Global Insight Perspective

Significance

The first round of talks in the strategic dialogue established by U.S. Treasury Secretary Henry Paulson in September concluded in Beijing today with agreement on the need to reduce the trade deficit, but not on how to achieve the reduction.

Implications

For the United States, the debate is focused on the equity of China’s fixed exchange rate, with the argument that the yuan is deliberately undervalued in order to inflate exports. However, the Beijing government counters that export competitiveness reflects the economy’s low operating costs, while over-rapid liberalisation of the capital account could prompt instability, as major structural adjustments continue.

Outlook

Both sides remain committed to the strategic dialogue, with a fresh round of talks scheduled for May. However, as Paulson returns empty-handed to an increasingly hostile legislature, his attempts to forge a policy of pragmatic engagement with the Chinese will be increasingly difficult to defend.

Slim Pickings

As China's remarkable economic progress continues, its relationship with the United States also evolves rapidly. The two countries are huge trading partners, yet there are acute tensions over issues ranging from currency policy to military strategy. The recent appointment of Henry M Paulson Jr as U.S. Treasury Secretary seemed to indicate that President George W Bush wanted to improve relations. The former Goldman Sachs boss had spent years dealing with China and building up good relationships with key figures. It was Paulson who led the high-powered U.S. delegation to China this week, and there were hopes of a breakthrough agreement. He was joined by several other cabinet-level officials, as well as Federal Reserve Chairman Ben S Bernanke.

In the event, there were no major deals to report. The two sides reported progress and warmer relations, but all they had to show for this were several new working groups and some general pledges. The working groups will look at healthcare, aviation, energy and the environment, and general regulation, with a focus on improving the investment environment in both countries. However, the U.S. delegation's primary objective was to persuade China to stop undervaluing its currency, and thereby reduce the yawning trade deficit between the countries, estimated at US$240 billion this year. An ongoing working group is looking at this, but there was nothing new to report. Indeed, it was highly unlikely that a two-day meeting would achieve this, although Paulson argued that the groundwork was laid for future progress. Bernanke was much more outspoken about the need for China to change its currency policy, remarking that the overvalued yuan amounted to an "effective subsidy for Chinese exporters".

In terms of general pledges, China expressed commitment to the further opening of its economy, the enforcement of intellectual property rights (IPR) and "greater flexibility" regarding exchange rates. However, Chinese officials were insistent that they would not be dictated to regarding their economic strategy, arguing that their approach is justified by the particular characteristics of the economy and its historical evolution. For its part, the United States said it would encourage a higher savings rate, and thereby reduce its borrowing dependence on China. The Chinese authorities pressed the United States to reduce its trade barriers—most notably on high-tech exports.

U.S. Protectionism on the Rise?

The U.S. administration may favour warmer relations with China, but its options are constrained by the situation in Congress. On both sides of the political divide there are arch-critics of China, who press the administration to take a much tougher line. Their main argument is the perceived damage that China's currency and trade policies do to traditional U.S. manufacturing, although there is also distaste for the country's political system and human rights record. The Democrats tend to be most vociferous on this front, and from the start of January they will control of both houses of Congress. This gives the party much greater leverage than in the past, and a number of prominent Democrats have made China a key priority. A wide range of legislation could be held hostage by China policy demands, and there is a range of new bills to target China in the works. The situation is not black-and-white, however, as there are others in the Democrat camp who resist protectionism and take a more pragmatic line.

The hardline camp in Congress was potentially given some ammunition by a controversial comment made by Bernanke during the trip. He called the undervalued yuan an "effective subsidy for China's exports"—strong language, upon which others may base calls for retaliation. The other toughest talker was U.S. Trade Representative Susan C Schwab, who accused China of failing to live up to its World Trade Organization (WTO) obligations regarding economic liberalisation. Paulson was keen to return from the trip to Beijing with something concrete to pacify the critics, but this was not to be. He has been trying to manage expectations, and will hope that the more vociferous critics will allow more time for the dialogue to run its course, with its next instalment in May.

