key trading partners.  The basket will be composed of the euro, yen and other Asian currencies as well as the dollar. Though the precise composition of the basket is not disclosed, it can nevertheless be deduced by China’s trade volume with key trading partners and by mathematic calculation from the set-daily exchange rate.

The valuation shift to a basket of currencies is only a superficial move because the exchange rate of the dollar in an efficient foreign exchange market already reflects the equilibrium of the exchange rates of major currencies around the dollar. This equilibrium is the function of the market by definition, sustained by the complex workings of hedging through derivative trading with the dollar as the base.  By a managed float for its currency, China will enjoy the flexibility of leading the market, but it cannot go against the market as soon as the yuan becomes freely convertible, which according to current policy intention, may not become reality for some years.

Even when the yuan is not freely convertible under China’s strict capital control regime, hedge funds and other speculators have been trading yuan for years in the derivative market and through the trading in the equities of companies with large operations in China, and through trading of Asian currencies with flexible but close links to the Chinese yuan.  Companies such as Wal-Mart and Motorola, which buy from China, and LVMH Moet Hennessy Louis Vitton, which sells to China, face opposite impacts from a stronger yuan, with Wal-Mart losing on higher import cost and LVMH gaining on more Chinese purchasing power for foreign goods.

Non-deliverable forwards (NDF) have been an instrument of choice for professional currency traders. The NDF market allows traders to speculate on the value of currencies whose fluctuation is restricted by government fiat. In recent years, the NFD market has grown from $3 to $5 billion a day. Despite the huge size of China’s $1.4 trillion-a-year economy, the volume of currency traded in Shanghai is tiny, averaging just under $1 billion per day. By comparison, daily currency trading on the Chicago Mercantile Exchange averages about $43 billion and worldwide around $2 trillion, with most of it transacted in London. Following the news of the yuan revaluation, NDF traders were taking bets for further revaluation ranging from 2.5% to 6% for 12-month contracts. In Singapore, one day after the news, one-year RMB NDF rose to about 7.64 yuan per dollar, a level that predicts further revaluation of more than 6% by the middle of next year. Big international banks routinely act as counterparties between opposing bets to generate risk-free fees.  Merrill Lynch forecast that the renminbi would rise to 7.5 yuan to the dollar by the end of this year. Other analysts were more conservative. Bank of America saw the reminbi being held at 8.11 yuan to the dollar until the year-end, while BNP Paribas believed Beijing would allow the renminbi to firm to 7.9 yuan to the dollar by the year-end. When market participants disagree, the market becomes active.

Xia Bin, director general of the Financial Research Institute under the State Council, China’s cabinet, warned speculators against harboring “illusions” about further revaluation, saying Beijing was likely to move carefully and slowly. Xia said no “clear” appreciation was likely in the remainder of this year. China Daily warned that expectation of a revaluation bigger than the 2.1% announced on July 20 “was, and will be, unrealistic.” Yu Yongding, a member of the monetary policy committee of the People’s Bank of China, the central bank, and a long-standing supporter of revaluation, was reported to have said he did not think China would allow dramatic changes in the exchange rate. “The principle is stability as well as flexibility,” Prof Yu said. “We don't want to encourage speculative capital inflows.” Gradualism has always been the hallmark Chinese economic policy.  As this article is being written, the flood of hot money into China and Hong Kong, which had begun some two years earlier when the market was anticipating eventual adjustments, has continued to accelerate.

China’s central bank repeatedly insisted with strongly phrased announcements that there would be no more government-led revaluation of the renminbi, saying that the currency’s exchange rate was already reflecting market forces. Zhou Xiaochuan, People’s Bank governor, unintentionally fuelled market expectations by describing the revaluation move as “an initial adjustment to the exchange rate level”. The central bank later clarified that the remark did not mean there might be more adjustments to come. “Some foreign people have tried to create misunderstanding by saying this adjustment is an initial move and there will be more to come,” the bank said, adding that such foreigners had come up with such explanation "to suit their own purposes". In fact, the bank said, the renminbi rate was being set “according to objective rules”. “These movements will be created by the floating mechanism and there will be no more official adjustments of the renminbi level,” it said, and that “in trading since revaluation, the renminbi had been reflecting market forces and movements in international currency exchange rates.”  Yet the more China stresses its determination to resist further evaluation, the more such announcements would induce stronger US pressure to push the yuan higher. China is caught between market pressure and US political pressure in that moves to quell market pressure to push up the yuan will increase political pressure from the US to push up the yuan. China should stay quiet to avoid agitating more US political reaction and let actions deliver the message to the market.  The most effective way to manage the market is to make speculators lose money.

