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Cost of unleashing China's currency

Congress: Be careful what you wish for.

By William H. Overholt, Pieter Bottelier / July 13, 2007



Santa Monica, Calif.; and Washington

Congress has become obsessed with the Chinese currency. Forty-two members recently demanded formal action against China under Section 301 of the 1988 Trade Act. The Bush administration rejected that, so a powerful group of lawmakers is proposing a bill that would make China vulnerable to antidumping penalties for alleged currency misalignment. Major presidential candidates have advocated heavy tariffs on imports from China if it fails to appreciate its currency.

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Why is this happening? US job losses in manufacturing industries and the trade deficit with China – which amounted to about $230 billion last year according to US government calculations – have put many American elected officials under pressure to do something.

Congressional critics say China's undervalued currency is the root of the problem. While China's currency may well be undervalued, the fundamental causes of the job losses and the trade deficit actually lie elsewhere. Sometimes solutions that seem like common sense and draw popular support turn out to be ineffective when examined more closely.

It's true that low-wage Chinese workers have taken jobs from Americans and that cheap Chinese imports have pumped up the trade deficit. But three other factors explain the state of US-Chinese trade:

•The low savings rate by Americans means the US will continue to have a large global trade deficit. Forcing Chinese currency appreciation will just shift the deficit to other countries.

•When Congress focuses on the currency issue, it is addressing the least important source of the US trade deficit.

•If Congress pressures the Inter-national Monetary Fund to censure China regarding its currency, the IMF might be obligated to censure the US for its domestic economic policies that are a more important cause of its global trade deficit.

China's exchange rate is a very small factor in US job losses in manufacturing. US productivity gains are far more important. Jobs lost to China and other countries are compensated by job gains elsewhere in America's flexible and growing economy. In fact, US unemployment is remarkably low in spite of the trade deficit.

Critics of China's currency system need to be careful what they wish for. Appreciation of its currency will not reduce America's global trade deficit by much and it will create few if any US jobs.

Completely freeing China's currency and capital flows could backfire. China has the equivalent of more than $4 trillion deposited in relatively weak banks earning barely more than 2 percent after taxes. Freeing China's currency and capital flows would allow some of this money to flow to safer and more lucrative uses in other countries, causing the Chinese currency to depreciate.

Conversely, if China suddenly stopped intervening in the foreign exchange market, it might trigger a sharp short-run decline in the international value of the US dollar and drive up US interest rates. That could cause a housing market collapse and a recession.

How did this problem arise? At the turn of the century, China's leaders finally achieved a reasonably well-balanced trade account. Rapidly rising exports were offset by imports that were growing equally fast. Economic growth was coming from housing, cars, infrastructure, and retail sales. Then an explosion of US imports and Chinese exports wrecked the balance.

Following the NASDAQ collapse in 2000, US consumption exploded due to relaxed monetary policy and a large swing in the federal budget from surplus to deficit. These policies kept the recession short and mild, but they also sucked in imports and created a massive US global trade deficit. China's exchange rate had very little to do with this. The US housing boom financed greatly increased consumption and removed the need for household savings, so American imports ballooned.

Second, Japan's huge trade surplus is increasingly credited to China. As Asian countries move final assembly of computers, shoes, and much else to China, the former surpluses of Japan, Taiwan, and Hong Kong increasingly show up as China's, while the good jobs and profits largely remain in those other places.

While China's share of the US trade deficit increased (from the previous peak of 27 percent in 1997 to 28 percent in 2006), the share of the rest of East Asia actually fell (from 43 percent in 1997 to 17 percent in 2006). America's trade problem with Asia has become proportionately smaller, but a superficial understanding of China's numbers makes it appear worse.

Third, China has experienced an explosion of credit, investment, and productivity. Banks had a lending frenzy that the Hu Jintao administration was slow to control. And China's privatization of urban housing and numerous state enterprises freed up large amounts of money for investment.

Simultaneously, the restructuring and privatization of China's inefficient state enterprises led to drastic improvements in manufacturing productivity and thus in China's competitiveness. There is no way that currency appreciation could have compensated for China's phenomenal productivity growth since 2001.

China's undervalued exchange rate is primarily China's problem. It creates too much domestic liquidity in China, which is driving potentially dangerous stock market speculation and other bubbles. The US Treasury Department is correct in trying to persuade China to marketize its currency faster on the basis of Chinese interest rather than foreign pressure.

While often well-intentioned, proposals to protect the US economy from foreign goods can backfire. A more protected US economy would be, like France's, an economy of far higher unemployment.

William Overholt is director of the Center for Asia Pacific Policy at the RAND Corporation, a nonprofit research organization. Pieter Bottelier, former chief of the World Bank Resident Mission in China, is a professor at the Johns Hopkins School of Advanced International Studies.

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