Find an intelligent way to deal with China and economy

Trade policy is a contentious issue in contemporary America. A common refrain in trade discussions is “all we want is a level playing field.” President Trump portrays his tough trade sanctions, especially against China, as a confrontation aimed at remedying decades of America being ripped off in the global marketplace.

This represents a major reversal in America’s China policy. Since President Nixon’s opening to China in 1971 and across eight subsequent administrations it was generally believed that engagement would induce China to work with the West and become a peace-loving democracy with no designs on regional or global power.

As a candidate, Trump stood out for his embrace of America-first policies and his promise to “Make America Great Again” by addressing the grievances of ordinary citizens who feel dispossessed. Once in office, Trump, a self-described deal maker, has not been fond of large multilateral deals. He was quick to withdraw from the Transpacific Partnership agreement. After first threatening to void the North American Free Trade Agreement by executive order, his administration renegotiated it.

Countries often use protectionism tools such as tariffs and quotas to support domestic industries until they are able to compete internationally. Tariffs are taxes imposed by a country that make imports more expensive. Quotas amount to quantitative restrictions on imports. It helps to keep in mind who loses and who gains from a tariff or quota. Domestic producers and employees gain and consumers lose. Governments also benefit from tariffs because they generate revenue, but tariff revenues are typically not a big consideration in developed countries.

Countries can also impose stringent quality and safety standards on foreign products. A country can tailor the standards to the product descriptions at home, thereby giving domestic producers an advantage. Consider the continuing debate over stricter standards for antibiotics in the European Union versus the United States. Are these measures of safety or a way to protect a domestic industry? Then there are all kinds of red tape that delay exporters from gaining access to a country’s market.

Still, there is another insidious tool that a country can use to promote its domestic industries. China and other countries build national champions with government funding of state-owned enterprises (SOEs). China is the world’s second largest economy, accounting for about 15 percent of global economic output. It has seen extraordinary economic expansion over an extended period, with double-digit growth for close to 30 years.

Its SOEs have facilitated that growth and are the backbone of the Chinese economy. The nation’s approximately 150,000 SOEs control around $16 trillion in assets, constitute about 40 percent of China’s gross domestic product and employ 35 million people in strategic industries such as energy, technology and telecom.

China’s government helped launch new and emerging industries by channeling capital into SOEs. For example, it flooded global markets, depressed prices, and literally shut down hundreds of U.S. solar-panel startups. China’s SOEs are front and center in implementing China’s One Belt One Road initiative, the nation’s vision for massive development of trade routes between Asia, Africa, and Europe.

These government subsidies stimulate excess production, depress market prices, and enable state-owned enterprises to capture market share. Closely related is the theft of intellectual property and forced technology transfers, often by SOEs, that highlight the need to constrain these enterprises. Countries such as China hesitate to allow state-owned enterprises to fail for fear that it would unleash a tidal wave of unemployment.

While trade talks between China and the United States may be productive in dealing with tariffs, the Trump administration should also address less traditional tactics that amount to cheating. They include China’s use of subsidies to key state-run companies to undercut their American competitors. What should be clearly understood here is that dealing with the Chinese is like engaging in unprotected sex.

Originally Published: January 27, 2019

A high-stakes contest for technological supremacy

Meng Wanzhou, chief financial officer of privately owned Huawei Technologies Corp., was arrested by Canadian police at the behest of American law enforcement authorities seeking extradition as she changed planes at Vancouver International Airport. Wanzhou is the daughter of the company’s founder, a former military engineer with China’s People’s Liberation Army.

She has been charged with conspiracy to defraud banks in connection with alleged violations of American sanctions on Iran. The December 1 arrest occurred on the same day that President Trump and Chinese President Xi Jinping agreed to a cease fire in the escalating trade war between the world’s two largest economies.

Huawei, China’s smartphone and telecommunications giant, has long been at the center of drama between the United States and China. The U.S. has pressured allies to limit use of Huawei products and technology.

