Political economy of Sino-US relations (2012)

US fiscal deficits and Fed quantitative easing have led to a lot of disquiet in Beijing. The Chinese government is worried about financial losses on its increasing US asset holdings and the nefarious consequences a super-loose monetary policy will have on its economy. With US unemployment forecast to remain high and China’s global and bilateral trade surplus set to widen, tensions over trade imbalances will not go away anytime soon. Neither, therefore, will the risk of trade protectionism or even a trade war. 

Fears of a full-blown Sino-US trade war are over-blown, at least in the short term. It does not focus on technical, legal and procedural obstacles that constrain or facilitate such a conflict. Instead, it analyses the economic-financial vulnerabilities and incentive structure both sides face in terms of escalating the present conflict over imbalances and RMB valuation into a broader trade war. It concludes that while both sides have an interest in avoiding a costly conflict, the US lesser vulnerability relative to China will make a full-blown trade war over the next couple of years very unlikely. However, as a rapidly growing China becomes less dependent on the US market, the risk of a conflict will increase tangibly – unless the bilateral imbalance issue is resolved. 

China benefits greatly from its access to the US market. It affords China to pursue an export-led growth strategy, underpinned by sizeable domestic and foreign investment in the tradable sector and supported by an undervalued exchange. It also provides China with access to advanced technology supporting productivity growth. Appreciating its exchange rate would make exports less competitive. All other things being equal, it might reduce economic growth at the margin due to a less favourable contribution from net exports and, possibly, lower investment in the tradable sector. However, it would also shift resources away from the tradable sector and might lead to increasing investment there. The net effect of RMB appreciation on employment would not necessarily be negative, for the non-tradable service sector tends to be more employment-intensive than the relatively more capital-intensive, export-oriented manufacturing sector. The relative strength of the growth and employment effects naturally depend on the magnitude and speed of the appreciation. It is nonetheless worthwhile noting that current account surplus adjustments do not necessarily have a negative impact on growth. 

Why then do the Chinese authorities seem so adamantly opposed to RMB appreciation? The uncertainty RMB appreciation would create is something China is concerned about, especially as regards its effects on employment in the coastal areas with its large pool of migrant labour. Thus far China’s economic strategy has been very successful. Not surprisingly, decision-makers prefer a very gradualist approach to economic reform. Rightly or, very likely, wrongly, there is also concern that acquiescing to US demands might get China into trouble similar to Japan after the Plaza and Louvre Accords of the 1980s. Finally, Beijing may be hoping that a more domestically-oriented growth strategy will bring about adjustment without significantly adjusting the RMB, for instance, via moderately higher inflation and concomittant real exchange rate appreciation. Whatever the precise reasons, Beijing is visibly keen to defend the status quo. 

The US benefits from large Chinese trade surpluses, allowing it to consume more than it produces, while finding in China a ready and affordable source of financing. Chinese demand and, more specifically, Chinese official demand for high-grade, liquid fianncial assets has helped keep US government financing costs down. (How many basis points this is worth is subject to intense debate.) On the other hand, a large bilateral deficit has a negative effect on US growth and employment. The Peterson Institute, which has taken a decisive stance on this issue, estimates that a 20-25% appreciation of the yuan would reduce the US current account deficit by USD 50-120 bn, assuming that other Asian currencies are similarly revalued, and create upwards of 500,000 jobs. This would reduce the US unemployment rate by one percentage point. The IMF estimates that US trade with China trade subtracted an annual 0.17 ppt from US growth in terms of negative net exports during 2001-08. Moreover, although the US ability to run up large debts is considerable given its reserve currency status, it is not infinite. If left uncontrolled, debt accumulation could jeopardise US economic and financial stability at some point in the future. It will make the US and the US government increasingly dependent on foreign financing. In short, the US would benefit from a RMB appreciation, but it would certainly not resolve all its economic woes. Nonetheless, Washington is eager to change the status quo. 

In this context, it is useful introduce some concepts from strategy and diplomacy as well as game theory. It is useful to distinguish between “coercion” and “deterrence”. An agent A exercises coercive power by getting B to do x by threatening y or promising z. An agent A deters B by persuading B that the costs of a given course of action will outweigh its benefits. In other words, deterrence aims to persuade the opponent not to an initiate action, actively or passively, 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 costs of an action and (2) denial of objectives by raising the costs in such a way as to offset to the 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 relations. 

