In recent years China has focussed on developing its economy. The strategy it has used has been to export at all costs. In order to achieve this China has kept its currency at a deliberately low rate, or at the very least has not allowed it to appreciate and has pegged its currency to the dollar.
In fact recent research has suggested that it is a very good strategy to have an undervalued currency as it can create an engine of long-term growth for an underdeveloped economy. However, huge export sales have led to huge current account surpluses. And, huge current account surpluses, predominantly with the US, have led to a huge build up of foreign exchange reserves, mainly in dollars. These reserves have grown to a level of about $2 trillion.
Unfortunately, it is no use putting piles of dollars into bank vaults for a rainy day – they need to be invested. Most of China’s international reserves are held in dollar assets and only 6% have been used in direct investment, in terms of buying into overseas companies. And, by November last year, China had invested nearly $700 bn in US treasury bonds, as can be seen in the graphic below.
Thus we have had the situation of a predominantly poor country lending money to the richest country in the world, so that it can buy their goods. This has worked reasonably well for the past decade but now China is getting very worried about the state of the dollar. With huge fiscal deficits needing to be financed in the US and the possibility of future inflation and increases in interest rates – even stagflation – the Chinese are concerned that the dollar will crash and they will suffer a huge capital loss.
In fact something similar has happened before. An article this month by Olivier Accominotti highlights the situation in France in the early 1930s. In 1926 France pegged the franc to sterling and the dollar whilst running a surplus on current account. This was such that at the end of the 1920s, France held more than half of the world’s volume of foreign reserves. Between 1929 and 1931 the Bank of France shifted funds out of pounds and into dollars as it feared sterling was going to be devalued. The result was that the Bank found itself in a trap. As it sold sterling, the price weakened, and it realised that a sterling collapse would involve it in huge losses, so French policy changed and sterling had to be supported once more.
Last May, Zhoy Xiao-chuan, governor of the Bank of China, suggested that the dollar could be replaced as a reserve currency with an international currency such as Special Drawing Rights which are issued by the International Monetary Fund. But, these have only been used on a very limited basis and are made up of a basket of 4 currencies which are the dollar, the euro, the pound and the Japanese yen. There would have to be a much larger basket than this to produce “a super sovereign reserve currency” and basically they have been in existence since 1969 and are not considered to work well. But again, if China were to transfer their existing dollar holdings into a Super SDR, this would again depress the value of the dollar, and like France in the 1930s, would result in huge Chinese losses of foreign reserves.
In fact, Paul Krugman in a recent article in the New York Times argued that China has “driven itself into a dollar trap, and that it can neither get itself out nor change the policies that put it in that trap in the first place.”
The other remedy comes more from the US side. On Monday this week, Tim Geithner, US Treasury secretary visited China. In the past he has blamed China for the current problems because they have not allowed their currency to appreciate, as it should if they are making huge balance of payments surpluses. However, the Chinese do not accept that they are to blame for the current world financial crisis which originated in the US and has led to the fall in value of the dollar.
This time Mr Geithner suggested a list of areas that China needed to address in order to make a contribution to a more balanced global economy, including more spending on social security, education and changing the structure of industry through the market mechanism. He did, however, say that: “An important part of this strategy is the (Chinese) government’s commitment to continue progress toward a more flexible exchange rate regime.”
At the moment the whole focus of the US economy is to increase consumption to kick-start economic growth, which is very worrying for the Chinese. On the one hand it will help their exports, but on the other, may inflict severe damage on their investment in US treasuries. However, Mr Geithner has promised that the US will move towards a more balanced, sustainable growth model as soon as feasible, which would include an increase in the savings rate and a lower level of consumption.
But, Mr Geithner said that China needs “a very substantial shift from external to domestic demand, from an investment and export intensive driven growth, to growth led by consumption.” However, China sells so much product abroad because of a low wage base and “relaxed” working conditions.
Will the positions of these two great nations, which are first and third in the world in the list of total GDP, change so that China is consuming more and the US consuming less?
This outcome is doubtful. US consumers have got used to living with a high level, debt fuelled economy and the Chinese can still see the advantages of a drive for export-led growth. There is no easy answer.