Huawei may not be a familiar name to Americans, but it is a global telecom behemoth, with about $93 billion in revenue 2017, almost on par with Microsoft.

Based in Shenzhen, near Hong Kong, it has the biggest research and development budget of any Chinese company. The firm has benefitted from Chinese government subsidies, contracts, and financing from the state-owned China Development Bank. These subsidies give Huawei a huge advantage over its competitors.

The company is the world’s second largest maker of smartphones, behind only Samsung. It is the world’s largest provider of telecom equipment, including switches, routers, cell tower gear, cloud computing and cybersecurity. It also sells personal computers and a wide array of wireless devices like smart watches.

Huawei is seen as a global leader in 5G, the ultra-fast wireless technology that will soon allow all the objects around us to be connected. That is good for China and bad for the United States. The U.S. worries that if Huawei wins the race to develop 5G technology, Americans may someday be buying their equipment to connect factories, vehicles, homes, utility grids and more.

Huawei is also seen as a cyber-security threat. Washington has accused it of being a potential conduit for Chinese spying and cyber theft. The Justice Department, intelligence agencies, and regulators have long believed the firm has violated American sanctions against Iran, that it works primarily for Chinese government interests and that its equipment contains back doors that allow that government to spy on customers.

In 2012, the House Intelligence Committee released a report that tagged Huawei’s products a potential security threat, accused them of engaging in intellectual property theft and recommended a ban on the company’s equipment. As early as 2003, Cisco Systems accused Huawei of infringing on Cisco’s patents and illegally copying source codes used in its routers and switches. Other accusations have also surfaced. Motorola named the firm as a co-defendant in a lawsuit and T-Mobile alleged that Huawei stole technology form its headquarters.

The Committee on Foreign Investment in the United States, an inter-agency committee of the federal government, has blocked deals involving Huawei on grounds that it had possible ties to the Chinese government and that the strategic nature of the telecommunications industry made such deals potential threats to national security. This August a defense policy bill prohibited the federal government from using Huawei equipment.

President Trump is considering an executive order that would bar American companies from using telecommunication equipment made by Huawei and other Chinese telecom companies because the equipment poses serious national security risks. Of course, the company strongly denies stealing intellectual property or enabling Chinese espionage.

It is unclear how the arrest of Meng Wanzhou will influence ongoing trade talks between the United States and China. One possibility is that the U.S. government will allow trade to trump national security concerns, as the president has suggested he would intervene on the Huawei issue if it would help secure an agreement.

Americans best stay tuned as this high-stakes contest for technological supremacy unfolds.

Originally Published: January 4, 2019


No doubt about it, China doesn’t play fair on trade

Trade issues are not everyone’s idea of a good time. With so many demands on their attention, ordinary Americans are wary of the truth quotient in commentary on the subject. They are cautious about separating the genuine from the meretricious comments from corporate America, which is concerned about maximizing shareholder wealth rather than doing the right thing for the majority of Americans.

General Motors has warned that President Trump’s threats to impose a 25 percent tariffs on imports of cars and car parts are projected to cost the auto industry billions of dollars, could raise some car prices by nearly $6,000 and result in fewer American jobs and a smaller GM. In contrast, a Ford Motor Company spokesperson said they believe they are somewhat insulated from the proposed tariffs because their most profitable vehicles are built here.

Currently, vehicles imported to the United States face a 2.5 percent tariff. Cars built in America face a 10 percent tariff when they are shipped to the European Union and a 25 percent tariff when they head to China.

During the financial crisis, the feds put $49.5 billion of taxpayer money into the GM bailout and the taxpayers ultimately lost an estimated at $10.5 billion. The firm has remained profitable since then. In retrospect, the bailout should have included provisions requiring that a portion of future profits go to fully repay taxpayers. Government Motors could also have been required to build automobiles and auto parts in the USA.

The automaker sold 4.04 million vehicles in China in 2017, a third more than the 3.02 million it sold in the United States. Last year represented the sixth consecutive year that China was General Motors’ largest market.

