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U.S.-China Tensions: Co-Dependency Pains
By Rachel Ziemba and Adam Wolfe
The fault lines in the U.S.-China relationship have been increasingly exposed in recent weeks, with rhetorical barbs exchanged on trade, the treatment of foreign companies in China, strategic issues such as U.S. support of Taiwan and Tibet’s Dalai Lama, responses to Iran’s nuclear ambitions and especially exchange rates. Domestic pressure in the U.S. congress on the need for action with regard to the pegged renminbi (RMB) is growing. Chinese leaders, including Premier Wen Jiabao, have recently hit back at the U.S. for what they characterize as interference in China’s security and economic affairs and U.S. economic mismangement. In this analysis, we look at some of the perennial issues that have returned to haunt the relationship, as well as some new issues that have burst on to the agenda. Although the chance that China could be labeled a currency manipulator, prompting compensatory trade measures (or other legislative responses), is the highest it has been for some time, RGE believes that the two countries are still likely to come to a grudging compromise, and that China will begin to gradually appreciate its currency, lest inflationary pressures get out of hand. The escalation of tit-for-tat protectionism could put a damper on global growth and add to security uncertainties.
Finding the New Normal
The friction suddenly afflicting the world’s most watched bilateral relationship stems from a struggle on the part of both China and the U.S. to find the “new normal” wrought by the changing dynamics of global economic and political power and influence since the financial crisis. To some extent, the financial crisis exacerbated ongoing structural changes that elevated the role of emerging markets in the global economy and increased their influence in debates on financial regulation, trade and currency policy. China’s ample resources, together with its ability to encourage its banks to lend and its state-owned enterprises (SOEs) to spend, also allowed it to be opportunistic, adding sharply to its resource holdings and supporting cash-strapped countries and companies during the recession. Yet its leverage on U.S. policy seems overstated, particularly as China’s willingness to diversify away from U.S. assets remains constrained by its desire for stable economy policy. Moreover its economic apparatus is stronger than its security position.
In this environment, there is a risk that one or the other player might overplay its hand or badly misinterpret the intentions of the other. The risks are especially fraught for the challenger, China. Given the importance of the relationship to global trade, growth and security, RGE believes that the two countries will avoid a full-blown confrontation, but uncertain relations and tit-for-tat trade policies could constrain global growth.
In part this normalization reflects the fact that the pressure for bilateral and multilateral cooperation, which helped stave off a near depression in 2009, has diminished. Given the role of the U.S. and China in sparking—and ultimately easing—the crisis, it was no surprise that bilateral tensions would be suppressed during this period as both countries looked inward to support growth. Now, both countries need to pay the costs of the policies that revived the global economy and exacerbated weaknesses in the others economic structures. China’s credit stimulus added to vulnerabilities at the local level and added to overcapacities in some sectors, the U.S. fiscal deficit has ballooned to levels that mean partial monetization is likely. China, and to a lesser extent, some of the other emerging market economies, have not yet fully embraced the series of economic and political multilateral policy initiatives that will help mediate the changes and continuities of the global economic order. By the same token, the existing institutions still do not reflect some of these changes. The G20’s rise to prominence does provide a potential venue for such negotiation, but it remains too large and diverse to be efficient, and many different policy goals have been thrust onto its agenda.
Although political tensions appear to have heightened after December’s Copenhagen climate change meeting, in part due to the American perception that China’s behavior prevented a more ambitious agreement on carbon emissions from taking shape, at least some of the recent friction seems designed to play to their respective domestic constituencies. The U.S sells weapons to Taiwan; China threatens sanctions on U.S. defense contractors; President Obama meets with the Dalai Lama, and China cancels bilateral military parleys; meanwhile, both cry foul with respect to the other’s economic policies in their legislative meetings. The need for both sides to rebalance their economies, mostly by correcting their savings rates, will complicate their interactions in the coming years.
The lull in the cycle of diplomatic summits and visits since the Copenhagen meeting has contributed to the falling out. But the diplomatic cycle picks up again in April, with President Hu Jintao expected to attend an April summit on nuclear proliferation in Washington, while U.S. officials prepare for the next round of the U.S.-China Strategic and Economic Dialogue (S&ED) scheduled for this summer in Beijing, as well as upcoming G-20 meetings. Each side will probe for new sources of leverage, and further chiding in public may be inevitable. Yet a full-blown U.S-China rift seems highly unlikely.
