The
dollar is on the decline, with its value having fallen
by around 30 per cent relative to other major currencies
since 2002 and by close to 20 per cent in trade-weighted
terms. Yet, the US government feigns being unconcerned
with the problem. In the G-20 meeting held in the
second half of November, the US Treasury Secretary
reportedly refused to talk about the dollar's decline,
though he reiterated the Bush administration's public
commitment to halve the US government's budget deficit
during its second term and bring it below two per
cent of GDP.
The relevance of the budget deficit for the problem
at hand is obvious, given the connection between the
dollar's decline and the twin deficits in the US-the
balance of payments deficit amounting to 5.5 per cent
of GDP and the fiscal deficit to 4.2 per cent of GDP.
With savings rates close to zero on average, private
spending is high in the US. But a large part of the
demand this generates spills over into the international
market given the lack of competitiveness of US producers.
However, this has not resulted in a domestic recession
because the government has in recent years been pump-priming
the economy with deficit spending (though a part of
that too leaks out abroad). In the event, the US has
required the two deficits to sustain its reasonable
rate of growth by developed country standards.
These deficits have not proved a problem because of
capital inflows, including in the form of investment
of surpluses accumulated by foreign governments and
central banks in dollar denominated financial assets.
According to one source, in 2002, 2003 and the first
half of 2004, foreign governments financed $564bn
(43 per cent) of a cumulative current account deficit
of $1,318bn (£695bn). The problem recently has
been that both private wealthholders and foreign governments
have begun to fear that the unsustainable value of
the dollar spells a decline in the currency that could
sharply erode the value of their assets. The resulting
rearrangement of their portfolio away from dollar
assets in favour of other currencies is what explains
the dollar's decline.
At one level this decline appears to be a boon to
the US. It cheapens the foreign exchange value of
its exports and renders imports more expensive in
dollar terms, improving US competitiveness. If this
helps reduce the trade deficit, the size of the fiscal
deficit needed to keep growth going would be lower.
A process of self-correction seems to be providing
a solution to the twin deficit problem.
The difficulty, however, is that the dollar's decline
would also result in lower inflows into and larger
outflows into US capital markets, resulting in a fall
in financial asset prices that would reduce the wealth
position of US households and institutions. This would
reduce consumer spending and curtail demand. That
problem could be aggravated by a possible liquidity
crunch in the system, as banks and financial institutions
experiencing a depreciation of their asset values
turn cautious. Further, lower financial asset prices
imply higher interest rates that could affect investment
adversely as well. Thus a correction of the twin deficit
problem through a depreciation of the dollar could
also imply a recession in the US.
All this makes the dollar's decline a problem for
the rest of the world as well, especially countries
in Europe and in Asia, like China, that are heavily
dependent on the US market. Dollar depreciation increases
the dollar value of their exports to the US and undermines
their competitiveness and recessionary trends in the
US would squeeze an important market for their exports.
It is this global effect of the dollar's decline that
the US exploits to make the decline everybody's problem
and not just its own. In its view, the twin deficit
problem can be best resolved through increased net
exports (exports net of imports) from the US. This
would reduce the trade deficit, contribute to demand
for US goods and help reduce the fiscal deficit without
affecting growth adversely. So, Europe, Japan and
China must help raise net exports from the US.
The G-20 meeting in November saw the Europe and Japan
partly going along with the US on this count. ''The
Group of 20 leading rich and emerging market nations
have agreed on a co-ordinated effort to reduce global
trade imbalances by cutting the US fiscal deficit,
reforms to boost growth in Europe and Japan and increasing
exchange rate flexibility in Asia,'' reported the
Financial Times on November 22. That is, the reduction
of the US fiscal deficit was made contingent on reflation
in Europe and Japan which, hopefully, would expand
the market for US goods, and reduced currency intervention
by Asian governments aimed at pegging their currencies
to the dollar. The latter, by resulting in an appreciation
of Asian currencies vis-à-vis the dollar is
expected to increase the competitiveness of US exports
to these countries and therefore in an increase in
the volume of US exports.
The country which would be most effected by the second
of these recommendations is China, which has pegged
the value of its currency the renminbi (yuan) at 8.27
to a dollar since 1997. China has been under pressure
for quite some time to revalue its currency and redress
the ''imbalance'' that its trade surplus ($124 billion
last year) with the US (Chart 1) and its large foreign
exchange reserves ($514.5 billion) ostensibly reflect.
That pressure has now increased, since Europe and
Japan would like to see China bearing a larger share
of the burden of global adjustment, by curtailing
its exports and increasing its imports with a flexible
and appreciating currency.
Chart
1 >> Click
to Enlarge
China's
fears on this count are not just related to its trading
position. It is more worried about the effects of
introducing a more flexible currency and allowing
the yuan to appreciate on its currency and financial
markets. A stronger yuan is bound to spur large capital
inflows, while capital account restrictions do not
permit money to flow out easily. This would increase
reserves further and drive the yuan even higher. And
once that happens, speculation on the value of the
yuan can increase capital inflows even more. Such
a spiral can be destabilising and weaken autonomy
in monetary policy.