The Sino-US economic-financial relationship is best described as one of “asymmetric interdependence” (and hence “asymmetric vulnerability”), heavily skewed in Washington’s favour for now. 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 conflict are substantially 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. Last but not least, China is more dependent on US technology imports than the US is on lower- tech Chinese imports. This severly diminishes China’s ability credibly to deter, let alone coerce, Washington with the help of its vast holdings of US debt and its continued financing of US current account and fiscal deficits. China’s relative greater trade vulnerability also accounts for Washington’s coercion potential. Washington would like to reduce its bilateral current account deficit with China and it would like to see this happen as a result of China adjusting its policies, notably RMB appreciation. Excluding “extraneous” measures (e.g. making threats and promises in non-economic areas), the US can take, or threaten to take, measures aimed at offsetting the benefits China derives from RMB undervaluation (denial) or at raising the costs above the benefits (punishment) in order to coerce China into appreciating its currency (e.g. tariffs, WTO case, meeting currency intervention with currency intervention, intellectually property rights). These measures differ in terms of their legal implications and economic effectiveness. But they all aim to raise the costs of Chinese exports or the costs of maintaining an inflexible exchange rate (in case of counter-veiling currency intervention), thus directly or indirectly leveraging China’s dependence on the US market. China would face significant economic costs in the event of incrementally rising US trade protectionism, much greater than the costs the US would incur even if China responded in a tit-for-tat manner. After all, Washington benefits from “escalation-dominance” as long as game remains confined to economic-financial sphere. 

What about Beijing’s deterrence potential? Deterrence seeks to preserve the status quo. China possesses an only limited economic-financial deterrent potential vis-à-vis the US. China’s influence has undoubtedly increased dramatically due to intensifying trade and investment linkages, especially vis-à-vis other countries. Ironically, its vulnerability has also increased due to greater openness and exposure to the international economy, at least vis-à-vis the US. (Just compare 1980 and 2010.) China’s trade integration and ownership of foreign assets have therefore become both a source of influence and vulnerability. In relations with the US, it translates primarily into greater relative vulnerability. Therefore, Beijing has a greater interest in avoiding a trade conflict than Washington. Being more dependent on trade than the US, China’s financial deterrence potential is often thought to derive mainly from both its large holdings of US government debt and its continued financing of the US federal government deficit. However, a threat to “boycott” Treasury auctions or dump US debt in the secondary market would not be credible. Similar to the threat to impose counter-veiling trade measures, it would only function as a deterrent if China were, irrationally, willing to incur higher costs than Washington. By triggering a rise in US interest rates, and possibly even financial market dislocation, such actions would push up US interest rates, slow US growth and Chinese imports – the very outcome, Beijing seeks to avoid. Furthermore, China would have to find other dollar assets to invest in, unless it is willing to accept RMB appreciation – and too rapid a RMB appreciation is again the one thing Beijing is keen to avoid. Second, the US has access to a more diversified investor base, with parts of which it maintains close political relations (e.g. Japan, Middle Eastern oil exporters) than Beijing has markets to invest in. Last but not least, any politically motivated fire sale of US debt would trigger a very severe political backlash – and not just from the US. The White House would find it very difficult to control a revanchist Congress dead-set on trade sanctions. 

All considered, China’s deterrent potential is limited – at least as long as it remains unwilling to accept RMB appreciation. Sino-US economic-financial-diplomatic action can be modelled as a sequential, perfect information, non-zero-sum game, where Washington might well end up making a strategic commitment (in game theory terms) by threatening and subsequently implementing trade sanctions if Beijing does not appreciate its currency. This might appear irrational from a purely economic benefit/ cost point of view. Free trade is a non-zero-sum game, after all. However, if the White House were forced into a brinkmanship strategy by Congress, China would be better off backing down, for both protectionist counter-measures and financial retaliation lack credibility, as both kinds of responses would undermine the very thing China is keen to preserve: unfettered access to US markets and solid US growth. This is so quite independent of the likely retaliatory measures Washington would take in response to Chinese retaliatory action. Faced with US trade sanctions, it would be irrational for Beijing to opt for anything other than a tension-reducing RMB appreciation. This this would allow Beijing to remain in control of its economic policy and stick with gradualism. The costs are also likely to be much smaller than the potential costs incurred in the event of trade conflict escalation. It would seem eminently rational for Beijing to back down and pre-empt US measures by letting its currency appreciate, modestly but gradually. It may, however choose to engage in a temporary tit-for-tat trade strategy to test Washington’s determination to pursue a gradual turning the screw strategy vis-à-vis China, thereby hoping to deter further US measures. However, if Washington calls it bluff, Beijing will be better off backing away from a politically more difficult-to-control trade conflict. 

