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THE COMING TRADE WAR, Part
6
Trade wars can lead to
shooting wars
By Henry C K Liu
(For
other parts in the series, click here)
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 widespread paranoia in the United
States. 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 own. 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 dependent 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 the 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 openly to contemplate preemptive
strikes against it. Furthermore, Chinese culture
commands close affinity with the peoples of 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 United States 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 workforce of 700 million as against a US
workforce of 147 million. To avoid being overtaken
by China in aggregate national income, US wages
would have to maintain a gap of five times Chinese
wages. Historically based technological and
economic advantages currently give US workers a
nominal wage gap of more than 35:1 over Chinese
workers, or 9:1 on a 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 its superior 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 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 its economy was the strongest in the
world. Friedrich List, in his National System of Political
Economy (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 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 Newspeak 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 World Trade Organization
(WTO) to stop unfair US farm subsidies, US cotton
growers try to fend off the mounting pressure by
offering help to growers in poor nations. The US
government spends US$4.5 billion annually in
subsidies on a cotton crop with a market price of
$5.9 billion, which otherwise would have to be
priced more than double in the world market. This
subsidy enables US growers to export profitably
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
textiles is merely the US wanting its cake and
eating it too. While $4.5 billion is a mere
pittance in the $2.4 trillion 2005 US fiscal
budget, the subsidy has the effect of ruining the
economies 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 exports increase by
350% between 1999 and 2004, from 4 million
480-pound (218-kilogram) 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 agricultural trade.
While China's economy has
grown by more than 9% annually for the past couple
of decades and its gross domestic product soared
from $147 billion in 1978 to $1.6 trillion in
2004, the US GDP, $11.75 trillion in 2004, was
still far ahead at 7.4 times that of China.
Because of the difference is population size, US
per capita GDP in 2005 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 this,
Americans are 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 toward China.
There is an economic basis
behind militant US antagonism toward China. The
United States won both previous world wars
primarily by its wartime productive power. This
fact has not been forgotten by US policy-planners.
While the US manufacturing base has been seriously
eroded by neo-liberal global trade in the past two
decades, a shooting war with China would relocate
much of the lost manufacturing back to the US in
short order.
In 1942, only weeks after the
Japanese attack on Pearl Harbor, Hawaii, US
president Franklin 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 B-17 and B-24 long-range
bombers, 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 matter of time
before the Axis powers would be defeated.
A
market economy is a feeble weakling compared with
a wartime command economy. That a war in Asia
would relocate manufacturing jobs back to the
United States 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 that
China's nuclear deterrence against attacks from
the US can be neutralized by the 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. [Karl von]
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 catapult themselves
into superpower status after World War II. 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 Soviet Union was the main cause of its
dissolution, not perverted communist doctrine. The
large aggregate population of the European Union
is 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 of 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, similarly to the 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 pre-eminent 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 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 preemptive 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
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 its
superpower status.
Kissinger observed correctly
in the Washington Post 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
United Kingdom, 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
declined. It is becoming increasingly obvious to
some in Washington that a military option is the
answer to arresting US economic decline that
threatens the country's superpower status.
Eleven of the 16 countries
surveyed in June 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
attitudes 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 Britain, traditionally free-trade
nations, have much more positive reactions to
China's economic growth. Public opinion in the
United States 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 a 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 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 its goal, per capita income will 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 as much as 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 a socialist market economy, the rich-poor
gap among Chinese urbanites may become threatening
to social stability. Popular resentment toward 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 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's 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," Wen said. "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." 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 maldistribution 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 United States 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 freeze, 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
has 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," said
Samuelson, who estimated 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 a 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 said.
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 of 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 United States.
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 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 someone elected to Congress 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 administration of President George W
Bush 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
American Federation of Labor-Congress of
Industrial Organizations (AFL-CIO) has been
pushing for trade with the poor nations to be
"fair" by forcing them to adopt 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 countries 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 ongoing 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
scales 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 era of
president Ronald Reagan.