Not surprisingly, China is not happy. In an interview
with the Financial Times, Li Ruogu, the deputy governor
of the People's Bank of China, warned the US not to
blame other countries for its economic difficulties.
''China's custom is that we never blame others for
our own problem,'' he reportedly said. ''For the past
26 years, we never put pressure or problems on to
the world. The US has the reverse attitude, whenever
they have a problem, they blame others.''
There were three unexceptional arguments that Li used
to justify his criticism. First, "The savings
rate in China is more than 40 per cent. In the US
it is less than 2 per cent. So the problem is that
they spend too much and save too little." Second,
there was a lack of correspondence between US wages
and productivity resulting from the tendency of the
government to protect low productivity jobs. US workers
enjoyed relatively high wages but remained excessively
engaged in low value-added industries such as textiles
and agriculture. Finally, US policies discriminate
against exports of goods that China needs. Restrictions
on exports of military and high-technology products
to China partly explains Beijing's huge trade surplus
with America, he argues.
In fact, the evidence on China's trade does not support
the view that it adopts a mercantilist policy that
pushes exports and restricts imports. In 2003, while
exports of goods and services amounted to 33 per cent
of GDP, imports of goods and services stood at 32
per cent of GDP (Chart 2). At present, China records
an overall trade deficit, which is expected to touch
$40 billion in 2004. In the first four months of 2004,
China's exports amounted to $162.7 billion, up 33.5
per cent from a year ago. Imports on the other hand
rose 42.4 per cent to $173.5 billion, resulting in
an overall trade deficit of $10.8 billion. A negative
trade balance is sure proof that mercantilism does
not drive trade and economic policy.
Chart
2 >> Click
to Enlarge
The reason why China is susceptible to international
pressure despite this trade record is the country-wise
distribution of its exports and imports. In 2003,
merchandise imports from China into the US amounted
to $163.2 billion, or 12.5 per cent of its total merchandise
imports. This figure had risen from 6.3 per cent in
1995. Imports into the European Union and Japan amounted
to $107.8 billion (3.7 per cent) and $75.4 billion
(19.7 per cent). Though relative to the total Japan
was a major importer, the US clearly dominated in
absolute magnitude. What is more, merchandise exports
to China in 2003 stood at $28.4 billion, $44.9 billion
and $72.5 billion respectively in the case of the
US, European Union and Japan. The US sucks in commodities
from China, but sends little back in return.
Chart
3 >> Click
to Enlarge
Finally, in recent years, China has provided space
for foreign firms in its domestic market. As Nicholas
Lardy, then of the Brookings Institution, wrote in
2002: At the turn of the twenty-first century in China,
''foreign manufacturers led by Motorola, Nokia and
Ericsson had captured 95 per cent of the market for
cellular phones. Coca-Cola was the dominant supplier
of carbonated beverages with a market share fifteen
times its closest domestic competitor. Its operations
in China have been profitable for more than a decade,
and Coca-Cola expects China to emerge as its largest
Asian market in 2002 or 2003. McDonald's and Kentucky
Fried Chicken, with almost 900 outlets between them,
dominated China's rapidly growing food market. Kodak
had captured half the market for film and photographic
paper. Volkswagen, through two separate joint ventures,
controlled more than half the domestic automobile
industry. Carrefour, the French company, had become
China's second largest retailer only five years after
entering the market. And, as unlikely as it might
have once seemed, Proctor and Gamble had more than
half of what is undoubtedly the world's biggest shampoo
market.''
Thus, the problem is not one of Chinese mercantilism,
but one of lack of competitiveness of the US. Not
surprisingly, the US has performed poorly despite
the fact that the yuan is pegged to the dollar. With
the dollar depreciating vis-à-vis the euro
and the yen, it is the EU and Japan that should lose
out in trade with China, not the US.
Despite all this evidence in its favour, China is
feeling the heat, as shown by Li Ruogu's response.
This is the result of China's reform-driven dependence
on exports in general and exports to the US in particular.
With exports amounting to 33 per cent of GDP and the
US accounting for 37 per cent of China's total merchandise
exports of $438.4 billion, the US market is too important
for China for US views to be ignored. Not surprisingly,
expectations are that China would soon loosen strings
on the yuan, which has since 1995 been allowed to
fluctuate only within a ultra-narrow 0.3 per cent
band around 8.28 yuan to the dollar. That band is
now expected to widen. But this is likely to be too
slow to satisfy the US because of what investment
banker Henry Liu sees as China's ''residual commitment
to socialist principles'', which makes it hope that
it can ''reap the euphoria of market fundamentalism
without succumbing to its narcotic addiction.'' The
US and the rest of the world will have to find some
other answer to the problem of the weakening dollar
generated by the twin deficits in the US.
