China v World as a Trade War Comes Closer

"When some foreign nation restrains ... the importation of some of our manufactures ... revenge naturally dictates retaliation."

It sounds like some trade-union protectionist, but actually this was written by Adam Smith in his Wealth of Nations, the bible of free traders. And once restrictions are installed, "freedom of trade should be restored only by slow gradations" to avoid throwing lots of people out of work.

Smith, of course, saw retaliation as a means of forcing a trading partner to end its restrictions in a process of mutual disarmament. Now, that process is played out in the World Trade Organisation and against a background of mounting Sino-US geopolitical rivalry.

After a 17.7% jump in its exports in December, China passed Germany as the world’s largest exporter. A 15% increase in imports from China helped to drive the US trade balance to the unexpectedly high level of $40.2 billion, up from $36.4 billion a month earlier. Both the EU (imports from China up 10% in December) and the US reacted with import restrictions, the EU on shoes, the US on tyres. To which China responded by restricting imports of poultry and car parts from the US, and complaining to the WTO about the 16.5% anti-dumping tariff the EU has imposed on shoe imports from China.

On one level this is all about jobs. President Barack Obama has promised to double American exports in the next five years to create 2m good, new jobs.

C Fred Bergsten, director of the Peterson Institute for International Economics, says that goal is attainable, but only if, among other things, the Chinese allow market forces to correct the "undervaluation of at least 25%" in their currency.

Fat chance. When the recession began, the Chinese halted a modest rise in their currency in order to stimulate exports. Now they say that if their imports continue to boom they would contemplate a 3% rise in their currency later this year. So much for Treasury secretary Tim Geithner's statement to a Senate committee: "I think it's quite likely they will move" on the currency issue — unless Geithner considers 3% a significant move.

One thing is certain. China’s continued rapid economic growth, combined with slower growth in the West, will increase pressure on Obama to have China declared a “currency manipulator”, and take the issue to the WTO. But whether Obama responds to that pressure will depend on more than the trade deficit.

This is also about geopolitical rivalry. The president feels he needs China, which is why he abased himself before his hosts on his visit to Beijing. Most of all, Obama hopes the Chinese will back him at the UN when he calls for sanctions on Iran. He also wants the Chinese to continue to buy the IOUs he is grinding out to support the spending programmes he insists on increasing even as he himself predicts the debt-to-GDP ratio will approach the 90% level that experts say will stifle growth. And he hopes good relations will induce China, which has surpassed Japan as our biggest lender, to allow its currency to appreciate by a meaningful amount, even though it should be clear to him that a regime with no democratic legitimacy can avoid threats to its existence only by offering its masses improved material well-being. That means keeping the export machine running at high speed to create jobs.

There is an even greater constraint on the president’s attempts to get tough with the Chinese. Arthur Herman, the respected historian, reports that America cannot rely on China’s fear of wiping out billions in the value of their dollar assets to stop them from dumping dollars. “On an issue like Taiwan or Japan, rational judgment can take a backseat to national pride, and the desire to reverse old humiliations,” he writes in the New York Post. In a Pentagon simulation of an economic war with China held last March, China won, reports Herman.

China, which emerged fairly unscathed from the global recession, clearly considers itself to be on a roll. One (unnamed) Chinese official told the Financial Times: “We used to see the US as our teacher but now we realise that our teacher keeps making mistakes and we’ve decided to quit the class”. Market capitalism is so yesterday, state capitalism so now. A new role model for the developing world: state, authoritarian capitalism. That gives impetus to the Franco-Chinese demand that the dollar be replaced as the world’s reserve currency by a new global currency.

Before consigning the American economy and the market-based capitalist system to the dustbin of history consider this. First, America is once again reforming its system, and is likely to emerge from its current difficulties with a financial system less prone to systemic collapse. Second, a populist wave is rising against borrow-spend-tax, and if it crests during the November elections, a very different Congress will convene in 2011. Third, America’s trade deficit and dependence on Chinese credit is now recognised as a national security problem, rather than merely an economic problem. That might mean action, if not now, soon.

Perhaps most important, poorer countries are also finding it difficult to compete with China’s undervalued currency — Chinese exports to India, Brazil, Mexico and Indonesia have been growing by between 30% and 50% in recent months. This gives the US and the EU new allies in their battles with China.

Best of all, Obama is stiffening his spine. He told members of his party that he plans “to get much tougher” on currency rates. He is going ahead with $6.4 billion in arms sales to Taiwan, plans to welcome a visit from the Dalai Lama this week, and has the State Department siding with Google in its dispute over Chinese censorship and cyberattacks. Next might — only might — come a decision to declare that the Chinese are indeed manipulating their currency. If that triggers a trade war, so be it. Pentagon simulations have been wrong in the past. After all, America holds an important trump card: we are China’s most important customer.