In
the private sector where most of the jobs are,
union membership dropped from 21.5% in 1975 to 8%
in 2004. The industries that had the largest
declines were 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 sectorwide aggregate job loss and
a drastic drop in membership percentage of the
remaining workforce, 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, and 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 increasingly 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 Unite 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
nationwide 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 woo 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 (Democrat, New York) and
conservative Senator Lindsey Graham (Republican,
South Carolina), with broad-based bipartisan
support reflective of popular sentiment,
introduced the China Currency Bill (S 295) in
April, calling for 27.5% tariffs on all Chinese
products sold in the US if China did 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 vote 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 bipartisan legislation was also introduced
in the House of Representatives by Representatives
Duncan Hunter (Republican, California) and Tim
Ryan (Democrat, Ohio).
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
moot, 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 Corp 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 US 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 (the 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 blocked the proposed
CNOOC/Unocal merger, forcing China National
Offshore Oil Corp to withdraw on August 4.
False hope on yuan
revaluation
The
People's Bank of China announced on July 20 that
effective immediately the yuan exchange rate would
go up by 2.1% to 8.11 yuan to the US dollar and
that China would drop the dollar peg to its
currency. Instead, China would move to a "managed
float" of the yuan, pegging the currency's
exchange value to a basket of currencies. In an
effort to limit the amount of volatility, China
would not allow the currency to fluctuate by more
than 0.3% 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 is composed of the euro, yen
and other Asian currencies as well as the dollar.
Though the precise composition of the basket was
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
yuan. Companies such as Wal-Mart and Motorola,
which buy from China, and LVMH Moet Hennessy Louis
Vuitton, 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 NDF market
has grown from $3 billion 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.
After 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 yuan 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
counter-parties between opposing bets to generate
risk-free fees. Merrill Lynch forecast that the
yuan would rise to 7.5 to the dollar by the end of
this year. Other analysts were more conservative.
Bank of America saw the yuan being held at 8.11 to
the dollar until the year-end, while BNP Paribas
believed Beijing would allow the yuan to firm to
7.9 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," 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 yuan, saying
that the currency's exchange rate was already
reflecting market forces. Zhou Xiaochuan, People's
Bank governor, unintentionally fueled 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 an explanation
"to suit their own purposes". In fact, the bank
said, the yuan 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 [yuan]
level," it said, and "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 will 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 US dollars.
In
market economies operating under central banking,
interest rates are the main means by which central
bankers manage aggregate demand, fight inflation
and rein in unruly financial markets when the
economy overheats, and fight deflation and
stimulate economic activity 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 stimulants 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 ongoing
projects were 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 have put all projects in distress, the
government chose to turn off the funding source
selectively 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
toward a central-banking regime are leading
China's economy toward being increasingly more
sensitive to interest rates. State-owned
enterprises (SOEs) 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 SOEs are
privatized and sold off at fire-sale prices to
foreign competitors, political pressure to keep
rates low for the remaining SOEs wanes, making
them more vulnerable to foreign takeovers.
More
private companies are accessing credit in the open
market and becoming rate-sensitive in business
decisions. Chinese banks now direct 11% of their
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 than 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 lose. As the yuan
is not a freely convertible currency, there is no
market basis to judge whether the yuan is
undervalued or overvalued. The trade imbalance, as
many economists have pointed out, is a complex
phenomenon of which the 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, a
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 payday, 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 from the banking system. The
PBOC also issues guidance to banks on which
sectors and regions to lend to and which to
restrict credit for, 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 (December 1, 2004).
The
revaluation move by China is basically a political
gesture to appease US pressure on an allegedly
overvalued Chinese currency against the dollar.
The market was expecting a lot more from China.
Key Asian currencies will now float with the 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 US 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 Hong Kong 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
after Japan and China. Philippine central bank
governor Amando Tetangco said China's 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%
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% 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 was
a response to the Schumer-Graham China Currency
Bill (S 295), which had been slated to pass before
the end of this 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's
planned visit to the Washington in September and
the pending US Treasury ruling, also due in the
autumn, 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 Singaporean managed-float model rather
than the Hong Kong currency-board model. This is a
significant move. It shows that the Hong Kong
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 US dollar
mistaken for a stable currency. The blind error
left by the parting British colonial rulers
launched Hong Kong into a bubble economy when the
US 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 US 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 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 (Bank for International
Settlements) 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%
and 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 the US inflation rate and dollar
interest rates. High dollar interest rates will
lift the exchange value of the dollar, pushing the
problem back to Square 1. 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
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