A Clash of the Titans Could Hurt Us All

Op-ed in the Financial Times

August 25, 2005

The United States and China have been chief locomotives of global growth for several years. With exchange rates calculated at purchasing power parity, they are the two largest economies. They rank first and third among trading nations.

An economic clash would thus be extremely costly for the world economy as well as for the two countries. Yet such a clash is now virtually inevitable and could occur as early as this autumn. Preventive actions, especially a much larger revaluation of the renminbi and a joint US-China initiative to revive the Doha round of global trade negotiations, are needed to head off this additional substantial risk to global prosperity and stability.

The problem is that China is rapidly becoming the world's largest and fastest growing surplus country, mirroring the United States as the largest and fastest growing deficit country. China's global trade surplus will probably triple in 2005 and its current account surplus will roughly double, approaching $150 billion (£83 billion) or about 7.5 percent of gross domestic product. The US current account deficit is already running close to $800 billion, or about 7 percent of its economy and continues to rise rapidly.

These imbalances are unsustainable in international financial terms. China, other surplus countries and private investors have so far been willing to fund the US deficits with only modest declines in the dollar and rises in US interest rates. But it is only a matter of time until the dollar falls by another 20 percent or so and adjustments are forced on deficit and surplus countries.

The coming clash of the titans will derive primarily, however, from domestic political unsustainability. Currency overvaluation and the external deficits they spawn are by far the most reliable predictors of trade protectionism in the United States (and Europe). Bilateral trade imbalances, while irrelevant in economic terms, are politically potent and the US deficit with China now exceeds annual rates of $200 billion. US imports from China are six times as large as US exports to China so those exports must increase six times as fast as imports just to keep the imbalance from increasing. The US-China conflict potential is magnified by other worries. Vulnerable US sectors, such as clothing, would seek protection against China whatever the currency relationship. Many Americans fear China is moving up the technology ladder and will start competing at the high end of the value-added spectrum.

China's scramble to lock up energy resources is of particular concern. Efforts by Chinese companies to take over US firms trigger emotional responses, epitomized by the de facto congressional rejection of CNOOC's bid for Unocal. There are anxieties that China is seeking a global military role that will threaten US security. Differences over Taiwan, human rights in China and Beijing's political system add further combustibility to the mix.

A clash, at least in the economic domain, thus seems probable. The United States has already limited Chinese exports in textiles, clothing, color television sets, semiconductors, wood furniture and shrimp. Steel pipe and more clothing are likely to be restricted soon.

The clash could escalate in the near future. Unless China increases the renminbi's 2 percent revaluation announced in July to at least 10 to 15 percent, and preferably 20 to 25 percent, the US Senate is virtually certain to pass the Schumer Amendment, which would place a 27.5 percent tariff on all imports from China until it does so. The House of Representatives adopted legislation last month that would make it much easier to apply new barriers against Chinese imports. The two bills could be meshed and come to the president before the end of the year, and a veto would be extremely difficult in light of the intense domestic feelings. China would justifiably retaliate, triggering a trade war.

The US administration, despite its desire to work with China on North Korea and other issues, will have to adopt a tougher position to avoid such developments on the Hill. The treasury department will almost certainly label China a "currency manipulator" in its report to Congress in October, a justified charge in light of China's massive intervention to keep the renminbi from rising for the past four years, after which it must produce a meaningful remedy; if it does not, Congress will take matters into its own hands.

Preemptive measures are needed to head off these risks, hopefully in preparation for or during the visit to Washington next month by Hu Jintao, the Chinese president. The most important is for China to revalue by a meaningful amount, using its large budget surplus to stimulate domestic demand to offset any adverse effect on growth. A 10 percent revaluation is needed simply to offset the renminbi's decline over the past three years. A 25 percent increase, if mirrored by other Asian countries, would take $100 billion off the US current account deficit and cool much of the congressional hostility for now. The United States, for its part, must initiate a serious program to increase domestic savings and thus sharply reduce its reliance on foreign capital, chiefly by restoring the budget surpluses of five years ago.

To regain positive momentum on trade, China should indicate willingness to liberalize further, though it already has the lowest import barriers of any large developing country. It could best do so by joining with the United States to provide needed stimulus to the Doha round through offering substantial reductions in their remaining agricultural and other trade distortions. The United States could encourage such cooperation by offering to treat China as a "market economy" at least in sectors that meet that test. Failure to take such steps will trigger large risks for the world's two growth locomotives themselves, for relations between them and for the global economy.