The tone of U.S.-China relations, as evidenced by General Electric CEO Jeff Immelt's provocative “colonization” remarks, are deteriorating rapidly and signaling trouble ahead. Given the importance of this relationship it is important to understand what's at stake and how events may play out.
Sizing Up the Sino-American Relationship
The U.S. has the world's largest economy and the U.S. Dollar is the world’s reserve currency. China has the world’s fastest growing large economy, and it has proven comparatively resilient in the wake of the ‘Great Recession’. China recently passed Japan to become the world's second largest economy, and Goldman Sachs has forecasted that China will overtake the U.S. by 2027.
While the export of manufactured goods to countries such as the United States has been a key driver of China’s growth story, benefits have accrued on both sides of the Pacific. Large U.S. government deficits have been underwritten in part by the thrifty Chinese, and U.S. consumers have snatched up voluminous quantities of low cost Chinese imports.
This seemingly symbiotic relationship, which Harvard Professor Niall Ferguson has termed ‘Chimerica’, avoided close scrutiny during the credit boom years. But amid high U.S. unemployment and a mounting public debt Chimerica is now under a microscope.
China’s “Unfair” Currency Policy
China has been accused of manipulating its currency by pegging the renminbi to the U.S. dollar at an artificially low rate, thereby allowing China to gain an unfair trade advantage. Critics point to China’s more than $2 trillion in largely U.S. dollar denominated foreign exchange (forex) reserves as prima facie evidence that the renminbi is grossly undervalued. Market participants have speculated that if the renminbi were allowed to freely float it would appreciate by 20-40% against the U.S. dollar.
Emerging market and EU officials have joined the U.S. in criticizing China's currency policy. Under pressure, China’s recent announcement that the renminbi would be allowed to float was initially greeted with widespread enthusiasm. However, since the announcement the value of the renminbi has moved within a narrow 0.5% range, remaining effectively unchanged. This has led some critics, such as NY Times columnist Paul Krugman, to accuse China of “playing games”.
A U.S.-China Economic War?
One of history’s unfortunate reoccurring themes is the tendency on the part of political leaders to create foreign scapegoats, particularly when faced with challenging economic times and an uncertain electoral environment. From this perspective surging, recalcitrant China makes for a nearly ideal political target.
Candidates for office can blame the U.S. unemployment problem on “unfair” China competition and the undervalued renminbi. China's large U.S. treasury holdings (estimated at up to $1 trillion, or roughly 20% of all foreign holdings) will also make a convenient target for fear mongers pointing at foreigners as the source of the U.S.’s troubles. Expect increasing criticism of China (reminiscent of 1980s Japan bashing) from politicians, labor groups, talk radio, etc. through this November's mid-term elections and through the next presidential election cycle.
What is the likelihood that the U.S. will go beyond rhetoric and take action? Seeing the renminbi revalued upwards is one of the few policy areas with bipartisan support. President Obama may feel pressure to appear strong and stand up to foreign powers to preserve the American economic way of life. Calls to “do something” will only grow louder in the face of the projected slow employment recovery. In short, formal trade action against China cannot be ruled out.
How would China respond to overt moves by the U.S.? The Chinese government detests foreign pressure. At the same time China's leadership, emboldened for example by the failure of The West to prevent the financial crisis and Google's recent blink, is growing more confident. Looking to flex its new economic and geopolitical muscles, China would almost certainly retaliate in some fashion against any U.S. trade action.
Both the U.S. and China possess numerous incentives to avoid a serious breakdown in relations. The economic and political consequences would be devastating for both countries and the rest of the world. The central question is will the U.S. and China be able – or willing – to find a path towards compromise which is also congruent with their respective interests?
It is human nature to underestimate the probability of seemingly unlikely, large-scale events like a U.S.-China trade and currency war. However, students of history know this to be an all-too-frequent mistake.
In considering whether such a conflict can be successfully avoided it is important to remember that policymakers often fail to properly diagnose and head-off the really big problems, such as war and financial crisis. Assurances by officials shortly before the near collapse of the financial system that the subprime problem was "contained" is but one recent example.
What could lead to a more serious escalation of tensions? A WTO ruling, U.S. Congressional action, China’s sale (or further purchases) of U.S. Treasuries, or an Asia Pacific geopolitical event (i.e., Taiwan, North Korea, etc.) are just a few of the possible triggers.
With China in the U.S.'s political crosshairs investors would do well to continue to closely monitor the world’s most important bilateral economic and political relationship. And given the stakes, let us hope that the current U.S.-China trade and currency war doesn't escalate further, for even a mild economic war could be devastating.