When it comes to economic relations with China, U.S. political leaders are responding to the problems of yesterday rather than preparing for tomorrow.
Lawmakers in both parties -- from Republican Mitt Romney to leading Democrats on Capitol Hill -- continue to criticize China for its currency manipulation just as economic problems in China are deepening, potentially leading to dangerous spillover effects for the U.S.
There is no doubt that for years China was guilty of currency manipulation. This and other policies helped Chinese exporters gain an edge over their competitors and allowed the government to accumulate a $3.2 trillion stockpile of foreign reserves. As a result of years of subsidized production, China retains its large trade surplus in manufactured goods.
But now, domestic and foreign economic pressures are causing cracks to emerge. Domestically, over-investment and excess capacity weigh on China’s economy. The housing market is deflating and the local-government debt on banks’ balance sheets will limit future fiscal stimulus. Monetary authorities are constrained from further easing for fear of inflation. And China’s major export markets -- the U.S. and Europe -- are facing slow growth at best.
The International Monetary Fund recently lowered its growth forecast for China and said if Europe’s sovereign-debt crisis worsens, China’s growth rate may fall by as much as four percentage points from current projections.
Movements in currency markets also suggest a lack of confidence in China’s economy. In September, currency forwards contracts, or bets on the value of the yuan in the future, started predicting that it would depreciate, rather than continue the appreciation trend that forwards markets had generally shown since China’s currency de-pegged from the dollar in 2005. Forwards contracts now predict China’s currency will be basically flat in the next 12 months, a reflection that concerns over the Chinese economy remain.
In the past, bouts of weakness in China’s economy weren’t as obvious because its capital account was closed, meaning that capital couldn’t leave the country. Even though the capital account is still largely closed, money can now flow out of the economy more easily than before: In the fourth quarter of 2011, China’s surplus in the trade of goods, services and transfers, known as the current account, was almost completely offset by outflows from the capital account or elsewhere, according to preliminary figures from the State Administration of Foreign Exchange. This indicates that despite China’s trade surplus, investors are still insecure about domestic economic conditions.
As Li Yang, a former adviser to the central bank, recently said, “One-way capital inflow or one-way bets on a yuan rise have become history.”
Although for years China’s central bank manipulated the currency by selling yuan at a below-market rate, in the fall it started setting the exchange rate above the market value and selling foreign-exchange reserves to support the yuan. China’s foreign-exchange reserves declined in September, November and December of 2011, evidence that the central bank was trying to hold up the value of the currency rather than push it down. Early data from 2012 show that foreign-exchange inflows resumed, but that the growth has been moderate.
Confidence is also slipping in China’s corporate sector. Based on central-bank data on purchases and sales of foreign exchange by banks to companies, exporters chose to hold more of the foreign currency they accumulated from trade in the fourth quarter than they did during the first three quarters of 2011. The lower rate of conversion to yuan accounted for an estimated $52 billion in foreign currency sitting on the balance sheets of Chinese companies.
Similarly, importers purchased more foreign exchange to finance their imports, accounting for an additional $74 billion in foreign currency held by companies. Both trends suggest that Chinese companies have lost confidence that the domestic currency will appreciate.
Lastly, there is mounting anecdotal evidence that Chinese are trying to protect their wealth by holding less yuan or even moving their wealth offshore. According to the Hong Kong Census and Statistics Department, China’s gold imports from Hong Kong increased threefold in 2011. This is often assumed to be a hedge against inflation, but it may also be seen as a store of value given a weaker economy and faltering real-estate market.
In a further sign that Chinese citizens may be trying to protect their wealth, gambling revenue in Macau increased 35 percent in January due to more traffic from mainland China, according to Macau’s Gaming Inspection and Coordination Bureau. Gambling is thought to be a way Chinese individuals can exchange their yuan for foreign currency and move wealth offshore. In this respect, increased gambling revenue in Macau may be a contrary indicator for the health of China’s economy and confidence in its currency.
Complaints from U.S. leaders about China’s currency manipulation may be misplaced and leave America more vulnerable to a Chinese economic decline. Rather than stoke the fire over currency manipulation, U.S. officials should consider reducing exposure to China through trade and financial flows and assess what stimulus and pro-growth measures America would undertake if China’s growth waned. At the same time, the U.S. should continue to pressure China to transition from growth driven by net exports and investment, to growth driven by greater household consumption.
Antagonism over currency manipulation will only inflame nationalistic sentiment in China and limit the ability of China’s leaders to enact necessary reforms. This only complicates China’s economic transition and leaves the U.S. unprepared for the difficult road ahead.