The Impossible Mission of Changing China

Mission Impossible. That's the best way to describe Hank Paulson's just concluded trip to Beijing, ostensibly to persuade the Chinese to do something to whittle down their huge trade surplus with the United States.

The secretary of the Treasury and his colleagues -the delegation included the commerce, labour, health and human resources, and energy secretaries in addition to the US trade representative, the administrator of the Environmental Protection Agency, and the chairman of the Federal Reserve Board -don't have much of substance to show for their 13,000-mile round trip. Indeed, if their aim was to pursue the oft-stated (with tongue-in-cheek) goal of American policy, a "strong dollar", the delegation that The Wall Street Journal derided as "the biggest economic expedition since Marco Polo's" should have been diverted to Riyadh.

While the Chinese have been accumulating dollars at the rate of about $200m a year, high oil prices have driven the oil exporters' trade surplus with America to $500m a year. These oil producers, members or fellow travellers of the Opec cartel that is keeping prices above competitive levels, are feeling put upon because the dollars they are getting for their oil now buy fewer pounds to spend in Harrods, and fewer euros to spend on the necessities of life in the south of France. Worse still, the dollars they have already accumulated are diminishing in value.

To protect against further declines, the oil producers are dumping dollars and moving into other currencies, most prominently euros and Japanese yen. The central banks of the Opec members cut their dollar holdings from 75% of total reserves in 2001, to 67% at the end of the second quarter of this year, and again to 65% at the end of the third quarter. That increased the downward pressure on the dollar, pressure that was alleviated a bit at the end of last week by two developments: it became clear that the American economy is sufficiently strong to make it unlikely that the Fed will soon cut interest rates, and it was announced that the trade deficit for October fell by more than $4billion.

The problem created for American policy by the oil producers' dollar holdings is that many of these countries are hostile to America -Venezuela, Russia, Iran - and others might wreak havoc with the dollar if the Palestinian-Israeli conflict flares up, putting pressure on Arab regimes to damage America. The fact that any dollar dumping would also harm the Arab states is irrelevant -the Middle East is not a region in which economically rational behaviour consistently trumps self-inflicted wounding.

The problem with China is different. To the consternation of many politicians, its policy of pegging the yuan to the dollar undervalues the Chinese currency. This makes made-in-America goods, as well as those produced in Europe and Britain, more expensive in China. China has allowed the yuan to rise in value by almost 6% since mid-2005 with no discernible effect on its huge trade deficit.

Paulson's mission was impossible for two reasons. First, the Chinese regime's top priority is to stay in power. That means providing jobs for the 300m farmers expected to migrate to the cities in the next two decades, which in turn means the government cannot allow the yuan to rise and cut sharply into exports.

Second, even if Paulson could persuade the Chinese to allow their currency to appreciate to a point where made-in-China goods became more expensive in America, the effect on the trade deficit would be trivial.

American consumers would simply shift to goods made in other countries in which labour costs are far lower than in the United States.Still, Paulson's trip probably was worthwhile, although the exaggerated importance it took on after the administration bloated the delegation with cabinet members and enhanced its prestige by persuading Fed chairman Ben Bernanke to join the junket, probably created expectations that were unattainable. My guess is that some bright blade in the White House thought it would appease the president's congressional critics if a large delegation was sent to prove that George Bush feels the pain of those who lost jobs because of imports.

Paulson is clever enough to distinguish the practically attainable from a political wish list, which is why he put the word out that his trip was designed to open a two-year "strategic economic dialogue" with China, not to produce a floating yuan. The Chinese are well aware that their policy of accumulating foreign currency creates problems for them, and that they would be better off if domestic demand grew so as to reduce their need to export. But they cannot figure out how to get from here to there -how to achieve that goal without creating huge unemployment during the transition from an export-led to a more balanced economy.

Paulson hopes to change the conversation from a shouting match over the yuan to a "dialogue" ranging over joint interests in increasing world oil output, reducing environmental damage in China, improving labour standards, protecting intellectual-property rights, and opening markets to American imports.

Apparently unaware that previous "road maps" drawn up by the administration have led to nowhere, commerce secretary Carlos Gutierrez called for another road map, this one to direct China to a more market-orientated economic model. If that's the destination China's rulers have in mind, Paulson is the man to help them find the way. Of course, they knew that before he came calling last week on a mission designed more to quiet protectionist Democrats than to have a real impact on America's trade deficit. This article originally appeared in the December 17, 2006 Sunday Times. (London)