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Boomtown China: Opportunity and Crisis

January 28, 2004

As the American economy reels from the consequences of the Federal Reserve's monetary manipulations, a burgeoning sovereign debt, an interventionist foreign policy, as well as a bevy of other no less onerous government-orchestrated distortions in the marketplace, it is fascinating to note the scorn with which the country's legislators, trade unions and manufacturing concerns regard China.

According to these people the giant "sucking sound" of American manufacturing jobs exiting the country can no longer be exclusively attributed to Mexico under the North American Free Trade Agreement. China, with its currency, the renminbi, pegged at 8.28 to one dollar, has mirrored the greenback's two-year downward spiral, bolstering Chinese exports sales, to the detriment of competing American firms already hampered by dearer labor costs.

Far from being a scourge to be feared, China's emergence as global economic power bodes well for consumers and producers all over the world through the blessings of trade. Although the Middle Kingdom is a boon to the international trading system, its fragile banking system, potential for boom and bust, and its role in bankrolling America's profligate tendencies all bode ill for the world economy in a manner unperceived by the mercantilist politicians, manufacturers, and trade unionists in Washington and beyond.

Shop floor of the world

Dubbed "a global factory," by the heads of several major multinational corporations, China, as a manufacturing entity, has turned heads around the world. Operating from an average remuneration rate of approximately 60 cents per man-hour and equipped to tap a burgeoning surplus of laborers made redundant by the retrenchment of state enterprises, Chinese firms undercut the competition the world over in a number of product fields. As any Wal-Mart patron can attest, toys, furniture, footwear and apparel are almost always "made in China."

In the sphere of textiles, producers from Mid-Atlantic America to the Asian subcontinent tremble, for the Middle Kingdom is already the world's largest exporter of this product. When the global Multi-fibre agreement, a Byzantine arrangement of import quotas and tariff barriers, expires in 2005, the World Bank reckons Chinese textile exports will by 2010 account for 50% of the aggregate, rather than the current 20% it commands[i].

To drive the point home, University of California-Berkeley economist Barry Eichengreen calculated that China, whose labor costs are a fraction of Mexico's, have surpassed America's southern neighbor in the annual production of sombreros[ii].

An importer/exporter

Nonetheless, the Middle Kingdom's exporting prowess is not to be outdone by its insatiable appetite for foreign goods. What politicians in Washington, Tokyo and elsewhere rarely mention is the fact that China's trade balance is barely in surplus: it runs a deficit with some countries and may even post a trade deficit in 2004. The only country with which China enjoys a whopping trade surfeit is with America (their bilateral economic ties will be discussed later).

Indeed, from Sept. 2002 to Sept. 2003, China's imports increased by 41%, outstripping export growth of 32%. Overlooked by the mercantilists on Pennsylvania Avenue, America's exports to China by grew by 21% in 2003 compared to a paltry export growth of 2% to everywhere else last year. Since 1995 China's annual import volume growth has doubled America's[iii].

Despite increasingly bitter complaints that China employs a myriad of unfair trading practices, its World Trade Organisation (WTO) accession commitments belie this argument. Beijing is required to adhere to an average bound tariff level of 8.9% with many products duty-free and only a triad of fertilizer lines receiving protection at the tariff ceiling of 50%. In January 2002 China began to junk several of its trade impediments, lowering the average tariff on approximately 5,300 items from 15% to 12% and rescinding non-tariff barriers on 238 products[iv].

Rather than being subjected to a WTO Trade Policy Review every couple years like typical member states, China has submitted to a yearly Transitional Review Mechanism for the next decade. Moreover, Beijing was compelled to negotiate 37 separate bilateral agreements before even being admitted to the world's premier trading club, a rigorous and daunting undertaking itself.

What are some of the items China is so vigourously purchasing from abroad? Modern amenities—microwaves, ect.; automobiles—Ford predicts China will become its most lucrative market outside of America by 2008; consumer items—fashion apparel perfumes, cosmetics; home improvement; all goods and services rich country citizens take for granted. More importantly, it imports the production equipment, managerial practices, Western expertise and capital-intensive goods that the country lacks.

What is more, investment bank Morgan Stanley pointed out that since 1994 two-thirds of China's export growth has been produced by the country's domestic firms through either joint ventures or as subsidiaries of foreign multinationals. Western investors should laud their corporation's efforts to lower costs and augment profits by undertaking operations in China.

Engine of Growth    

It is also imperative to appreciate the importance of China to world economic growth. Valuing GDP figures according to purchasing-power parity rather than on the basis of fluctuating fiat currencies, Canadian research firm Bank Credit Analyst calculated that America's GDP growth from 1995 to 2002 comprised 20% of global growth whereas China accounted for a quarter of it.

As the second largest economy in the world, again in purchasing-power parity terms, China's importance to the world economy cannot be understated. Although the temporary dislocation of workers will arise in inefficient industries displaced by Chinese competition, the redundant will find employment with growing firms in other sectors of the world and domestic economies. Meanwhile, consumers will enjoy the fruits of lower prices that the "workshop of the world" provides, assuming protectionist forces in Washington, Brussels, Tokyo and elsewhere do not impede trade between their citizens and China's.