GM and other multinational companies headquartered in America view China’s emerging middle class as the world’s largest market for their products. The firm’s future growth relies as much on China as it does on how the automaker responds to emerging disruptive technologies such as electric and autonomous vehicles, and changing patterns of car ownership and use that will ultimately force the modification of its current business model.

Multinationals are concerned that the tariffs will cause the Chinese government to retaliate by imposing bureaucratic rules and regulations that could cause them to lose market share. China used this approach to roll back Japanese automakers’ market share during a dispute with Japan over contested islands in the East China Sea.

When China was violating the World Trade Organization rules on subsides for wind turbines, General Electric and other firms that were in the business were reluctant to bring a dispute to the WTO for fear of Chinese retaliation. It was the United Steel Workers who ultimately brought it to the WTO.

It is hard for multinational corporations to resist the temptation to placate the Chinese. China doesn’t have to send lobbyists to walk the halls of Congress, they just have the multinationals do what they want.

It is implausible to argue that China does not engaged in unfair trade practices. China is a one-party communist dictatorship. It is not bound by the political constraints of a democratic government with a constitution that imposes presidential term limits and secures the rights of free speech and association.

This political structure enables China to promote state subsidized industries such as steel, aluminum, and solar panels that have flooded global markets, depressed prices, and shut down hundreds of manufacturing plants, all in violation of World Trade Organization rules. Along with currency manipulation and stealing intellectual property, China’s actions amount to a thumb on the scale.

“Free” trade is a concept that works in classrooms insulated from the harsh realities of unfair practices and policies. They ignore predatory practices by foreign governments who view trade as a competition between nations and play dirty to grab a competitive advantage for their industries.

Like that of multinational corporations, China’s position on trade will be based on maximizing their own interest

Originally Published: July 14, 2018

Lessons from the Great War still apply

On June 18, 1914, the Austrian archduke Francis Ferdinand, nephew of Emperor Francis Joseph and heir to the throne of the Austria-Hungary empire, and his wife Sophie were assassinated by a Bosnian Serb in Sarajevo, the capital of Bosnia-Herzegovina. The assassination was the flash point that triggered a global conflict.

The Great War had a kaleidoscope of causes, including mutual defense alliances, imperialism, militarism, and nationalism. Its origins have eerie parallels to the present and hold important lessons for the future, especially for China and the United States. The emergence of China as a major power trying to assert itself has echoes of Germany’s rise in the late 19th and early 20th centuries, which was viewed as a threat by Britain, so the theory goes.

The two bullets fired in Sarajevo precipitated an international crisis, as various military alliances were activated, dragging everybody into a devastating global war. At the time of the royal murders, nobody believed it to be the “shot heard round the world,” but Europe went from peace to war in five weeks. As British Foreign Affairs Minister Sir Edward Grey said, “The lamps are going out all over Europe; we shall not see them lit again in our lifetime.”

Germany backed Austria after it declared war on Serbia, which was supported by Russia. When Germany then declared war on Russia, France was committed to Russia, and Germany attacked France through Belgium, pulling Britain into the war. Later Japan and the United States entered on the side of Britain, France and Russia, along with Italy, which switched sides in 1915. As Henry Kissinger explained, “the Great Powers managed to construct a diplomatic doomsday machine …” The war to end all wars (until it didn’t), later known as World War I, broke out in the summer of 1914 and was expected to be over by Christmas. Kaiser Wilhelm told his troops, “You will be home before the leaves have fallen from the trees.”

But it lasted until Nov. 11, 1918. Like the 2003 invasion of Iraq, it was to be swift, easy and victorious. Those who plan on fighting short wars often end up losing long ones.

By the time World War I ended, nine million had been killed, including over 100,000 American soldiers. Eight million were prisoners or simply missing. Twenty-one million had been wounded and who knows how many were damaged psychologically.

