Paulson Goes to China

A high level delegation led by the Treasury Secretary Henry Paulson is off to China this week but it is far from clear that anything particularly useful will be accomplished. Bashing Chinese exchange rate policy is a favorite passtime in the U.S. but Paulson is unlikely to score any points on that front even if the Chinese agree to talk about it. Since they have said clearly that this is “a sovereign issue” it would seem that talk is about as far as they are willing to go.

China has responded to pressure to allow the yuan to float by allowing an appreciation of about 5% since mid 2005 – but this hasn’t been big enough to do much to the bilateral deficit, reported as $202 billion last year and on course to be at least that big this year. But there is reason to believe not only that a realignment of the exchange rate wouldn’t by itself cure our trade balance problems but also that eventually China’s own internal problems will slow down the growth of its export sector.

On the question of the dollar/yuan exchange rate, it is important to remember that the IMF’s typical advice to countries with balance of payments problems applies as much to the US as it does to anyone else – if you want to achieve external balance while maintaining some semblance of internal balance then you need to use BOTH exchange rate policy and tax/spending policy to achieve the twin goals. (This is broadly true of any set of goals – you need as many policy levers as you have goals or you will only hit on a happy solution by highly improbable dumb luck). It is because of this that the IMF typically advises governments to devalue their currency while at the same time cutting government spending (and/or raising taxes) as a fundamental basis for any stabilization plan.

If the U.S. tried to rely solely on exchange rate policy (insisting on a Chinese appreciation is the same as a depreciation or devaluation for the US) it might help to some extent but the fundamental problem would remain unaddressed: If we continued to spend more than we produce as we have been doing for some years, then we will continue to run deficits on the current account and the only way to cure THAT problem is to either spend less or produce more. To the extent that higher Chinese prices reduced our real income we might get some narrowing of the gap between income and spending and to the extent that higher Chinese prices shifted our demand to other countries’ exports we might see a narrowing of the bilateral gap, but to rely on the exchange rate alone to address the problem won’t achieve the goal of narrowing the trade gap while maintaining internal growth and stability.

The same type of reasoning can be applied to China itself and shows that there is another way to achieve the goal of reducing the competitiveness of Chinese exports. The US has been focused on raising the prices of our imports from China through letting the yuan appreciate against the dollar. Another way those prices could rise with a fixed exchange rate is if there is inflation inside China. So far, Chinese inflation (to the extent that we can believe the data in an economy with as many controls as China has) remains in the low single digits.

But there is reason to believe this can’t go on indefinitely if the economy continues to grow at a rate of 10% per year. Sooner or later there will bottlenecks for skilled labor or other inputs that will raise costs for exporters. Apparently, the Chinese authorities are trying to cool things down themselves, having engaged in contractionary bond sales in the past few weeks ( See here) and raising reserve requirements several times this year. (See here ) Whether this will work remains to be seen but even if it doesn’t the Chinese real exchange rate might eventually help out.

Bottom line? Paulson may not achieve much but even if he did it wouldn’t make much difference.