The latest U.S.-China spat is all the more extraordinary because it is unnecessary. For years, Chinese economists have advocated liberalizing the exchange rate and allowing it to rise, weaning the country off its addiction to exports. But when President Obama suggested that last week, China's leadership reacted with a furious snarl. The central bank's vice governor accused Obama of "politicizing" the currency issue; never mind that his own boss had hinted at liberalization a week earlier. Then China's premier, Wen Jiabao, weighed in. Clearly referring to Obama's unremarkable remarks, Wen growled, "This is a type of trade protectionism."
What to make of this outburst? It is not right on the merits. If any country is responsible for protectionism and for politicizing the exchange rate, it is China: Beijing's leaders have made a political decision to peg their currency at an artificially low level, handing their exporters a competitive advantage. Yet China's outburst reflects the insecurity behind its confident facade. It serves as a reminder of how autocratic political systems suffer from the lobbies and gridlock that bedevil democracies.
The reminder is timely because China's financial comeback has made autocracy look good lately. The country's export-driven growth model made it acutely vulnerable to the global slump; at the end of 2008, growth fell to almost zero. Then China roared back, growing at 8.7 percent last year. No rival comes close to matching its dynamism.
But the currency flare-up hints at China's vulnerabilities. The government engineered its comeback with desperate measures: As well as the announced budget stimulus, it embarked on a largely unannounced monetary stimulus, which consisted of ordering banks to shovel loans out the door as fast as possible. Now, inflation is rising; the banks are wallowing in loans that will never be repaid; and the government is scrambling to close the monetary spigot. As the United States may discover in its turn, withdrawing a stimulus can be difficult.
The first worry for China is that lending won't come down fast enough. Banks have made commitments to finance projects and cannot easily back out; besides, money may leak into bubbly real estate projects via channels that circumvent the banking system. Moreover, even if lending is reined in, the banks may do so inefficiently: China sets monetary policy by targeting the quantity of loans rather than their price, so powerful state-owned enterprises are liable to get capital while more productive private firms are starved of it. Meanwhile, ambitious provincial politicians such as Bo Xilai, the party boss in the western city of Chongqing, may defy the central government. If he wants bank loans to build popular projects such as affordable housing, it may be hard to stop him.
So while China's leaders frequently sound smug, they are nervous. In the news conference at which he chastised Obama, China's premier also referred menacingly to "the unsteady, uncoordinated and unstable development of the Chinese economy." Amid all the uncertainty about how to let the air out of an asset bubble and bring runaway bank lending under control, the last thing Chinese leaders seem to want is to abandon the yuan's peg to the dollar, which they regard as a source of stability.
Again, though, this view is wrong on the merits. Chinese growth is unstable partly because of the yuan-dollar peg, which obliges the government to set interest rates with an eye toward the exchange rate rather than using them to manage the cost of capital. But the technocratic arguments are trumped by political pressures. Exporters lobby the government not to let the yuan rise, and the lobbying is effective. Nationalists reflexively oppose policies that Washington demands; no Chinese official wants to look soft on foreign policy. In conversations in Beijing this week, several Chinese analysts suggested that Google's protests against Chinese hacking were a deliberate provocation orchestrated by the Obama administration. Such is the climate of suspicion toward Washington.
Sooner rather than later, China needs to free its exchange rate and switch from rationing capital to pricing it. Sooner rather than later, China needs to rely less on exports that foreigners cannot afford to buy without borrowing too much and setting the stage for another credit crisis. But while China's autocratic system was good at quickly delivering a stimulus, it is not so good at tackling trickier structural challenges such as revamping its currency policy.
Good at spending money but not good at complex reform? Does that sound a little like American democracy?
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