When the guns went silent, the Ottoman, Hapsburg and Russian empires had collapsed, a new German empire was foiled and France and Great Britain were greatly weakened. The war sowed the seeds of the Great Depression, the rise of fascism and communism and World War II. The dismemberment of the Ottoman Empire created the modern Middle East and laid the foundation for the chaotic conflicts that continue to plague the region. The Great War was also the catalyst for the coming American century.

China is an economic superpower and is translating economic might into military capabilities roughly in the same league as the United States. It is making a run at dominating northeast Asia through various territorial disputes with Asian neighbors over claims in the contested East and South China seas. By themselves, these neighbors are not powerful enough to check China.

The historical lesson for leaders in both China and regional rivals like Japan is to recognize that growing political and military tensions are a potential flash point.

Given the network of bilateral and collective defense agreements the United States has in the region, supporting its allies could draw the U.S. into disputes with China.

A clash between China and the United States is hardly remote. As recently as 2014, President Obama reaffirmed America’s bilateral defense agreements with South Korea, Japan and the Philippines. A lesson from World War I that seems so relevant today is that local conflicts can escalate into a great war.

Originally Published: June 16, 2018

China flexes its muscle in the Pacific

Just as Imperial Japan did in the 1930s, China is developing and asserting its own version of the Monroe Doctrine in Asia, so it may enjoy the same continental hegemony America does. The new reality is reflected in the South China Sea. China maintains that it has sovereignty over almost all of the South China Sea. The United States should respond by fostering closer ties with its allies in the region.

Beijing continues to militarize artificial islands in the South China Sea. It was reported earlier this month that China had installed antiship cruise missiles and surfaceto- air missile systems for purely defensive reasons on fortified outposts in the hotly contested waters of the South China Sea. Taiwan, the Philippines, Vietnam, Malaysia and Brunei are also contesting at least part of the chain of islands, reefs and their surrounding waters in the South China Sea.

Each year, a third of the world’s shipping passes through the South China Sea, carrying around $3.4 trillion in trade. In 2016, 21 percent of all global trade passed through it. Any conflict in the South China Sea would likely have serious consequences for global commerce.

Following the logic of the Monroe Doctrine, which opposed European colonialism in the Americas, Communist Party leadership believes China’s security would be better served by muscling the American military out of the Asia-Pacific region.

After all, the Chinese remember what happened in the century between the First Opium War (1839-1842) and the end of World War II, when the United States and European powers took advantage of a weak China. The current generation of Chinese Communist Party leaders are so bitter about the 100 years of humiliation that they can taste it.

In 1823, President James Monroe, on the occasion of his annual message to Congress, wrote “the American continents, by the free and independent condition which they have assumed and maintain, are henceforth not to be considered as subjects for future colonization by any European powers.”

The United States put European nations on notice that it would consider any foreign challenge to the sovereignty of existing American nations an unfriendly act.

The Monroe Doctrine, sweeping in scope, proclaiming hegemony over an entire hemisphere, was an expression of a growing spirit of nationalism in the United States in the 1820s. In short, it warned everybody to stay out of the Americas; this is a United States preserve.

China’s assertiveness in the South China Sea echoes the Monroe Doctrine. It wants to dominate Asia the way the United States dominates the Western Hemisphere. Why should anyone expect China to act differently than the United States?

China’s actions are not catching the United States at its best. The U. S. has been busy chasing bad guys in the Greater Middle East. Is it too late to contain and deter China as it did with the Soviet Union in the Cold War? Or is China just too big and powerful? It should be remembered that the United States did not have deep economic relationships with the Soviet Union, so Cold War-era policymakers did not have to contend with powerful American multinational corporations’ economic interests as they managed foreign relations. Lawmakers in Washington, special interest groups, and the business elite eat at the same table.

China’s moves in the South China Sea can be regarded as a threat. But it is also represents an opportunity to deepen relationships with American allies in Asia and leverage their resources to serve as an effective counterweight to China’s moves before China absorbs these countries into its economic orbit. The President may want to reconsider his decision to withdraw the United States from leadership of the Trans-Pacific Partnership. Keeping America secure means having partners and allies to magnify US power and extend US influence.