Currency complaints

On the campaign trail in America the resounding indictment of China—besides its low labor costs—is its currency, the renminbi, and its peg to the dollar. Like other East Asian countries whose currencies either officially or implicitly track the greenback, China's fixed exchange rate of 8.28 renminbi to one dollar has enabled its exporters to enjoy enhanced competitiveness and surging sales as the dollar has slid during the past two years. Indeed, in the year to December 2003, China's exports to the U.S. rose by 81%[v].

American politicians cry foul, arguing that China should subject its fiat currency to market disciplines via floatation, despite commending Beijing's firm commitment to the peg amid the East Asian financial crisis of 1997 and 1998. Few, if any, of these detractors of China would dare attribute America's ballooning trade deficit with the Middle Kingdom to Washington's deficit spending or aggressive Federal Reserve monetary easing.

Fiat money fallacies and follies

Unfortunately, Washington fails to appreciate just how important China is in underwriting its spendthrift ways and misperceives altogether the different danger loosening the currency peg poses to both economies.

To begin, it is important to note that only China's export sector—where two-thirds of its growth can be attributed to domestic firms in tandem with foreign multinationals—exclusively benefits from a cheap currency, while the country's consumers and businesses have to contend with dearer import prices. Since the Middle Kingdom's trade account is almost in balance, the benefits and drawbacks of a cheap currency are negligible.

Secondly, as foreign capital and export receipts flow into the country, China's central bank, the People's bank of China (PBOC), as the ultimate purchaser of foreign currency, maintains the exchange rate peg by buying up dollars from domestic enterprises and exchanging them for renminbi. Strikingly similar to French economist Jacques Rueff's description of the fiat dollar system as "a childish game in which after each round the winners return their marbles to the losers,[vi]" China then acquires U.S. treasury bonds and other American investment vehicles in exchange for the dollars it holds.

In effect, Beijing furnishes cheap credit to finance Washington's fiscal deficit and consumer indebtedness in America, accentuating an already grave misallocation of capital and investment priorities propagated by the Fed-backed fiat money.

Banking blights

Of course, underwriting America's borrowing binge does not come without hazards for China itself. As the PBOC buys dollars for renminbi, it enlarges the domestic money supply, notwithstanding efforts to "sterilize" the excess liquidity by selling Chinese government bonds. As of October 2003, the annualized increase in China's broad money supply topped 21% and domestic financial institutional lending climbed by a yearly rate of 71%. Consistent with a burgeoning boom and bust sequence, property, automobile, home amenities prices, and GDP are all accelerating at a breakneck pace[vii].

Exacerbating China's economic distortions, the country's four largest state-owned banks, which together claim 61% of the country's loans and 67% of its deposits, are saddled with mounting bad debts. By some estimates, over a third of these loans are nonperforming, which is about the same for the country's financial system as a whole, meaning the nonperforming loans may amount to 45% of GDP.

Likewise, estimates of Chinese government debt stand at about 45% of GDP with unfunded retirement and welfare liabilities totaling another 70% of GDP. Coupled with the country's financial system's propensity to award credit based on political connections, rather than the commercial viability of the projects, these gross malinvestments squander capital and generate a growing mountain of bad debt, especially when the inclination to lend recklessly is exacerbated by the heady times of a fiat money-induced credit expansion.

In the autumn of 2003 the PBOC tried to gently apply the brakes by lifting banks' reserve requirement to 7% from 6%. Beijing's leaders also recently injected $45 billion into two of its largest state banks to help alleviate the fetters of their numerous nonperforming loans, the third time since 1998 the Chinese state has at least partially bailed out its largest banks, blatant moral hazards.

Nonetheless, China and by extension America, are in a dire dilemma. Chinese banks will continue to lend recklessly as long as Beijing maintains its currency peg and the attendant expansion of the domestic money supply. Yet to scotch the fixed exchange rate when the country's financial institutions are not prepared for a floating currency portends disaster. Capital flight could ensue if ordinary Chinese were permitted to acquire foreign currency and withdraw their deposits from an essentially insolvent banking system, bringing the country's economy to its knees.

With China's finances in disarray, would the country's robust purchases of American debt instruments for dollars continue at the same rapid clip? Washington may find it much more difficult to obtain cheap underwriting for its gaping fiscal deficits and rampant borrowing.  

In sum, terminating China's currency peg would really give America's politicians and populace something to gripe about.


Grant M. Nülle is a Research Fellow at the Council on Hemispheric Affairs in Washington D.C. He can be reached at grantn007@yahoo.com. See his archive.

[i] "Is the wakening giant a monster?" The Economist. 13 Feb. 2003.

[ii] "Mercantilism with Chinese characteristics." The Economist. 13 Aug. 2003.

[iii] "Tilting at dragons." The Economist. 23 October 2003.

[iv] Moore, Mike. A World Without Walls: Freedom, Development, Free Trade and Global Governance. Cambridge University Press. 2003.

[v] "Exports and weak dollar lift China trade surplus." Financial Times. 9 Jan. 2003.

[vi] Duncan, Richard. The Dollar Crisis: Causes, Consequences, Cure. 1st ed. John Wiley & Sons. 2003.

[vii] "Ying and Yuan." The Economist. 28 Aug. 2003.

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