The bilateral trade imbalance is creating tensions between China and the United States. China contends that U.S. trade protectionism has been growing ever since the global financial crisis began, while U.S. leaders continue to urge China to appreciate its currency as complaints mount that China’s undervalued exchange rate puts American exports at a disadvantage.
Michael Pettis discusses global trade, looming trade tensions, and the avenues for reducing disputes in a new video Q&A. Pettis explains that trade tensions will continue to rise: “things are going to get worse before we reach a point where leaders in the three or four major economies can come to an agreement over a long-term solution.”
Are bilateral trade frictions between the United States and China on the rise and is a global trade war possible?
It’s hard to imagine that we’re not going to see a significant increase in global trade tensions. And the reason I say that is because we have competing needs from the two major players in the system—and this is true of the whole system.
In the United States we’ve had extremely low savings rates matched by very high savings rates in China. As part of the adjustment process in the United States, savings rates must rise. And since it’s unlikely that total investment is going to rise as quickly—in fact total investment may decline—that means that the gap between the two, which is the trade deficit, is going to contract over the medium term (or ought to contract).
The problem is that in order for there to be a global balance we would need to see the savings rate in China come down as quickly as the savings rate in the United States goes up. And that’s very, very unlikely. The development model that China has followed—which has been exacerbated by the fiscal, credit, and monetary stimulus in response to the crisis—is likely to continue with a process in which total income, GDP, grows faster than consumption. Over the short term you can change that a little bit by an increase in investment, but that increase in investment is probably not sustainable.
So in China you are going to have persistent, high savings rates and in the United States you are going to have rising savings rates. And that means that somehow there needs to be an adjustment and the brunt of the pain is going to be determined by the trade account. If the U.S. trade deficit stays high, that means that much of the adjustment—much of the pain—will be born by U.S. workers. If the U.S. trade deficit comes down quickly, that means that much of the pain will be born by Chinese workers and there will be rising unemployment in China.
And this is true with a whole bunch of countries. This is going to happen in Europe and this is going to happen in Asia too. The way the burden of the adjustment is distributed will be determined by the trade account. That means that the trade account is going to be highly politicized, and we’re going to be spending a lot of time working on the trade account and deciding how the adjustment is going to be carried out.
Can China reduce its trade surplus?
In order for China to reduce its trade surplus, it’s not that consumption needs to grow—everyone says that we need Chinese consumption to grow—Chinese consumption has been growing very quickly. In the past decade it’s grown around eight or nine percent a year which is a much faster growth rate than in any other major economy. But that’s not enough.
The problem is that Chinese production is growing faster than Chinese consumption and so the gap between the two is increasing. Why is it growing faster? I would argue that the reason it is growing faster is because Chinese consumption growth is more or less in line with the growth in Chinese household income.
So that national income—that is the total amount of stuff that China produces—is growing faster than household income. And the reason for that is that the development model that China has followed—the very successful Asian Development model—one of it’s key components is that the household sector via low interest rates on their bank deposits, via an undervalued currency, and via a number of other mechanisms are effectively forced to subsidize producers.
The simplest way to think about it is through interest rates. With interest rates so low on banking deposits, that means basically savers are getting a portion of their income taxed away. Those low banking deposits translate into very low lending rates—lending rates that are well below any definition of what the natural borrowing costs should be in China. So users of capital—which are mostly infrastructure investment and manufacturers—are getting very cheap capital and that cheap capital is being subsidized by the household sector. So unless China reverses this process of subsidy, it’s extremely difficult to get household incomes to grow much more quickly and therefore consumption to grow much more quickly.
And that’s the problem that we face, because if you do eliminate the subsidy—and even reverse the subsidy—the manufacturing sector—which is very heavily dependent on these subsidies—becomes unprofitable. So, we can’t do it quickly because if we do it quickly we’ll see a rise in unemployment in China. We have to do it slowly over six, seven, eight years.
It won’t be easy but if it’s stretched out over many years it can be done. The problem is, if the trade deficit countries want a very quick resolution, then China is in a very difficult position because they cannot resolve it quickly.
How does China's exchange rate impact other countries and influence international trade? Will China appreciate its currency?
Most of the focus is on the currency, even though the currency is simply one of many factors—but it’s the most visible one. My guess is that China will appreciate the renminbi, but not by a lot, because if it does it too quickly it runs the risk of what happened to Japan.
