Collin Spears, BFPR Chief Foreign Policy Correspondent, Washington, DC Bureau
In 2001, the Bush Administration characterized China as a “strategic competitor” to the United States. This may still be an accurate depiction of U.S. – Sino relations, at least as it applies to certain aspects of the multifarious relationship between the two nations. Financially, China and the U.S. have long been symbiotic. Despite the mutual benefits attained from this situation, there have been numerous points of contention, issues that have only been aggravated by the global financial crisis. The U.S. and China will have to find politically palatable ways to work though some of these differences, because the future economic viability of both nations depends on it.
The People’s Republic of China (PRC) is the world’s largest single holder of U.S. Treasury Securities, which total about $700 billion U.S. dollars (USD). China also purchases U.S debt through third countries, which could bring the total closer to $1 trillion as of January 2009 (Shambaugh 2009). Much of these securities are held by China to regulate the Yuan against the dollar in order to ease the flow of the massive amount of trade between the two nations. In 1979, China – U.S. trade was valued at $2.5 billion as compared to over $400 billion in 2008 (Shambaugh 2009).
Today, America is China’s single largest national trading partner and Americans invest in over 50,000 Chinese enterprises in the amount of $57 billion (Shambaugh 2009). Still, bilateral foreign direct investment (FDI) from the U.S. to China declined from its peak of $5.4 billion in 2002 to $2.6 billion in 2007, but this trend is not reflective of overall inflows, as China saw a total of $92 billion in 2008, about a 23.58 percent increase from the previous year (Prasad 2009).
In sharp contrast, flows from China to the U.S. have surged in recent years. This largely reflects large Chinese central bank purchases of U.S. treasury bonds. Due to current account surpluses created by exporting to the U.S. and other developed markets, China has little alternative but to buy U.S. treasuries to manage its exchange rate. In fact, in 2008 about half of China’s total reserves went towards net purchases of U.S. treasuries. In the wake of the U.S. Financial Crisis of late 2008, these facts have created great concern in the Chinese government.
Following statements earlier this month by Premier Wen, which voiced apprehension concerning the future stability of the USD, the head of the PRC’s central bank, Zhou Xiaochuan called for a new international reserve to replace the U.S. dollar, a truly global currency, which is independent of “economic conditions and sovereign interests of any single country”. This reserve would be an enhanced version of the International Monetary Fund’s (IMF) Special Drawing Rights (SDR).
SDRs are valued based on a basket of currencies, the USD; Euro; Japanese Yen; and British Pound Sterling. They were originally proposed to replace the Bretton Wood’s “gold standard”. The SDR has never gained the popularity of the U.S. dollar; only a handful of nations peg their currency against SDRs. Since Bretton Woods ended in 1971, the global market has set currency prices of “floating” exchange rates. This put more power in the hands of national central banks, such as the U.S. Federal Reserve. Due to the economic downturn it is tempting for nations to devalue their currency to make their exports more competitive, which could spark a trade war. This goes to the heart of Chinese Premier Wen Jiabao’s concern over the safety of Chinese investments. China does not completely trust the government and Federal Reserve to do what is best for the world economy over what is in America’s best interest. The various bailouts and liquidity schemes that the U.S. government and the Federal Reserve have promoted appear to China as an attempt by America to pay for financial stimulus by “printing money”. This could create inflation which will weaken the value of China’s assets.
One problem with Zhou’s proposal is that the IMF would determine the value of the SDR, a multinational institution where there would be much political pressure from major contributing nations to bend the exchange rates in a given nation’s favor. When the IMF does allocate SDRs, countries exchange them for local currencies at domestic central banks. The country then uses it to buy capital assets which often inflate domestic currency, which is also problematic. Such a proposal has been suggested before by Russia and other lesser developed nations, but the United States has always been wary that this could be inflationary and affect the central role of the USD.
Recently, Treasury Secretary Timothy Geithner said he was “quite open” to an “international reserve currency” to replace the dollar, but then quickly reversed, trumpeting the dollar’s dominance as the USD and various stocks market values begin to drop. The U.S. will likely work to reduce currency fluctuation and ease world trade where politically possible in the current climate, not find a means to remove the special status the dollar holds in the world economy.
This was not the first time an Obama cabinet member has made controversial remarks concerning China. Geithner also accused the Chinese government of currency manipulation. China angrily responded that the U.S. needs to fix its own financial issues, especially since they have affected most of the world. President Obama quickly moved to quail rising tension; any further stimulus spending will require Chinese financing. U.S. borrowing costs could rise if China starts divesting at the same time that America is trying to stabilize its financial market. China did say it would continue to buy U.S. bonds. It is in their best interest to avoid any rapid market fluctuations. Despite this, Energy Secretary, Steven Chu, stated that if China did not sign an agreement for the mandatory reductions in greenhouse gas emissions he would favor import tariffs on Chinese imports. A trade war with China in the middle of a global economic crisis definitely not prudent. Then, Former Fed Chair and current head of the Obama Administration’s President’s Economic Recovery Advisory Board, Paul Volker, recently stated that China has accumulated a large amount of USD because they do not want to appreciate their currency, so they are “crying foul”.
