Effects of the financial crisis on the U.S.-China economic relationship.

• Author: Prasad, Eswar S.

The U.S. and China are two of the dominant economies in the world today and the nature of their relationship has far-reaching implications for the smooth functioning of the global trade and financial systems. These two economies are becoming increasingly integrated with each other through the flows of goods, financial capital, and people. These rising linkages of course now stretch far beyond just trade and finance, to a variety of geopolitical and global security issues. Getting this relationship right is therefore of considerable importance.

The global financial crisis has brought this relationship under the spotlight of international attention. Indeed, the United States and China together epitomize the sources and dangers of global macroeconomic imbalances. U.S. regulatory and macroeconomic policies may well bear a lion's share of the blame for the current crisis. But there is a deep irony in the fact that Chinese virtue--its high national saving rate--and its policy of tightly managing the external value of its currency abetted U.S. profligacy by providing cheap goods and cheap financing for those goods, setting the stage for a cataclysmic crisis rather than a bubble. The consequences of those policies are now rebounding on the Chinese economy itself.

Paradoxically, the crisis is likely to intensify the embrace between the two economies. In the short run, China needs export growth in order to maintain job growth and preserve social stability. As China continues to run current account surpluses by exporting to the United States and other advanced country markets, it has little alternative to buying U.S. Treasuries with the reserves it accumulates while managing its exchange rate. The United States needs willing buyers for the Treasuries issued to finance its budget deficit, which is certain to increase due to bailout and fiscal stimulus operations.

There are certain unhealthy facets of this relationship that have generated tensions between the two economies, with each of the partners seeing the other as benefiting disproportionately. Indeed, these tensions are likely to intensify at this time of worldwide economic distress, with financial markets and economic activity around the world crumbling and economies increasingly hunkering down to protect and insulate themselves as the aftershocks of the crisis reverberate around the globe.

On the economic front, China's exchange rate policy has become a flashpoint for these tensions between the two countries. With the U.S. trade deficit and, in particular, the bilateral trade deficit with China swelling in recent years, China's tightly managed exchange rate regime has come under increasing scrutiny. China's rising overall trade surplus and its rapid accumulation of foreign exchange reserves have revived accusations of currency manipulation. There have been calls by U.S. legislators for imposing large tariffs on U.S. imports from China or taking other retaliatory measures if there isn't rapid progress on exchange rate reform. Meanwhile, the U.S. is falling prey to its own protectionist tendencies. The "Buy American" clause in the stimulus bill, which will impact imports from China and other emerging market countries, could be a harbinger of rising trade tensions. Indeed, China responded in June 2009 by putting in place some "Buy China" measures in its stimulus package.

A confrontational approach and a rattling of sabers by both sides will almost certainly be counterproductive. This would poison the U.S.-China relationship in a manner that could have deleterious long-term consequences on many fronts. Furthermore, this approach is unlikely to have a large or lasting impact on problems such as the U.S. trade deficit or imbalances in the Chinese economy, and could make matters worse for everyone by creating instability in the global economy.

There is a great deal of commonality of economic interests between the two countries, and it is these shared interests that should be the basis for a mutually beneficial economic relationship. In this article, I will lay out file key facets of this complicated bilateral relationship, present my prognosis for how this relationship is likely to evolve, and then discuss how I believe progress could be made in terms of finding common ground between the two economies.

Trade and Financial Linkages between the United States and China

Trade between the two economies has continued to increase in volume, and the United States remains one of China's major export markets. Chinese exports to the United States rose from $100 billion in 2000 to $338 billion in 2008, while imports rose from $16 billion to $71 billion. Interestingly, however, the share of China's exports going to the United States has actually declined over time, from about 22 percent in 2000 to 19 percent in 2008, roughly the same share as that of the European Union. (1) China's bilateral trade surplus with the United States has risen from about $84 billion in 2000 to nearly $266 billion in 2008 (about 1.9 percent of U.S. GDP).

Financial flows between the two economies have increased but have also become more lopsided over time, with bilateral foreign direct investment (FDI) flows from the United States to China declining from $5.4 billion in 2002 to less than $3 billion in 2008 (this accounts for only about 3 percent of China's gross FDI inflows). FDI constitutes the principal category of inflows into China as many other types of private capital flows, especially portfolio equity investment, have been restricted until recently (many of these restrictions are now gradually being lifted).

In sharp contrast to declining FDI flows from the United States to China, official flows from China to the United States have surged in recent years. This largely reflects Chinese central bank purchases of U.S. Treasury bonds and, until the middle of 2008, agency bonds (including those of Fannie Mae and Freddie Mac). Although precise numbers are difficult to come by, estimates based on the U.S. Treasury's International Capital (TIC) data suggest that...