This approach merits consideration as long as the United States can avoid its usual perfection of getting things wrong when it comes to foreign affairs.

Originally Published: April 19, 2018



Trade tariff battle will not lead to any long-term damage

President Trump’s views on trade have never been a secret. Trump finally delivered on his campaign promises by announcing unilateral tariffs on steel and aluminum imports coupled with the imposition of about $60 billion in new tariffs on China. The moves generated frightening headlines, with experts predicting they will have dire consequences for the global trading system, but such claims are exaggerated.

Trade is a competitive game and every country plays hardball. The Trump policy is supposedly designed to counter a series of unfair Chinese trade practices, such as its longstanding restrictions on American companies, the forced transfer of American intellectual property, and many cases of patent and trademark infringement. The administration has demanded that China shave $100 billion off its record $375 billion trade surplus with the United States.

U.S. firms have been unable to sell advanced goods and services to China’s rapidly expanding middle class. It is widely acknowledged that in many market segments China requires foreign firms to share proprietary technology as a  condition of market access. The firms provide innovation and their Chinese counterparts imitate foreign design.

Many of the president’s media antagonists say these actions threaten to unleash a trade war; that the  moves appease the resident’s Rust Belt constituency but are unlikely to end America’s trade deficits or bring back manufacturing jobs. They also warn of rising consumer prices and are convinced that the U.S. would lose a trade war with the emerging market giant.

Yet it is unclear whether the president and the economic  nationalists in his administration will govern as tough as they talk. It is quite possible that actual tariffs will fall short of  the threats. For example, the tensions with American allies generated by the steel and aluminum tariffs are likely to be resolved through cometic concessions.

Following the president’s tariff announcement, China initially targeted tit-for-tat tariffs to put pressure on politically sensitive states that voted for Trump, hitting him where it hurts the most ahead of mid-term elections later this year. China’s Ministry of Commerce quickly said that it would impose a 15 percent tariff on $3 billion worth of American fruit, pork, wine, seamless steel pipes and more than 100 other products that represent about 2 percent of total American exports to China.

But soon after all this huffing and puffing, China’s Premier Li Keqiang, at a conference that included global chief executive officers at the Great Hall of the People in Beijing, pledged to open markets to avert a trade war with the United States and to ease access for American businesses. Also, China offered to buy more American made semiconductors and allow foreign financial firms to take majority stakes in Chinese securities firms.

Then on April 1, the Chinese Finance Ministry said the previously announced tariffs will take effect immediately.

China is reliant on foreign trade for growth and job creation and needs to retain access to the U.S. market. The country certainly doesn’t want to engage in a trade  war with its best customer. China’s exports to the U.S. are equal to about 4.5 percent of its GDP. In contrast, U.S. exports to China are equal to about two-thirds of 1 percent of GDP. Although less important to the economy than it was, trade accounts for almost 40 percent of Chinese GDP versus less than 30 percent in the U.S.

America’s decline relative to other countries is an old story. First the Russians were going to leave the U.S. in the dust, then the Japanese. But consider the strong and intrinsic advantages America enjoys. They include being functionally energy and agriculturally independent, having more favorable demographics and a consensual society. Drug dealers still prefer suitcases full of dollars, not yuan, and global investors still seek Treasury bonds as a safe haven in times of crisis.

President Trump’s trade moves may temporarily roil U.S. markets, but there is no need to panic or bet against the United States.

Originally Published: Apr 7, 2018

The eye-for-an-eye approach to trade

On March 8, America’s populist-in-chief signed an executive order slapping a 25 percent tariff on steel imports and a 10 percent tariff on aluminum imports. President Trump said he did it to protect the nation’s economic and national security. It came a little over a month after Trump said he would impose tariffs and quotas on imported solar panels and washing machines.

The United States has had the world’s largest trade deficit ever since 1975. In 2017 imports were about $2.9 trillion and exports were just over $2.3 trillion, as Americans continue to consume more than we produce.