Still, the past several months have revealed some dangerous misperceptions. Last year the Obama administration pushed for China’s cooperation on a global climate change deal, but expectations that China would ever sign a binding emissions deal that might slow its economic growth seemed optimistic at best. Recently, China appears to have pressed U.S. diplomats to foreswear future weapons sales to Taiwan in return for cooperation on Iran, a position the administration could not legally take. RGE does not think either side will seriously overplay its hand in 2010, but the risk is that in areas where contact is infrequent and superficial, like military-to-military ties, one side may adopt policies or postures which inadvertently provokes the other. A series of miscues involving U.S. and Chinese warships and aircraft in the past decade should serve as a warning to both sides given their mutual interest in avoiding any outright hostilities. The first year of the Obama administration saw diplomatic exchanges increase across the board, with rather dramatic results on some under-the-radar issues like clean tech. While each side has taken the recent lull in diplomatic exchanges to recalibrate, RGE expects the resumption of these exchanges to struggle under the burden of most of the recent tensions. Meanwhile other U.S. allies, ranging from Australia to the Europeans, seen to be calling on the U.S. to retain its firm position with China, a message that may pervade President Obama’s Asia trip next week.
The tit-for-tat trade tensions seem fated to continue simmering into 2011, given subdued global trade growth, but RGE regards it unlikely the U.S. will to declare its second-largest trading partner a currency manipulator, which would set in motion an economic and political response. China will drag its feet on Iranian sanctions, but ultimately it is not in a position to block any deal on Iran’s nuclear program if Russia is really on board. Yet in the medium-term the coincident political cycle in the U.S., China and Taiwan could prove dangerous, with each country holding presidential elections (or a Communist Party succession in China’s case) in 2012. The incentive to act tough for a domestic audience will increase, especially if the China-Taiwan quasi-free-trade deal proves unpopular on the island.
No Coordination in Economic Rebalancing
As RGE has argued in the past, there is broad agreement about the economic and political rebalancing measures needed, but there is a wide divergence on the timing and specific measures. China flatly rejects the theory that excess savings in Asia reduced U.S. borrowing costs, causing the subprime lending boom and bust. Still, China’s leaders, especially Premier Wen, have worried for years that its economy is “unstable, unbalanced, uncoordinated and unsustainable,” and that it needs to reduce its reliance on investment and net exports for economic growth. The current Five-Year Plan, introduced in 2005, placed heavy emphasis on boosting China’s domestic demand. Chinese officials belatedly began implementing some of these measures in 2006 and 2007 but when the global financial crisis hit, Chinese policymakers quickly pared back the austerity measures of this rebalancing plan and funneled money to anything that might bring growth. Some of these efforts, like building out the interior’s infrastructure and increased spending on health care, will help boost rural consumption and productivity. Other measures, like reduced down payments for second mortgages and cheap loans to already oversupplied heavy industries, look counterproductive. As policymakers prepare the next Five-Year Plan this year, policies that reinforced China’s imbalances should be removed, and credit and monetary conditions will slowly normalize. RGE does not expect a consumption boom, but government incentives and a modest strengthening of the social safety net should help to marginally increase private consumption’s share of GDP in 2010.
From Washington, China’s progress on rebalancing looks far too slow. Pressure is mounting to impose sanctions on Chinese goods, something Congress will likely talk up during this election year, but RGE still thinks the passage of of major legislation is unlikely. Inertia should prove powerful on both sides. Both the U.S. and China have agreed to G-20 level economic check-ups, but details on the framework for sustainable growth remain sparse. After all, there isn’t even consensus among the G-7 about what a healthy financial system looks like, let alone among the broader group.
As we argued in a recent analysis "Who Will Buy the U.S. Treasurys?" the U.S. still relies on China to fund a significant portion of its debt, though its share came down in 2009 as U.S. investors bought more of the debt. If China were to dramatically boost its domestic consumption, its current account would close, and there would be little need to add to its US$1 trillion U.S. Treasurys. As long as the U.S. savings rate continues to slowly drift toward the high single digits, the U.S. will be less reliant on China and other nations to fund its fiscal deficits, but the need for foreign finance will not disappear. While China builds up its domestic demand, it will be loath to give up the safety valve of dumping overproduced goods on the profligate U.S. consumer.
