by Sara Eisen
The world is out of balance.
In the West, a sovereign debt crisis is looming, with troubled developed countries being politically unable to restructure their debt or create long-term programs to pull themselves out of downward spirals exacerbated by a series of international austerity frenzies. The U.S. government, in the aftermath of a brutal financial collapse, is squabbling over tax cuts for the wealthy. Meanwhile, the European Union has been incapable of resolving its core structural problems, and its democratic governments are once again proving incapable of facing the collective challenges of a systemic economic crisis. The rituals of austerity that we’ve seen in the United States and Europe—ill-fated attempts to spur growth in depressed economies by contracting the public sector—would be familiar to any scholar of the early twentieth century and the Great Depression. Indeed, the global economy is beginning to exhibit symptoms similar to those of the 1920s and 1930s, except with a modern twist. Today, the world is suffering the consequences of having its stability and growth tied to the U.S. economy and of Europe’s failure to emerge as a viable alternative to America’s economic strength.
Through this dysfunction, China has experienced a meteoric rise. In just a few decades, China has become the world’s second largest economy and its largest export economy. And it won’t be long before China passes the United States to become the biggest overall economy on earth. The International Monetary Fund (IMF), for instance, estimates that by 2016, China will have the world’s largest gross domestic product (GDP).1 What’s all the more remarkable is that China has managed to achieve this unprecedented growth even amidst a global economic crisis. In 2010, its GDP rose an estimated 10.328 percent.2 By comparison, U.S. GDP over the same period grew by just 2.8 percent.
On the surface, China’s growing influence is not dissimilar to America’s emergence in the late nineteenth and early twentieth centuries at the expense of Great Britain, the dominant power at the time. However, as you start peeling back the layers of China’s economy, those similarities fall apart.
First and foremost, the magnitude of China’s size and scale is unmatched in recent history. Based on this alone, China commands the world’s attention. But second, and possibly more importantly, China is the first true world power to have achieved its international status before it has approached anything approximating economic parity with the current world leaders. This is essential to understanding why it will be so much more difficult for society to integrate China as a leader of the global economic system than it was to handle the transition in power from Britain to the United States.
In many ways, China is still a desperately poor country. Despite its rampant growth, its GDP per capita in 2011 was around 16 percent of that of the United States.3 Furthermore, much of China’s population remains at near-subsistence levels, and the country has yet to establish a true middle class whose consumption can sustain a domestic demand–led economy. China’s economy remains thoroughly export-driven, and this trend is likely to continue into the near future. China’s consumer demand will not grow fast enough in the short term to make up for the decrease in consumer demand from developed countries, particularly the United States. It will take many years before developing countries see private consumption in China replace investment as the key driver of economic growth. The countries that will benefit from China’s investment will largely be those that are rich in the natural resources that China requires in increasing amounts to continue its growth and development.4 So while China’s economy is catching up to the developed world, its growth cannot become the locomotive that tows developed nations out of their slump.
In fact, China’s current economic policies appear to be hurting the economic growth of the developed world, particularly the United States. Given the wide disparities in wealth, technology, and resources, China has been able to achieve its success in large part by preventing its currency, the renminbi (RMB), also known as the yuan, from appreciating against the dollar. This enables Chinese exporters to be ultracompetitive in the global market and keeps the American and European economies vulnerable to the deflationary impact of a growing low-cost Chinese manufacturing base.
China’s insistence on using a peg for its currency is very uncharacteristic for leaders in the global economy, which typically allow their currencies to float because the world needs a multilateral system. But China has refused to set its currency free. While this strategy may have accelerated China’s growth, it also has created dire consequences throughout the world, especially in the United States. The country’s RMB currency peg may have produced massive trade surpluses for China, but it also contributed to similarly large trade deficits for the United States. America’s current account and global merchandise trade deficits peaked in 2006 at a staggering $857 billion, or 6.5 percent of GDP,5 though by 2010 this deficit had declined to $470 billion, or 3 percent of GDP, as a result of the recession.6
China’s currency peg has also been shown to contribute to increased income inequality in the United States.7 Not only does a pegged RMB suppress wages in the U.S. manufacturing sector, but it also leads to rising unemployment and increased use of transfer payments (government sepending on unemployment compensation and various social benefit programs).8 China’s development is, in effect, imposing severe adjustment strains on the developed countries by overtly exporting unemployment to those countries, particularly the United States. In an era of deficient consumer demand, China’s policy has contributed to a sharp decline in household income in the United States in areas affected by the loss of manufacturing jobs because of exposure to Chinese imports.9 Overall, China’s pegged currency has accelerated the hollowing out of the American middle class—the very same middle class that Chinese exporters have long depended on to fuel their growth.
