Protectionism and the “China Problem”

Monday, October 30, 2006

The trend toward world protectionism is a great concern. In the United States, this tendency shows up in the increased popularity of proposals to restrict international trade in goods and assets. The United States has not been the world’s greatest offender against free trade, but we are also not taking the pro–free trade leadership position that might be expected.

In contrast to the Clinton administration’s successful push for NAFTA, the Bush administration has been a mixed bag on trade (and the Demo-cratic congressional opposition has been far worse). Sometimes the U.S. government advances free-trade agreements, such as in Central America. Other times it embraces anti-trade practices, such as steel tariffs, agricultural subsidies, duties and quotas on Canadian timber, and restrictions on imports of Chinese goods, especially textiles. Even more worrisome are prohibitions of foreign ownership, notably the rejections of the offer by the China National Offshore Oil Company to buy Unocal and the nixing of the sale of U.S. port operations by the United Kingdom’s P&O Company to the United Arab Emirates’ Dubai Ports World. These actions are more serious and less amusing than the French government’s opposition in July 2005 to PepsiCo’s rumored takeover bid for Danone—apparently regarded as a French national treasure. Particularly because the U.S. net international investment position is now so negative, we have to allow foreigners to own something in the United States. (It is pleasant but unrealistic to imagine that foreigners will perpetually accumulate vast amounts of low-yielding U.S. Treasury paper.)

Much Ado about Exchange Rates

The odd thing is that “buy and own American” is a politically popular theme, even though U.S. consumers benefit so much from cheap, high-quality Chinese products. How is it that the United States is harmed by the inflow of low-priced goods? What if they were free? Of course, it is not surprising that U.S. producers who compete with Chinese companies favor restrictions on imports of Chinese goods. The puzzle is that those benefits to a small minority attract enough political influence to generate import restrictions that harm the vast majority of Americans. Even more surprisingly, these specious arguments for protection have gained traction during a time when the U.S. labor market has been strong, including a reduction of the unemployment rate to 4.6 percent.

The United States has not been the world’s greatest offender against free trade, but we are also not taking a pro–free trade leadership position.

Much of the protectionist sentiment against China shows up as claims that the renminbi is undervalued. This argument may well be correct from the Chinese perspective, in the sense that China’s real income would be higher if it received more foreign goods in exchange for its exports. In recognition of this self-interest—and not in response to foolish U.S. arguments about currency manipulation—China did move in summer 2005 toward freeing up its currency. Since then the renminbi has appreciated modestly from 8.28 to 7.91 per dollar (or by 5 percent).

As in many areas, the Chinese favor a gradualist policy on the exchange rate. Although now committed to a flexible rate that is sensitive to market forces, the Chinese want to manage a slow appreciation along with gradual moves toward open capital markets and a convertible currency. This gradualism makes sense in light of concerns that rapid appreciation would have adverse consequences for the Chinese financial system, notably for bank balance sheets. Moreover, gradualism has served the Chinese well in many respects, including expansions of free markets, enhancements in the rule of law, and increases in civil liberties and democracy. Clearly, this process has gone further in markets than in elections, which are thus far limited to a few local contests. Improvements in civil liberties, however, have been substantial, and China gets too little credit for that.

The odd thing is that “buy and own American” is a politically popular theme, even though U.S. consumers benefit so much from cheap, high-quality Chinese products.

I have made a calculation about the likely long-run appreciation of the renminbi. The argument centers on the real exchange rate, which is the ordinary exchange rate—currently roughly 8 RMB to the dollar—divided by the ratio of Chinese to U.S. prices. Today, this real exchange rate is around four. That is, because of the low cost of services and other nontraded goods, one can use dollars to buy roughly four times as much in China as in the United States. If the Chinese economy continues to grow rapidly, substantial convergence toward the U.S. real per capita GDP will occur in 30–40 years. In that case, China will become more similar to currently rich countries in the costs of nontraded services and goods. In other words, the real exchange rate will have to get close to 1.0.

There are two choices about how the long-term real currency appreciation can come about. First, if the ratio of Chinese to U.S. price levels does not change, the ordinary exchange rate would appreciate by a factor of four. Second, if the ordinary exchange rate is fixed (as it was from the mid-1990s until summer 2005), the ratio of Chinese to U.S. price levels would rise by a factor of four. This means that the Chinese inflation rate would exceed the U.S. rate by about 4 percent a year over the next 30–40 years. My sense is that the Chinese favor a disciplined monetary policy and would not tolerate such high inflation. Most likely, their average inflation rate will be low, similar to the U.S. rate. In that case, the only possibility is for the ordinary exchange rate to appreciate from the current 8 RMB to the dollar to around 2 RMB per dollar in 30–40 years. Although this dramatic long-term appreciation is a reasonable forecast, I cannot predict the timing. In particular, I cannot accurately gauge the additional currency appreciation in the rest of 2006 and 2007 (and I doubt that other economists can do better).

The Most Capitalistic Country on Earth

Looking forward, China and the United States will likely be the two most important economies in the world. In both cases—and in contrast to much of Western Europe—this economic prowess derives from commitments to market-based economics. In some ways, the Chinese now seem more committed than the United States to a market economy. When I made a trip to China in May 2005, my colleague expressed surprise that I would visit a communist country. I replied that China was now the most capitalistic country on earth. And this view was confirmed in August 2005 when I saw in Chengdu, on the campus of the South Western University of Finance and Economics, a magnificent statue of Adam Smith, the great classical economist. As far as I know, no U.S. university has such a statue—at Harvard, there would probably be a mass protest.

The United States should embrace China’s transition to a market economy and take pride in the U.S. influence—mostly by example—over the great movement since 1979 away from communist economic organization. We should stop complaining about Chinese gradualism, whether on exchange rates or democratic liberalization. We should avoid the protectionist policies that now seem so threatening. And we should enjoy the flow of low-priced Chinese imports—this great deal won’t last forever.