Global Investor William Hess: Why Paulson Will Hit a Wall
We have a pretty good idea what Paulson wants: a looser yuan, trade access and IP protection. But Beijing is not in a position to give.
During the recent u.s. congressional campaign, Democrats indulged in a degree of China-bashing, and won as outsiders. Ironically, though, the neo-mercantilism articulated by many of the Democratic candidates is similar to elements of the agenda–including a tacit weak-dollar policy and the threat of trade sanctions–that Treasury Secretary Henry Paulson will take with him to Beijing this week. The assumption of both American outsiders and insiders is that China, the rising giant, needs to be restrained. This is a recipe for Paulson and his cabinet colleagues to return home empty-handed.
So far, the rising trade imbalance that ties the United States as buyer to China as seller has provided both sides with full employment and price stability. Yet both sides feel vulnerable going forward. Afraid of its rising trade deficit, the United States believes China has become an economic fortress, with its $1 trillion surplus, and should take steps to right the imbalance. Yet in China the mood is hardly triumphal. The Chinese media are full of reports about rising urban unemployment, cash-strapped local governments, a falling proportion of consumption to overall GDP and export losses from trade frictions.
Rising unemployment in the world’s fastest-growing economy? This scenario sounds implausible. However, policymakers in Beijing are increasingly concerned about the slowdown in job creation in recent years, combined with stagnating real-wage growth and softness in consumer markets. This has all occurred as they are attempting to urbanize tens of millions of people and use “macro controls” to restrain wasteful investment spending.
Inflation and employment conditions in the United States appear under control, partially as a result of cheap imports of goods and capital from China, but on the other side of this equation is a Chinese central bank struggling to restrain “blind investment” in redundant industrial capacity. China’s policymakers face a bind: the options available to them to help reduce external imbalances–such as allowing a more rapid appreciation of the Chinese currency–could work against restraint by attracting even larger inflows of foreign capital. Similarly, raising interest rates to cool investment growth could attract further inflows of speculative capital.
Hot-money flows returned to China earlier this year, though they have ebbed in recent months, as institutional investors and overseas Chinese alike have poured billions of dollars each month into yuan assets, including stocks, real estate and currency. These inflows have been fueling rapid growth in liquidity within the Chinese economy. Efforts by the central bank to soak up this extra money have predictably increased short-term interest rates, thus attracting even more funds into China’s money markets. The same result would be predicted for increases either to long-term interest rates or to the value of the Chinese currency.
But wouldn’t increasing levels of investment help to maintain high rates of growth? Certainly, but official China has recognized that it needs quality growth, not simply double-digit growth, and is concerned that rising levels of fixed capital spending are increasingly inefficient, measured in terms of both new output and new jobs. With domestic savings rates high, Chinese banks already can’t get their funds out the door fast enough. That said, the Chinese authorities will proceed cautiously when addressing the issues that the Paulson show will bring to Beijing. We have a pretty good idea what Paulson wants: faster appreciation of the yuan, enhanced market access to address the trade deficit and further commitments on protecting intellectual property.
With their external accounts wholly out of whack and the consequences of persistent structural issues within the otherwise booming economy rising to the surface, the Chinese are well aware of the policy binds they face. Yet they have taken steps to smooth Paulson’s arrival. They have allowed a modest appreciation of the yuan, which has risen by a total of more than 5 percent against the dollar since July 2005; reduced operating hurdles and capital requirements for the expansion of foreign-bank branches ahead of the Dec. 11 deadline for WTO commitments, and publicly pledged to purchase more high-tech exports beyond airplanes.
But don’t expect Beijing to go much farther. To be sure, meaningful dialogue is a big story in itself, and the global audience should rejoice if the two sides find ways to lower tensions. One easy gesture that could make a splash: to consider holding their next meetings in either Tokyo or Brussels, as weakness in both Japan and the EU makes the U.S. and Chinese economies need each other more.
So Secretary Paulson will likely return home empty-handed, or nearly so, if only because the Chinese don’t have much they can give. Domestic priorities and stability will prove to be as important to them as they were to the winners in last month’s U.S. congressional elections.