Despite its recent rhetoric, the Chinese central bank itself is widely seen in Beijing as favoring a more substantial revaluation than was announced, and is suspected of accepting the 2.1% move with open reluctance, only under pressure from other government departments.

Yuan credit and interest rates are mostly administered by Chinese government policy which is normal for a national banking regime. In such a regime, state-owned enterprises are not affected by the short-term market cost of loans. That means the People’s Bank of China (PBoC), the central bank, does not have as much leverage over the economy as the US Federal Reserve does. Also, the large foreign-exchange inflows into China affect the flexibility of PBoC to set interest rates to manage the credit needs of the domestic economy. A stable currency has macroeconomic merits, but a currency kept below market expectations produces inflationary fallouts.  In a central banking regime, it is the central bank’s responsibility to fight inflation with interest rate policies. But China is still in a transition stage between national banking and central banking. The PBoC is working feverishly on building the finance infrastructure of monetary policy needed for changing China’s previous national banking regime to a new central banking regime. Shifting the yuan’s peg to the dollar to crawling rates pegged to a basket of currencies will help facilitate structural reforms that will enable monetary policy to act as a key tool for managing China’s economy in a central banking regime.  Whether a shift to a central banking regime in the context of global dollar hegemony is good for an economy that cannot print dollars at will is another question.  A central banking regime for China serves only the interest of foreign capital denominated in dollars.

In market economies operating under central banking, interest rate is the main means by which central bankers manage aggregate demand, fight inflation and reining in unruly financial markets when the economy overheats, and fighting deflation and stimulating economic activities when the economy slows. This approach remains controversial as it can lead to liquidity traps under certain conditions, as in Japan in the last decade, or debt bubbles as in the US in recent years. Yet most neo-liberal monetary economists continue to view interest rate policy as the best tool for managing aggregate demand in market economies.

In the late 1990s, China used fiscal policy to stimulate the stalled economy and to fight deflation. Treasury-bond issuance rose, and in 2001 the central bank encouraged Chinese banks to lend more, leading to huge credit expansion and an investment boom that the government now is trying to slow down. Fiscal stimulant worked in China and not in Japan because the Chinese economy had not yet been saturated with built infrastructure, as was the case in Japan where new unneeded expressways were built that led to points of no economic significance. Fiscal spending in China, even if indiscriminately applied, while suffering from less than optimum effectiveness, still produced positive impacts on the vastly underdeveloped Chinese economy.

Year-on-year annual M2 growth in China hit 21.6% in August 2003, overall bank credit grew at 23.9%, and annual fixed-asset investment was booming at 30% to 40%. By 2004, the government was compelled to curb over-investment and speculation, particularly in the real-estate sector. Over-investment was creating overcapacity, causing a new wave of nonperforming loans for the banks. As monetary policy had repeatedly proved ineffective in directing market trends, raising rates was decidedly not a policy option, as such broad-brush measures would hurt the healthy sectors along with the speculative sectors. Instead, the government administratively managed its fiscal stimulus and imposed planned-economy measures.

In April 2004, a “macro-economic adjustment” program was launched targeting over-investment in key heavy industries, including steel, cement and coal. National Development Reform Commission (NDRC) approval was required for all new investment, with some on-going projects suspended in midstream. Control over land development rights was tightened, and banks were instructed to curb their lending selectively, instead of responding to market demand by lending only to borrowers who were prepared to pay high interests. Instead of raising interest rates which would put all projects in distress, the government chose to selectively turn off the funding source for undesirable projects. By June 2004, M2 growth was back below 16% year on year, domestic credit growth had fallen back, and consumer price inflation was heading downward. The PBoC was allowed to raise bank rates just once, in October 2004, by 27 basis points, perhaps just enough to signal rates could rise. Apart from that, it has played a subsidiary role in macro-policy over the past 18 months.