Trade Politics Get Dirty
A sluggish recovery in global trade following the waning of inventory adjustments boosts the competition for market share, spurring protectionist claims. While trade issues are global (Brazil, the EU and other countries have also entered the fray) the world’s largest consumer and the largest exporter will see more than their share of the spotlight in the WTO complaint process, which should diffuse some of the tensions. Still, the U.S. will not file a complaint against China’s censorship laws as advocated by Google—the WTO has made it clear that governments can censor media content. Obama pledged to double U.S. exports in five years, something he will find hard to achieve without pushing forward on the stalled free-trade agreements in Congress. China might prove a useful foil in speeches, but imposing broad sanctions or an import tax could be counterproductive. Still, defined tariff measures, like those on Chinese tires and steel, are likely again this year, with China going tit-for-tat.
In the mid-term election year, Congress is acting tough on Chinese imports. In the past, Beijing’s preferential treatment for foreign companies operating in China strengthened the business lobby’s resolve to fight any such legislation, but the “Buy China” stimulus measures, “indigenous innovation” procurement lists and inconsistent application of some of the very regulations the U.S. and EU pushed China to implement dampened support in 2009. The European and American chambers of commerce have been stepping up their advocacy in Washington and Brussels. Food and product safety measures would be the most likely to come to the floor in the House, but in RGE’s view, anti-trade bills are unlikely to pass in 2010.
Brother, Can You Spare a Renminbi?
The RMB is a particular flashpoint. U.S. officials have been pushing to China to allow its currency to float for a decade. Despite exasperation with this approach, a currency manipulator label still seems unlikely. With Chinese reserve growth having accelerated in H2 2009, U.S. officials are likely to point to China as an obstacle to global rebalancing but they may hold off on the label which would require the government to implement measures to compensate for the trade benefit to China. China will counter with a reminder that its trade balance narrowed sharply in 2009, falling to about 5% of GDP. RGE expects that trade surplus will continue to narrow in 2010, but the rebalancing of global demand seems to have stalled, especially if RGE’s assumption of significantly slower global growth in H2 comes to pass. Import taxes are a possibility, but as noted above, make the broader U.S. goal of export growth unlikely. The introduction of a bill to assess whether China's currency is misaligned, a broader term than currency manipulation, is a sign of the political pressure stemming from Congress. While it is uncertain whether the bill will pass, or even that Treasury Department would label the RMB a misaligned currency if it does pass, the mood from Washington is wary of China. With Premier Wen having already condemned U.S. pressure and the export promotion initiative as trade protection, expect some harsh words and retaliatory measures from China.
The heightened rhetoric about the RMB is a bit of a red herring. Although the fixed RMB is delaying global adjustment, blaming China is a distraction from all the other intractable issues now facing Congress. Even when the RMB was appreciating between 2005 and 2008, China’s trade surplus with the U.S. expanded at an annual rate of 14.4%, according to the Chinese data, slowing only when the U.S. entered recession as China diverted other U.S.-Asia trade . The currency’s role in the trade imbalance is key (note the increase in Chinese trade with Europe in early 2008) but it is not the only problem.
Wen’s promise of a stable RMB does not preclude a slight gradual appreciation. China is likely to let the RMB appreciate modestly later in the year (around 4%) as inflationary pressures pick up. This is unlikely to be enough for either Chinese or U.S. economic imperatives. The U.S. administration is likely to continue lobbying for more significant RMB appreciation behind closed doors and in public, emphasizing how doing so would help alleviate China’s imbalances, but making it official policy would be counterproductive as it might harden the line of Chinese trade officials.
Although the U.S. would like to see 10-20% RMB appreciation (or really, it would like to see a weaker dollar against a host of Asian and EM currencies), increased volatility in the currency markets will not help global trade in 2010. As in the past, RMB appreciation will come from domestic imperatives not international pressure.
