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Cool Heads and Calculations Needed to Avoid a China-US Currency War

Feb 14 , 2011

Although the US Department of Treasury has decided to postpone its scheduled report on whether China is manipulating its currency to gain trade advantage until after upcoming G20 conference in Seoul next month, The prospect of a trade war, or even worse a currency war, between the world’s two largest economies has far from being defused. Given the extremely complicated nature of the RMB exchange rate in the global economic context, the United States should undertake a rational cost-benefit analysis instead of threatening sanctions.

An economic perspective: few US gains, huge global costs

Since July 2005, China’s RMB has appreciated by up to 21 per cent. But this has not significantly improved the US trade deficit, nor reduced China’s trade surplus. The driving forces of today’s exchange rate have gone far beyond bilateral trade. To understand what is happening, an analysis of the open global production and trading system is necessary. It is unlikely that greater RMB appreciation, as demanded by some US Congress representatives, can alter China’s status as ‘workshop of the world’ and substantially boost American exports.

While the US could experience limited economic gains if any form of sanctions are imposed, the Chinese economy will suffer serious damage. First of all, a surcharge tariff of 20 per cent or more will drive a large proportion of Chinese exports out of the US market, and will significantly reduce external demand; secondly, many workers in coastal export processing zones will lose their jobs, resulting in a slowdown of economic growth and possibly social unrest; third, as more speculative capital enters China with a bet on RMB appreciation, the problem of an asset bubble in the Chinese economy will worsen and could spiral out of control.

A US-China trade and currency war would threaten the entire East Asian economy. Goods marked as ‘Made in China’ have actually involved a collective division of labor across the region. In the past 15 years, East Asian economies, including Japan, South Korea, Taiwan, Hong Kong and Singapore, have moved their assembly lines to the Chinese mainland to take advantage of its cheap labor costs, and they continue to target their exports at the US market. As a result, these economies have greatly reduced their trade surplus with the US, while China is perceived as having the largest trade surplus. A trade and currency war between the US and Asia would therefore trigger significant knock-on effects for the region.

As China leads the world out of recession, the Chinese economy has replaced the US economy as the greatest engine of global economic growth. Consequently, a US-China economic war could undermine the faltering recovery of the global economy. For example, panic-induced capital holders could dump dollars and buy euros, resulting in a substantial appreciation of the euro. This is definitely not in Europe’s current interests. Among other consequences, it would exacerbate the impact of the Greek debt crisis on the European Union economy.

When US President Barack Obama took office in early 2009, he sought to strengthen US-China cooperation on North Korea, Afghanistan and Iran; on global governance reforms such as at the IMF and the G20; and on climate change and anti-terrorism policies. Despite quarrels over US arms sales to Taiwan and Obama meeting the Dalai Lama, strategic cooperation between the two countries has remained strong. Faced with continuing global challenges, the US needs China’s continued cooperation.

If the US’s unilateral act (of citing Chinese currency) triggers a trade and currency war, the relationship will be severely damaged. A dispute over the RMB could, for example, lead to the absence of a Chinese leader at the upcoming nuclear summit hosted by the US. The G20 meetings and the multilateral climate change convention could also face immediate barriers due to the mishandling of this exchange rate issue.

Why has the US continued to put pressure on the RMB? And how likely this pressure will lead to action? These questions can be answered by an analysis of US domestic politics and the recent diplomatic friction between the two countries.

As the US mid-term election approaches, the weakening political support for the Democratic Party and President Obama is evident. Maintaining a Congress majority will be a difficult challenge for the Democrats. Scapegoating China is always helpful to domestic politics, as it diverts popular dissatisfaction with Obama’s economic policies. Taking action on the Chinese RMB would please voters who complain about the high unemployment rate in the US. On the other hand, China’s rapid economic rise is a source of public fear. It is good timing to ‘take on China’.

Threatening sanctions on the RMB may be regarded as saving ‘face’ in the recent bilateral diplomatic fighting over US arms sales to Taiwan and Obama’s meeting with the Dalai Lama. The Chinese government views Taiwan and Tibet as the nation’s ‘core interests’ and publicly condemned these moves. In the US, Chinese actions are now interpreted as ‘arrogant’ or ‘tough’, altering the former ‘low profile’ perception of China. Undoubtedly, the confrontation reflects some changes in the relative power position between the two countries following the global financial crisis. The assumption can therefore be made that Americans want to teach the Chinese that the US is still the largest power in the world. This could be a game of ‘saving face’ in response to China’s ‘overreactions’ on Taiwan and Tibet.

This essay is not intended to discuss whether the RMB exchange rate should appreciate against the US dollar from a theoretical perspective. The economic theories of exchange rates conflict with each other, and there is no easy answer to this issue.

One lesson we can learn from this exchange rate dispute is that we are faced with an increasingly integrated global economy, and the global financial crisis and structurally imbalanced global economy indicate that the macroeconomic authorities of most countries have failed to adapt to this new reality. As a developing country, China has learned from the successful experience of export-led East Asian countries, and has pursued a stable exchange rate policy and a moderate accumulation of foreign exchange. But five to ten years ago, few could have predicted such close interdependence between the Chinese and global economies.

We must be extremely prudent about the impact of the global economy in which China, the United States, East Asia and other regions are closely linked. We have to handle the RMB exchange rate with rational analysis. There are already signs that the US and China may find a sensible way to resolve their dispute and avoid the tremendous negative consequences for the recovering global economy. In the US, domestic political imperatives could give way to a more rational policy making process. A rational decision will benefit all economies, including that of the US.

Wang Yong is Professor in School of International Studies, Peking University.

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