China's growing foreign reserves make inflation more likely as a means of adjusting the real exchange rate. Photo Credit: Flickr

Internal and external pressures are placing China in a precarious position. Domestic imbalances are reflected in a record current account surplus that could exceed 12 percent of GDP this year, an overheated stock market that has seen the Shanghai Composite Index advance by 240 percent during the past two years, and foreign reserves that could reach $1.6 trillion by year-end. The US Congress, meanwhile, is growing increasingly impatient with the slow pace of yuan appreciation against the dollar, the growing US bilateral trade deficit with China, and the lack of progress on disputes over subsidies, piracy, and market access.

Stephen Green, senior economist at Standard Chartered Bank in Hong Kong, predicts, "Before too long, the unstoppable force of PRC exports is going to hit the immovable object that is US politics." The lack of any significant results from the latest Strategic Economic Dialogue in Washington means that Congress will move forward with more than a dozen bills aimed at China's so-called unfair trade practices.

No wonder Vice Premier Wu Yi stated, "Attempts to politicize trade issues should be resisted." She recognizes that voluntary exchanges are win-win deals for the parties involved and that U.S. consumers have gained significantly from access to cheap Chinese goods, saving more than $600 billion since 1997.

Congress tends to ignore the growth of market liberalism in China, preferring to focus on the narrow issues of the exchange rate and the bilateral trade deficit.

More important, China's trade liberalization has created a new mind-set. In a recent poll of 18 countries, the Chicago Council on Global Affairs found that 87 percent of the Chinese respondents (the highest proportion in the survey) thought, "Globalization … is mostly good." That positive attitude toward international trade contrasts sharply with Russia (41 percent) and India (54 percent).

Yet, Congress tends to ignore the growth of market liberalism in China, preferring to focus on the narrow issues of the exchange rate and the bilateral trade deficit. Because of the failed SEDII, there is now a high likelihood that Congress will unilaterally act to sanction the application of countervailing duties to nonmarket economies (specifically China) and treat the undervalued yuan as an actionable subsidy. Such legislation would violate the spirit of the World Trade Organization, harm US consumers, and endanger US-China relations.

In addition to applying CVDs to NMEs, The "Nonmarket Economy Trade Remedy Act of 2007" (H.R. 1229), sponsored by Rep. Artur Davis (D-AL) and Rep. Phil English (R-PA), would further politicize trade by shifting the decision regarding China's NME status from the Department of Commerce to the Congress.

It is unfair that the United States recognizes Russia as a market economy but refuses to extend market-economy status to China, which is by far the most open of all emerging-market economies. To treat China as a NME for anti-dumping cases and at the same time apply CVD law, as if China were a market economy, is discriminatory. The United States should recognize the progress China has made and treat China as a market economy. Doing so would do more to help liberalize China's financial sector than threats of protectionism.

Even though most prices in China are now market determined, the exchange rate and interest rates ("macro prices") are still subject to administrative controls. Indeed, the growing imbalances in China are the result of the lack of market forces to determine the exchange rate, the structure of interest rates, and the allocation of capital. Financial repression and the lack of private investment alternatives hamper the normal adjustment process that occurs in competitive financial markets.

Even though most prices in China are now market determined, the exchange rate and interest rates are still subject to administrative controls.

Suppressing the nominal exchange rate and nominal interest rates, and funneling loans through state-owned banks to state-owned enterprises, is a recipe for an overheated economy and misdirected investment. If market forces were allowed to freely determine the yuan-dollar rate, there would be no need to hold massive foreign-exchange reserves or to engage in sterilization to offset capital inflows. China's trade surplus, foreign direct investment, and other sources of foreign exchange would simply translate into an appreciation of the yuan. The People's Bank of China could then concentrate on preventing inflation.

As it stands, China's growing foreign reserves make sterilization more difficult and inflation more likely as a means of adjusting the real exchange rate. Moreover, as the PBC accumulates dollar reserves, in order to suppress the dollar price of the yuan, China's risk exposure to a falling dollar will increase.

The establishment of a new investment arm of the PBC to manage dollar reserves and to invest them in higher yielding (riskier) assets makes sense on the surface. But the government, not private citizens with ownership claims, is investing those funds. With a market-determined exchange rate, competitive interest rates, and a wide range of private domestic investment alternatives, a more efficient allocation of funds would be possible.

Structural and political reform will be necessary if China is to remove domestic imbalances and quell U.S. protectionist pressure. If China does not take a faster path toward market-determined macro prices and private capital markets, Secretary Henry M. Paulson's advice that "we must not heed the siren song of protectionism" may fall upon deaf ears in the U.S. Congress.




Contributed by James A. Dorn, a China Specialist at the Cato Institute and Vice President for Academic Affairs. Reprinted with permission from The Cato Institute.

To read another Global Envision article about China's economy, see China's New Economic Model.



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