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Trade is Front and Center as Trump and Xi Meet

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Trade is Front and Center as Trump and Xi Meet

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As Presidents Trump and Xi meet at Mar-a-Lago, trade is one of the two big issues on the agenda, along with North Korea. The smart strategy for the United States is to 1) recognize the progress that has been made on currency, 2) press China on measures that would reduce national savings and hence the trade surplus, and 3) negotiate greater openness of China’s markets for agriculture, manufacturing, and services.

Don’t make an issue of the exchange rate
For years, China’s exchange rate policy has been a thorn in the side of the US-China relationship, as China intervened to accumulate reserves and to keep the value of its currency low. But this is one area in which there has been progress in the dialogue. China’s trade-weighted exchange rate has appreciated 17 percent since 2010 (see figure). The problem for the United States is that the dollar has appreciated even more strongly (24 percent), while the euro and especially the yen have depreciated. There are many factors behind these moves, but if the United States is concerned about currencies, it makes sense to have consultations among these four rather than to single out China.

Big 4: Trade-weighted exchange rate indexes (2010=100)

 

Starting two years ago, China has been selling reserves to keep the value of its currency high, and its reserve pile has dropped from $4 trillion to $3 trillion. There are several factors at work here. China’s enormous trade surplus has come down as a share of its GDP: the broadest measure of trade, the current account, declined from a surplus above 10 percent of GDP in 2007 to below three percent in 2016. The other change is that a long pattern of net capital inflows to China has shifted to a steady net outflow of capital. China has built up excess capacity throughout its economy so that the return to further investment has diminished. Private investment grew at a rate of only three percent last year.  The large outflow of capital has put downward pressure on the currency, which so far China has resisted.

We should welcome the helpful role that China has played keeping its trade-weighted exchange rate stable for the past year. Naming it a currency manipulator would be inaccurate and unhelpful. China would probably agree to enhanced currency consultations, especially if it included other major currencies such as the yen and the euro.

Do make an issue of the saving rate
Even at three percent of GDP, China’s trade surplus is large in absolute terms. The real issue behind persistent trade surpluses is the saving rate, which is far beyond the norm of other major economies. China’s saving rate has been around 50 percent of GDP, coming down a couple of percentage points in the last few years. The current account, as a share of GDP, is equal to the saving rate minus the investment rate. From 2009 to 2014, China deployed almost all of this saving at home—as a result, its trade surplus was modest (see figure). But this investment binge is what has led to the problem of excess capacity. Now investment is declining as a share of GDP, which is rational in the face of the excess capacity. The problem is that, unless savings decline as well, the trade surplus is likely to grow in the next few years.

China: Saving, investment, and current account (as a percent of GDP)

 

The problem is not fundamentally with households, whose behavior is similar to elsewhere in East Asia. Rather the problem is that the state controls a lot of GDP—through state-owned enterprises (SOEs) and the government budget—that never reaches households. If more of the national income went to households, the national savings rate would naturally come down. This points to measures such as SOE reform: China is keeping zombie state enterprises alive with credit from state-owned banks. We should encourage China to close bankrupt enterprises and privatize viable ones. China could easily afford more generous pensions for its large number of military and civilian retirees, and this would be an immediate way to increase household income for a group that is likely to spend it. China also spends little public money on health and education, and greater social spending would increase households’ real income and bolster their consumption.

The general point is that there are many measures that could encourage the shift of China’s economy towards consumption, which is needed to sustain its growth in a manner that does not rely on rising trade surpluses, which would in turn be a problem for the US and the rest of the world.

Focus on market access
Faster consumption growth in China will help prevent large trade surpluses. It would help further if consumption in China had more import content. In general, China’s market access restrictions prevent the consumption of American goods and services. In automobiles, a 25 percent import tariff plus domestic content rules in the past mean that American-brand cars sold in China have little US content. Agricultural imports, though significant in some products, are highly restricted in important markets such as beef. In the modern service sectors such as finance, telecom, media, logistics, and health, direct investment is needed in order for the United States to export services in large volumes. However, China is the most closed among G-20 countries in terms of investment openness in these and other sectors.

