What is the real solution to America’s trade deficit?

The US Congress seems more determined than ever to tighten the noose on China.  The issue is trade policy – and the legislative response to America’s outsize bilateral trade deficit with China.  The way things look today, bipartisan support for such efforts is deep enough to assure veto-proof passage of tough trade sanctions on a broad array of Chinese products shipped to the US.  I continue to believe this could be a policy blunder of monumental proportions.  By going after China, the US Congress is playing with fire.

US-china trade policy: a flawed ‘remedy’

For starters, this legislative “remedy” is based on seriously flawed macroeconomic analysis.  China bashing doesn’t address the real problem that Capitol Hill believes is bearing down on American workers – a multilateral trade deficit that hit a record $836 billion in 2006.  Since the Chinese bilateral deficit of $232 billion amounted to the largest slice of the overall trade gap – 28% for all of 2006 and fully 34% in the final period of the year – Congress has concluded that China is the major culprit behind the trade-related squeeze on middle-class American workers. 

That overlooks one key point: The United States runs trade deficits not because it is victimized by unfair competition from China or anyone else but because it suffers from a chronic shortfall of domestic saving.  That’s right, lacking in saving – as evidenced by a net national saving rate that plunged to a record low of 1% of national income over the 2004-06 period – the US has no choice other than to import surplus saving from abroad if it wants to keep growing.  That means running current account and trade deficits in order to attract the foreign capital.  China turns out to be the biggest piece in this equation not because it is unfairly undercutting American-made products but because its menu of products satisfies the tastes and preferences of a chronically saving-short US economy.  China bashers continually overlook the macro context of America’s bilateral trade deficits at great peril.

US-China trade policy: consequences of legislation

Consider the consequences if Congress gets its way and US trade with China is significantly curtailed: The immediate impact would be a tax on US multinationals like Wal-Mart, which sourced some $18 billion of goods from China in 2006.  That would either squeeze profit margins or, if passed through to retail prices, raise the cost of living for American consumers.  Over time, if the sanctions were onerous enough, the impact would be to redirect US trade away from China.  But here’s where the problem gets especially thorny: Unless America increases its domestic saving, sanctions on Chinese products will do nothing to alleviate the overall trade deficit.  The outcome would follow the “water balloon analogy” to a tee – squeezing the Chinese piece would simply reallocate the deficit elsewhere.  And most likely that would redirect saving-short America’s multilateral trade deficit away from low-cost Chinese producers toward higher-cost foreign sourcing.  Again, that would be the functional equivalent of a tax increase on American consumers.

Of course, by going after China the US Congress is also biting the hand that feeds it.  China is one of America’s most important external lenders.  To a large extent this is an outgrowth of the same currency policy that has US politicians so up in arms – a “managed peg” that has allowed the renminbi to increase by only about 7% versus the dollar since July 2005.  To keep the RMB in this range, China must recycle a disproportionate share of its massive build-up of foreign exchange reserves into dollar-denominated assets.  As of February 2007, China held $416 billion of US Treasuries – second only to Japan and up nearly $100 billion from the level a year earlier. 

And there is good reason to believe that the Chinese hold another $300-400 billion in other dollar-based assets, such as agencies and corporate bonds.  By continuing to allocate at least 60% of its ongoing reserve accumulation into dollar-denominated assets, China remains an important source of demand for American securities – thereby helping to keep US interest rates lower than might otherwise be the case.  In effect, Chinese currency policy is subsidizing the interest rate underpinnings of America’s asset economy – long an important driver of the wealth effects that support the US consumer.

Congressional pressure on China could put its bid for dollar-denominated assets at risk for two reasons: On the one hand, if China accedes to US pressure and allows the RMB to appreciate a good deal more against the dollar, there would be less of a need to recycle such a massive amount of FX reserve accumulation into dollar-based assets.  Absent such buying, US interest rates could rise.  On the other hand, if Washington enacts onerous trade sanctions on China, there is a good chance that the Chinese government could retaliate and order its reserve managers to diversify incremental reserve accumulation out of dollars.   In that case, the dollar could plunge and longer-term US real interest rates could rise sharply – a crisis-like scenario that could tip an already weakened US economy quickly into recession.  Either way, by imposing sanctions on one of its major foreign lenders, the Congress could be putting a saving-short US economy in a very precarious situation.