With that experience, one would think that Chinese policymakers would learn the lesson of the ineffectiveness of central banking with its fixation on keeping banks profitable at the expense of the economy, and revert back to a national banking regime to support industrial policy for effective development of the Chinese economy.  Yet the central banking movement in China, urged on by neo-liberal economists both inside and outside of China, is adopting a “damn the torpedoes, full steam ahead” mentality.

Ongoing structural changes towards a central banking regime are leading China’s economy towards being increasingly more sensitive to interest rates. State-owned enterprises will be forced to manage their operations with an eye on quarterly earnings for repayment of short-term loans, preventing them from making long-range plans for growth. They are subjected to the unpredictable short-term fluctuation of the market cost of funds, while they are still at a stage of undercapitalization which puts them at structural disadvantage in the global arena of market capitalism. As more state-owned enterprises are privatized and sold off at fire sale prices to foreign competitors, political pressure to keep rates low for the remaining state-owned enterprises wanes, making them more vulnerable to foreign takeovers. More private companies are accessing credit in the open market and be rate sensitive in the business decisions. Chinese banks now lend 11% of their outstanding loans to consumers who are sensitive to rate changes. Recent upstream imported raw materials inflation is pushing interest rates up and slowing economic expansion generally, rather just in overheated sectors.  In a global regime of financial liberalization based on dollar hegemony, it is not wise for a nation such as China, which lacks capital denominated in dollars, to expose its economy to market capitalism, a game in which those with less capital always loses.

As the yuan is not a freely convertible currency, there is no market basis to judge if the yuan is undervalued or overvalued. The trade imbalance, as many economists has pointed out, is a complex phenomenon of which exchange rate is only a last resort compensating factor.  Besides, the US-China trade imbalance is only nominally in favor of China, with China earning a foreign fiat currency that can only be spent in the dollar economy and not the yuan economy.  Even then, Chinese held dollars are not fungible as they can only be spent under political constraints imposed by the issuer of the dollar, as the failed CNOOC/Unocal merger has shown.

And for a currency that is not freely convertible, fixed exchange rate has no basic effect on trade balance except as a positive stabilizing force against price volatility. Usually, undervalued currencies, even if nor freely convertible, cause domestic inflation, thus making export prices higher even if the exchange rate remains unchanged. This is because a cheap currency means more exports than imports, and the resulting current account surplus causes net inflows of money from overseas. These inflows add to the monetary base, allowing banks to lend the added money out to new customers. Prices will rise as a result of more money chasing goods and services which expand at a slower rate than money supply expansion. Domestic inflation translates into higher export prices. But for China, the bulk of the profit from higher export prices goes to pay unlimited returns on foreign capital, not to higher domestic wages.

Even then, there are domestic economic benefits from this inflow of funds if it goes to facilitating domestic economic expansion beyond the export sector. But with dollar hegemony, these economic benefits of China’s trade surplus are blocked from domestic economic expansion, with all the dollars from the Chinese trade surplus going back into US Treasuries to finance the US debt bubble with which to incur more US trade deficits.  It is a classic example of the poor lending their meager wages received from the rich back to the rich to enable the rich to make the next pay day, with the rich demanding that the money they pay the poor should buy less in the neighborhood where the poor live. The US is confusing the spread of freedom with an expanding collection of freebies.

Dollar inflows into China were $206 billion in 2004. This came on an accelerated basis, meaning the rate of inflow increased toward the end of the year. Some $101 billion flowed into China in the first half of 2005, a 50% year-on-year growth rate for first halves. The PBoC uses open market operations, mainly selling PBoC bills, to deal with these inflows. These bills allow the PBoC to take high-power money from the commercial banks in exchange for bills that the banks cannot re-lend to customers, thus stopping the creation of new money by banks issuing loans on partial reserve requirements. Net bill issuance accelerated in late 2004 to cope with dollar inflows of up to $30 billion a month, and remained at high levels. During 2004, the PBoC withdrew a total of 616 billion yuan ($74.5 billion) from the monetary base through bill issuance in the interbank market. This was the equivalent of 36.1% of forex inflows for the year.

In addition, the PBoC issued 196.6 billion yuan ($23.8 billion) in PBoC bills in May 2004 to the four major state-owned banks. In total, the PBoC sterilized 812.6 billion yuan ($98.3 billion) during the year, equivalent to 47.5% of forex inflows during 2004. In the first half of 2005, there was an estimated increase in outstanding PBoC bills of 645 billion to 672 billion yuan, soaking up the equivalent of $78 billion to $81 billion worth of the forex inflows. In other words, the PBoC sterilized 68% to 71% of the inflows.  Still, some 30% of the forex inflows went into the expansion of the yuan money supply.