Threatening high tariffs is not likely to encourage China to yield
China has long indicated that it will gradually open these markets—but in fact, there has been very little progress for 10 years now. The United States does not have a lot of leverage to push China to open up. Threatening high tariffs is not likely to encourage China to yield, and would backfire by hurting the US economy if actually implemented. The United States should consider restricting SOE mergers and acquisitions in the United States, given the lack of reciprocity on the Chinese side. The United States also has trade remedies that it can deploy in individual sectors.

The first Xi-Trump summit will be a get-to-know-you meeting, to some extent. The US side should refrain from making harsh threats, especially publicly. But it would be good diplomacy to indicate to China the kinds of measures that the United States is considering.

Bottom line: Encouraging consumption and opening up the economy more are the keys to China’s sustainable growth, so it should be possible to negotiate changes in the economic relationship that are good for both economies.

David Dollar is senior fellow – Foreign Policy, Global Economy and Development at the John L. Thornton China Center of the Brookings Institution. This article originally appeared here.

China's currency exchange rate impacts shipments of export cargo and import cargo in international trade.
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China is Struggling to Keep its Currency High, Not Low

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Candidate Trump promised to label China a currency manipulator on day one in the White House. In recent months, however, China has been intervening to keep its currency high, not low. It turned in another good growth performance in 2016, with a 6.7 percent expansion. But it took a lot of credit to generate this growth—as a result, risks are building up in China.

One risk is of a classic financial crisis; another risk is unruly devaluation of the currency driven by market forces. China can probably avoid a hard landing this year, but it is relying on ad hoc measures that throw sand in the wheels of normal commerce.

Excessively fast credit growth is a good predictor of financial crises. The Bank for International Settlements (BIS) calculates the credit gap as the difference between actual credit growth and trend.

That figure shows the evolution of the credit gap in China and in a number of previous, well-known cases that ended in financial crisis: Japan in the late 1980s and early 1990s; Thailand in 1997 and 1998; and Spain in 2007 and 2008. The measure here is credit to the private, non-financial sector, both households and corporates. (In China’s case, credit to state enterprises is counted as part of the private, non-financial sector.)

In the three earlier crises, credit growth ran well ahead of trend for a few years. There was an investment boom that was somewhat different in each case, but with a similar end result: that a lot of poor investments were financed. Eventually, these investments failed to provide sufficient return to service the loans, bad loans became manifest both in banking and in bond defaults, and a financial crisis ensued. One of the key features of these crises is that, as bad loans start to build up, banks are unsure about which clients will fail and tend to restrict lending, even to potentially good clients. That drying up of credit is a key reason that the real impact of these crises is so severe. In each of the previous cases, it can be seen that the crisis is followed by a period of deleveraging in which the stock of credit relative to GDP falls sharply.

In China’s case, the BIS calculates a credit gap of about 30 percentage points of GDP; that is, the actual build-up of the outstanding credit stock is about 30 percentage points of GDP higher than would have been predicted by trend. This is alarming, and Chinese officials have spoken of the need to reduce leverage. Yet credit growth continues to grow much faster than the growth of nominal GDP.

While many outside analysts worry about a financial crisis in China, there are reasons to think that it will not take the predictable form. There are some special features of the Chinese financial system. First, this credit growth is domestically financed. China has a very high savings rate, around 50 percent of GDP. So, China does not rely on external financing in any meaningful way. In the earlier crises of Thailand and Spain, their credit booms were largely funded by external capital; as their crises unfolded, capital outflow accelerated their credit contraction. Japan’s case was more similar to contemporary China in that the country’s credit and investment boom was self-financed. A second, related feature of China is that the main backing for credit expansion is household deposits in banks, which tend to be very stable. This is somewhat less true in the past year, as financing from non-bank institutions (shadow banking) has played a big role in credit expansion.

The formal banking system primarily consists of state-owned banks lending to state-owned enterprises, including local government investment vehicles. It is hard to see a traditional banking crisis in this sector. Already many state-owned enterprises are in distress and cannot service their loans. But banks continue to lend to them, and it is hard to see households losing confidence in the system and withdrawing their deposits. What is less clear is how the shadow banking system will operate in an incipient crisis. As some of the wealth management products backing shadow lending start to fail, it is possible that households will withdraw significant amounts from these products and that the non-bank lending will contract. But given the state’s role in the financial sector, it seems unlikely that overall financing would contract as in a traditional financial crisis.

