By Charles W. Calomiris
April 17, 2017 6:58 p.m. ET
In its first months, the Trump administration has pivoted on trade, backing off from threats to overhaul the North American Free Trade Agreement and reversing Mr. Trump’s campaign pledge to label China a currency manipulator. Those changes are welcome, but in an interview last week with The Wall Street Journal, the president went further, saying that he might soften his trade stance in exchange for help with “the problem in North Korea.”
Mr. Trump may be ceding too much ground. In fact, he may have more leverage over China than he thinks.
Claims that Beijing manipulates the value of the yuan never made much sense as an explanation for Chinese growth or for the persistent U.S. trade deficit with China. First, it’s impossible for monetary policy (including exchange-rate policy) to produce long-run growth or trade consequences. This principle of long-run “monetary neutrality” is one of the few tenets of economics that is nearly universally accepted.
Second, the facts show that the Chinese government has not been trying to keep its currency weak. The opposite is true. The yuan appreciated 26% from 1995 to 2014. And China’s “real exchange rate” (which captures the relative competitiveness of the prices of goods sold by China and its competitors) increased even more, 53% over the same period.
When a country’s real exchange rate appreciates, economists understand it as reflecting high productivity growth. This is called the Harrod-Balassa-Samuelson effect. Circa 1978, China’s total factor productivity—a measure of how much value an economy adds to a basket of inputs—stood at roughly 3% of America’s. Starting from that very low efficiency, China was able to improve quickly for more than three decades by removing some of the limits that the Communist government had placed on markets. Today China’s total factor productivity stands at about 13% of America’s.
Lifting restrictions on market transactions has propelled China’s growing share of world exports and foreign direct investment in recent decades. China has also kept its tariffs relatively high, and government policies favor domestic producers while limiting the ability of foreigners to compete, factors that boost its trade surplus.
Since 2015 China’s currency has depreciated, but Beijing has tried to limit this weakening, partly with an eye toward the possibility of a political backlash in the U.S. Last Thursday, for example, government intervention in the foreign-exchange market raised the value of the yuan 1%.
Despite such interventions, it will be hard for the government to resist yuan depreciation. The weakening reflects a long-term growth slowdown—the natural diminishing returns of economic development. Autocracy contributes to China’s financial fragility. As Minxin Pei predicted in his 2006 book, “China’s Trapped Transition,” the Communist Party ensures its survival by propping up inefficient state-owned enterprises that fund its operations. The financial system cannot truly liberalize because it must remain an instrument for channeling credit subsidies to these firms.
Moreover, as the Chinese economy cooled off over the past decade, the government juiced growth with high spending, especially on buildings and infrastructure. These investments were also mainly funded with debt guaranteed, explicitly or implicitly, by the state. China’s combined household, government and nonfinancial corporate debt now stands at roughly 2.5 times gross domestic product. In 1999, China paid off its banks’ bad debts, but since then a combination of slow growth and high borrowing imply a nonperforming debt bill of about $3 trillion—10 times the cost of the 1999 bailout. The likely path of least resistance would be for China to let inflation solve some of the problem.
In any case, a combination of slower growth, debt defaults and inflation will continue to weaken the yuan and reduce capital inflows. Foreign reserves, which grew for decades, have declined since 2014. The Chinese elite are cognizant of these problems, hence their increasingly desperate attempts to smuggle wealth out of the country.
In this environment, the Chinese regime could fracture or lose popularity. That is a scary prospect for Beijing, which already faces other major challenges, such as an aging population, a lack of pension funding to support the elderly, and life-threatening levels of pollution. Despite the regime’s autocratic nature, protests directed at its shortcomings are becoming common. The government is not immune to public pressures.
Negotiations between China and the U.S., which are now beginning in earnest after the uneventful retreat at Mar-a-Lago, may actually bear fruit. Chinese leaders cannot afford a significant drop in exports to the U.S., which would be interpreted at home and abroad as evidence that the bellicose American president got the better of them.
Mr. Trump has been dealt a stronger hand than he could have asked for on trade with China, which has more incentive to negotiate than ever. He should walk away with a better deal from Beijing than any of his predecessors were able to extract. Mr. Trump may even be able to make progress on geopolitical issues, such as limiting China’s military adventures in international waters and securing its help on North Korea.
If he plays his cards right.
Mr. Calomiris is a professor of financial institutions at Columbia Business School and a fellow of the Manhattan Institute.