In the 1980s, the Japanese postponed an appreciation of the yen for much too long until it reached the point where it became politically difficult and it was forced to appreciate the yen very quickly, which, as we saw, led to all sorts of problems. But much of the focus was on the currency back then and will be on the currency currently.
In that sense it’s very instructive to look at what happened in the 1930s—and this is based on work by Barry Eichengreen—and what Eichengreen argued was that in the 1930s at the beginning of the trade conflict, a number of countries that were able to devalue their currencies did so. And it was the famous beggar thy neighbor devaluations or depreciations. A number of countries, however, were not able to depreciate their currencies—this included the United States and the so-called gold block nations.
And what Eichengreen argues was that in the scramble to grab a larger share of this contracting demand, the countries that were able to depreciate did so. It was the most efficient way of beggaring thy neighbor. But the countries that weren’t able to depreciate, they chose the second best set of policies which was import tariffs or import quotas.
My suspicion is that we’re going to see a replay of this. Countries that are able to intervene heavily to keep their currencies low, are going to do so. Unfortunately, the United States and Europe will not be able to do so. The United States won’t be able to do so because most of the intervention is against the dollar. Europe won’t be able to do so because as the dollar is forced to depreciate to bring some kind of balance to the United States and the dollar can’t depreciate against Asian currencies or against most developing country currencies, all the depreciation takes place against the euro.
So, the euro and the dollar and other floating currencies like sterling are sort of stuck. They can’t depreciate their way into grabbing a bigger share of global net demand, so these are the countries that are most likely to resort to the second best set of solutions, which is to raise import tariffs.
There has been a lot of talk about U.S.-China trade frictions, but how are China’s trade relations with other major economies, including Europe?
One of the mistakes we make is by looking purely at U.S.-China relationships to understand the nature of trade tensions. U.S.-China is very important for symbolic reasons—if we start seeing a significant increase in U.S. tariffs, that becomes a signal that the rest of the world can also engage much more aggressively on trade issues.
The fact is that the most difficult trade disputes are not taking place between the United States and China, they are taking place between China and some of its Asian neighbors. For instance, India and Indonesia have enacted some very tough measures. There is a lot of conflict and tension between China and Korea. Secondarily, there are very strong trade tensions between China and Europe.
I would say that trade tensions between the United States and China, even though the United States is running, by far, the largest trade deficit, have also been the least aggressive and the least painful. But I think that’s starting to change.
If it does change, I think it has a very bad effect on the rest of the world because once the United States blatantly engages in trade protection as a response to China’s policies, that opens the door for everyone in the world to be much more aggressive.
In that sense, Smoot-Hawley—which is often a very bad example that we use—was the wrong policy for the Unites States in the 1930s because the United States was the leading trade surplus country. As the trade deficit country, Smoot-Hawley is not a useful way for thinking about the consequences for the United States.
Once it was clear that the president was not going to veto Smoot-Hawley—it passed in June 1930—that was a signal for the rest of the world to raise tariffs (although some countries like Canada actually started before, once it was clear that the United States was going to respond). And that began that degeneration into the collapse of international trade.
How can Beijing and Washington work together to avoid serious trade conflicts? Can a breakdown in global trade be prevented?
It’s very important for the United States, China, and Europe to come to some kind of grand agreement. China needs to recognize that the trade surpluses it needs to absorb its excess capacity are politically unacceptable in countries suffering from high unemployment.
Europe and the United States need to understand that China simply can’t adjust quickly enough. In an ideal world, the leadership of the three economies would get together and work out a plan—six years, eight years, however long it took—in which China committed to taking the necessary steps.
Most importantly, raising the value of the currency, liberalizing interest rates, and liberalizing the banking system, that would go a long way to rebalancing the Chinese economy. It will be painful and it will be difficult, but it’s what China will need to do one way or another.
In exchange, in order to make the difficulty much less, the United States and Europe would commit to slowing down their own adjustments. The United States would continue to run large fiscal deficits in order to slow down the increase in savings in the United States. And they would commit to keeping their markets completely and totally open to Chinese goods, so that the adjustment in China could be slowed down over a seven or eight year period.
When I put it that way, I am immediately a little bit pessimistic that we are going to arrive at that kind of grand bargain. At least, I think it’s unlikely that we do so before things get worse.
My guess is that trade tensions are going to continue rising and things are going to get worse, especially for China as the trade surplus country—trade surplus countries are always the most vulnerable to a contraction in global demand—before we reach a point where leaders in the three or four major economies can come to an agreement over a long-term solution.