While the state’s intervention works against a traditional financial crisis, it creates other problems. There are lots of examples of central and local authorities intervening to keep open state enterprises that are essentially bankrupt. Recently, Chinese authorities announced a new fund, with 350 billion yuan of capital, that would be used to help distressed state firms. The money is coming from state enterprises that are doing well, so the state is essentially taxing the more successful firms to subsidize the unproductive ones. These kinds of measures will keep the average productivity of investment low and contribute to ongoing problems of generating total factor productivity growth. In other words, state interventions may prevent a large, visible financial crisis, but they are likely to lead to continuing slowdown in the growth rate.

A second, growing risk concerns China’s exchange rate and capital account. Until recently, China had a current account surplus and a capital account surplus, as foreign direct investment flowed into permitted sectors (mostly manufacturing). The twin surpluses created balance of payments problems for China, since large-scale reserve accumulation was required to prevent rapid appreciation of the Chinese currency. China had pegged its currency to the dollar at a rate of 8.3:1 in 1994, not an unreasonable choice for a developing economy. But by the mid-2000s, productivity growth in China meant the currency was increasingly undervalued. China moved off the peg in 2005.

Over the last decade, China’s effective exchange rate has appreciated more than any other major currency, rising a total of more than 40 percent. The fact that the dollar had no trend between 2006 and 2013 means that the yuan was rising against the dollar during this period. China’s balance of payments situation began to change around 2014. First, the dollar began rising quite sharply against other currencies with an effective appreciation of about 20 percent over a year. Initially, China followed the dollar up, but began to worry that the appreciation was too much, especially if the Federal Reserve was going to raise interest rates. Second, the capital account entered a deficit. With excess capacity in many sectors of China’s economy and declining profitability, China’s capital account began to be dominated by state enterprises going out for investment and private Chinese capital moving some assets abroad. For a short period in 2014, the net capital outflow roughly matched the continuing current account surplus: China’s exchange rate was stable without any significant central bank intervention. But as 2015 began, the net capital outflows accelerated and China started selling reserves in order to prevent the currency from depreciating.

In August 2015, China carried out a mini-devaluation that was poorly executed and communicated. The small, discrete devaluation spooked global markets. It was taken as a sign that China’s economy was much weaker than previously thought and as a herald of a new exchange rate policy. Capital outflows accelerated. In a little more than a year, China’s reserve holdings went from $4 trillion to $3 trillion. It’s ironic that US officials continue to call China a currency manipulator when it has been intervening to keep the value of its currency high, not low.

Chinese officials have said publicly and privately that they have no intention to devalue the currency to spur exports and that they see no foundation for sustained depreciation of the currency. In terms of fundamentals, they are right that there is no foundation for depreciation. China has a large and rising current account surplus, and its share of global exports hit a new historical high in 2015. Clearly there is no competitiveness problem. Given China’s large trade surplus, any significant depreciation now would be disruptive to the world economy and could well spark trade protection from China’s partners.

The problem that the country faces is that it is still fighting large capital outflows. The national savings rate has come down only slightly from 50 percent of GDP, and it is likely that saving behavior will change only slowly. With diminishing investment opportunities within the country, it makes sense that significant amounts of capital are trying to leave. The reserve loss and the outflow pressure also create a reasonable fear that, whatever authorities say, they may not be able to prevent a large depreciation. That just encourages capital to try to leave sooner.

During 2016, the balance of payments stabilized to some extent. Capital outflow pressures were eased by authorities’ clear communication that devaluation wouldn’t happen, as well as the somewhat better data from the real economy and ongoing stimulus of investment. It also seemed that the government tightened up on its capital controls to make moving money more difficult.

The issue of capital controls is of crucial importance. The IMF considers a ratio of broad money to reserves of 5:1 a warning level for a country with bank-dominated finance and an open capital account. The ratio was very high in the early 2000s, but that was when China had extensive capital controls. The ratio came down in the mid-2000s as China built up reserves and as credit growth aligned with nominal GDP. Since 2010, however, there has been an alarming rise in the ratio from below four to nearly seven. China would be at risk of a currency crisis if it had an open capital account. Hence, it is no surprise that China has tightened up its capital controls over the past year.