The steel and aluminum tariffs have aroused little enthusiasm and much criticism. Naysayers argue they will do nothing to strengthen America’s economy or national security, and spark a global trade war. They say the tariffs will result in higher prices as steel users pass costs onto consumers.

Supporters claim there already is a trade war underway and it is being waged by China. That country accounts for more than two-thirds of America’s current trade deficit. We import $506 billion – mainly consumer electronics, clothing, and machinery – from China, but export only about $131 billion in goods.

China has been blocking high-value exports from the United States. For example, it charges a 25 percent import duty on cars, 10 times the 2.5 percent levy the United States puts on imported vehicles.

China also imposes steep tariffs on imported automobile parts. As Elon Musk tweeted, “No US auto company is allowed to own even 50% of their own factory in China but there are five 100% China-owned EV auto companies in the US.” Obviously, engaging in tough trade talks with China is long overdue.

It will take years for the United States, China and the global trading system to work out imbalances on a wide range of goods. America’s prosperity depends on a robust approach to correct failed trade policies, with a focus on the industries of the future. It makes no sense for America to excel at innovation without securing the domestic and foreign markets for its products.

It merits mentioning that instances in which American companies ship raw materials to China for assembly at a lower cost, then sell the finished products count as imports. American multi-national companies are happy to hire foreign workers from emerging markets with lower standards of living to keep their labor costs low and profits high. They figured out that to make income redistribution work on a global scale: American workers have to be less welloff so their overseas counterparts can be less poor.

But the new tariff on steel imports will not impact China. The United States is the world’s biggest steel importer, buying 35.6 million tons in 2017. Nearly 17 percent come from Canada, 13.2 percent from Brazil, and 9.7 percent from South Korea. Unless the Chinese are routing their steel exports through American allies, the U.S only imports about 3 percent of its steel from China.

After pushback from Canada, wiser minds prevailed within the administration and tariff sanctions were suspended indefinitely pending renegotiation of the North American Free Trade Agreement.

The tariffs may trigger reprisals. The day after President Trump signed the tariff executive order, the European Union published a 10-page list of American products that would be targets for retaliation, including peanut butter, grains, and motorcycles.

While steel and aluminum account for only a small portion of trade, the President’s rhetoric indicates that this is just the opening salvo from the White House bunker after years of benign neglect. The primary target is China. Trump has already called its unfair trading practices “an assault on our country.”

As the head of the World Trade Organization, one of the guardians of the global trading system, noted after the tariffs were announced, “Once we start down this path it will be difficult to reverse direction. An eye for an eye will leave us all blind and the world in a deep recession.”


Originally Published: Mar 22, 2018

The Marshall Plan and China’s “belt and road”

In 1945, Europe lay in ruins. Its cities were devastated, its industries destroyed, and millions of its people homeless. The key to the recovery of Western Europe lay with the Marshall Plan, a decisive tool for the United States to rebuild Europe after World War II.

Seventy years later, history may be repeating itself. Only this time it is China that is the strategic benefactor with the United States playing the role of the post-war Soviet Union, on the outside looking in as China strategically uses its largesse to develop lucrative new markets.

In June 1947, Secretary of State George C. Marshall, gave a speech at Harvard’s commencement announcing a plan to provide economic assistance to all European nations, including the Soviet Union. Although Russia and its Eastern satellites predictably rejected the plan, 16 Western European nations eagerly participated.

The Marshall Plan, the largest peacetime foreign aid program in U.S. history, channeled over $13 billion of American aid (some $150 billion in 2017 dollars) into 16 Western European countries between 1948 and 1952, to help them rebuild their economies and normalize their societies. The Congressional Research Service estimates the plan’s 1949 appropriation accounted for 12 percent of the entire federal budget.

