The G-20 summit left the global imbalance issue unresolved. While initially it appeared as if the forceful counter-cyclical Chinese response to the global slowdown and a narrowing US trade deficit might diminish tensions, the renewed rise in Chinese surpluses and widening US deficits have again intensified bilateral frictions. In the US, high unemployment and large fiscal deficits, necessary to support growth while the private sector is de-leveraging, have led to increasing criticism of Chinese exchange rate policies. Meanwhile, the very same 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. This comment argues that fears about 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 concomitant 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 financial 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.
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 a 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 the prospect of 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.
Naturally, 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.