The View from China

For the Chinese, the U.S. focus on exchange-rate reform is arguably misplaced. The competitiveness of Chinese exports is fundamentally grounded in low labour costs and open trade regimes, and most estimates concur that a revaluation of the Chinese yuan in the order of 30.0% would be required to make an impact on export prices. Moreover, rapid exchange-rate revaluation and the relaxation of controls on the capital account could destabilise Chinese growth. Sharp increases in the exchange rate could fuel speculative inflows of capital; so-called "hot money" has already poured into domestic real estate, prompting concerns about possible overheating in the sector. Meanwhile, capital-account controls ring fence the domestic financial system, which is currently undergoing major restructuring. The removal of those controls before the process is completed could prompt financial instability, as starkly exemplified by the Asian financial crisis of 1997-98. Finally, strong exports are required to support growth, as authorities pursue the restructuring of the rump state sector, which should result in a strengthening of domestic demand. Given China’s growing weight in the global economy, instability is in no-one’s interests.

However, exchange-rate and capital-account liberalisation is a policy objective of the Chinese authorities. Intervention by the central bank, to neutralise the upward pressure being exerted on the currency by huge foreign-exchange inflows, fuels rapid money supply growth, which in turn underpins unstable investment boom cycles in the economy. Foreign-exchange accumulation accounted for around 40.0% of M2 money growth in 2006. In the interests of stability, policy is geared towards a gradual revaluation of the currency, through an incremental widening of the yuan’s trading band. Global Insight projects that the currency will appreciate by around 3.5% and 4.1% in 2006 and 2007 respectively. The stronger appreciation expected in 2007 reflects renewed pressure on the U.S. dollar, which will allow the Chinese to steer the yuan up more aggressively than initially thought.

In China’s formulation of the strategic dialogue, the United States accepts progressive capital-account reform in return for more accelerated liberalisation of Chinese domestic markets—particularly in financial and service sectors. This approach recognises the structural roots of the U.S deficit, and the need to shift exports from traditional manufacturing (increasingly encroached upon by producers in emerging markets) to service and information sectors. Prior to the arrival of Paulson’s delegation, Beijing announced new regulations that opened up the domestic banking sector to foreign lenders. However, significant restrictions remain, obligating foreign lenders to incorporate locally. The cautious approach to reform in China reflects a growing conservative backlash against reformists. Opposition has emerged to land reform, while reversals in policy towards foreign media reflect a reassertion of central government control. However, such selective liberalisation is an example of Chinese perfidy for U.S. hawks.

Outlook and Implications

The high-profile nature of the U.S. delegation demonstrated the central importance that the United States now attaches to its relations with China. There was no breakthrough, but the two sides also avoided damaging clashes. Paulson has helped to improve the mood, but there is always the potential for a new row to blow up. Meanwhile, it remains to be seen how hard the Democrats will press when they take charge of Congress. The fact that Paulson has apparently returned empty-handed will help to galvanise them, but the truth remains that U.S. leverage over China is steadily diminishing, as the countries' economic interdependence becomes ever stronger. Paulson is struggling to pursue a pragmatic path of engagement, but the trade deficit is now so politicised that he has to appear tough—at least in public. It was Schwab in particular who was clearly keen to satisfy the constituency back home, focusing on a range of ongoing trade disputes and China's WTO commitments.

China is frustrated with the hectoring it receives from the United States, and has tried—unsuccessfully—to focus the debate on economic theory instead. However, the country remains committed to the policy of engagement that Paulson is attempting to foster, recognising the growing interdependence of the two economies. Symbolically, the yuan was allowed to float towards the top end of its trading band during the delegation’s visit. However, China also stands firm on its interpretation of its trading relationship with the United States. Not for nothing did Vice-Premier Wu Yi highlight the role of cheap Chinese imports in fuelling low inflation growth in the United States, while China’s huge foreign-exchange reserves continue to provide steady financing of bloating American debt stocks

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