But the Marshall Plan was more than economic and financial aid; it was a way for the United States to promote its anti-communist agenda, rebuild the economies of the recipient countries and make them prosperous enough to buy large quantities of American goods. By the end of 1950, European industrial production had risen 64 percent, communist strength was declining in Western Europe and opportunities for American trade had revived.

The Marshall Plan boosted American exports, manufacturing, and employment, and led to the economies of the participating countries surpassing pre-war levels. In the two decades that followed, Western Europe achieved unprecedented growth and prosperity.

American goods flooded eastward and political and economic ties with Western Europe grew even stronger. One unintended consequence is that it later made it possible for Western European companies to compete against American business in the automobile and other industries.

Some observers have compared China’s ambitious new endeavor, the so-called Belt and Road Initiative unveiled in 2013, to the Marshall Plan as a game-changing effort to revolutionize trade and recast many long- standing relationships. The multi-trillion-dollar proposal is China’s largest economic and foreign policy undertaking since the founding of the People’s Republic. The infrastructure plan that spans more than 60 countries, about 65 percent of the world’s population and about one-third of the global economy, would spread Chinese investment and influence across Asia, Europe, and Africa.

The “belt” refers to a land route from western China through Central Asia to Europe; the “road” links to Europe by sea, connecting the country with Southeast Asia, the Middle East, and North Africa. The initiative has gained momentum thanks to the decline of American influence in East Asia in the wake of withdrawing first from the Trans-Pacific Partnership and then the Paris climate agreement.

After World War II, the United States needed to export excess capacity. Today, China’s economic growth is slowing and it too is looking for new markets. And just as the Marshall Plan was a blueprint for undermining the influence of the Soviet Union, so can the Belt and Road Initiative marginalize U.S. influence by improving relations with traditional American allies.

As German Chancellor Angela Merkel, Europe’s most influential leader, said after three days of trans-Atlantic meetings, “The times in which we can fully count on others are somewhat over.” She was referring to America’s positions on NATO, Russia, climate change, trade and its apparent relinquishing of a leadership role in world affairs contributing to a post-hegemonic era in which no country has a dominate role.

If she’s right, it could mark the end of 70 years of American world leadership.

originally published: June 24, 2017

Is China in a currency war with U.S.?

China’s recent surprise decision to devalue its currency, the renminbi (also known as the yuan), versus the dollar sent shock waves through financial markets. It could trigger a race to the bottom to gain an export price advantage, which would have a major impact on the U.S. economy and on looming decisions by the Federal Reserve.

Many believe China’s move was an effort to gain a trade advantage. A drop in the yuan’s value makes Chinese products cheaper, costing thousands of jobs by forcing factories outside China to close.

China said the devaluation was a one-off event, but the move could set off a currency war, which is when two or more countries engage in currency devaluations to improve the competitiveness of their products in global markets.

Over 35 years, China has developed from abject poverty into an economic giant. It is the world’s second largest economy and accounts for about 12 percent of global exports. A country so reliant on trade must maintain the growth of exports, which have been the most important driver of China’s growth since liberalizing its economy in 1978. The U.S. is their biggest customer.

Chinese farmers continuously leave the countryside for higher paying jobs in urban areas. Robust economic growth is needed to absorb this workforce and maintain social stability and the existing political order, which is a top priority. If the economy worsens, China may further devaluate its currency to export its way out of the decline. Chinese exports were down 8.3 percent in July compared to 2014.

More importantly, China’s economic growth has slowed to an annual rate of 7 percent. That’s healthy for most countries- the U.S. struggles to keep annual gross domestic product growth above 2 percent­ but far below the previous decade’s double-digit growth.

Even though its GDP remains smaller than that of the United States, China is the world’s largest trading nation and is many countries’ most important bilateral trade partner. In the future, the yuan may well eclipse the dollar as the preferred currency of trade.

Some believe the devaluation may cause other countries’ central banks to respond, triggering a currency war. Both Japan and the European Union have repeatedly depressed their currencies in the past two years to promote exports. The U.S. certainly does it. The dollar took a deep dive after the Federal Reserve cut interest rates to near zero and flooded the world with cheap money through its quantitative easing initiative.

