Chinese and American officials will discuss trade balances at this week’s Strategic and Economic Dialogue in Washington. This discussion must involve more than just exchange rates.
Many analysts have long pointed to exchange-rate manipulation as a quick fix for trade imbalances, or the gap between what a country produces and what it consumes. When the Japanese and German currencies soared in value against the dollar after the Plaza Accords of September 1985, many analysts thought that these countries’ trade surpluses with the U.S. would decline. They were partly right. The German trade surplus with the U.S. declined. But even though the value of the yen doubled, Japan’s trade surplus surged.
This should not have been surprising. In response to the Plaza Accords, Tokyo directed a flood of low-interest credit into the manufacturing sector while informally guaranteeing corporate borrowers. Manufacturers increased production for export markets even as household consumption declined. The trade surplus with the U.S. rose.
China is trying to do the same thing, despite a rising yuan. Policies include low lending rates enforced by the central bank, energy and commodity subsidies and most importantly, a flood of implicitly guaranteed credit aimed at investment in infrastructure and the manufacturing sector. Yet consumption is still repressed thanks in part to very low deposit rates, constraints on consumer financing and low wages.
China’s trade surplus with the U.S. won’t necessarily soar. In the short run, American consumers are hamstrung by wage stagnation and rising unemployment. For the next few years, U.S. consumption will grow more slowly than its production, and the trade deficit will narrow.
Still, the U.S. should care what China does even if a rising U.S. savings rate forces the necessary rebalancing. The best-case scenario for the U.S. would see healthy GDP growth buttressed by decent consumption. The worst-case scenario would see a contraction in GDP driven by even faster contraction in consumption. For China, the best-case scenario would be explosive consumption growth driving slightly lower GDP growth. China’s worst-case scenario would be slower consumption growth that drags down GDP growth sharply.
Both countries face balancing acts between short-term employment needs and long-term adjustments. As the U.S. government races to replace debt-fueled household consumption, it helps create jobs and gives more time to China to adjust, but at the expense of lowering the savings rate. As China pours new loans into the system at a rate of more than a quarter of last year’s GDP in just six months, it creates short-term employment but increases additional excess capacity and degrades the government’s balance sheet.
Both countries need time to adjust. If this week’s summit in Washington fails to address the timing of the trade adjustment and coordination among the two countries’ fiscal and monetary policies, both countries will see the inevitable rebalancing—but with slower GDP growth. If rising savings in the U.S. clash with government-induced production hikes in China, both countries could be forced into mutually destructive policies. The consequences, especially for China, could be brutal.
The next few years are going to be difficult in the best of cases. Conflicting adjustment policies, especially if they lead to protectionist trade clashes, could make it much worse. The Strategic and Economic Dialogue should aim to resolve what seem like domestic policy conflicts but which are ultimately trade rebalancing issues.