JOINED AT THE HIP WITH CHINA—FOR NOW      (Part 1)

      Too few people’s surprise, the just-concluded trip to China by U.S. Treasury Secretary John Snow proved a relative disappointment.  The purpose of the trip was for Snow to try to cajole Chinese authorities into modifying—if not severing—the link of the Chinese currency, the yuan, to the U.S. dollar.   Such a move, advocates believe, would make U.S. exports more competitive with Chinese products, supposedly leading to more business for U.S. manufacturers, more jobs, and less trouble for President Bush when he runs for reelection in 2004.

      This is perhaps the single largest “macro” issue we’ll need to follow in the months ahead.  China’s trade surplus with the United States has exploded, to an annual rate of over $100 billion.  That its currency is linked to the dollar has meant that the latter’s weakness over the last year has had no effect on our bilateral relationship with China.  In fact, by thus running a de facto depreciation regimen against many other emerging market/low wage nations, China has actually “stolen” business from many of them.  Even Mexico has suffered, as businesses that several years ago moved operations to that country move them yet again to China.

      Last but not least, the running of such enormous trade surpluses has allowed China to quickly accumulate an enormous reserve of dollars.  This growing war chest of, largely, Treasury securities (now approaching $400 billion and growing rapidly) has created two problems.  First, this influx has caused China’s own financial system to become dangerously overheated, with bubbles purportedly being created in some areas.   Second, these developments mean that now another country has sufficient quantities of U.S. debt that might arguably allow it at some future point to use that debt as a powerful weapon against the United States.

      As usual with issues of such far-reaching magnitude, most of what you’re hearing from both Washington and Wall Street mucky-mucks is quite worthless.  As far as the politicians are concerned, there will be all kinds of hand-wringing, threats from Democrats and promises from Republicans.  Almost everything coming from these sorts assumes that America has something to say about how this whole issue is resolved—which, as things are these days, is simply not true.  As far as the financial community and economists are concerned, most of the commentary from even these quarters is off base as they, too, are looking at things from the wrong country’s perspective.

CHINA’S PERSPECTIVE

      China was once a major world power.  I believe it operates with the conviction that it will be again one day; if not the world’s pre-eminent power, then at least the major force in Asia.

      Unlike the way in which the U.S. unfortunately conducts policy, China is very patient, and is looking at the longer-term implications of everything it does.  It fully realizes that it won’t achieve all of its aims next month, or even next year.  In fact, it will likely be many years.  The country’s leadership knows this, and is carefully attempting to craft the kind of trade, currency and economic policies which over time will help it achieve its goal of dominance.

      Through its linkage of the yuan to the dollar (the pegged exchange differential since 1995 has stood at 8.28 yuan per dollar) China has turned itself into much of the world’s “shop floor.”  The number of manufacturing facilities in particular has exploded in recent years.  This is in China’s interest; as it attempts to both grow its economy and minimize the occurrences of popular dissent against the government, it must create jobs on an enormous scale.  As Economics Correspondent Christopher Swann reported in the July 26 issue of the Financial Times, “China needs to create 20-25 million jobs a year for the next decade in order to absorb people moving from villages to the cities and workers being made redundant from state-owned enterprises.” 

      It needs to be remembered here that China has been furthered toward its goals by U.S.-owned businesses.  As Morgan Stanley Chief Economist Stephen Roach penned in an August 7 op-ed piece in the FT, “For more than a decade, the vigor of Chinese export growth has come far more from the deliberate outsourcing strategies of western multinational companies than from the rapid growth of indigenous Chinese companies.”  He goes on to detail that, of the growth in China’s exports over the last decade from $121 billion a year to $365 billion, “fully 65 per cent” was attributable to Chinese subsidiaries of global multinationals.

      Its huge trade surpluses have, among other things, created some near-term problems for China’s financial system.   Together with having to “sterilize” these surpluses, the country has also received huge inflows of foreign direct investment, now running at a higher rate than net foreign direct investment to the U.S.  All told, the nation’s central bank must spend an average of $600 million per day to maintain the yuan’s peg to the dollar.  This has caused the nation’s money supply to soar, leading to various problems not unlike those currently faced here: among them are a real estate bubble (especially for commercial property generally and residential property in and near the fastest-growing areas), over-investment in some areas and irresponsible lending.

            In doing anything where its trade and currency postures are concerned, China has as its goals keeping its domestic economy and employment growing, shoring up its financial/banking system, keeping its export markets growing and preparing for the day when it will have no choice but to break the yuan’s link to the dollar.

                                     AMERICA’S PERSPECTIVE

      As the hemorrhaging of jobs and the destruction of entire industries and communities continues, politicians and policy makers are under intensifying pressure to change the equation.  Yet, our leaders are speaking out of both sides of their mouths.  While feigning sympathy with those who have been “downsized” in recent years or otherwise have been sacrificed on the altar of so-called free trade, most continue pursuing policies that can only result in more of the same grief for American industries and workers.  Most do so for either their own self-interest or that of their corporate benefactors, the latter of whom—as outlined above—have profited immensely from helping to build China’s export economy.  Others naively believe that if U.S.-based multinationals are allowed to bolster their profits by outsourcing jobs and facilities to China (and elsewhere) they will later magnanimously hire back Americans and re-open shuttered American facilities. 

      Perhaps the most hypocritical (and especially misleading) statements have come from both Treasury and the Federal Reserve.  Whatever they may say publicly, America desperately needs continued Asian purchasing of huge amounts of U.S. debt in order to keep interest rates here from skyrocketing.  Together with its satellite Hong Kong, China is now purchasing Treasury securities at a whopping $290 billion annual pace, dwarfing any other nation’s purchases, even Japan’s.  This huge demand for Treasury debt has, among other things, allowed the U.S. to run what would otherwise now be debilitating deficits.  These deficits have allowed the U.S. government and, arguably, consumers alike to continue living well beyond our means, among other things running tens of billions of dollars into debt (so far) in order to invade and occupy Afghanistan and Iraq.

      You will hear a lot between now and Election Day, 2004 about how the Bush Administration in particular intends to “make” China more receptive to U.S. imports as well as to allowing its currency to appreciate.  But make no mistake—U.S. policy makers need that nearly $300 billion per year in Chinese purchases of Treasury debt a whole lot more than they need you or your neighbor to have a job.  So take everything you hear over the next 14 months with a tablespoon full of salt.

      Eventually, of course, something will have to give.  Everyone, including officials both here and in China, realizes that the current “out of whack” relationship between our two countries cannot be sustained indefinitely.  For now, China will not be severing the yuan’s link to the dollar.  Rising exports from that nation to America—and rising exports of jobs from America to China—will continue. 

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