Another tactic the PBoC used to control forex reserve inflows was higher required reserve ratios, (RRR) which banks are required to place with the central bank in proportion to their deposits. On September 21, 2003, RRR was raised to 7% from 6%, and to 7.5% on April 25, 2004. These moves had the effect of withdrawing 203 billion yuan ($24.5 billion) and 111.2 billion yuan ($13.4 billion) from the banking system.

The PBoC also issues guidance to banks on which sectors and regions to lend and which to restrict credit, less to cement plants and real estate, and more to agriculture and small- and medium-sized enterprises and less to the coastal regions and more to the interior west.

China’s commercial banks are trying to meet the new capital-adequacy ratios of 8% by January 2007 that bank regulators have imposed. Investments in PBoC paper and most other forms of debt, which carry no capital requirement, are now preferable to loans to corporate borrowers. This is causing banks to draw back lending.  China had to pay a price to defend the yuan’s peg to the dollar. Faced with massive forex inflows, fast-growing bank deposits and limited profitable investment options, commercial banks are eager buyers of PBoC paper. The ample liquidity in China’s money markets drove yields low. The overnight borrowing rate in the market is now hovering around 1.2%, and one-year PBoC bills sold for 2% in late May, down from an average in 2004 of 3.2%. 
For a more in-depth analysis of the exchange rate issue, see: China steady on the peg

The revaluation move by China is basically a political gesture to appease US pressure on an allegedly over-valued Chinese currency against the dollar. The market was expecting a lot more from China. Key Asian currencies will now float with the RMB yuan. As global trading began after the initial news of the yuan revaluation, the dollar was falling against other major currencies. The dollar dropped to 110.97 yen from 113.06 in New York at the end of the day of the news, while the 12-nation euro jumped to US$1.2196 from US$1.2108. Minutes after China announced its decision on the evening news, Malaysia said it was also un-pegging its currency, the ringgit, from the dollar, replacing it with a managed float in a move similar to that of China. That left Hong Kong as the only major economy in Asia that pegs its currency to the U.S. dollar. As long as the yuan is still not freely convertible, Hong Kong can keep its currency peg to the dollar, albeit at a high cost.  Eventually, as the yuan fluctuates against the dollar, the HK peg to the dollar will create transactional inefficiencies and instabilities and possibly new manipulative attacks from hedge funds. In South Korea, the news was received in stride, and government officials said they didn't expect it to have a big impact on the nation's economy, the third largest in Asia following Japan and China. Philippine central bank Governor Amando Tetangco said the move was expected to strengthen all regional currencies, including the Philippine peso.

The yuan will now be allowed to trade in a tight 0.3 percent band against an undisclosed basket of foreign currencies. Under the new system, the yuan immediately jumps to 8.11 to the dollar. But once off this starting block, it could, in theory anyway, rise (or fall) as much as 0.03 percent a day, since each day’s closing price against a basket of currencies becomes the center of the next day's trading band. Each step is tiny, but over time they add up.  Yet gradualism is a key to stability.

The yuan revaluation move is a response to the Schumer-Graham China Currency Bill (S. 295), calling for 27.5% tariffs on all Chinese products sold in the US if China does not revalue its currency by 27.5% within 180 days of the passage of the bill, which had been slated to pass before the end of the summer. A deal was worked out months ago to postpone a vote in exchange for a Senate hearing to be followed by a token gesture by China, so everyone could claim they won something without any real changes.  The desire to ease tension in preparation for President Hu Jintao’s planned visit to the Washington in September 2005 and the pending US Treasury ruling, also due in the Fall, on whether China is a “currency manipulator” also played a role in the timing of the move. The 2.1% upward revaluation of the yuan against the dollar was immediately neutralized by readjustments by other Asian currencies.

