by Michael Pettis
Last week’s Senate bill on Chinese currency intervention predictably enough brought out all the same old arguments about international trade, and just as predictably has hardened the opposing positions in the debate. Unfortunately the difference between a good outcome, intelligently negotiated, and a bad outcome, is pretty large, but with each side hardening its position the likelihood of a good outcome is declining.
The biggest problem with the debate, I think, is the muddled thinking and half-baked arguments that characterize each side. For example many of those who believe China is cheating on trade go through complicated exercises to prove the currency is undervalued and should be sharply revalued.
The currency may well be undervalued, but a significant rise in the RMB, especially if it is countered domestically by an increase in credit at lower real rates, might actually make the global imbalances worse and, more worryingly, cause China’s debt burden and capital misallocation to rise. This would make China’s eventual adjustment far more difficult.
Correct Focus for China
The focus should be on shifting China’s economy towards the more labor-intensive and efficient sectors, and an appreciating RMB might actually make things worse, especially if it encourages hot money inflow. It is much better, I think, for China to raise interest rates than to raise the value of the RMB.
A Common “Truth” that is Wrong
The other side’s arguments are even more muddled. The US-China Business Council, for example, issued a release on October 12 that exemplifies one of the major misunderstandings on trade. I realize that the USCBC is primarily an advocacy group, and so their arguments are aimed at supporting a position rather than adding to the debate, but I wonder if making arguments that are so easily refuted helps their cause.
Here is what the USCBC said in their October 12 release.
USCBC believes that the currency legislation passed yesterday by the US Senate will do more harm than good. USCBC continues to advocate that China needs to move faster toward a market –determined exchange rate; passing tariff legislation on imports from China will not get us closer to this goal and will hit the pocketbooks of American households at a time they least can afford it. Limiting imports from China would not mean an increase in US employment or lower the trade deficit; we’ll just shift our imports to another overseas supplier. If this is intended to be a jobs bill, it is a jobs bill for Vietnam, Indonesia and Mexico.
For their first point, we should be clear. Tariffs will hurt the pocketbooks of American households as consumers, but not as workers. If there is a positive impact on employment, under conditions of high unemployment households are likely to be better off, not worse off, if there is a resulting contraction in the trade deficit, even if the cost of consumption rises. This is just arithmetic.
So the key question is whether actions taken by the US can cause the trade deficit to contract and with it US unemployment. This is where their second point comes in. The USCBC says there will be no domestic employment impact – which also means that it will cause no contraction in the current account deficit – because any reduction in exports from China will merely shift the US trade imbalance to countries like Vietnam, Indonesia and Mexico.
Others make the same argument. David Pilling, for example, someone with whom I usually agree, in Thursday’s Financial Times says:
Even if Chinese exports do become less competitive, jobs are unlikely to flock to high-wage economies such as the US. Rather they will tend to go to other low-wage ones such as Bangladesh, Vietnam, Indonesia and Mexico.
But no. As I have pointed out many times, this argument is wrong for at least two reasons. The first reason is the implicit claim that there is no overlap between US production and Chinese production – it assumes that the US produces, or can produce, none of the things that China exports. This is clearly and demonstrably false.
The second, and much more important, reason is that this argument implicitly assumes that changes in trade flows only have first order impacts – in other words if a Chinese textile exporter loses his American client to a Mexican exporter, there will be no further economic impact on the US trade account. This, of course, is nonsense.
Let us assume for a moment that 100% of any reduction in US imports from China results in an equivalent increase in US imports from Mexico and none of it from an increase in US production. This is very unlikely but I am willing to concede the point for the sake of argument.
Trade is Global, not just Bilateral
Lucky Mexico, right? But the story of course doesn’t just end there. Why do Mexicans want to increase their exports – just so that they can rank higher on the export league table? No, of course not. They want to increase their exports so that they can increase their own incomes and so consume more at home.
Since Mexico’s own current account will be determined by the gap between domestic savings and investment, depending on how much excess capacity and unemployment there is in Mexico, the increase in Mexico’s exports will be more or less matched by an increase in Mexican imports. After all a surge in Mexican exports to the US should cause Mexican wages to rise, Mexican unemployment to fall, Mexican interest rates to rise, and the peso to rise.
All of these things will increase household income and so increase domestic consumption and domestic investment in line with the increase in domestic production, and this will require additional Mexican imports. Some of these additional Mexican imports will come from the US, and some from some other country, but the other country from which Mexico imports more will then go through the same process. Ultimately many countries’ trade accounts will be affected, and the net impact will be an increase in US production.
The key (and indisputable, since it is just an accounting identity) point is that if China’s trade surplus falls and Chinese net purchases of dollars decline correspondingly, the US current account deficit must decline by an equal amount. There are many ways this can happen, some good and some bad, some directly and some through changes in the trade balance of other countries, but it must happen.
To claim otherwise shows a marked inability to understand the balance of payments mechanism. What we really should be debating is how to accomplish this shift in trade in a way that is optimal for China, the US, and Mexico. Denying that it will happen really doesn’t help.
There is more. In his Financial Times article Pilling provides some other very common arguments as to why US trade intervention will have no effect on US employment, and I think these arguments are also wrong, or at least more complicated than he makes out. He says:
Many items supposedly made in China are just assembled in China. A report by the Asian Development Bank Institute in 2010 found that, of the estimated $178.96 wholesale cost of an iPhone, the value of assembly work in China accounted for only $6.50. Most of the manufacturing cost comprises high-precision components made not in low-wage economies, but in high-wage ones such as Japan and South Korea.
Since June 2005, when the renminbi was first unpegged, the Chinese currency has appreciated 30 per cent against the dollar. The real rate of appreciation is greater given higher Chinese inflation. We should not be surprised that this has failed to do the trick. The yen virtually doubled in value within two years of the 1985 Plaza Accord, with little impact on Japanese exports.
