Brian Fallow: China's rise holds US in its thrall

COMMENT

The United States, like the rest of us, faces the challenge of adjusting to the rise of China as an economic superpower.

Valid or not, concerns about "offshoring" - the loss of jobs to lower labour cost countries like China and India - have been a feature of this election year. George W. Bush risks being the first US president since Herbert Hoover to end his first term with fewer Americans working than when he began it.

But in the view of Martin Wolf, the Financial Times associate editor and chief economics commentator, who gives the Business Roundtable Trotter lecture tonight, the way China has managed its emergence as a major trading power has minimised the risk that a protectionist backlash will seriously retard its growth.

"There is a real danger that as China's exports explode there will be a pronounced protectionist resistance in the big Western markets on which it depends," Wolf told the Herald.

"But the Chinese have been clever in developing a growth pattern which is different from the Japanese and which creates important vested interests in their success."

First, there is a high import component in their exports. Many of China's neighbours, in particular, have developed major trades supplying China with bits of things which end up in its exports.

Second, China has assiduously and successfully courted foreign direct investment (FDI). Much of its export trade flows from it. It has the third-largest stock of FDI in the world and is the largest recipient in terms of new investment.

"What that means is there is pretty much no significant company in the world that doesn't now have a large vested interest in Chinese production and export success. Most of the large companies in the world engaged in international trade rely on Chinese production for a large part of their sales," Wolf said.

"To that you would have to add the weight of retailers, the WalMarts and so forth [which sell a lot of Chinese wares], and the companies which are looking to China as their greatest market."

Openness in trade terms has been a feature of China's rise, a process Wolf believes has barely begun. "The potential of the country is barely tapped. As conventionally measured, in purchasing power parity terms, it is roughly where Japan was in 1950 - the beginning of its period of rapid growth," he said.

"It has essentially unlimited reserves of labour. Its savings rate is simply phenomenal and so is its rate of capital formation. And it is extraordinarily open. The value of its exports and imports, at market prices, is about 50 per cent of GDP."

One consequence of China's rise has been to shift the relative value of commodities (upward) and manufactures (downward). That shift in the terms of trade has contributed to the strength of the New Zealand economy in the past few years.

The main losers are likely to be its competitors among other developing countries, rather than rich ones.

Nevertheless, the risk of scapegoating and protectionist pressure is real.

"Although John Kerry himself is clearly a free trader, the Kerry campaign has flirted with that sort of rhetoric," Wolf said.

"One of the genuine dangers if the deficits continue to grow, as I fear they may, is the protectionist danger in the course of the next Congress could get worse."

Because of its strong productivity growth, US output has not been able to expand fast enough to absorb the labour force, even with an expansionary fiscal and monetary policy.

"And that problem will continue. Assuming productivity growth stays high, output growth in the US economy needs to be about 4 per cent a year, so demand growth needs to be that or probably higher, and you need aggressive money and fiscal policy to make that happen. So it may mean the Fed does not raise rates nearly as much as people assume," Wolf said.

"The danger with a long period of an aggressive monetary policy to drive strong consumer private sector spending is that, at some point, this will lead to a significant erosion of the dollar's value against other floating currencies. And that could be destabilising."

The optimistic view is that, after a considerable period of retrenchment, there will now be a big corporate investment boom.

"It might generate enough growth in demand and enough credibility as to the underpinnings of US growth to support the dollar, generate employment and keep the protectionist demons at bay."

The crucial thing is overall US employment growth. Wolf said: "I think they can cope with adjustment in particular sectors provided the overall employment growth rate is sufficient to generate full employment. But if you have a lot of unemployment in aggregate and job losses in politically sensitive industries, then you have a big political problem."

He sees similarities with the situation in 1971.

"The US had a big current account deficit after the Vietnam war and there was quite a bit of protectionist rhetoric. The Nixon Administration decided they wanted a devaluation. They announced as a shock action that they were abandoning the dollar's link to gold and proposed an import surcharge in order to force other countries to accept revaluations against the dollar."

The shock worked. It destroyed the Bretton Woods system of fixed exchange rates and it forced the Europeans to revalue.

"I get a lot of emails about this saying, 'Look, we have to impose tariffs or some sort of protectionist fees on any country which runs a current account surplus with us'.

"Such bills would not pass Congress, but they would put pressure on the Administration, which could go to those countries and say, 'If you don't revalue your currencies we are going to have to succumb to protectionist pressure'."

China's policy of maintaining a fixed exchange rate has created a form of co-dependency between the two countries.

In essence, huge purchases of US dollars by the Chinese and some other Asian central banks has allowed the US to run massive current account deficits without paying the full price of a weaker exchange rate and slower growth.

But some observers worry that adjustment will only be the greater for being delayed. Meanwhile, the burden of adjustment to a softer US dollar is being unfairly shared.

"The peg to the dollar has served China pretty well. In the absence of an independent central bank with a credible ability to target inflation, it has supported its openness and growth."

On conventional estimates of long-run fundamental equilibrium, the Chinese currency was undervalued, Wolf said.

But he expects the present situation could be sustained for quite some time.

"Having demonstrated their willingness to purchase essentially unlimited quantities of US dollars in the 2001 to 2003 period, the Asian countries have essentially put a floor under the US dollar," he said.

US authorities might be unhappy about deficits, but the transfer of resources from the rest of the world was helpful to the US, Wolf said.

"It allows it to accommodate a huge fiscal deficit without crowding out private spending in any way.

"The excess of household spending over income is at an all-time high and, at the same time, the Government is running a huge deficit. All paid by foreigners."

This could carry on for a long time.

"What worries me is that at some stage, and it might be many years hence, the peg will go, probably as the yuan becomes a floating currency and the anchor currency of the entire region.

"At that point, the dollar could become fantastically vulnerable, a huge and wrenching adjustment being imposed on the US, with a real reduction in the value of the dollar as a reserve asset."

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