Diary

Warning: Possible Trade War Ahead

The news has been full of big economic stories this past week. And as often happens, some very important things got lost in the noise background. I told you about one of them
here.

Very interesting doings are afoot in China. You may have caught the handful of stories which quoted key figures in the Chinese investment world, to say that the United States needs to be “nicer” to the countries that lend us money.

Since that’s a none-too-veiled reference to the big role that China takes in funding our fiscal and current-account deficits, it’s worth looking closer at what’s going on.

China is showing signs of a shift in their policy regarding exports. In a speech last weekend, Premier Hu Jintao said that the government can and will act to increase exports.

And then on Monday, the People’s Bank of China dramatically reversed its course on the dollar/renminbi exchange rate, allowing the Chinese currency to fall sharply, a move which continued over several days.

Now this is noteworthy for a lot of reasons, but let’s start with the obvious ones: China’s share of global manufacturing is now as high as it’s ever been, and it’s still rising. Even though the global economy is slowing sharply in every country, including China.

The only way for China to continue increasing export volume in an economic slowdown, is for them to increase their already-large share of a shrinking pie. They’re trying to counteract the economic slowdown (which has hit them as hard as everyone else) by exporting their way out of trouble.

And what’s the most effective way to pursue such an overtly mercantilist policy? By devaluing their currency.

China enjoyed a true economic boom during the recent period (roughly from 2004 to 2006) when the US dollar (to which renminbi is loosely pegged) was depreciating. During their boom, they had high real rates of demand growth and internal consumption.

China appears then to have experienced a fairly classic investment-led overexpansion. The signs of this were evident by about 2006. If you’ve been reading my RedState posts that long, you may remember that I raised a flag about apparent credit-quality problems in China back then.

Well, rather than allow their country to go into recession (the usual cyclical response to over-investment), the Chinese stepped up their exports.

By no coincidence, the period from 2004 was also when China started accumulating dollar reserves. When a country runs export surpluses, their currency naturally tends to rise. (You need to buy their money in order to pay for their goods.) But China keeps the yuan artificially weak.*

So with the aid of an undervalued currency, Chinese exporters have been steadily increasing their share of global manufacturing for years now. And that means the government has a surplus of dollars left over, after they convert their exporters’ earnings into local currency.

Those dollar reserves have gone from near zero in 2004, to more than $2 trillion today. And they continue to increase rapidly, even as the pace of global trade has slowed sharply. China’s reserve position is well on its way toward $3 trillion.

Now keep this in mind, because it bears on what comes next: by definition, China has overpaid for its dollar holdings. When you systematically undervalue your money while running a current-account surplus, you’re forcing the rest of the world to run deficits, and the resulting imbalance has to show up somewhere.

China is necessarily going to take big losses in real terms on their dollar holdings. And when that day inevitably comes, it will create a big ugly mess, with a powerful impact not just on trade but on diplomacy as well.**

Since domestic demand growth began to slow in 2006, the Chinese have in effect been importing demand from the rest of the world and exporting unemployment.

That worked rather well until just recently.

Who is the world’s primary source of aggregate demand available to surplus countries? The good old US consumer, of course. And we’ve had nearly full employment for years as well. So, contrary to the fears of many economists, we’ve been able to sustain huge current-account deficits.

But as you and I very well know, the US consumer suddenly benched herself about two months ago, as the current financial crisis intensified. And US employment, which has been weak all year, just fell off a cliff.

Now internal demand in China has been falling just as much as it is here, by all recent reports. China should be looking for ways to stimulate internal demand, and they will do that. But as we saw last week, they’re also going to try to fire up the export engine again by undervaluing their currency some more.

The Chinese aren’t interested in importing our manufacturing jobs.*** They want to import our demand.

But we don’t have any demand available to export now, and we can’t import any more of China’s unemployment.

That’s going to turn a very challenging international situation into an explosive one, over the next few months.

We’re already getting news reports that the Keynesians are back to Washington in a big way. Obama has started talking about replacing every light bulb, HVAC system , and personal computer in every school and government building in the country.

China is thrilled to hear this. Who do you think makes all those light bulbs, air conditioners and computers?

But what good does it do us to spend a trillion dollars on fiscal stimulus, only to put millions of Chinese people back to work?

Wait for it. You can expect to see calls for trade protectionism from Congress next year. We may even see the Democrats propose an updated version of the Smoot-Hawley Act, to go along with the New New Deal.

-Francis Cianfrocca

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*China doesn’t do it that way. Their exporters accept payment in dollars, euros, yen or whatever, which then must be exchanged for yuan at the People’s Bank of China. And the PBC deliberately undervalues the local currency in the exchange.

Ah, but you exclaim, such currency imbalances can easily be exploited by hot-money inflows! Well, no. The Chinese already know that trick. They severely restrict the ability of foreigners to deposit money into Chinese banks, and they tightly control the interest rates and reserve levels of those banks anyway.

**This may already be happening. There is a persistent point of view that pressure from China and possibly Russia was a major factor in the nationalization of Fannie Mae and Freddie Mac.

***A lot of Americans think that the rise of manufacturing in China comes directly out of our hides, but that’s a misreading of the facts. As a proportion of our economy, Americans don’t manufacture very much (roughly 15% of GDP) and we don’t trade very much (10% of GDP).

Instead, China’s export growth will come at the expense of the other surplus countries that are their main competition: Japan and Germany, of course, but mostly the other emerging Asian countries, like South Korea, Singapore, Thailand, Vietnam, and Malaysia.

The other key surplus region in the global economy is the Middle East. In their case, the fall of oil prices benefits no one in the world more than it benefits the Chinese, because it reduces their production-factor costs.