The Obama administration is in a complicated position. Obama often says he does not want to governor out of fear or anger, but the American populous is doing what oft happens in a financial downturn, becoming increasingly xenophobic in regard to free trade. Pew Research Center found that there has been a significant drop in support for free trade within the United State.
The reality is that the average unemployment from 1999-2006 was 5 percent, a decrease from the 6 percent in 1991-1998 (Woo 2009). The total compensation for blue-collar workers rose during the same period. Chinese exports to the U.S. rose over 3 fold since 2000 to $338 billion in 2008, while imports rose from $16 billion to $71 billion (Prasad 2009). The actual percentage of China’s exports going to the U.S. has declined over the same period, from about 22 percent in 2000 to 19 percent in 2007 and 17% by August 2008 (Prasad 2009). The EU surpassed the United States as China’s largest export market in 2007. Still, China’s bilateral trade surplus with the U.S. continues to rise. It has moved from $84 billion in 2000 to over $266 billion in 2008, about 1.9 percent of U.S. GDP (Prasad 2009). Even if the overall volume of U.S.-Sino trade decreases that will only the current parallel the sharp fall in global trade as a whole. The U.S. trade deficit with China could still be as much as $200 billion in 2009 (Prasad 2009).
No amount of statistical realism has tempered the calls from the U.S. Congress for large levies on Chinese imports or other such acts of legislative retaliation if China does not allow the Reminbi (RMB, also known as the Yuan) to float. This great acrimony continues in some political quarters despite China having allowed its exchange rate to appreciate by 21 percent relative to the U.S. dollar since 2005 (Hamlin et al. 2008). This is not seen as enough; especially since it is obvious China continues to accumulate foreign reserves at a rapid rate, even after mid-2005. This indicates the continued intervention by China’s central bank in the foreign exchange market. Senior IMF officials have also recently noted that the RMB remains substantially undervalued.
Some American analysts even argue that the Chinese government aided in creating the current global financial crisis. The argument is that the large current account deficits only occurred because it was financed by China (and other Asian and oil producing nations). The “excess” savings in these nations were invested in America because most of them do not have the financial capacity to allocate large amounts of capital. The result was artificially low interest rates in the U.S. that lead to risky lending behavior for a prolonged period.
Other China critics complain that the trade imbalance is fundamentally due to unfair competition, citing the protectionism present in the Chinese market and the pervasive subsidization the Chinese government gives its corporations. Much of this was outlined in “China and the Global Recession: Part I”, but there are also subsidies for land and fuel, which reduce the total production cost of Chinese industries. These appropriations, when combined with the economy of scale and low labor costs, result in a major competitive advantage in international markets. This argument is somewhat weakened by the various recent financial bailouts of the U.S. governments, but these bailouts pale in comparison to the depth and scope of the Chinese system.
The current global financial crisis has not changed the calculus; it is still mutually beneficial for both parties to maintain their symbiotic relationship. To do this the U.S. government will need to avoid making any provocative financial moves that will cause the U.S. dollar to rapidly depreciate and specifically address its deficit spending and public debt. The extent to which this is likely to happen and the threshold at which the Chinese government will be placated remains in question. The U.S. may be at a political disadvantage due to the current economic situation, which would require some additional concessions, such as increasing China’s role in international financial institutions, such as the IMF. This is something China feels its current stature entitles it too. In the end, China will continue to purchase U.S. reserves at a rate that will fund the American stimulus and war spending.
For China’s part, it is not likely to rapidly adjust the value of the RMB in a global recession, let alone, allow it to float. The common wisdom among neoclassical economic adherents is that China should allow for a larger float and improve their domestic economy. The resulting investment abroad as capital flows out of China will cause the Yuan to naturally drop in value. China’s dollar holdings must be considered here, re-equilibration of the Yuan to the dollar could result in a 20% capital loss or roughly 10% of Chinese GDP, which is about one year of average Chinese GDP growth (Editor 2007).
To compound this, if the domestic economy can not make up the difference of a reduction in exports caused by an appreciated Yuan the economy could contract. As discussed in “China and the Global Recession: Part I”, China’s domestic market is weak, especially for a nation of its size, in the best possible situation, this would be a risky slow growth formula. China is not as socially stable as popularly believed in the West and still needs significant economic investment from outside its borders to continue to progress technologically. The Chinese government is well advised to continue its current economic growth model, because it more than offsets the potential cost of getting caught with holding deprecating U.S. dollars.
Despite Chinese complaints about U.S. monetary policy and American charges of Chinese Mercantilism, for the foreseeable future, both nations will maintain the status-quo as much as politically possible. The alternative is a potential U.S. fiscal default and a politically and socially unstable China. Putting speculation aside, one thing is certain; the strength and stability of this bilateral relationship will directly influence the future of global economy far beyond the current financial crisis.
Editor. 2007. “Forcing fast RMB rise will be lose-lose situation”
People’s Daily Online.
Hamlin, Kevin and Li, Yanping. 2008. “China’s Economic Growth Cools to Slowest Since 2005 ”
Prasad, Eswar. 2009. “The Effect of the Crisis on the U.S.-China Economic Relationship”
Shambaugh, David. 2009. “China and the U.S.: A Marriage of Convenience”
Woo, Wing Thye. 2009. “China’s Short-term and Long-term Economic Goals and Prospects”