Following the mid-term elections in 2010, the Republicans were widely expected to shift US policy from a narrow focus on RMB appreciation to broader bilateral economic issues (incl. IPRs, procurement policies, state support for Chinese SOEs). While the Republican leadership in the House did end up preventing the anti-Chinese currency legislation from reaching the White House, parts of Congress remain highly critical of the executive’s handling of bilateral trade and currency issues, showing how high unemployment and large bilateral trade deficits continue to carry the potential of triggering a rise in bilateral tensions.
Nonetheless, tensions should remain manageable for the foreseeable future. Beiing has resumed a gradual, controlled nominal appreciation of the RMB against the USD. A shift towards greater domestic-consumption-led growth in China, as laid out in the 12th five-year plan, and a rising real exchange rate should help limit bilateral imbalances. Even if bilateral imbalances remain sizeable, this should allow the Treasury to manage political pressure emanating from Congress. Pro-business House Republicans are also likely to resist protectionist pressures on Capital Hill, holding the line against the more labour-oriented, less free-trade Democrats.
It is nonetheless worth asking what would happen if the US administration were to take a more aggressive stance towards China regarding the RMB. Here it is useful to distinguish between “coercion” and “deterrence”. An agent A coerces agent B by getting B to do x by threatening y or promising z. An agent A deters by persuading B that the costs of a given course of action will outweigh its benefits. Deterrence aims to persuade the opponent not to initiate action by threatening to impose (or raise) the costs of this action, or by rewarding the other party for not doing so. Deterrence comes in two forms: (1) punishment by raising the costs of an action and (2) denial of objectives by raising the costs in such a way as to offset tthe coveted benefits of an action. Finally, deterrence is associated with maintaining the status quo, while coercion is usually associated with changing it. These concepts can be profitably applied to Sino-US economic relations.
China seeks to maintain the status quo (export-oriented growth & undervalued exchange RMB), while the US would like to change the status quo (reduction in bilateral trade deficit & appreciation of the RMB). Rising cross-border asset holdings and trade have increased interdependence, raising the absolute costs of economic conflict for both sides – but the costs of a trade conflict are relatively higher for Beijing than for Washington. This is so because the US market is substantially more important to China in terms of both exports and imports than vice versa. Chinese exports are also relatively more employment-intensive than US exports.
While China’s substantial creditor position does not provide it with coervice power at present, it has arguably increased its deterrent potential, thanks to its vast holdings of US debt and its continued financing of US current account and fiscal deficits. Nonetheless, if push came to shove, Beijing’s deterrent would not be powerful enough to deter US pressure completely, but it is likely to make the US administration think twice before lending its support to a more aggressive stance vis-à-vis Beijing.
True, China’s export dependence on the US diminishes its ability to take advantage of its creditor position and credibly coerce the US to adjust its economic policies by selling (or threatening to sell) its US debt holdings or withholding financing. China does, however, possess a growing economic-financial deterrent potential vis-à-vis the US in terms of raising the absolute costs to the US in the event of exploiting its bilateral creditor status. Incidentally, this may help explain why the US has thus far abstained from naming China a currency manipulator. After all, the US Treasury did name South Korea, Taiwan, and (then, less powerful) China currency manipulators in the late 1980s and early 1990s.
China is benefiting from its deterrent potential in terms of preserving, or at least minimising, changes to the status quo. Beijing does stand to lose more in relative terms in case of a conflict. This is certainly a plausible interpretation of the BPoC’s greater tolerance of RMB appreciation whenever US pressure rises. From Beijing’s point of view, a controlled appreciation of the RMB is a small(er) price to pay to stave off protectionist measures. Meanwhile, the rising absolute costs of a Chinese financial response will make the US administration think twice before taking a more aggressive stance vis-à-vis Beijing.
The US will continue to run current account and fiscal deficits and it will rely on Chinese financing. From a US perspective, rising indebtedness will translate into a rising transfer of fiscal resources to China. If Chinese holdings of US treasuries were to amount to 20% of GDP in 2015 (as it would under quite plausible scenarios), this would roughly translate into a fiscal transfer from the US to the Chinese government of around 0.6% of US GDP annually, assuming a nominal average interest rate of 3%. A doubling of nominal interest rates (or the debt ratio) would, all other things being equal, double US interest payments to China as a share of GDP. Rising interest payments would also add to the current account deficit. But this wouldn’t break the bank.
That said, unless the US manages to implement a very significant reduction in its fiscal and current account deficits, the financial balance of power will shift in China’s favour. Such a shift is far from inevitable, however. Given that its liabilities are denominated in dollars, the US government is in a position to maintain a balanced relationship even after Sino-US trade relations become more symmetrical. If the US manages to put its fiscal house in order, its vulnerability vis-à-vis China will remain quite manageable. By ensuring debt sustainability, the Treasury will always be able to find a marginal buyer for its debt at a reasonable price, even if a major investor (like China) were to lose appetite for US debt. If, on the other hand, the US fails to put its fiscal house in order, the economic-financial balance of power will shift decisively in China’s favour and may provide China with gradually growing coercive financial power by 2030 or so.
With China lacking coercive power in the – from Washington’s point of view – benign scenario, Washington will continue to run its fiscal and monetary policies as it sees fit without facing the risk of being coerced by China into changing its policies. The ability to do so is underpinned by the United States’ “exorbitant privilege” (Giscard), that is, its ability to finance large and persistent current account deficits in its own currency. Sheer market size and developed financial markets and, ultimately, the dollar’s reserve currency status account for so-called structural power and weaken the financial-political power of the surplus countries (incl. China), as long as they are– or perceive themselves to be – dependent on the US market in terms of economic growth. This certainly was the case in the past when Germany and Japan were running large surpluses. China’s inevitably diminishing bilateral trade dependence and increasing creditor status will therefore not necessarily tip the bilateral balance in China’s favour.