This simple, abstract game-theoretical framework may have to be enlarged in order to include Chinese “linkage” strategy. Economic-diplomatic interaction takes place in a much broader bilateral (and multilateral) framework. In game-theoretic terms, Beijign and Washington play multiple games simultaneously. Excluding extreme and extraneous measures such as expropriation or the freezing of financial assets, the broader relationship does give Beijing a greater deterrence potential than a purely economic-financial analysis suggests. If China makes co-operation in areas considered vital by Washington (e.g. Korea, Iran) conditional on Washington not taking more aggressive action on the bilateral imbalances issue, Washington may be deterred. The bottom line is that even if a broader perspective is adopted, a trade war would be avoided, for Washington or at least the White House will work very hard to avoid it in the first place and prevent Congress from forcing it into an aggressive first move. Nonetheless, a limited escalation is possible, if Congress succeeds in making a first move and China temporarily chooses a tit-for-tat strategy to verify US commitment. An outright “war” is unlikely. Several safety valves exist that make this so. 

First of all, Beijing may simply resume a gradual, controlled nominal appreciation of the RMB against the USD. Even if bilateral imbalances remain sizeable, this should allow the Treasury to manage political pressure from Congress more easily. From China’s point of view, less risk attaches to this course of action than allowing the US to take the initiative. In the context of shifting towards greater domestic-consumption-led growth, which given the rapidly increasing size of the economy, will sooner or later become inevitable, this will be a desirable “exit strategy” – and may yet be embraced by Beijing. 

Second, the imbalances may resolve themselves, via the real appreciation of the RMB, making a nominal appreciation unnecessary. Greater focus on domestic growth in the context of the next five-year economic plan (2011-15) may help limit the overall current account deficit to levels similar to what the Chinese authorities forecast. The IMF forecasts the Chinese current account to move back to 8% of GDP by 2015 (or USD 800 bn) from last year’s 300 bn deficit. The Chinese authorities, by contrast, see it settling down at 4% of GDP. This may not be enough to eliminate frictions altogether, but 4% of GDP, incidentally, would be close to the quantitative targets that the Treasury floated a few months ago. However, a lot will depend on what happens to US unemployment and growth. Most likely, the bilateral trade balance will remain a cause of friction. 

Third, even if the bilateral trade imbalance remains significant and Beijing does not revalue the RMB, the US administration may continue to hold the line in order gain support for policies whose success depend on Chinese co-operation (e.g. Iran, North Korea). 

Fourth, if the trade deficit remains large and if Congress succeeds in pushing the administration to take more forceful action and if the president decides not to veto legislation, then forceful US coercive action will take place. While this may lead initially to a tit-for-tat game, an escalation to the point of a full-blown trade war remains unlikely, for Beijing will have a huge incentive to avoid a broader confrontation. From China’s perspective, it would preferable to accept RMB appreciation rather than ultimately risk a trade conflict that would end up imposing higher costs on China than a largely, self-managed RMB appreciation. 

Naturally, the wild card remains Congress and its ability to override presidential vetoes and force the White House to take action against China.If Congress is the wild card on the US side, Chinese public opinion and “saving face” may be the wild card on the Chinese side – both of which might throw a spanner into rational, diplomatic game. If raison d’etat, rationality and pragmatism prevail in both Beijing and Washington, recurring tensions will remain manageable. This is based on the assumption that both parties seek to maximise employment and growth rather than purchasing power. Because Washington would incur substantially lower costs in the event of a bilateral trade conflict, it is in a position to coerce a rationally acting China in to making concession on RMB valuation. Naturally, Washington may refrain from taking action, lest Beijing refuses co-operation in other games Washington and Beijing are engaged. In reality, however, domestic forces may lead a state to pursue “irrational” policies. 