Managed Float

China has now officially adopted the Singapore manage float model rather than the HK currency-board model. This is a significant move. It shows that the HK tycoons are losing their myopic influence on Chinese economic/monetary policy.  The smug Hong Kong Monetary Authority has been emanating false pride of superior monetary wisdom by stubbornly hanging on to its currency board arrangement pegged to a volatile dollar mistaken as a stable currency.  The blind error left by the parting British colonial rulers launched Hong Kong into a bubble economy when the dollar was undervalued throughout much of the 1990s that burst with unprecedented disaster in 1997 as part of the Asian financial crisis a day after the British left Hong Kong.  The same currency board regime kept the Hong Kong economy from recovering for more than seven years after 1997 when Hong Kong was returned to China, until the dollar began to fall in 2004.  During that painful period, , the Hong Kong equity market was exposed to manipulative attacks by hedge funds in 1998 that required massive government incursion in the market to foil.

By contrast, Singapore has used what is known as the “basket, band and crawl”, or BBC, system since the early 1980s. The Singapore dollar is managed against an undisclosed basket of currencies of its main trading partners and competitors. It allowed Singapore to devalue its currency immediately after the Asian financial crisis to moderate unnecessary pain on its economy.  John Williamson, the neo-liberal economist who coined the term Washington Consensus, is credited with developing the BBC model in the 1970s. The Monetary Authority of Singapore asserts that the BBC policy has given it flexibility in responding to changes in local, regional and global conditions to maintain export competitiveness and control inflation. The composition of the currency basket is revised periodically to take into account changes in trade patterns. The secret policy band is also regularly reviewed to ensure it remains consistent with economic changes, with adjustments every six months if needed.  Singapore, whose currency was first pegged to the US dollar and then floated in the 1970s, chose the BBC regime because of a close link between exchange rates and interest rates in a small and open economy. Whether the BBC system will work for a gigantic, relative closed economy like China remains an open question.

The city-state of Singapore has since guided monetary policy through exchange rates instead of directly adjusting interest rates. This in theory has the advantage of insulating borrowers from interest rate risks. But for an international finance center, exchange rate risks are equally problematic.  In recent years, derivatives have been the instruments of choice in hedging both interest rate and foreign exchange rates.  Inflation has been relatively low at 2% a year since the early 1980s. Under the BBC managed float, the Singapore dollar has appreciated by about 20% against the US dollar as the dollar fell against other key currencies, although its strong currency policy has eased since the Asian financial crisis in 1997. In contrast, the currency has fallen 40% against the levitating Japanese yen.

Both China’s and Malaysia’s managed float exchange rate systems appear broadly similar to that of Singapore, although details remain sketchy on their operations. But there are several obvious differences. The most significant is that the yuan is not freely convertible. The currency trading bands in China and Malaysia are narrower than in Singapore, which means smaller currency movements. China’s trading band is also adjusted on a daily basis.  The fundamental difference for China lies in the option of administrative measures to manage both interest rates and exchange rates, with consistency between the two less critical because the yuan remains not freely convertible.

The International Monetary Fund has listed about 40 countries that use some type of managed float system. But Singapore officials say their system is in some ways unique since it is used also to control monetary policy, while policy statements provide a clear indication to the markets of where the currency is headed. Some neo-liberal economists have argued that a BBC regime could provide the basis for the eventual adoption of a common Asian currency. Others suggest the system is not widely applicable in spite of Singapore’s success.  Supporters of floating exchange rates argue that Singapore has strengths, such as a well regulated banking and financial system and large fiscal reserves that many other countries do not have to support a BBC system. A managed float system for a freely convertible currency largely rests on gaining the confidence of the markets. Only if other macroeconomic policies are consistent with a managed float will it be a success.  Many economists and market participants believe China faces a potential challenge in introducing a managed float since a small revaluation would continue to attract speculative foreign capital in anticipation of further currency appreciation. As a result, China may have to widen its currency trading band eventually to gain market acceptance.  This problem will be magnified if  and when the yuan becomes freely convertible, which is not likely to happen until China’s banking system is brought up to BIS standards, in which case, the problem shifts from exchange rates to interest rates.

A strong yuan not good for US economy

The US has been saying that the Chinese yuan is between 20-40% undervalued against the dollar and this undervaluation is a key factor in recurring US-China trade imbalance. Reality shows a very different picture.

Let us examine the economic impacts on the US economy of a yuan suddenly trading at 20% higher against the dollar. The first impact will be that prices of US imports from China will rise some 20%, significantly pushing up US inflation rate and dollar interest rates. High dollar interest rates will lift the exchange value of the dollar, pushing to problem back to square one. Since the bulk of US consumer goods are imported from China, a sudden and drastic rise in import prices of 20% will dampen US consumption of Chinese imports at a time when consumer spending is holding up the US economy.