For decades, the United States has served as a buyer of last resort for goods produced by the rest of the world. During this time, the United States has also gone from being the world’s leading net exporter to being the world’s leading net importer. What’s more, the United States’ rapacious consumer demand has helped create a situation in which the three largest economies after the United States are all export-led. Throughout the twentieth century, developed countries found success by exporting goods to feed the U.S. consumer engine. As a result of this international trade structure, the global economy has become increasingly dependent on the value of the U.S. dollar and addicted to U.S. consumer demand.
Even now, after the U.S. government’s credit rating has been downgraded, investors are still flocking to the security of U.S. Treasury bonds. Why? Because the market for U.S. dollars remains the deepest and most liquid foreign exchange (forex) market in the world. The dollar is the currency of denomination for more than 60 percent of central banks’ foreign reserves and 85 percent of all forex transactions worldwide.10 The dollar’s status as the world reserve currency thus allows the U.S. Treasury to pay much lower interest rates on the debt it issues because U.S. Treasury bonds are seen as very safe investments—the risk involved in buying U.S. debt (basically the risk that the United States will default on its debt) historically has been very low. However, perpetually low interest rates also mean that America’s reserve currency status allows it to finance a ballooning national debt, even while showing few signs of emerging from its economic crisis.
Nonetheless, with the 2008 financial crisis and the unraveling of trillions of dollars in consumer debt in the years that followed, this time may have come to an end, just as the period of British economic dominance faded in the early twentieth century. Simply put, the buyer of last resort is exhausted. At present, the U.S. economy is overburdened with debt: corporate debt, household debt, and, to a lesser extent, government debt. The problems with debt management became overwhelming after the housing bubble burst in 2008 and sent America into a balance sheet recession. The nation’s balance sheet had expanded over many years, in no small part because the United States used its “exorbitant privilege” of reserve currency status to finance
its growing current account deficit in the period leading up to the financial crisis.
As a result, the United States is now looking at the end of its economic hegemony. And the world is facing another period of transition, in which the old dominant economic power cedes sole control to the new or, at the very least, shares control with the new in ways that it never has before. The trouble is that this next transformational phase will be much more challenging than the transition of power between the United Kingdom and the United States, two countries whose financial markets were at similar levels of development and structure and that shared cultural, legal, historical, and religious traditions. The gap between the United States and China today is much wider than the earlier gap between the United States and the United Kingdom, with the United States being at a far higher level of GDP per capita than China and with both countries evolving out of very different cultural traditions. These differences will make Sino-American economic and political interactions more fraught with tension than those between the United States and the United Kingdom. As a result, the relative decline of U.S. global leadership and the emergence of Chinese authority are likely to be much more difficult to evolve on a cooperative trajectory.
This is why China’s currency policy is such a crucial diplomatic issue for the United States. While the dollar’s status as a global reserve currency has kept the overall balance of payments stable, China’s currency peg has had the effect of weakening the U.S. economy and imposing adjustment in the United States, where the exchange rate is too high and interest rates are too low. These currency imbalances are the lynchpin on which China’s own economic success has been dependent. This weakening effect is most apparent during periods of significant underemployment, so a pegged RMB is especially detrimental as the United States faces a demand shortfall following the 2008 crisis.
In response, pressure has grown for U.S. policy makers to challenge China on its currency peg. China’s economy serves to set the global price of labor, and many people in the developed world may come to share this antipathy toward China’s heavily managed currency as it continues to pressure the manufacturing sectors of the West. This trend was evident at the 2011 G-20 conference, where the G-20 leaders issued a statement asking China to reconsider its currency peg.11
As the developed world faces domestic pressure amid national economic crises, it is not likely to allow China to continue funding its growth at the expense of the developed countries’ welfare. And while China will probably become the world’s largest economy and remain so for the foreseeable future, it is still dependent on access to export markets and on inflows of foreign direct investment and natural resources to fuel its growth. It must take international political developments into account when plotting its way forward. In today’s fraught economic environment, China’s current economic policy could create a situation in which other countries are forced to look after their own national interests more than global growth. The threat of a potential trade war still looms if China proves unwilling to begin allowing the RMB to appreciate. As South Korean President Lee Myung-bak said, “If the countries fail to reach an agreement and continue to seek their own interests, they will eventually see protectionism prevail across the world.”12 This “beggar thy neighbor” approach would be disastrous for the world economy, and its long-term effect would be to dampen growth—even in China.
After the Asian crisis in the late 1990s, other emerging nations followed China’s lead and started accumulating large currency reserves in an attempt to insulate themselves from risk in the world economy. This was done with an eye toward preventing a repeat of the devastation caused by the shifts in foreign financial capital that occurred in 1997. For example, China’s massive foreign reserves enabled the country to introduce an almost $600 billion stimulus package, which helped it mitigate the impact of the global economic slowdown.