If one accepts that the investment rate needs to come down as part of the control of leverage and in response to diminishing returns, then the savings rate needs to come down as well in order to prevent the capital outflow from expanding to levels that would be destabilizing for China and the world economy.

In the meantime, China will tighten its capital controls as necessary to maintain control of its exchange rate. Firms are already complaining that it has become harder to move money in and out of the country for normal trade purposes. The micro-management of foreign exchange transactions is analogous to government actions to prevent firms from closing; it throws sand in the wheels of normal commerce. China can probably avoid an exchange rate crisis, but it will pay a price in terms of the efficiency and growth of the economy.

David Dollar, is a senior fellow at the Brookings Institution’s John L. Thornton China Center.

Trump needs to consider how he wants to change China policy with regard to shipments of export cargo and import cargo in international trade and foreign direct investment.
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Playing Responsible Hardball on China’s Trade and Investment

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Americans are frustrated with the imbalance in the U.S.-China economic relationship. From January through October of this year, the United States had imported $381 billion of Chinese goods, mostly manufactures; it exported $92 billion in return, mostly soybeans, aircraft, and passenger vehicles. The imbalance is slightly lower if services are included (the 340,000 Chinese students in the United States represent American exports of education services). And a new imbalance that has developed recently is that there is more Chinese direct investment flowing into the United States than in the other direction. This does not reflect the fact that China is a bigger investor in the world—just that China itself remains quite closed, while the United States is very open.

If President Trump wants to play hardball with China, a good place to start would be restricting the acquisition of American firms by China’s state-owned enterprises. The Obama administration just stopped the purchase of Aixtron, a German chip maker with significant U.S. operations, on national security grounds. But there have only been a handful of such moves over the years. In general, the United States is very open to foreign investment, including mergers and acquisitions. So far in 2016, Chinese companies have more than doubled the record $106 billion of overseas deals that they announced in 2015. The United States is the number one foreign destination for Chinese investment.

Some of the other economic measures directed at China that have been floated during the election season either do not make sense or carry a large risk that they will backfire on the U.S. economy. Calling China a currency manipulator made sense 10 years ago; but since then, the currency has appreciated significantly, and over the past 18 months the People’s Bank of China has been intervening to keep the currency high, not low. This is the opposite of currency manipulation. Imposing large import tariffs both violates our World Trade Organization (WTO) commitments and invites retaliation. If tariffs are aimed only at China, then production will easily shift to other low-wage locations. If they are aimed at all developing countries, then that is a general trade war that will be lose-lose. We may not export a lot to China, but we export a lot to the world. And our exports to China are significant for certain sectors and communities. There are global rules on trade which it is in our interest to respect.

For direct investment, however, there are no global rules. The United States is open to foreign investment, including mergers and acquisitions, because we think it creates jobs and raises productivity. If a foreign firm is willing to pay more for a U.S. asset, then there is a presumption that they will make better use of the asset and the American economy and workers will benefit.

So, what’s the problem with Chinese investment in the United States? The problem is that China is not a typical capitalist economy. First, it is itself quite closed to foreign investment. It has allowed significant amounts of foreign investment in specific manufacturing industries, hence those value chains stretching deep into China. But in key sectors—such as automobiles—it requires foreign firms to operate in 50:50 joint ventures, in the process sharing their technology with Chinese state firms.

In the service sectors, which is where the majority of FDI globally occurs, China is almost completely closed. This includes financial services, social media, telecom, logistics, health care, and education. China is less open to direct foreign investment than other large emerging markets such as Brazil, India, or Russia. In these service sectors in particular, it is difficult for America to sell to China if it cannot invest there.

The second problem with China’s outward investment is that the closed sectors are dominated by state-owned enterprises whose managers are appointed by the Communist Party. They earn profits behind protected walls and then go out in the world to buy their competitors. There is no presumption that this current pattern of investment benefits the American economy. What would actually benefit the U.S. economy would be if China opened up its foreign trade and investment regime and the United States were able to export more. In both services and manufacturing, it is difficult for U.S. firms to export as much as they could if they cannot invest in the target economy.