China’s Treasury Haul Grows and Grows
China’s stock of U.S. Treasury bonds and bills, which we put at close to US$1 trillion, and Agency bond holdings of over US$400 billion, are quite unpopular within China. Some members of the Chinese military have even suggested jettisoning them. We still see China as reluctant to use its “nuclear” option of selling its Treasurys because foregoing U.S. asset purchases would imply RMB appreciation. Yet in the face of stronger EM growth, a change in asset allocation would require a shift away from the peg.
Some of China’s diversification talk in 2009 was just that—pondering a new reserve currency and heavy investment in commodities actually added to the pegged RMB, meaning China added massively to its reserves in 2009. Currency swaps of the state banks suggest the increase in Chinese dollar holdings was even higher. As long as China runs huge current account surpluses it will have to buy USD-denominated assets, but public and private equities, including U.S.–listed foreign equities, should account for a greater share of this portfolio. A bilateral investment treaty would be a major breakthrough for both sides, but the two countries remain far apart.
The Strait Jacket Tightens
The trilateral relationship of the U.S., China and Taiwan has undergone a dramatic shift since the election in Taipei of Ma Ying-jeou. Ma sees Taiwan’s exclusion from Asia’s “noodle bowl” of free trade agreements as restraint on economic growth. Cross-strait tensions also added to Taiwanese outflows. Closer economic cooperation with China, beyond nurturing a relationship with Asia’s fastest growing and largest economy, is a necessary step to further integrating Taiwanese firms into the Asian supply chain. Still, Ma can only be successful as long the Taiwanese electorate does not perceive this cooperation as threat from the mainland. Continuing purchases of U.S. weapons could help prevent the opposition from picking off voters from the right in 2012. China seems well aware of this dynamic, after its belligerence in 1996 tipped the elections toward nationalists, China has tread more carefully on the question of Taiwan’s arms purchases.
China’s stance toward the U.S., however, has hardened. Beijing not only cut off military-to-military ties, but said it would impose sanctions on those companies involved in the sale. Any sanctions look to be rather narrow. China does not buy any weapons from the U.S., but it does buy commercial aircraft and heavy equipment made by defense contractors. More dangerous, perhaps, is the response of temporarily suspending military visits.
As China’s navy pushes further from its coast, it enters waters controlled by the U.S. Seventh Fleet. China disagrees with the U.S.’s interpretation of sovereign waters, arguing that foreign navies should not be allowed within its 200-mile exclusive economic zone, but the U.S. Navy observes UN rules that allow it within 12 nautical miles of China’s coast. The emergency diplomacy required after the collision of a U.S. spy plane and a Chinese fighter in 2001 showed the danger of not talking. Although the two sides set up an emergency military hotline in 2008, remarkably nobody thought to use it during the minor confrontations in 2009. Nurturing relationships between their officer corps could go a long way should another crisis arise.
Since the election of Ma in 2008, and the apparent weakening of the U.S. due to the financial crisis, some Chinese hawks appear to believe that Taiwan is a pawn that the U.S. would trade for cooperation on other issues. The U.S.’s ties to Taiwan reportedly came under unusual criticism during the recent visits by Deputy Secretary of State James Steinberg and National Security Council’s Jeffrey Bader. This could prove dangerous as China’s political cycle heats up in the next two years. Seven of the nine seats in the Politburo are up for grabs in 2012, and the competitors may try to bolster support by stoking nationalist feeling over the island, which China regards as a renegade province. Elections in Taiwan and the U.S. in the same year will not increase their flexibility on the issue either.
Still, cooler heads are likely to prevail. Taiwan is benefitting greatly from trade with China, which helps it recover from a sharp recession. Chinese leaders are likely to take the long view, and press for a Hong Kong-type solution to the “One China” problem when the balance tilts further in their favor. The U.S.’s primary goal in the Strait is to prevent a conflict that would disrupt the region’s balance, which still tilts heavily in Washington’s favor.
