Don't Be Afraid of China

As its global trade surplus grows, other countries are getting panicky. But if handled right, this situation could lead to a more balanced global economy

The angst levels of U.S., European, and Japanese trade officials shot off the charts on Jan. 11 when China reported that its 2005 global trade surplus had tripled to a record $102 billion. It seemed further evidence of the nonstop rise of China's $2 trillion economy. The reaction to that number, and a lot of the media coverage that followed, suggested this was a dangerous development for rich world economies, particularly the U.S. (see BW Online, 1/13/06, "Parsing China's Trade Surplus").

There's no question that some domestic-focused companies in the West and Japan that can't match the fabled "China price" on the electronics, computers, clothes, and toys pouring out of the mainland are feeling the heat. In the U.S., you can count on cries for trade protection and for China's central bank, the People's Bank of China, to let the yuan (now considered by most economists to be undervalued by 20% to 40%) appreciate against key global currencies -- and quickly.

GOOD FOR THE WEST. China does need currency reform (it abolished its fixed-dollar peg last July and replaced it with a currency basket), but the key reason isn't necessarily trade. About half the exports coming out of China are actually from big foreign multinationals that use the mainland as a production base. They sell most of that stuff in China but also reexport to other markets.

In the Chinese high-tech sector, the percentage actually is closer to 90% penetration by foreigners. Global auto companies such as Volkswagen, General Motors (GM ), Toyota (TM ), Nissan (NSANY ), and Honda (HMC ) dominate market share in on the mainland. Global banks such as HSBC (HBC ), Bank of America (BAC ) , Goldman Sachs (GS ), and Citibank (CITI ) are making serious inroads into China's rapidly growing banking and financial services markets.

This is actually a win-win arrangement. In fact, some Chinese officials have openly wondered if China's development strategy has been too much of a good thing for the West. One could argue that it's China that faces the risk of losing out by ceding too many key markets to foreign interests in higher-end markets, which could make it difficult for Chinese world-beating companies to emerge.

MASSIVE RESERVES. If you really want to worry about something, though, it's the news that China's foreign exchange reserves (which finished 2005 at $819 billion) likely will top $1 trillion in late 2006, overtaking Japan as the country with the biggest stockpile in the world. One trillion, about half the size of China's total economy, would be an astonishing figure, even for a rapidly developing economy like China.

The superfast growth in reserves is being fueled by heavy inflows of foreign money and the repatriation of earnings that Chinese companies earn overseas. Given China's tight capital controls, a good chunk of that money has to be converted back into yuan and then reinvested by the central bank into other investments, mostly U.S. Treasury bonds and Euro assets. In recent years that, again, has been a great deal for the U.S., which relies on foreign capital, particularly from Asia, to make up for its massive current-account deficit with the rest of the world.

Chinese officials in charge of managing those reserves said a few weeks ago that they want to diversify away from the dollar investments. China is the No. 2 holder of Treasuries behind Japan, and a sudden pull-out would be felt keenly in both the Treasury bond markets, where long-term interest rates would likely rise, and in the dollar, which would probably tumble and unsettle U.S. stock markets. That's unlikely to happen in all at once, but Beijing does have some serious leverage over the U.S. on this score.

CURRENCY REFORMS. China could sell off its investments in U.S. and Euro bonds for any number of reasons, including further capital injections into weak Chinese banks that have heavy dud loans, massive infrastructure investments at home, or even bailing out state-owned mainland companies that are struggling. Again, this wouldn't happen in one massive jolt to global markets, but Beijing could conceivably start things trending that way.

If the U.S. wants to avoid that kind of thing, it needs to clean up its side of the street -- that is, improve its consumer savings rate and tighten government spending to bring down its monstrous budget deficit. China, in turn, needs to move forward with currency reforms and liberalize its capital controls. The first step this year would be to let the yuan more accurately reflect its current value and adjust against foreign currencies depending on trade flows.

Longer term, China needs to abandon its tight capital controls, and it's taking steps in that direction already. It has a savings surplus -- $1.8 trillion in household savings -- but that's largely bottled up inside China's banking system. That may sound like a great thing, but it isn't if banks use that money to lend recklessly at home, and Chinese lenders have a long record of doing just that.

If China wants to truly avoid the boom-and-bust cycles that have tripped up other economies at this stage of development, it needs a more flexible currency and capital flow regime.

INVESTING BORDERS. The savings surplus is also a bad deal for Chinese consumers who can't invest in foreign bonds and stocks that may deliver better returns than bank deposits or China's smallish, corruption-prone stock exchanges in Shanghai and Shenzhen (see BW Online, 1/9/06, "Where China's Top IPOs List: Offshore"). Giving Chinese savers more investment opportunities both abroad and at home would mean better returns -- the kinds needed to help fund their kids' education and their own retirements.

More liberalized capital flow is also important to China having a truly free-floating yuan. Achieving that in the next year or so is probably too much to hope for, but steady improvement in that direction is key for a more balanced global economy. Right now, we live in a very lopsided global economy. This can't go on forever and could end badly.

If foreign investors lost confidence in the U.S. debt market, you might see a sharp downturn in the U.S. economy, which would in turn depress Chinese growth, not to mention that of Japan and other big exporters.

FINDING BALANCE. China is already a world-class trading economy and destined for superstar status in the years ahead. There's no question that will have big implications for living standards and corporate competitiveness in the West and Japan. Yet it could be a good thing both for Chinese families and other big economies that trade and invest in the mainland.

So don't get too caught up in the hysteria about the Chinese trade numbers. The real issue is how steadily China proceeds with opening up its capital and currency markets, and plays a role equal to its growing clout in helping achieve a more balanced global economy.

READER COMMENTS

Brian Bremner is Asia regional editor for BusinessWeek in Hong Kong
Edited by Patricia O'Connell

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