What are the domestic forces influencing government policy? In China, the PBoC is primarily concerned about monetary and financial stability. Cognisant of the need to sooner or later re-balance the economy towards greater domestic consumption driven growth, the PBoC is relatively sympathetic towards gradual nominal exchange rate appreciation, especially if domestic inflation and asset prices surge further. The MoF, linked to the export sector, on  the other hand strongly opposed to currency appreciation. The ultimate arbiter is the prime minister, responsible for economic affairs, and the president, who needs to take into account the broader Sino-US relationship. The prime minister and president have sent ambiguous signals, occasionally decisively rejecting foreign pressure. The political leadership appears to be concerned about the RMB issue in as far as employment and economic and domestic political stability are concerned, but they will also be influenced by the desire to maintain good relations with the US. 

While bureaucratic politics no doubt influences economic decision-making, China’s top leadership does not face the cross-pressures as the White House. This should make easier for the Chinese government to act “rationally” which the US government that is more open to domestic pressure, especially from Congress and, arguably, from public opinion. In the US, Congress is in a position to push, even force, the executive to take a tougher stance vis-à-vis China. This is also more likely happen than in China due to the more democratic nature of the political system where members of congress have to run for re- election frequently. It is no coincidence that high unemployment has forced the RMB issue back on the domestic political agenda. The government in the guise of the Treasury may seek to “hold the line”. The White House’s reluctance to take a more forceful, coercive stance vis-à-vis the RMB issue reflects the acknowledgment that Washington needs Beijing’s support on a number of top priority foreign policy issues rather than the belief that behind-the-scenes diplomacy will yield better results than coercive measures. But the White House may at some point find it opportune for domestic political reasons to give in to domestic pressure. After all, “all politics is local.” Ironically, US-based companies with extensive export capacity in China and exporting to the US benefit from an undervalued RMB and therefore oppose RMB appreciation. In other words, the US government is more open to influence and pressure from domestic political forces than the Chinese government. 

This makes it more likely for Washington to become more aggressive vis-à-vis China, while China, with a government more insulated from domestic political pressures, is more likely to act “rationally”. It also makes it easier for the US to credibly adopt a brinkmanship strategy. If this analysis is correct, it has two very major implication: in the very short term, a trade war is very unlikely; but over the medium term, the risk of a trade conflict will increase – unless, of course, imbalances narrow substantially. Here is why. Offering the largest market to other countries and issuing the reserve currency provides the US with immense (structural) power. Any country highly dependent on trade with the US, even if holding US assets will be in a relatively weak position to deter aggressive US action, let alone exert economic-financial pressure on the US. This is why China, for now, would find it in its interest to acquiesce into RMB appreciation in order to avoid a trade war. However, China’s relative trade dependence will be declining as the size of its economy approaches and outstrips the US. Relatively speaking, US trade and financial dependence on China will be increasing. Similarly, the increasing international use of RMB may help gradually make China less dependent on US dollar assets (relative to the size of its economy). 

Rapidly rising GDP combined with a greater focus on domestic growth will help tilt the balance-of-economic-and-financial power in Beijing’s favour. Once the tipping point is reached, the balance could change very dramatically given large Chinese holdings of US government debt. A declining Chinese dependence on the US market will make Beijing more confident on account of lower costs of an economic conflict. A declining and over-confident US relative to its actual position and a rising China might end up engaging in an economic-financial conflict. When China’s economy approaches the position of the US and its trade dependence on the US dimnishes but its financial leverage remains large due to large US debt, its leverage will increase increase rapidly. Beijing will then not only be more likely to stand its ground in the event of US pressure; it may also become more aggressive vis-à-vis Washington. This would also be a time when an escalation would not be easily contained by either side’s recognition that it is in a substantially weaker, more vulnerable position. Near economic parity, when it is not obvious who is more vulnerable, the risk of misperception and miscalculation will also rise. Then, the risk of a wider trade conflict will be much higher than it is today. In short, if this analysis is correct, Sino-US trade conflict and protectionism will be increasing over time, unless the issue of bilateral imbalances is resolved to both side’s satisfaction. Policy-makers in Beijing and Washington take note.