4 April 2017
When Chinese President Xi Jinping visits Florida, trade will be at the top of the agenda. The meeting occurs at a pivotal moment when President Trump’s “America first” agenda has put China in the unusual position of being the champion of liberal global trade. Indeed, America’s withdrawal from the Trans-Pacific Partnership provides China with the opportunity to deepen its trade relationships in that key region. President Trump undoubtedly will express his concern about the large bilateral trade imbalance between the two countries. During the campaign, he threatened to impose punitive tariffs of up to 45% unless China took steps to reduce its $347bn bilateral surplus. Furthermore, the US leader has often indicated his belief that such gaps are the result of unfair trade practices, including deliberate efforts to undervalue currencies. Both leaders will be aware also that Treasury Secretary Mnuchin will determine in April whether China has gained a trade advantage though currency manipulation. Surely, such tactics must play a role, as China alone accounts for nearly half of America’s $734 billion trade deficit?
This is not a new complaint. Indeed, all US Presidents since Bill Clinton have raised this concern, but China has always passed the test. Currently, the case now is weaker than ever. To be sure, China’s bilateral surplus meets the definition for an excessive imbalance. However, China’s global current account surplus is only about 2-3% of GDP, well below the 8% experienced a decade ago, and does not meet the standard of a persistently large imbalance.
The real problem, however, is that manipulators must be engaged in persistent market interventions to maintain an undervalued exchange rate. Arguably, this was true ten years ago when a cheap RMB supported China’s export-oriented policy, and led to the dramatic rise in international reserves — from $500bn (seemed a lot in 2004) to a towering $4 trillion in 2014. Since the mid-2000s, however, the real exchange rate has appreciated over 30%, and the IMF believes the RMB is correctly valued (I believe it is still 5 to 10% undervalued).
In addition, rather than trying to push the currency lower, the PBOC since mid-2014 has been aggressively intervening to prevent a disorderly RMB collapse. Indeed, during the past 2 ½ years, central bank reserves have shrunk to $3 trillion. Taking into account, the nation’s current account surplus and direct investment inflows, capital outflows probably totalled nearly $1.5 trillion during this period (and would be exhausted in two years at this pace). And, while the red ink has slowed in recent months, China is not out of the woods. Following the financial crisis, Chinese corporations borrowed heavily overseas. As part of the current deleveraging process, the repayment of these liabilities is responsible for about one-third of recent outflows. Unfortunately, corporate deleveraging still has a long way to go. In addition, foreign direct investment, which helped fuel China’s export-led industrialisation, has ceased lately, as investors consider both RMB risk and the consequences of China’s transition to a domestically driven growth paradigm.
As usual macro-factors lie at the heart of current trade imbalances, which highlights the futility of a bilateral approach to correcting trade gaps. To state it simply, the US saves too little and China saves too much (see my blog on the G20 for more on this issue). The two countries differ, however, in their willingness to change course. On the one hand, the Trump administration appears set to implement an expansive fiscal program, which will further lower America’s already meagre savings rate. Meanwhile, China’s current strategy focuses on reducing the nation’s reliance on exports and rebalancing the economy towards consumption. Indeed, China’s savings rate has been declining, albiet too slowly, in recent years. In addition, China also accepts that a stronger RMB inevitably will play a key role in this transition. Importantly though, China is prepared to take a long term perspective, and will seek to limit the immediate growth and employment consequences of this historic transformation. As a result, the PBOC will remain prepared to accept RMB weakness, if necessary in order to offset cyclical risks, but not a disruptive currency collapse.
The transition from an export and investment led growth model to one driven by consumer spending represents a fundamental shift in China’s role in the global trading system. Indeed, China often correctly argues that the bilateral trade imbalance in part reflects the two nations’ differing roles in the world economy: China the global factory, the US the world’s top consumer. China’s new strategy will be supported by additional reforms aimed at opening/deregulating the service sector, strengthening the social safety net, liberalising currency and credit markets, and boosting productivity to offset the impact of its aging population and to narrow the gap with the more advanced economies.
As China shifts beyond its traditional role as the world’s producer of low value added manufactured products, there will be winners and losers. Commodity producers, e.g. metals, are already feeling the pinch. In addition, China aims to expand “onshore” production of previously imported, high value added manufactured products, such as capital equipment. Japan, Taiwan, Korea, and Germany (all countries enjoying a surplus with China) will take a hit. Also, following a rapid rise in labour costs, China is now boosting low valued added imports and direct investment in its low cost Asian neighbours.
While the world economy will benefit from a successful transformation of the Chinese economy, the United States is arguably uniquely positioned to exploit these historic changes. American consumer companies will gain from Chinese household spending. Chinese demographics and widening safety net create an array of opportunities for pharma and biotech. Reforms aimed at lifting productivity play into America’s technological strength. In addition, America’s service sector firms will discover new opportunities as China deregulates and liberalises this vast segment of their economy.
Market Impact
Rather than worry about currency manipulation, American policymakers should focus on gaining Chinese commitments to accelerate the reform programs, and reach agreements to expand commerce in key sectors. In particular the US should push for greater access and reduced non-tariff barriers in key segments of China’s domestic economy: consumer, tech, health care, finance, and other services. In addition, Chinese imports have been surprisingly weak the past few years, as the decline in industrial imports has exceeded the rise in consumer purchases. Chinese authorities should be encouraged to support demand until consumer spending takes off in earnest.
I expect the RMB (in inflation-adjusted terms especially) to resume its earlier appreciating trend in the long term, as China narrows the productivity gap with more advanced economies. However, as Chinese firms delever and reduce foreign indebtedness, further RMB weakness is still likely in the near term until economic growth picks up. Recent economic and international reserve releases have been more encouraging, so stay tuned.