The devaluation engineered by Beijing also complicates the Federal Reserve’s September decision about whether to raise interest rates, which have been near zero since the 2008 financial meltdown. A weaker yuan would reduce the price of Chinese goods in the U.S. This would further depress the 1.3 percent inflation rate, which is below the Fed’s target of 2 percent.

Last month, the U.S. government reported that the economy added 215,000 jobs and the headline unemployment rate remained at a low 5.3 percent. That could support a Fed decision to raise its key interest rate.

But low inflation, weak increases in hourly wages and continued low labor-force participation could be reasons to delay their planned 0.25 percent increase until early next year. A rate hike would increase the dollar’s value, which would cause even more angst for American exporters, kill manufacturing jobs and sales of American goods; and slow economic growth.

To further complicate the situation, China has stockpiled more than $1.2 trillion in U.S. bonds, which help finance wars and huge budget and trade deficits. If foreign countries stop buying treasury bonds, rising debt would mean higher interest rates because investors would insist on higher returns.

The bottom line is that while there are a number of incentives for countries to devalue their currencies, every effort should be made to avoid the kind of competitive devaluations that exacerbated the Great Depression in the 1930s.

Originally Published: August 22, 2015

China’s power over US interest rates

While the Greek debt crisis and the Iran nuclear deal are all the buzz in the media, you may have noticed a major selloff on the Shanghai Stock Exchange over the last several weeks. There are global implications when the stock market of the world’s second largest economy is out of control, and the impact could be felt right here in the U.S.

China is a country of superlatives. Its population of more than 1.3 billion is larger than that of any other country. Its foreign reserves are about $4 trillion. The Chinese government owns $1.27 trillion in United States bonds.

As recently as the early 1990s, China was a minnow on the global trading stage, now it is the world’s largest exporter. It has helped lift hundreds of millions of citizens out of poverty and its per capita GDP has more than tripled since 1980.

Now that China has established itself as an economic powerhouse fueled by rapid growth, its foreign policy is becoming increasingly aggressive. It is asserting territorial claims over much ofthe South China Sea and their cyber-attacks on both business and government networks in the United States are creating a potential bipolar global rivalry with America just as the Cold War with the Soviet Union did.

China has evolved a system of state capitalism since the government began to introduce some market forces into the economy in the late 1970s. But the government is still the dominant economic actor despite all of President Xi Jinping’s rosy rhetoric about allowing markets forces to play a decisive role in allocating key resources and investment decisions.

The last two months have felt like a rollercoaster for the estimated 90 million retail investors in the Chinese stock market. With the government hoping companies would raise capital in the stock exchanges rather than seeking bank loans, novice investors bought stocks on margin with huge amounts of borrowed money, helping to create a stock bubble and runaway bull market.

Over the last several weeks the Shanghai Stock Exchange was down 30 percent. While no single factor appeared to spark the selloff, analysts attribute it to fear of slowing economic growth and the worldwide slowdown in demand for Chinese exports.

Fearing the slide might cause the economy to fall off a cliff, it was met with heavy-handed intervention by Beijing. The government cut interest rates, suspended trading for 1,400 companies, banned short sales, prohibited major shareholders from selling shares to stop the selling stampede and halted new initial public offerings.

The United States had better hope China doesn’t decide to bail out its stock market and stimulate its economy by starting to cash in some of its United States bond holdings. If that happens, U.S. interest rates will rise whether the Federal Reserve likes it or not. Of course, Japan and OPEC may step up and buy the U.S. debt if interest rates rise and U.S. bonds become more attractive.

The Chinese government’s tight control of the stock markets is not exactly consistent with allowing market forces to allocate financial resources. It’s unclear whether a government-dominated economy can have a free stock market.

International Monetary Fund chief Christine Lagarde recently said that, “China is still learning how stock markets work.” And that learning curve could have a big impact here on the other side of the world.

Originally Published: August 8, 2015