from Follow the Money

Will China get hit by the cover jinx?

May 1, 2005

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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It is a bit hard to start shorting the renminbi (RMB/ the Chinese currency) just because China has now made its appearance on the cover of Newsweek. It is hard to short something that has yet to be allowed to rise ...

But maybe a Newsweek cover is a leading indicator that China’s current boom is on its last legs. Nouriel and I certainly are far less optimistic than Fareed Zakaria, who rather blithely dismisses concerns about the sustainability of China’s current expansion.

For a decade now they [the naysayers] have been predicting, "This cannot last, China will crash, it cannot keep this up." So far at least, none of these prognoses has come true. And while China has many problems, it also has something any Third World country would kill for—consistently high growth.

I generally like Zakaria’s work. But he seems to have spent a bit too much time reading Tom Friedman and not enough time reading Stephen Roach -- his analysis of China leaves out a bit too much for my taste.

Consider his argument that:

"the result [of China’s growth] is that much of the world now relies on the China market. From the United States to Germany to Japan, exports to China are among the crucial factors propelling growth."

Alas, the facts are not terribly kind to his argument, as least for the US. US exports to China rose from $28.4 billion in 2003 to $34.7 billion in 2004. A $6.3 billion increase is nice, but it is not doing a whole lot for the US economy. US exports to the European Union rose by far far more ($17.4 billion). Indeed, in 2004, US exports to stagnant old Europe (France and Germany) grew by more than US exports to China ($6.7 b v. $6.3 b). And if you add in US exports to the Netherlands, which is a common port of entry for US exports to the rest of the old world, not just the Netherlands, the increase is more like $10 b.

A good rule thumb: make sure your research assistant knows how to use the US trade data.

To be fair, US exports to China have increased significantly in percentage terms over the past four years, though off a very low base. And no one doubts that demand from China has been a huge boon to the world’s commodity exporters, from Argentina to Brazil to Australia to anyone with oil.

US exports of goods to China certainly matter for a few specific companies (Boeing, GE), but they are still too small to have much of an impact on the US economy.

Want to find the parts of the US economy that are benefiting from China? Listen to Warren Buffet’s sidekick Charlie Munger: "You have a real asset-price bubble in places like parts of California and the suburbs of Washington, DC." China is both the largest and the fastest growing foreign market for US debt. Recorded US exports of debt to China ($65 billion)exceed US goods exports to China -- and recorded Chinese purchases of US debt clearly lag behind China’s real purchases of US debt. The US realtors association probably does not realize just how much of its good fortune was made in China.

The word "trade deficit" did not appear prominently in Zakaria’s esssay. I understand the aversion to focusing on the bilateral US/ China deficit in an article that wants to steer away from the domestic politics of trade, and focus on the broader issues associated with China’s rise. But I don’t think it works.

The US bilateral deficit with China is embedded in a broader pattern of global trade (and global savings and consumption) that is generating a large and growing overall Chinese trade surplus and a large and growing overall US trade deficit. China’s projected 2005 current account surplus is every bit as large as the United States projected 2005 current account deficit, relative to each country’s GDP.

Moreover, after three years of extraordinary growth in Chinese exports to the world -- and equally extraordinary growth in domestic credit inside China -- I think it is worth at least asking if China’s "investment in the export sector" model is likely to run into real limits soon. 35% y/y export growth is hard to sustain, even if you are China. 35% y/y export growth over the next two years would imply China’s 2006 exports would approach $1100 b, up from around $600 b in 2004.

I have said it before and I’ll say it again: it generally is not a good sign if your largest customer can only afford to buy your products if you lend him (or her) your credit card.

I heartily agree with Zakaria’s call to cut the US fiscal deficit to cut the United States’ dependence on China for financing.

It [the US] has run irresponsible fiscal policies, knowing that foreign governments and people would provide it with unlimited credit. But that credit comes at a price. When China holds huge reserves of dollars, it also holds the power to damage the American economy. To do so would certainly hurt China as much or more than it would America, but surely it would be better if U.S. policy were less vulnerable to such possibilities. Fiscal responsibility at home means greater freedom of action abroad.

But I also felt Zakaria’s call for the US keep its borders open and compete, compete, compete was a bit simplistic. Not because I believe that the right response to China’s economic rise is a new wave of protectionism, but because I don’t think you can disentangle protectionism from concerns about the exchange rate. I’ll put it this way. The following combination is not politically sustainable: the renminbi/ dollar peg at 8.28; free trade across the Pacific; and a political system where those benefiting from low interest rates (made possible in part by China) don’t do much to help those hurt by competition from China.

The US textile industry is a dinosaur, but it is not obvious to me that the US automobile industry (including Japanese and German transplants) is a dinosaur as well. I suspect that the location of the next generation of auto plants (or perhaps auto parts plants) hinges in part on something Zakaria ignores: whether the renminbi/ dollar is going to be closer to 8.28 or 4.14 in five years. Remember, Daimler Chrysler is building a plant in China to produce for the US, not the Chinese, market.