The iPhone example in the first claim always seems to come up, but of course it would only be relevant if iPhone-like products consisted of all, or at least the bulk, of China’s production of tradable goods.
Do they? Perhaps they do, in which case the claim – that there is too little Chinese pricing component in China’s exports for a revaluation to matter – may well be plausible, but to the extent that it is true it also means that there would be no cost anyway to China of revaluing the RMB. Revaluing would not affect China’s export competitiveness one whit.
Of course if this true, China should quickly revalue even without US pressure. After all why worsen China’s terms of trade and give up control of monetary policy if there is no positive employment impact of currency intervention? Simply to annoy the US Senate?
The fact that China isn’t immediately revaluing in a massive way, I suspect, suggests that no one in China buys this claim. The iPhone is probably a very atypical example of Chinese exports or of products aimed at import substitution (which, let us not forget, are just as relevant to the debate over trade intervention as are actual exports).
Exchange Rates and Account Balances – It’s Complicated
The second argument is more complicated and perhaps more confused. The experiences of Japan after 1985 and China after 2005 are often used to prove that exchange rates don’t matter to trade imbalances. In both cases, after all, rising current account surpluses followed currency appreciation.
Of course, and again, if anyone in China (or Japan, for that matter) really believed that the level of the currency is unrelated, or even inversely related, to the size of the trade surplus, the conclusion would be all the more urgently in favor of appreciation. If raising the value of the RMB really does give China the same or a bigger current account surplus, then why not do it immediately? There would be nothing but positive benefits for China.
Getting the Logic Right
The answer, of course, is that currency does indeed matter, but it is not the only thing that matters. In both cases – Japan after 1985 and China after 2005 – the currency appreciation was matched by a significant expansion of domestic credit and a reduction in real interest rates.
As I have often argued, repressed interest rates are an even greater cause of the current account surplus than a repressed currency. If China forces up the RMB but then lowers real interest rates even further, the combination could easily cause the current account surplus to rise, but at the expense of more capital misallocation in China – as Japan’s experience in the 1980s amply demonstrated.
Bloomberg recently had an interesting article on Friday showing just how this relationship between credit and the international competitiveness of the tradable goods sector works:
China has taken on General Electric Co. (GE) and Western peers that control the $70 billion wind-turbine market, striving to repeat its 2010 coup when the Asian nation sold more than half the world’s solar panels for the first time.
Armed with at least $15.5 billion in state-backed credit, China’s biggest windmill makers Sinovel Wind Group Co. and Xinjiang Goldwind Science & Technology Co. won their first major foreign orders in the past year. They plan to set up plants abroad, including China’s first in the U.S., easing entry into markets for delivering machines that can weigh 750 tons each.
…Sinovel, Goldwind and China Ming Yang Wind Power Group Ltd. (MY) have disclosed at least $15.5 billion in loans and credit lines since May 2010 to aid their international expansion from CDB and Industrial & Commercial Bank of China (601398) in statements and filings. Goldwind and Sinovel announced plans to raise as much as 10.5 billion yuan by selling bonds. Goldwind disclosed its move in June, and Sinovel announced regulatory approval yesterday.
As part of Sinovel’s biggest European deal, CDB will provide debt financing to its Irish partner, Mainstream Renewable Power Ltd. A-Power plans to raise $260 million in debt from Chinese lenders for its Texas wind park, it said in May. CDB is offering a yuan-denominated loan for Florianopolis- based Desenvix’s 34.5-megawatt project at an interest rate about four percentage points lower than what’s available through Brazilian banks, though hedging the yuan currency risk might offset that discount, Desenvix’s Antunes said.
Aside from suggesting that there is indeed some overlap (wind turbines and, as the article mentioned elsewhere, solar panels) between Chinese exports and US production, the main point here is that it is possible to change relative competitiveness not just be adjusting tariffs or the value of the currency, but even more importantly by adjusting local financing costs, especially for capital-intensive products.
Deterioration of Trade
I hope I am not cherry-picking weak arguments, but I think every article I saw opposing the Senate bill used one or more of these three arguments. In general there are altogether too many muddled arguments in favor or against trade intervention. It is even possible for someone like Guido Mantega, Brazil’s finance minister, to take major interventionist steps all the while decrying the rise of currency and trade wars.
The truth is that I am very pessimistic about the evolution of trade over the next few years. I expect further sharp deterioration in the international trade environment and the continuation of trade and currency wars. Part of the reason for my pessimism is the dishonesty or muddle-headedness of both sides of the debate, and this cannot but lead to grandstanding, unrealistic expectations, and more fighting.
If we are going to do better, at the very least we need to accept two pretty straightforward claims that both basic trade theory and economic history confirm pretty overwhelmingly:
- Trade intervention is bad for global growth, and the world would be poorer, not richer, if international trade collapsed.
- Diversified economies with high unemployment and large current account deficits generally benefit, at the expense of their trade partners, from trade intervention. Surplus countries, by the way, have almost no real ability to retaliate. In fact it is very hard to find a significant counterexample in history, in which an increase in tariffs or a devaluation of the currency did not cause employment growth for a diversified country with a large trade deficit. I, for one, haven’t found any, but I find it easy to remember cases in which trade intervention resulted in relative outperformance.
If trade warriors refuse to accept the first claim, and free traders refuse to accept the second claim, I really don’t see how we can possibly arrive at a globally optimal outcome. Trade will continue to contract as deficit countries discover that trade intervention indeed works, just as Keynes claimed that it would, to shift the unemployment burden of adjustment from deficit countries to surplus countries.
This argument, by the way is not just about China and the US. It is just as much about Germany and deficit Europe. And it is no closer to being understood there either.