Because there are no global rules on direct investment, China can close off important parts of its market, restricting opportunities for American firms and workers. We should not change our basic openness to foreign investment, which has served us well. But restricting acquisitions by foreign state enterprises is a sensible precaution. We should not expect China to change its investment restrictiveness anytime soon, but a tougher U.S. stance makes it more likely that the two sides will eventually negotiate an investment agreement that opens up China’s markets.

David Dollar is a senior fellow in foreign policy, global economy, and development at the Brookings Institution’s John L. Thornton China Center. This article originally appeared here.

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Trump and China: A Losing Strategy

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Trade with China has led to the loss of manufacturing jobs in the United States and put downward pressure on wages for blue-collar jobs here. This is a real problem and campaigns in both political parties are grappling with how to address it.

In a recent speech, Donald Trump proposed high tariffs on imports of Chinese goods, labeling the country a “currency manipulator,” and ripping up the Trans-Pacific Partnership (TPP). These measures are not likely to reverse the damage that trade has done to blue-collar workers in the United States.

First, on high tariffs: There is a long-term trend for manufacturing employment in the United States to decline as a share of employment. This reflects the fact that automation and productivity growth are easier in manufacturing than in services. The United States is still a manufacturing powerhouse from the point of view of production, but it simply does not take that many workers to produce the output. Trade with China accelerated that trend, and that was bad for the United States because slow adjustment is easier than the rapid adjustment that occurred. But imposing tariffs on Chinese imports now is truly closing the barn door after the horse has left. Jobs in apparel and footwear or the low end of electronics are not coming back to the United States.

Tariffs aimed at China will divert that production to other developing countries. If we try to keep out imports from all of the low-wage countries then we are contemplating an end to the open trading system that has been a source of political and economic stability in the world. Economic results for the United States are not likely to be good even if there is no retaliation. But there is almost certain to be retaliation, especially from China which is a powerful and nationalistic country.

The fact that protectionism is likely to backfire and make matters worse for American workers does not mean that other measures would not work. Spending public money on infrastructure is the most obvious measure—it would create jobs immediately and enhance the productivity of the economy down the road. Improving education at all levels from pre-K through adult education is another obvious measure. Workers and communities are looking for more support in the face of uncertainties created by globalization, and providing that support will be more effective than trying to wall off the U.S. economy from the rest of the world.

Second, on currency manipulation: This is also a matter of fighting the last war. Ten years ago China was intervening heavily to keep the value of its currency low. But between 2005 and 2015 the yuan appreciated about 25 percent against the dollar, and this was one factor that brought down its large current account surplus (the broadest measure of its trade surplus) from 10.1 percent of gross domestic product in 2007 to 2.7 percent in 2015. Over the past year there has been pressure in Chinese currency markets for the yuan to depreciate because of large capital outflows in the face of diminishing investment opportunities at home. The Chinese central bank has been intervening to keep the currency high, not low. We should be happy that China is intervening to keep the currency high because this is a source of stability in the world economy at the moment. Congress passed a law in 2015 creating a rigorous definition of a currency manipulator and China does not meet that standard because it is selling reserves not accumulating reserves.

Third, on TPP: China is not a negotiating party to the Trans-Pacific Partnership and if the agreement is implemented, China cannot join without the approval of the United States. U.S. relations with the countries negotiating the TPP provide an interesting contrast to U.S. relations with China. It happens that the TPP partners have about the same sized economy as China—around $10 trillion. But the United States has much more balanced trade with the TPP partners: We export six times as much to them as to China. And we have 15 times as much investment in the TPP partners as we have in China. In other words, the TPP group is a much more open set of economies. The TPP agreement would deepen the integration among us while addressing important issues of labor and environmental standards.

The fact that China remains relatively closed to imports and to inward investment is a source of frustration for the United States. Frankly, we have little leverage over China to force them to open up. China’s communist leaders are much more concerned with domestic political control and territorial disputes with neighbors than with economic relations with the United States. Protectionist measures aimed at China are likely to be met by Chinese retaliation, not by China suddenly opening up. For the United States, deepening integration with the like-minded countries that have negotiated the TPP, as well as with European partners, is a sensible strategy. There are many good jobs in the United States tied to our exports and we want to encourage the expansion of a rules-based trading system, not spark a trade war that is likely to have no winners.

David Dollar, is a senior fellow at the Brooking Institution’s John L. Thornton China Center.