Steering Out of a Smash-Up No One Wants

Export Push

With the Fed restricted by inflation and the government paralyzed by gridlock, the only policy option for the United States is to pursue export expansion. The U.S. trade deficit peaked in 2006 at US$ 760 billion, with exports equal to one-third imports. Last year's deficit was probably half that peak, although the contraction was due to an import collapse rather than an export expansion.

This is a contractionary approach to resolving the deficit problem and, hence, not sustainable. If the U.S. economy expands, the deficit will rise again, with trade subtracting from rather than adding to economic expansion. With no internal levers for sustaining demand growth, the United States must change the external situation and make trade a positive element for its economic expansion. This is why Obama called for doubling U.S. exports in five years.

One option for expanding exports is to devalue the dollar. But as the Fed enters a tightening cycle, the dollar can't fall much. Indeed, as I wrote a few months ago, the dollar has bottomed. Its lowest point was in May 2008 when the dollar index reached 71, and it peaked during the crisis at 90 when safe haven trade pushed money into the dollar. It has been in the 75-80 range for the past six months, and will likely stay there for the rest of 2010.

As devaluation isn't a way out, the United States will likely turn to trade policy to increase exports. China is the most obvious target. The yuan peg to the dollar is likely to be the focus again. During the crisis, the peg was a stabilizing force, preventing a total collapse of the dollar while the Fed maintained a zero interest rate. Now that financial stability has been restored, and the Fed is ready to raise interest rates, the yuan's dollar peg isn't as important to the stability of the dollar. Actually, it could make the dollar stronger than what the United States wants. So breaking the yuan-dollar peg is now in the best interest of the United States.

U.S. pressure over China's exchange rate policy began with protectionist measures, such as tariffs on steel pipes, tires, poultry and electric blankets. Protectionist measures against China are so far worth several billion dollars, which is small relative to total imports from China and won't create enough U.S. jobs to make a dent in the unemployment rate. But the publicity is good for Obama, who will likely step up protectionist measures. Since unemployment is a do-or-die issue for the administration, it must be seen as doing something.

U.S. trade policy will likely morph from political publicity to serious tool for economic expansion. With monetary and fiscal policies constrained, this is the only way to decrease unemployment. The administration's goal to double U.S. exports won't happen organically. U.S. exports rose one-third in the past five years. Even if we assume U.S. exports could rise another one-third over the next five years, exports to financial crisis-weakened overseas markets would fall short of Obama's goal by more than US$ 600 billion. China would become an obvious target for making up the difference, requiring that China appreciate its currency dramatically and make a major switch to consumption-oriented economy.

Avoiding Japan's Fate

Current U.S. woes mirror the economic difficulties seen in the 1980s, when it pushed Japan to double the value of its currency. To cope with the negative effects of the yen's appreciation, Japan's central bank followed a loose monetary policy, which in turn created the biggest property bubble in history. During the restructuring, Japan's bubble economy did give some help to the U.S. economy because the U.S. economy was restructured for another growth cycle after the bubble burst. That ended in 2008 with the bursting of the U.S. property bubble.

It is extremely likely the United States would push China to play the same role Japan played two decades ago. Its policy focus could be aimed at forcing China to double its currency value. But as the profitability of China's export sector is already poor, the economy would face enormous pressure.

China is already experiencing a big property bubble. The overvaluation of China's property stock may already exceed 100 percent GDP, higher than the peak excess value during the U.S. property bubble but still much lower than the 300 percent GDP overvaluation that Japan saw during its bubble period. So it is possible that China's bubble may triple.

Even before lurching into a destructive property bubble, Japan was a high-income economy. China is still at a lower-middle income level, with a per capita income that's one-tenth Japan's. So a China property bubble bursts would stagnate the economy a la Japan but at a lower income level, trapping China at a low level, perhaps permanently.

However, it would be unwise not to respond to U.S. pressure constructively. Without benefiting from China's growth, the United States lacks incentive to be China's biggest export market. So to pressure China, I expect many more U.S. protectionist measures this year. Before the November mid-term election, Congress could pass a bill that calls for a 30 percent tariff on all Chinese products unless China appreciates its currency by the same amount.

China's best reaction would be a proactive policy that benefits the United States and China's economy at the same time. First and foremost, as China's competitive advantage has shifted from cheap labor to cheap capital, it could open its capital markets to U.S. companies, thus decreasing bubble pressure at home and giving the U.S. economy a lift during a troubled time for its financial system. This would give Chinese investors more choices and a chance to benefit from the success of multinationals in China.

I think the proposed International Board for the Shanghai Stock Exchange should be set up as soon as possible. Among the first listed should be U.S. companies with major interests in China, such as Proctor and Gamble, Kimberly Clark, Coca-Cola, Pepsi, Yum!, Starbucks, General Motors and Monsanto. The list could be much longer, China already accounts for their biggest growth markets and boosts profits; it would be good for Chinese investors to invest in their China successes.

Second, China should lower tariffs on some imports that benefit the U.S. economy. For example, China has the largest and fastest growing auto market, and the government has been using the market's attraction to lure international companies to produce in China. But the tariff and tax structure prevents foreign production from benefiting. If China opens its auto market, U.S. labor unions might shift their position and support trade with China, giving Obama an incentive not to push for a doubling of China's currency value.

Third, the U.S. agriculture sector has a disproportionate influence over its political system, so it would be wise for China to open its agricultural market. This may exert more pressure on China's rural sector, but any negative effect could be offset by more fiscal support. China's rural problem is tied to a low labor-to-land ratio and the way out is urbanization, which could be accelerated by reforming the household registration system and letting farmers own their land.

Clouds are gathering over China's exchange rate policy. We've seen these clouds before. This time, however, the U.S. pressure is much more serious. Without careful handling, a stormy trade war could erupt, with negative consequences for all. So rather than playing defense, China should move soon to adopt constructive measures and prevent confrontation.

Full article in Chinese: http://magazine.caing.com/2010-02-07/100116652.html