U.S.-China relations: the case for economic liberalism.

• Jurisdiction: United States
• Date: 22 September 2006
• Author: Dorn, James A.
• Published date: 22 September 2006
• Author: Dorn, James A.

In its 2005 Report to Congress, the U.S.-China Economic and Security Review Commission--also known as the U.S.--China Commission (USCC)--recommended that China appreciate its currency, the renminbi (RMB), "by at least 25 percent against the U.S. dollar" or face "an immediate, across-the-board tariff on Chinese imports." The commission argued that such an action could be justified under Article XXI of the World Trade Organization (WTO), "which allows members to take necessary actions to protect their national security." The key idea behind the commission's protectionist policy stance is that "China's undervalued currency has contributed to a loss of U.S. manufacturing, which is a national security concern" (USCC 2005: 14).

There is no doubt that financial repression in China has led to an undervalued currency, but that in itself does not pose a national security risk to the United States. Workers in U.S. manufacturing lose their jobs for many reasons. Blaming China for displacing American textile workers, for example, and thereby jeopardizing our national security is rather farfetched, to say the least. Moreover, U.S. manufacturing output has been increasing as American workers become more productive (Griswold 2006: 12).

When China hawks and protectionists on Capitol Hill join forces, as they did to defeat CNOOC's acquisition of Unocal in the summer of 2005, a dangerous precedent is established that threatens the future of a liberal global economic order and undermines a constructive U.S.-China policy of engagement (Dorn 2005). Although it is proper to criticize China for its human rights violations and its lack of a transparent legal system, we should not ignore the substantial progress China has made since it embarked on economic liberalization in 1978. U.S. economic security, as well as China's, will depend on promoting economic liberalism, rather than fostering protectionism.

In this article, I first address four major questions posed by the USCC at its August 22, 2006, hearing on "China's Financial System and Monetary Policies," and then elaborate on those questions by considering China's repressed financial system, the case for economic liberalism, and the politics of China's economic reform movement.

Major Questions

In my testimony before the USCC (Dorn 2006b), I briefly addressed the following questions as presented to participants on Panel IV, "The Macroeconomic Impact of Chinese Financial Policies on the United States."

1. Is the present equilibrium sustainable? That is, are we in a New Bretton Woods Era? Or, do we need a new Plaza-Louvre Agreement to manage adjustment?

   The "present equilibrium" is an equilibrium only in the sense of a status quo. In an economic sense, it is a disequilibrium due to financial repression in China and government profligacy in the United States. The status quo is sustainable only to the extent that China and the rest of the world are willing to accumulate dollar assets to finance our twin deficits.

   We may be in a "New Bretton Woods Era" in the sense that China and other Asian countries peg their currencies to the dollar as a key reserve currency, but the analogy to the original Bretton Woods system is misplaced. There is no golden anchor in the present system of fiat monies, and private capital flows and floating exchange rates have fundamentally changed the nature of the global financial architecture. (1) The International Monetary Fund (IMF) has been searching for a new identity since the collapse of the Bretton Woods system of 'fixed but adjustable" exchange rates in the fall of 1971 when the United States closed the gold window and suspended convertibility. The Mexican peso crisis in 1994-95 and the Asian currency crisis in 1997-98 resulted in large part because of excessive domestic monetary growth and pegged exchange rate systems in the crisis countries. (2) Since that time many emerging market countries have adopted inflation targeting and floating exchange rates. Trying to form a new IMF-led system of managed exchange rates with central bank intervention would be a step backward rather than forward (see Schwartz 2000).

   We do not need a new Plaza-Louvre Agreement to manage global imbalances. Just as the negotiations approach to trade liberalization gets bogged down in the global bureaucracy, government-led coordination of exchange rates is apt to fare no better. There are many more players today than in the 1980s, when China was still in the minor league. A surer route to successful adjustment is for each country to focus on monetary stability, reduce the size and scope of government, and expand markets. International agreements are difficult to enforce, and no one really knows what the correct array of exchange rates should be. Millions of decentralized traders in the foreign exchange markets are much better at discovering relative prices than government officials who are prone to protect special interest groups. The United States, for example, wants the renminbi (also known as the yuan) to float--but only in one direction.

2. What are the chances for an orderly vs. disorderly adjustment? What are the implications of each for U.S. capital markets?

   If China continues to open its capital markets and to make its exchange rate regime more flexible, it will eventually be able to use monetary policy to achieve long-run price stability (Taylor 2005). At present, the People's Bank of China (PBC) must buy up dollars (supply RMB) to peg the RMB to the dollar and then withdraw excess liquidity by selling securities primarily to state-owned banks. This "sterilization" process puts upward pressure on interest rates, which if allowed to increase would attract additional capital inflows. The PBC thus has an incentive under the current system to control interest rates and rely on administrative means to manage money and credit growth. But the longer this system persists, the larger the PBC's foreign exchange reserves become and the more pressure there is for an appreciation of the RMB/dollar rate.

   The July 21, 2005, revaluation and a number of changes in the institutional setting to establish new mechanisms for market makers and hedging operations are steps in the right direction. Financial liberalization will take time, and China will move at its own pace. The United States should be patient and realistic. Most of the costs of China's undervalued currency are borne by the Chinese people. Placing prohibitively high tariffs on Chinese goods until the RMB/dollar rate is allowed to appreciate substantially is not a realistic option. It would unjustly tax American consumers, not correct the overall U.S. current account deficit (or even our bilateral trade deficit with China), and slow liberalization. (3)

   Adjustment requires that China not only allow greater flexibility in the exchange rate but also allow the Chinese people to freely convert the RMB into whatever currencies or assets they choose. Capital freedom is an important human right and would help undermine the Chinese Communist Party's monopoly on power by strengthening private property rights. A more liberal international economic order is a more flexible one based on market-determined prices, sound money, and the rule of law. We should help China move in that direction--not by threats, but by example. The U.S. government should begin by reducing its excessive spending, and removing onerous taxes on saving and investment.

   An orderly adjustment based on market-liberal principles would help ease the costs to the global economy and to the United States in particular. Keeping our markets open sends an important signal to the rest of the world, and getting our fiscal house in order--by trimming the size of government and by real tax reform--would show that we mean business. Reverting to protectionism, on the other hand, would have a negative impact on the global financial system, and adjustment would be slower and more costly (Greenspan 2004).

3. What is the likelihood that China will seek to diversify its foreign currency holdings? How would they do so? What would be the consequences?

   The composition of China's foreign exchange reserves is a state secret, but a reasonable estimate is that about 80 percent of China's $941 billion of reserves are held in dollar-denominated assets, especially U.S. government bonds. Any sizable one-off revaluation of the RMB/dollar rate would impose heavy losses on China. Other Asian central banks would also suffer losses on their dollar reserves as the trade-weighted value of the dollar fell. No one wants to be the last to diversify out of dollars. If the euro becomes more desirable as a reserve currency, the PBC and other Asian central banks can be expected to hold more euros and fewer dollars in their portfolios.

   The future of the dollar will be precarious if the United States continues to run large budget deficits and fails to address its huge unfunded liabilities. Foreign central banks would not wait for doomsday; they would begin to diversify now. Markets are ruled by expectations, so it is crucial for the United States to begin taking positive steps to get its own house in order--and to reaffirm its commitment to economic liberalism.

   For its part, China can help restore global balances by moving toward a more flexible exchange rate regime and liberalizing capital outflows so that...