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For much of the year, the spectre of the 1930s has loomed large over the global economy. With the world facing its steepest economic downturn since the Great Depression, there has been understandable concern that key countries could, as in the 1930s, raise import barriers and succumb to ‘beggar-thy-neighbour’ policies. So far, this fear has mostly proved misplaced. True, many countries have struggled to honour their commitment not to erect new barriers to trade, given at the G20 summit in Washington in November 2008. But for now, a damaging protectionist free-for-all seems to have been averted.
There are good reasons why the international trading system is proving more resilient than it did in the 1930s. One is simply that governments are avoiding repeating the same mistakes. They have focused on easing monetary and fiscal policy, rather than raising trade barriers, to cushion the impact of the economic downturn. Another reason is that countries enjoy less elbow room on trade policy than they used to. Membership of regional trade agreements and the World Trade Organisation (WTO) insulates about 75 per cent of world trade from increases in tariffs. No EU country, for example, can impose tariffs on imports from a fellow member-state without violating a basic condition of its membership.
Protectionism has not, however, been eliminated. Trade barriers have increased over the past year. Some emerging economies have been able to raise tariffs without breaking WTO rules because the tariffs which they had previously applied were lower than their ‘bound rates’ (internationally-agreed ceilings). WTO rules also allow countries to take special measures, such as antidumping duties, to protect domestic firms against ‘unfairly low’ prices. Since the middle of 2008, the number of antidumping investigations opened worldwide has grown by a third, while the number of anti-dumping measures applied has increased by a fifth.
More opaque forms of protectionism have also proliferated. Numerous countries have disbursed subsidies to struggling companies – notably in the car industry, a sector which suffers from global surplus capacity (and could therefore do with some pruning). Banks which have been recapitalised have been leant upon by governments to lend domestically rather than abroad. Discriminatory provisions have wormed their way into fiscal stimulus plans. And some governments have publicly encouraged their consumers to buy domestic goods and services, rather than foreign ones. Such responses have certainly challenged existing rules, both within the EU and the WTO. But they have not, as yet, overwhelmed them.
International pressures are helping to contain protectionism. In the EU, the Commission has come down hard on countries that violate the integrity of the single market. For example, it has forced President Sarkozy to stop bullying French firms to maintain employment at home at the expense of jobs abroad. Outside the EU, the ‘Buy America’ clauses in the US’s draft fiscal stimulus package have been revised in the face of pressure from the EU and Canada. The G20 leaders took a useful step to curb protectionism when they met in April: they agreed that the WTO should be notified of trade-distorting measures and that it should monitor and report on the adherence of G20 countries to their pledges.
Some observers make much of the fact that 17 members of the G20 have broken the ‘standstill’ commitment to avoid any form of protectionism that they made last November. It is certainly true that national measures over the past year have pushed the world trading system towards less freedom, rather than more. But it helps to retain a sense of perspective. The WTO and the World Bank, which have monitored restrictions on trade since the start of the financial crisis, have both concluded that trade-distorting measures have had a marginal impact to date. The volume of world trade may have collapsed since late 2008, but this has had little to do with rising import barriers. Protectionism has been a consequence, not a cause, of the downturn.
Several risks remain. One is that national subsidies could get out of hand. Almost every country that produces cars has extended financial support of one kind or another to help local manufacturers. Banks have been even larger recipients of state largesse. These are exceptional times, and extraordinary measures cannot be avoided. Nevertheless, there is a risk that yesterday’s tariff wars could morph into today’s subsidy wars – with countries vying to obstruct necessary economic adjustments by propping up uncompetitive national champions.
Another risk is that the underlying cause of the current crisis – the build-up of vast, unsustainable imbalances in the world economy – goes unresolved. Countries that have run large current-account surpluses (such as China, Germany and Japan) may be unwilling or unable to boost domestic demand sufficiently to offset the rise in savings in deficit countries (such as the US and the UK). Any hint that surplus countries are ‘free-riding’ on fiscal stimulus programmes in the deficit countries, or resisting the task of reorienting their economies away from exports towards domestic demand, could provoke conflict. China could yet become the target of American or European protectionism.
The good news is that international rules and institutions are helping to contain protectionist excesses in many countries. The bad news is that protectionism is becoming more opaque and that international mechanisms have so far proved incapable of tackling global imbalances. If the G20 is serious about stemming the protectionist tide, it will have to devote more time discussing global imbalances than it has to date.
Centre for European Reform © CER 2009
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