What To Do About China

Yesterday, the US and China concluded high level talks between Secretaries Geithner and Clinton and China's State Councilor Dai Bingguo and Vice Premier Wang Qishan on the relationship that President Obama said, at the outset of meetings, will define the 21st century.  The President is right.  How the US and China manage their relationship will determine the balance of growth and contraction, war and peace and freedom and its opposite in the 21st Century.  This then was an important set of meetings raising the deeper question of what should the US do about China.

China's rocket-like growth over the last decade has been extraordinary. However, beyond the sparkling towers, new roads and designer airports lies the fact that China's rise has inextricably altered the economic and diplomatic balance of power of the 20th century.  According to economist Steven Roach, China's growth alone is likely to keep global growth above zero this year.  China, America's largest creditor, holds about $2 trillion in US dollar debt, an amount growing daily. To put that sum in perspective, the entire balance sheet of the US Federal Reserve prior to the financial crisis was less than $1 trillion.  China is quite simply rocking the global economy.

Rapidly emerging powers, by definition, alter the status quo and in prior epochs success or failure in accommodating that change has proven critical to global stability.  At the end of the 19th century, Europe mismanaged the rise in power of Germany which (with Bismarck's dismissal by the erratic Wilhelm II) contributed to World War I.  Then in the early 20th century, the world failed to recognize Japan's emergence as a major power after she defeated Russia in 1905 and began building airplanes capable of crossing the Pacific.  In contrast, through the post war framework of the Bretton Woods institutions including the GATT, the Bank for International Settlements (designed to lessen exchange rate imbalances), the IMF and the World Bank and the UN as well as the European Union and other organizations, the world did a much better job of accommodating the rise of Japan, the NICs and the peripheral European states at the end of the 20th Century.

Now, with China's emergence, however, the world faces a new rebalancing of political and economic power.  And the task, as President Obama suggested, is to manage it in a way that benefits the US, China and the world.  

Economic theory--in contrast to the popular notion of competing nations--teaches that one country's rise should benefit others.  A richer China should consume more US goods.  It should produce more and through spillovers and the creation of knowledge, contribute to the global commons. 

One country, moreover, cannot succeed as China has without others.  China remains dependent on the US as the major market for its exports.  In some ways the US China relationship is deeply symbiotic.  We design goods.  China makes them cheaply.  We buy them, allowing US consumers to get more for less.  However, to the extent that the Chinese consistently sell more to us than we buy--as a result of the Yuan being kept artificially low, America gets more stuff but loses industry, China gets less stuff but gains industry and China ends up holding US dollar denominated debt.  That is the story of our recent relationship in a nutshell.  Chinese economic officials, waking up their huge exposure to the value of the US dollar, have scolded the US about its deficits which could weaken the dollar and have floated the idea of diversifying into other currencies.  The threat to unseat the dollar as the world's reserve currency is a serious shot across our bow.  Besides these economic issues, other matters on the table in Washington this week included nuclear proliferation and climate change.

In many ways, China in its economic strategy has followed the same trajectory of Japan and the other Asian tigers.  She has pursued a policy of export-oriented growth leveraging her low cost base built on the four pillars of a cheap currency, high savings financed through suppressed consumption, an aggressive state role in the economy, and a policy of securing technology transfer for market access.  The strategy is neo-mercantilist which is to say, its practical effect is to generate a trade surplus and accumulate hard currency.  (The original mercantilism practiced in Europe prized trade surpluses to accumulate gold and silver.) 

However, China's story is qualitatively different than that of Japan and the NICs in certain respects.  First, on the political track, beginning as a Communist country, China has, so far, not followed South Korea and the other NICs toward authoritarian democracy.  China remains a totalitarian police state. And second, she is simply larger in scale and scale changes everything.  Long before China reaches western standards of living, her overall GDP will be the largest in the world.  And, unlike the other Asian NICs, she is so large and her labor supply so abundant that her cost of labor can stay low even as her exchange rate appreciates.

On the political side, China does not appear aggressive in foreign policy.  Like the 19th Century resource-hungry European powers, she has been courting natural resources in Africa to fuel production.  However, she has pursued a commercial as opposed to political strategy.  While she is a nuclear power, she appears more preoccupied with economic growth currently than military objectives.

In many ways, the relationship with the US has proven beneficial for both.  An example of positive symbiosis would be the manufacture of the Apple iPhone.  Designed in the US, it is made in China by a company called Foxconn.  Both the US and China benefit from the success of the iPhone.  As an example of the political and human pitfalls of the relationship, however, one can point to the case of a Foxconn employee recently hounded to the point of defenestration by police and company security after he lost an iPhone prototype. Afterward, Apple issued a statement saying it was awaiting results of an investigation into the employee's death.

The US China meeting this week made no news on the issue of climate change or nuclear proliferation, a complex initiative that will take time.  The principle outcome was that the US pledged to work to lower US budget deficits to protect the value of the dollar and China pledged to increase domestic demand.

With respect to the US concession, the very fact that the US had to apologize for our deficits shows how the balance of power in the relationship has changed.  As for the Chinese concession, it is indeed the right policy for the US and China to pursue.  As a result of the massive stimulus package enacted in China of close to $600 billion, some 88% of China's GDP growth this year will occur in investment, much of it in infrastructure.  Most of the rest of the growth will come from exports.  Virtually none will come from consumption and increased living standards for the Chinese people.  This must change.  By allowing its people to consume more and buy more of the world's products, China can help its own people live better and the rest of world produce more.

For its part, the US has to stop living beyond its means which means borrowing less both to fund government and imports.  That will put the US back on track toward more sustainable growth.

Economically, what remains unresolved is the depressed Yuan which continues to drive the Chinese trade surplus and the US deficit.  Clearly the Yuan has to appreciate to the point where US goods are competitive with Chinese ones.  The US should exert its negotiating leverage sooner rather than later on this point because the more US debt China accumulates, the worse the negotiating position of the US will become. 

The one issue not explicitly on the table--apart from sympathy expressed by the US toward Chinese minorities--but that ultimately must underscore our relationship with China is how Chinese success will impact the US commitment to freedom and democracy.

The strategy not only of the US but of the West in general has been to encourage economic growth in China while hoping this will lead to greater freedoms.  This policy of engagement as opposed to containment is  the right strategy for now because it would be absurd for the US to disengage when China is moving in the right direction. However, China has moved far more slowly than many hoped and the US posture toward China has, all too often lacked even a semblance of muscularity. 

The US has been a poor or non existent negotiator on behalf of US companies in standing up for values we hold dear such as freedom of expression.  The government has left companies such as Google and Yahoo to cut individual deals with the Chinese to gain market access.  Our government has also been missing in action when it comes to allowing companies to negotiate away technology in exchange for access to the Chinese market.  The US could be doing far more to strengthen the negotiating position of US-based companies which ultimately would benefit not only us but the Chinese people by widening their access to goods and information.

President Obama is right that the US China relationship will be critical to shaping the 21st century.  And ultimately, this is about accomodating China's rise without sacrificing America's values or our standard of living.  This week's meeting was a useful first step.  Still problematic, however, are the huge trade imbalances resulting from an exchange rate imbalance and China's negotiating position toward US firms that is far tougher than ours in the opposite direction  As we go forward, we should accelerate action to move the two countries toward a truly sustainable, long term partnership.