I think this raises a broader issue, one that I would like to have seen Zakaria take on:

Imagine two type of growing economic and financial integration. In one form, this integration comes from balanced trade and financial flows. Exports and imports more or less balance, on both sides. US investors are buying the financial assets of the foreign country, and that country’s investors are buying US financial assets. The US ends up with a stake in the foreign countries’ economic success, and the foreign country ends up with a stake in the United States’ success.

That more or less describes the post-war US relationship with Europe, leaving aside the brief period when the US financed Europe’s reconstruction and the recent emergence of a significant bilateral trade deficit between the US and Europe. That deficit reflects Europe’s relatively slow growth, but even more so the extraordinary expansion of US consumption/ fall in US savings. US exports to Europe have grown nicely recently on the back of the dollar’s fall; US imports are just increasing more rapidly.

Compare the "balanced" form of integration where exports are (generally speaking) matched with imports and US investment in Europe is matched by European investment in the US with another form of integration. In the second model, one country saves, the other does not. One country exports, the other imports. One country runs a large current account deficit, financed to a significant degree by the other country’s government reserve accumulation.

That, as we know, describes the current US-China economic relationship.

The result: China’s financial investment in America far exceeds the United States financial investment in China. US FDI in China is quite small. According to recent work by Eswar Prasad and Shang-Jin Wei of the IMF, the US has accounted for less than 10% of the roughly $540 billion in cumulative FDI inflows toward China between 1990 and 2004 -- that works out to around $55 billion, plus any capital gains. There is relatively little US investment in China’s stock and bond markets, in part because of China’s capital controls. Total US claims on China are, I would guess, well under $100 billion. By the end of 2005, roughly $700 billion of China’s projected $950 billion in reserves will be invested in US debt. The $950 billion estimate includes the $57 billion in reserves now used to recapitalize China’s banks, along with an assumption that China’s reserve will rise by $300 billion this year.

Some say that gives China a huge incentive not to do anything that would reduce the market value of its US holdings (like sell them). That is a bit too simplistic. The value of China’s investment in the US hinges in part on what China does, but also in part on what the US does. China’s leaders clearly are starting to worry that the US is not pursuing economic policies, notably taking steps to cut the fiscal deficit, that would help to at least limit China’s future losses on its US debt holdings. The interests of a creditor country are not always perfectly aligned with the interests of a debtor country.

China’s goverment won’t have to go before a domestic legislature and explain why the government is looking to the country’s taxpayers to cover the government’s losses on its speculative bet on the dollar. But that does not mean China’s leaders don’t worry about the long-term value of their dollar assets -- or that US economic policy choices won’t emerge as a source of friction.

Conversely, by the end of 2005, the US may import something like $260-270 billion of goods from China, and export only $45 billion of goods to China. Firms that rely on Chinese goods to fill their US supply chains have an enormous stake not only in China, but also an enormous stake in an undervalued Chinese renminbi.

Lots of Americans are employed selling Chinese goods to other Americans. But relatively few Americans are employed making goods to sell to China. Politically speaking, the benefits from trade with China are both too diffuse (lower prices for a wide range of goods, lower interest rates) and too concentrated (Walmart). Setting Boeing aside, the natural constituency for trade created by the US employees of firms that export to China is, by and large, lacking.

That -- along with the sense that competition with China is keeping US real wages low in a range of industries -- has something to do with the current bipartisan consensus to bash China.

I would feel much more comfortable that economic and financial ties would help to ward off potential geopolitical frictions created by China’s rise if the relationship was far more balanced and symmetric. Right now, though, it keeps getting more unbalanced.

I think this raises two sets of risks. The first set of risks arises if the current unbalanced relationship continues for much longer. There are plenty of winners from the status quo, but the winners from the unbalanced relationship (think suburban Los Angeles home owners, New Yorkers who don’t drive and who own million dollar apartments, the owners of Chinese factories and Shanghai property owners) don’t necessarily compensate the losers (think Carolina textile workers, Ohio auto parts workers facing higher gas prices living in factory towns that the real estate boom has passed over, Chinese peasants whose land is effectively given over to real estate developers at below market prices, and the Chinese taxpayers who will have to bailout China’s central bank for all the subsidized credit it is now providing the US). There are people in China who do not think they are getting their fair share of the boom. And a slowing US economy combined with surging Chinese imports is likely to make the US domestic debate on trade explosive.

The other set of risks arises from the transition to a more balanced relationship. That transition is essential, but it won’t be easy. In the short-run, there are probably far more folks on both sides of the Pacific who benefit from the continuation of the unbalanced relationship than who will benefit from the first steps towards a more balanced, and ultimately more healthy, economic and financial relationship. The transition to a world where the US saves more and consumes less, imports less and exports more -- a world where China saves less and consumers more, imports more and exports less -- seems likely to generate its own set of frictions.

There is a risk that the next Chinese slump, at least in part, may be made in the USA -- the US consumer cannot keep on consuming more than he/ she earns forever. Conversely, there is a certain risk that the next US slowdown will be, at least in part, made in China: China’s capacity to finance the US is not infinite. The forthcoming set of adjustments will test the US-Chinese relationship, in ways that are hard to predict.

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