Among the more disappointing aspects of US international economic policy over the past few years is how little progress has been made in putting Sino-US trade relations on a sounder footing.

Resident Fellow Desmond Lachman

While China keeps talking the talk of taking the necessary steps to wean its economy from an excessive and unfair reliance upon export-led growth, it singularly fails to walk the walk in either pursuing greater currency flexibility or in cracking down on rampant intellectual property piracy. And there is every reason to expect that China will continue to do so as long as the Bush administration perseveres with its kid gloves approach to the Sino-US trade relationship.

The basic flaw in the Bush administration’s approach to China over the past three years has been to take the Chinese government’s word that it intended to rebalance its economy away from export-led growth and to curb intellectual property piracy. In particular, with the benefit of hindsight, it appears to have been a major mistake for the US to have bought the Chinese government’s argument that China would move on the currency and piracy issues in due course if only the US would desist from publicly pressuring China to do so.

To be sure, in July 2005, China did revalue its currency by 2.1 per cent and it did commit itself to greater currency flexibility. However, over the past 16 months, China has allowed its currency to move by
barely 2 per cent against a steadily weakening US dollar. As a result, China’s real effective exchange rate today is little changed from its pre-July 2005 level, while it is as much as 15 per cent below its 2002 level. This is the case even though China’s balance of payments position has gone from strength to strength over the past four years.

The continued undervaluation of the Chinese currency, together with domestic policies that discourage consumption, have considerably increased China’s reliance on the export sector as an engine of growth. This reliance is vividly underlined by the ballooning of China’s external current account balance over the past few years to a surplus of about $US200 billion ($254 billion) in 2006 and to an expected $US250 billion surplus in 2007.

As a result, China has now eclipsed Japan as the country with the world’s largest current account surplus. Further, China’s international reserves have now surpassed $US1 trillion and they continue to increase at an annual rate of over $US250 billion.

At the same time that China’s current account surplus has ballooned, China has done little to rein in the veritable explosion in intellectual property piracy. Official estimates of the US embassy in Beijing suggest that American, European and Japanese companies are now losing more than $US60 billion a year though Chinese piracy of one sort or another.

Up to now, the American approach to the Chinese currency issue has been to patiently try to convince the Chinese that it is in China’s own interest to allow a significant revaluation of its currency. In that context, it has argued that a more appreciated currency, together with measures to stimulate domestic consumption, would be helpful in reducing China’s current account surplus, which is needed to head off protectionist pressure in the industrialised countries.

It has also argued that increased currency flexibility would allow China a greater degree of monetary policy independence and that such flexibility would obviate the need for any further wasteful build-up in international reserves.

Judging by the results to date, Washington’s approach of low key persuasion appears to have been a dismal failure. Indeed, with seeming impunity, the Chinese leadership clings to its mercantilist exchange rate policy of deliberately keeping the currency undervalued with the explicit objective of promoting export-led growth and of protecting the Chinese rural sector. It does so in the belief that America’s need for China in resolving the political issues in Iran and North Korea gives China a free hand to artificially manipulate its currency.

On reviewing America’s present approach to China, one cannot help but ask whether there is any reason to expect that a continued kid gloves approach to China will be any more fruitful on the currency issue in the future than it has been in the past. Might not an alternative approach be indicated that credibly threatened China with a progressive closure of the US market to Chinese trade unless China took concrete action to redress its ever growing external payment imbalance?

While a harder US line towards Chinese trade is not without its risks, it at least offers the prospect of heading off an even larger train wreck further down the track since China’s current account surplus would only continue to swell if the status quo were to be maintained. It also would allow America to leverage the fact that a breakdown in Sino-US trade relations would be of very much greater consequence for the export-dependant Chinese economy than it would be for the more closed and diversified US economy.

Desmond Lachman is a resident fellow at AEI.