Has the time for a currency war with China arrived? The answer looks increasingly to be yes. The politics and economics of an assault on Chinese exchange rate policy are increasingly convincing. The idea is, of course, deeply disturbing. But I no longer believe there is an alternative.
We have to address four questions. Is China a “currency manipulator”? If it is, does it matter? What might China reasonably be asked to do? Finally, can other countries shift China’s policies, with limited collateral damage?
The first question is the easiest. If a decision to invest half a country’s gross domestic product in currency reserves is not exchange rate manipulation, what is? Moreover, by sterilising the monetary effects, the Chinese government has also thwarted the mechanism of adjustment in a fixed-rate regime, which was explained by the great Scottish philosopher, David Hume, in the 18th century (see chart below).
Now turn to the second question: does this matter? One answer is that it is a protectionist policy. By keeping its real exchange rate down, China subsidises production of its exports and import substitutes. Since China is now the world’s biggest exporter, this has to be a significant distortion of world trade.
The Chinese current account surplus is far from the only explanation for the US current account deficit. Yet it is also true that China’s currency policies have driven those of other countries; that capital-importing high-income countries are unable to make productive use of the surplus savings of the emerging countries; and that the net flow of funds from the poor to the rich is altogether perverse.
Moreover, if high-income countries such as the US are to have more prudent household sectors and more fiscal discipline, they must either enjoy a big investment boom or a shift into current account surplus. More plausibly, they need both.
Given, in addition, the continued savings surpluses of Germany, Japan and a number of other high-income countries, a return to stable growth in the world economy requires the battered high-income countries, as a group, to move into sizeable current account surplus. China is the most dynamic and solvent emerging country. It also runs the world’s largest current account surplus. If all the offsetting shift towards deficit is in much weaker emerging economies, the ultimate result is likely to be another round of financial crises. Yet China could move today’s current account surplus towards deficit, by $300bn a year, at negligible risk.
This leads us to the third question: what might China reasonably be asked to do? An adjustment in the nominal exchange rate is neither a necessary nor a sufficient condition for the rebalancing of the world economy: not necessary, because higher inflation could bring about changes in relative prices, instead; not sufficient, because it would still require an increase in domestic spending, relative to output. At most, therefore, an adjustment in the nominal exchange rate is a facilitator of a wider set of desired adjustments.
Thus the menu of possible options for the Chinese authorities could include a cap on the intervention, an end to sterilisation of the monetary consequences and targets for real domestic demand, household consumption and the current account. Meanwhile, China should demand complementary actions elsewhere, notably in the US.
In any such discussions, one would have to address Chinese concerns that letting the exchange rate appreciate significantly would not only damage export industry, but risk a “lost decade” similar to that of Japan in the 1990s. What happened to Japan was largely the result of using monetary policy after 1985 to offset the negative impact of the rising exchange rate on net exports. Naturally, China does not wish to enter the same trap. But, as Gabriel Stein of Lombard Street Research argues in a paper released in June, the two situations are very different: China has far greater potential for fast growth than Japan did in the late 1980s, because Japan’s GDP per head (at purchasing power parity) was already close to that of the US, while China’s is less than a fifth; and China, above all, has huge potential for higher consumption rates. Aggressive credit expansion is a dangerous way to achieve a permanent rise in domestic spending relative to output. That will also require structural changes in the economy. But these are very much in the interest of the Chinese people.
This leads to the final question: how might China be cajoled or coerced into changing its policies? Negotiation remains a hope. The rest of Group of 20 leading countries should unite in calling for these changes. But if negotiation continues to fail, alternatives must be considered. Import surcharges are one possibility. Fred Bergsten of Washington’s Peterson Institute called for countervailing currency intervention in the FT this week; and Daniel Gros of the Centre for European Policy Studies in Brussels recommends capital account reciprocity: affected countries could prevent other countries from purchasing their financial instruments, unless the latter offered reciprocal access to their financial markets. This idea would also make the Bergsten plan more effective.
I find ideas for intervention in capital markets far more attractive than those involving action against trade, as the US House of Representatives proposed last week. First, action on trade would have to be discriminatory: there is no reason to attack all imports, merely to change Chinese behaviour. But this would almost certainly be a violation of the rules of the World Trade Organisation. A trade war would be very dangerous. Insisting that China stop purchasing the liabilities of other countries so long as it operates tight controls on capital inflows is, instead, direct and proportionate and, above all, moves the world towards market opening.
Some fear that a cessation of Chinese purchases of US government bonds would lead to a collapse. Nothing is less likely, given the massive financial surpluses of the private sectors of the world and the continuing role of the dollar. If it weakened the dollar, however, that would be helpful, not damaging.
The post-crisis world economy will not work so long as its most dynamic economy is also its largest capital exporter. Moreover, China has insured itself to a vastly more than adequate extent. Adopting a set of policies that would turn China into a net importer would benefit both its own people and the rest of the world. The time has come to move beyond rhetoric. Action is urgent.
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