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NEWS & COMMENTARY 2008 SPEAKERS 2007 2006 2005

Friday, February 09, 2007

The effect of China's economy on the US

China's economic clout is on the rise, along with its political clout and analysts are speculating as to what effect this will have on US financial interests.

By EastWest Center Wire staff

There is continued concern in Washington that China's economic rise, and its relatively weak currency, could threaten the dominance of the US dollar over the next 5 to 10 years. That will not happen, according to Paul Bowles.

The University of Northern British Columbia professor, and a recent visiting lecturer at the East-West Center, says "China's re-emergence as an economic power is unlikely to point to an end of the dominance of the dollar." He notes that even if some predictions that China may overtake the US as the world's largest economy by mid-century prove true, the dollar "would likely to continue for decades after that as the world's leading currency."

He points out historical experience is on his side of the argument. "The pound sterling continued to play a significant role in the international monetary system long after Britain's economic pre-eminence was lost."

Bowles says there is little chance China's currency, the renminbi, will become a significant international currency any time soon, "given that many of the factors required for an international currency are not present." As for talk of an "Asia dollar" with the Chinese currency at its core, he is also pessimistic. "An Asian currency is also a long run possibility at best and, even then, only if long standing regional rivalries between Japan and China can be resolved."

But, that does not mean the dollar is home free, he cautions. "The threat to US dollar dominance does not come from China's re-emergence or from a possible Asian Currency Unit, but rather from the current imbalances (in foreign exchange rate regime, trade surpluses, and official reserve holdings) and the policy history which lie behind them."

Bowles says the current situation is "one marked by China having a large bilateral trade surplus with the US, a rapid build up of official reserves to over $1 trillion and a very slowly appreciating renminbi against the US dollar." What to do about those factors lie at the heart of the policy matters that must be dealt with in both Beijing and Washington. But, he adds "the scope for mismanagement is considerable."

The US continues to pressure China into letting the renminbi appreciate, as Bowles puts it, "in an effort to reduce the bilateral trade deficit." Meanwhile, he points out, "China's policymakers have continued with their public declarations that they are moving to a more flexible exchange rate system but have provided no details of when or to what degree." To be fair, he adds, China has switched from a fixed rate against the dollar to a tightly managed float against a basket of currencies, and the renminbi has appreciated a percentage point or two against the dollar.

Bowles says Chinese leaders have analyzed the 1985 Plaza Accord and its impact on Japan. They did not particularly like what they saw. And, he says China "will not be pressured into entering a similar type of agreement with the US" Bowles adds, "Such an agreement would be seen as serving US rather than China's interests and the types of numbers being bandied around in Washington as the desirable appreciation of the renminbi are non-starters in Beijing."

On the trade front, Bowles sees the possibility of China gradually shifting over the next 5 to 10 years to a more domestic-oriented economy from today's export-led industrialization strategy. And, the shift has nothing to do with pressure from Washington. Bowles points out, "From a policy perspective (the export-led economy) is seen within China as being responsible to a considerable degree for the widening regional income inequalities, inequalities which the new leadership view as threatening social stability." That shift, if and when it comes about, could lower the trade surplus to a certain degree.

China's hoard of foreign reserves are another issue. Approximately 80 percent of Beijing's reserves are held in US-dollar denominated assets, and not all are due to the trade surplus. Of the approximately US$220 billion increase in reserves in the period from June 2005 to June 2006, roughly US$132 billion (61 percent) was the result of trade surplus and US$85 billion (39 percent) was the result of foreign direct investment and/or "hot money" inflows.

Bowles says there is a growing argument within China that the current level of reserves is harmful because a build up of reserves "is associated with the loss of real output, higher risks as a result of a potential US dollar depreciation, higher political risks associated with more conflict with the US, increased difficulty of domestic monetary management as a result of the need to sterilize the inflows, and a reduced ability to borrow from the World Bank." In response to these arguments, he says "it is not surprising to find Chinese leaders indicating that they do not wish to see a further build up of reserves."

But, as of yet, the comprehensive measures Chinese leaders have talked about have led to nothing specific being tabled. Bowles says, "Barring a major political upheaval and/or a rapid relaxation of outward capital flows, we might expect the current level of official reserves – the world's largest – to continue." And until a major policy retooling is put in place, he adds, over the short term "it is not in the interests of Chinese leadership to spark a fall in the value of the dollar."

Bowles says "both sets of policymakers have their own interests and objectives, which may not be realizable in full separately and certainly not jointly." China's leaders, he points out, "would be quite content to have a lower level of reserves; the problem is how to achieve this without having a rapid appreciation of the renminbi and without causing too much disruption to the export sector." On the US side, Bowles says Washington "has thus far proven unwilling to view China as an equal partner. Indeed the US continues to struggle to come to terms with China's economic rise and the scope for misperceptions are larger." The US may have "dealt with an emerging Japan in the past, but an emerging China is a different proposition", Bowles adds, pointing to the different political systems between the countries.

Bowles says both the US and China have an "overarching common interest in preservation of a stable international economic and monetary order." But, within that larger common interest are home-grown ones. And therein lays the real threat to the US dollar. "US unilateralism, hectoring and demands coupled with Chinese nationalism and exclusion from a major role from the international financial institutions leave plenty of room for over-reactions, political miscalculations and policy errors." Bowles adds, "The future of the dollar rests in no small measure on the ability of the two powers to successfully navigate the rocky road head."

The East-West Center is an education and research organization established by the US Congress in 1960 to strengthen relations and understanding among the peoples and nations of Asia, the Pacific and the United States. The Center contributes to a peaceful, prosperous and just Asia Pacific community by serving as a vigorous hub for cooperative research, education and dialogue on critical issues of common concern to the Asia Pacific region and the United States. Funding for the Center comes from the US government, with additional support provided by private agencies, individuals, foundations, corporations and the governments of the region.

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