Same Old, Same Old at the Security Council
Despite contributing peacekeepers to some global missions and warships to the international anti-pirate patrol in the Gulf of Aden, China is not inclined to play a leadership role in matters requiring close international cooperation. China objects in principle to U.S.-led punitive sanctions against Iran, which is its largest energy supplier. Similarly, on North Korea, China’s values the trade that benefits its Manchurian rust belt and worries in the longer-term that isolating North Korea could precipitate a collapse that ultimately sends millions of hungry refugees across the border. A political transition in North Korea (or Iran for that matter) could prove a dangerous wild card in 2010-11. China is likely to try to run out the clock on both counts, rather than push for a significant change in policy or veto any UN sanctions. The recent reshuffling of China’s diplomatic cadres was partially driven by internal Party dynamics; it also provided an excuse for China to disengage from the Iranian negotiations. Although not completely settled, the reassignments should be completed soon, bringing China back into the scrum just as the U.S. officials are lining up allies for tighter sanctions. Chinese companies may not be able to hold out.
China may find itself out on a limb sooner rather than later regarding Iran. A host of foreign oil companies have agreed to stop supplying refined gasoline to Iran at Washington’s behest: China may find it difficult to keep its promise to supply Iran with the needed fuel. Chinese banks did participate in tighter sanctions on Iranian banks in 2007, when the country struggled to find access to lines of credit.
Chinese commodity investments and supply contracts with countries like Iraq, Nigeria, Russia and Saudi Arabia contribute another source of U.S. unease as security authorities raise concerns that China is locking up oil supplies and supporting unfriendly regimes. Others, like Australian companies, fear that China is trying to under pay. Yet, the most recent opportunist deals all are based on purchasing oil at market price and most of the production of Chinese oil companies is still sold in international markets, rather than being shipped home. China is increasing its role in the global oil supply chain, but absorbing its new investments and joint partnerships in countries like Iraq will be a challenge for 2010 and beyond. In the longer term, Chinese demand for natural gas will prompt quicker exploitation of the natural gas in the pacific, providing another source of cooperation and competition.
Downgrading Climate Change to Boost Cooperation
Neither country was really willing to compromise on climate change at Copenhagen, leading to a very narrow, disappointing deal. Behind the scenes there is more cooperation going on. Energy has been a focus of many of the cabinet and sub-cabinet level bilateral meetings of 2009 as both China and the U.S. found it useful to boost investment in clean tech as part of their stimulus packages. Renewable fuels will be a key part of meeting China’s growing power needs, recognizing that coal-fired power costs are climbing. In fact, environmental protection spending was among the few areas slated to climb in 2010.
However, the chance of a U.S.-China deal feeding into a global deal may have been a miscalculation by the U.S.. President Obama seems to have thought that he could push China to cooperate and sign onto emissions targets in return for less pressure on other issues. A deal could then be used to deflect criticisms that his administration’s soft approach was not paying dividends. The obstacles to a binding deal were myriad: A Chinese reluctance for binding targets that might chill growth and impose on its interpretation of sovereignty, protracted delays in bringing the U.S. climate change bill to a vote and concerns by a range of other countries including India, Russia, Canada and Australia. There is plenty of room for smaller cooperative efforts, like items proposed during Obama’s China trip, but energy policy is unlikely to be a means to a grand bargain with China.
The global recession has not dramatically shifted the geopolitical balance of power in China’s favor as it remains difficult to absorb its new acquisitions and to translate its soft power into hard power, even were it to desire to do so. Even its economic influence has its limits, given China’s continued reliance on exports. China suggested ending the U.S. dollar’s hegemony as a reserve currency, stepped up its purchases of strategic commodities and provided financing and swaps agreements for its trade partners. Yet the strengthening of U.S. dollar at the height of the crisis, the Fed’s massive swap lines and continued U.S. role in global security apparatus showed that there is still only one (albeit weakened) superpower in the world. The crisis may have accelerated the gradual shift of relative global power to the East, but Beijing and Washington are far from peer competitors in the strategic sphere and the Chinese consumer is not ready to replace its U.S. counterpart.
RGE expects tensions to simmer in the coming years between the U.S. and China, as each tries to find new sources of leverage, but the incentives to cooperate will still dominate. Tit-for-tat trade disputes and disagreements in the Security Council and G-20 will be part of the “new normal,” but both sides will tack back toward cooperation on most issues. The 2012 political cycle adds fuel to the simmering relationship, but in RGE’s view the fire will not spread.