Wednesday, January 12, 2011

Is There a Zone of Cooperation in U.S./China Economic Relations?

The economic game between China and the U.S. is changing. For the last decade, we were both better off in trade because China bought U.S. commodities like coal and steel and the U.S. bought China's low priced manufactured goods and used China’s trade gains to finance our doubling debt.

But as the leaders of both countries prepare to meet next week, that grand bargain is showing signs of crumbling. The U.S. wants to boost exports to China but argues that China’s weak currency and trade barriers make this too difficult. Meanwhile, China has pumped so much money into its economy that it is suffering from 10% inflation which is way above the 5% level that its population can tolerate.

Is there a way out of this mess? If so, what moves are likely to make both the U.S. and China better off? The answers: Yes; through a two-pronged strategy of encouraging China to shift to more of a consumer-driven economy while the U.S. adjusts from a consumption- to an innovation-led export economy with lower deficits and debts.

China's Booming and Its Inflation's Looming

China is phenomenally successful on many fronts -- but its economy is overheating. GDP is growing at 10% a year with 10% inflation (twice the official rate according to the New York Times) -- food prices were up 11.7% in 2010 and the median Chinese house price rose 7.7% in 2010 and costs 111 times the median Chinese income, according to my DailyFinance post. 

Meanwhile, China's economic policies are yielding huge reserves of capital that dwarf those of other large countries. For example, according to the Washington Post, Beijing's foreign cash and securities spiked 20% from the year before to $2.85 trillion in 2010 -- a third of total IMF reserves -- with $200 billion of it coming in the fourth quarter alone. And China is complaining that the Fed's $600 billion QE2 program is boosting the flow of capital into China just when it does not want it.

If only China didn't have to worry about the well-being of its 1.3 billion people, all this would be great news. But when inflation exceeds 5%, the populace gets restive and its anger becomes difficult to control. So China has taken steps to try to keep that inflation under control -- including raising interest rates to 5.81% in 2010 and perhaps 6.56% in 2011, limiting the flow of foreign capital and boosting bank reserve requirements above the current 18.5%.

Is The U.S. Too Dependent On China?

Meanwhile the U.S. business sector has been booming while its consumers, millions of whom don't have jobs, have been suffering despite low official inflation. U.S. GDP is growing at 2.8% but its inflation is lows, CPI that was up 1.1% in November. And the U.S. economy, 70% of whose growth is due to consumer spending, still suffers from a 9.4% unemployment rate -- leaving some 15 million in search of work and bringing into question how much longer the U.S. can sustain the 5.5% growth in retail sales it enjoyed during the 2010 holiday season.

But America's corporate sector earned record 2010 profits of $1.66 trillion and piled up cash balances near $2 trillion. Corporate profit has been growing rapidly -- the S&P 500 enjoyed 47% operating earnings growth in 2010, according to S&P's Howard Silverblatt, and in December 2010, that growth was forecast to continue at a 13% rate in 2011.

A big reason for the growth is globalization. Specifically, exports into faster growing markets like China, India, and Brazil are helping U.S. companies grow. But the U.S. is complaining that China wants to give too much of its business to China-owned enterprises and that it does little to protect intellectual property, according to the Times. Meanwhile the U.S. also benefits from globalization as a way to reduce costs by outsourcing services to lower wage countries like India and the Philippines and manufacturing goods in China.

China is also aiding the U.S. by helping to finance its deficit and debt. U.S. budget deficits exceed $1 trillion while our national debt has risen 180% to $14 trillion from $5 trillion a decade ago. China's $906.8 billion in U.S. debt securities as of Oct. 2010 is helping to keep U.S. interest rates very low (the 2-year government bond yields a mere 0.64%).

A rise in U.S. rates would likely choke off the U.S. economic recovery as interest expense crowded out capital investment. And such a rise is imminent if we start to import China's 10% inflation rate and the Fed raises interest rates to keep inflation below its 2% target. Fortunately, a spike in U.S inflation is not a guaranteed outcome because only about 25% to 40% of the price to U.S. consumers of Chinese imported goods -- that climbed an uncomfortable 3.6% in the fourth  quarter -- is attributable to the cost of the product, according to the Times.

U.S. retailers have other ways to keep prices from rising. The final sticker prices also includes the costs of shipping, storing, store rent and wages and some of those costs can be reduced to keep a lid in price increases. And retailers are afraid of losing sales due to price increases to economically traumatized consumers. So they are likely to try to keep the lid on price increases.

But price increases from Chinese-made goods are not going to be held off forever. Since Chinese wages are growing at 15% a year, according to the Times, many companies are trying to shift production to lower wage countries like Vietnam and Bangladesh -- but those countries do not always have sufficient factory capacity to handle the boost in volume.

Zone of Cooperation

If we think of trade between China and the U.S. as a game, there are four possible outcomes:

  • The U.S. wins as China loses
  • China wins as the U.S. loses
  • China and the U.S. go down together
  • China and the U.S. rise together
The best outcome is for both countries to be better off. One way to achieve that would be for the U.S. to become more like China in some ways and for China to become more like the U.S. in others. More specifically, the U.S. should become less dependent on consumer spending for economic growth and China should become more-so.

How would this work? If China lets its currency rise so it's no longer about 10% undervalued, then consumers there will become a bigger part of China's overall economic growth. This will benefit China's politicians because they will have fewer worries about political instability since a stronger yuan will boost Chinese consumer spending power.

A stronger yuan would also reduce Chinese surpluses as U.S. exporters to China would become more price-competitive there. But that would not be enough for U.S. exporters -- they also would also welcome some loosening up of the requirement that China's state-owned enterprises (SOEs) buy mostly from other SOEs.

China should open up its markets to real competition from the U.S. and other countries so that market pressure provides an incentive to upgrade its skills. The fear that China lags the world in innovation could be overcome by exposing it to the gales of global competition.

Meanwhile, the U.S. needs to build an economy that is less dependent on consumption and finance and puts greater emphasis on innovation-led exporting. At the same time, the U.S. must find a way to lower its budget deficits and debt levels.

If China and the U.S. could pull off such changes, they could both grow while making life better for more of their citizens.


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