But while large foreign currency reserves may be beneficial for one nation, this approach could be disastrous if many emerging nations continue attempting to do the same—and the size of the currency reserves in many of these countries, as well as the conservative nature of where those reserves are invested, suggest that they are. This could create a “paradox of risk aversion” similar to Keynes’s paradox of thrift, whereby each country’s attempts to insulate itself from risk serves, when taken collectively, to increase risk in the world economy, and in the end to actually increase that country’s risk exposure.13 By definition, not all countries can avoid risk in the current world economy, and a noncooperative approach is liable to make the present situation much worse. An inward-focused, mercantilist economy the size of China’s will lead to lower growth for both China and the rest of the world. No one can afford a trade war, and a paradox of risk aversion could lead to an unnecessarily long and deep worldwide slump. It is in everyone’s interest to find a new way forward.
Even without international pressure, China will eventually have to allow its currency to appreciate for domestic reasons. While China has managed its nominal exchange rate (the rate of exchange between the RMB and the U.S. dollar in the open market), its real exchange rate (how each currency is valued against the other after changes in prices in China and the United States are taken into account) is still appreciating. One way or another, either through nominal exchange-rate appreciation or through inflation-rate differentials caused by China’s rapid growth and export-fueled economy, the Chinese real exchange rate will rise. Further, while China’s foreign currency reserves helped it to weather the storm of the current crisis, maintaining more than $2.5 trillion in reserves represents an enormous misallocation of resources for a country in which most of the population remains very poor, living at just above subsistence levels.14 China cannot invest all of its reserves at home, as this would lead to rapid increases in domestic inflation. And China does not have the capabilities to invest large sums of money overseas in anything but government securities, such as low-yield U.S. Treasury bonds. Even if China could do so, it’s not clear that many countries would allow heavy Chinese investment, as China is still not considered a “friendly” country in much of the world because of suspicions regarding the different nature of its government.15 In particular, developed countries and other developing nations that could support China’s large-scale investments are wary of allowing a nondemocratically controlled China to gain significant influence in their domestic affairs. China’s political history is still an impediment to its economic future.
Allowing the RMB to appreciate is also necessary if China is to make the transition from a manufacturing- and investment-dominated economy to a service- and consumer-driven economy. While China’s undervalued exchange rate has helped its growth so far, this same policy may become a hindrance as China’s economy evolves. From 2000 to 2010, investment has been growing at a far greater rate than consumption. The growth of fixed investment averaged 13.3 percent, while the growth of private consumption averaged only 7.8 percent. Over that same period, fixed investment increased from 34 percent to 46 percent of China’s yearly GDP, while private consumption shrank from 46 percent of GDP to 34 percent.16 If China is to transform its economy to a consumption-based model, this trend needs to be reversed. China’s currency peg was a large part of what brought about this investment-led growth trend, since an artificially depreciated RMB suppressed wages, allowed for expansion of cheap credit, and repressed the exchange rate, all of which effectively transferred incomes from households to businesses, and thus from consumption to investment.17
However, this type of economic reorientation almost always leads to a significant, economy-wide deceleration in productivity growth, as nascent service industries exhibit much lower efficiency gains than China’s manufacturing sector created during the major transition from agricultural to manufacturing production. To some degree, this kind of growth slowdown is unavoidable as China’s economy matures. But recognizing this issue now could make the transition much smoother. A wise approach for China would be to begin making this chang
e slowly and in a controlled manner, rather than allowing its currency to appreciate rapidly, as Japan did in the late 1980s, leading to economic stagnation.
The reality is that if China wants its economy to continue growing, one way or another it must begin facing the issues that its underappreciated currency has created. Real exchange-rate appreciation can be achieved through nominal exchange-rate appreciation, domestic inflation, or deflation in the rest of the world. The question is whether the pace of RMB appreciation will be fast enough for the rest of the world to be rescued from pressing deflation. And here the evidence is not encouraging.
Potential domestic resistance to RMB appreciation in China is ample. As George Soros has noted in the Financial Times, the government’s discretion over the use of this surplus gives it a significant political edge in domestic and foreign policy issues. Given that most of the investment of surplus foreign reserves is handled directly or indirectly by the Chinese government, the domestic effect of a pegged RMB is essentially a tax on Chinese consumers that accrues to the government in the form of large currency reserves.18 This strategy has had the effect of concentrating power in the hands of the Chinese leadership, both at home and abroad. Though the magnitude of China’s current reserves glut means that additional inflows of surplus foreign reserves may not be necessary for the Chinese government to retain this influence, any shift away from China’s currency peg may meet with significant resistance from China’s entrenched bureaucratic elite. China’s exporters, who gain a significant competitive advantage from an artificially deflated RMB, also are likely to resist RMB appreciation, and heavily leveraged state-owned enterprises (SOEs) and local governments are also likely to resist any attempt to allow the necessary rise in China’s interest rates that would accompany a shift toward consumer-led growth.