Nor does the Congress appear to be all that sensitive to the internal pressures that trade sanctions might impose on China or the broader Asian economy.  Despite its rapid growth and increasingly important role as one of America’s major suppliers of goods and financial capital, China is still a very undeveloped economy.  That’s especially the case with respect to its financial system, dominated by four large banks that are only just starting to go public.  Banks and China’s other international borrowers need to be able to hedge their currency exposure – especially in the face of the large exchange-rate fluctuations that Washington lawmakers are seeking.  Lacking in well-developed capital markets, such hedging strategies are very difficult to implement in China.  A large RMB revaluation could, as a consequence, deal a lethal blow to China’s embryonic financial system

Moreover, there is the distinct possibility that Washington-led China bashing could inflict major collateral damage on the rest of Asia.  Contrary to popular folklore, China has not become the world’s factory.  Instead, it is functioning much more as the final destination of a huge pan-Asian supply chain – directly involving inputs and supplies from the region’s other major economies like Korea, Taiwan, and Japan.  China is, in fact, the largest export market for the first two of these externally-led economies and is rapidly closing in on the US as Japan’s largest export market.  Professor Lawrence Lau of Stanford and the Chinese University of Hong Kong has estimated that domestic PRC-based content accounts for only about 20% of the total value of Chinese exports to the US (see Lau’s 2003 paper, “Is China Playing by the Rules?” presented as testimony in September 2003 before the US Congressional Executive Commission).  More recent research by economists at the central bank of Finland underscores how shifts in the RMB would reverberate throughout a vertically integrated pan-Asian production platform (see Alicia Garcia-Herrero and Tuuli Koivu, “Can the Chinese trade surplus be reduced through exchange rate policy?” Bank of Finland, BOFIT discussion paper #6, 2007).  The US Congress is operating under the false presumption that trade sanctions would be a surgical strike on China.  That is unlikely to be the case.  Instead, there would undoubtedly be major cross-border spillovers that could quickly put pressure on the rest of a China-centric Asian supply chain.

There is a final misperception about the oft-feared Chinese exporter.  It turns out that China has become an important efficiency solution for many of the world’s multinational corporations.  China’s so-called foreign-invested enterprises – basically, Chinese subsidiaries of multinationals – have accounted for more than 60% of the explosive growth of overall Chinese exports over the past decade.  That raises serious questions about the real identity of the widely feared, all-powerful Chinese exporter.  It may be less of a case of the indigenous Chinese company and more an outgrowth of conscious decisions being taken by Western companies.  Who is the new China – is it them or us?

Unfortunately, the US Congress is seeing the China problem from a very narrow perspective.  At the root of Washington’s approach are understandable concerns about increasingly acute pressures bearing down on American middle-class workers.  But the link between this painful problem and China is based on flawed macro analysis – mistakenly focusing on the bilateral piece of a major multilateral imbalance of a saving-short US economy.  As is often the case, one error can beget another, and the real risk is that Washington-led China bashing could trigger a host of unintended consequences – not only taxing American consumers and US multinational corporations but also triggering currency and real interest rate pressures that could tip the US economy into recession.  But the biggest tragedy could come from a United States that squanders an historic chance to engage China as a strategic partner in an increasingly globalised world.  And if Washington pushes China away, I fear the rest of an increasingly China-centric Asia won’t be too far behind.

globalisation isn’t easy.  It puts pressure on developing and developed countries, alike.  As the world’s leading economic power, it falls to the United States to assume the special role as a steward of globalisation.  China bashing is tantamount to an abdication of that role.  globalisation may have an exceedingly tough time recovering

By Stephen Roach, global economist at Morgan Stanley, as first published on Morgan Stanley’s Global Economic Forum