There is a possibility that US consumer spending will hold in dollar terms, but the actually amount of goods sold will be reduced, lowering US living standards while not reducing the US trade deficit. The dollar value of US-China trade may remain the same, with more Chinese goods available for export to other countries or staying in the Chinese domestic market, raising Chinese living standards, and shrinking the relative size of the US economy.  And if the US Federal Reserve further accommodates consumer credit to absorb the rise in import prices to prevent a real reduction in consumer product sales, the US trade deficit may actual increase while US standard of living remains unchanged.  Even if US trade deficit with China should moderate, it would only lead to a corresponding reduction in US capital account surplus with China.  With a slower growth of Chinese holdings of dollars, China will buy less US sovereign debt, pushing US interest rates higher, possibly bursting the already precarious US debt bubble.

With a yuan pegged to a basket of currencies of which the dollar is only one among several, China will have less of a need to hold dollars.  With a drop in Chinese export to the US, China may see its ability to buy US sovereign debt reduced. And with the uncertainty of the exchange values of the dollar against the other volatile currencies in the Chinese basket, the market price of the yuan may at times fall as well as rise against the dollar.  If market forces should act against the yuan and push the dollar higher against the yuan, US political pressure on letting the market determine the value of the yuan would have proved to be counterproductive toward its goal of a stronger yuan against the dollar.  And the adverse consequences the misguided cure can be significantly worse than the current malady.  For one thing, with a stronger dollar, US assets not directly related to import prices, such as real estate, will suffer a price collapse, adding a last straw effect to the already precarious housing bubble.  A strong yuan may not be a blessing for the US economy.

On the Chinese side, a stronger yuan will have to be compensated with lower Chinese wages, or a slowdown of rising wages, in order that Chinese exports remain price competitive. Lower Chinese wages will slow the development of a vibrant Chinese market for US exports.  The better option would be to let the peg stand, and push China to raise wages. In a global market dominated by dollar hegemony, it is idiotic to expect that the complex problems of the US economy can be solved by the exchange value of one single foreign currency.  Dollar hegemony by definition eliminates the impact of the exchange value of the dollar on the dollar economy.

Hostile, ill-considered US political pressure on China’s economic/monetary policies has opened a can of currency worms with highly unpredictable and possibly negative consequences for the US and the whole world.  Just as the 1985 Plaza Accord on the Japanese yen destroyed the Japanese export economy and brought stagflation to the US that led to the 1987 crash, forcing the yuan off its decade-old dollar peg now may well be the spark that will ignite a raging forest fire in the US debt-infested economy in the coming years.

The Danger of Trade Wars

US geopolitical hostility toward China will manifest itself first in trade friction, which will lead to a mutually recriminatory trade war between the two major economies that will attract opportunistic trade realignments among the traditional allies of the US.  US multinational corporations, unable to steer US domestic politics, will increasingly trade with China through their foreign subsidiaries, leaving the US economy with even less jobs, and a condition that will further exacerbate anti-China popular sentiments that translate into more anti-free-trade policies generally and anti-China policies specifically.

The resultant global economic depression from a trade war between the world’s two largest economies will in turn heighten further mutual recriminations. An external curb from the US of  Chinese export trade will accelerate a redirection of Chinese growth momentum inwards, increasing Chinese power, including military power, while further encouraging anti-US sentiment in Chinese policy circles.  This in turn will validate US apprehension of a China threat, increasing the prospect for inevitable armed conflict.

A war between the US and China can have no winners, particularly on the political front. Even if the US were to prevail militarily through its technological superiority, the political cost of military victory will be so severe that the US as it currently exists will not be recognizable after the conflict and the original geopolitical aim behind the conflict would remain elusive, as the Vietnam War and the Iraq War have demonstrated.  By comparison, the Vietnam and Iraq conflicts, destructive as they have been on US social fabric, are mere minor scrimmages compared to a war with China. US policymakers have an option to make China a friend and partner in a peaceful world for the benefit of all nations. To do so, they must first recognize that the world can operate on the principle of plentitude and that prosperity is not something to be fought over by killing consumers in a world plagued with overcapacity.

(End of series)