Image: U.S. Treasury Secretary Henry Paulson and Chinese Vice Premier Wu Yi
Reuters
U.S. Treasury Secretary Henry Paulson urged China on Thursday to work towards a freely floating currency, only to be told by Chinese Vice Premier Wu Yi that America fails to understand how Beijing is making headway on economic reform.
By John W. Schoen Senior producer
msnbc.com
updated 12/15/2006 11:27:23 AM ET 2006-12-15T16:27:23

As a high-level U.S. delegation wraps up trade talks in Beijing, there were few major policy changes to announce. But that may not be such a bad thing. As massive American trade deficits with China have become a hot political issue, some of the proposed economic remedies could have some nasty unintended side effects. And they may mask more difficult solutions many American would rather not have to face.

U.S. Treasury Secretary Henry Paulson, a former Goldman Sachs chairman and no stranger to the Chinese, was joined in Beijing this week by Federal Reserve Chairman Ben Bernanke and other senior U.S. officials for what was described as a long-term look at U.S.-China trade relations — at a time when an incoming Democratic Congress is becoming increasingly restive about trade policy.

"The purpose of dialogue is to deal with the most pressing issues," Paulson told CNBC shortly before the trip. "When we talk about reform with the Chinese there is total agreement in terms of what they need to do. We're in agreement about the policies, so the question, the debate, is about timing."

One of the main issues on the agenda was the Chinese government’s policy of “managing” the value of its local currency, the yuan, at below market rates. By keeping a lid on its currency's value, the Chinese government helps domestic manufacturers sell products more cheaply in export markets like the U.S.

But American manufacturers, trade unions and some politicians and commentators have long argued that policy is hurting the American economy, and that relatively cheap Chinese labor has destroyed higher-paying U.S. jobs, reducing the standard of living for many middle-class American workers. 

Though China has been gradually letting its currency rise against the dollar, it has rebuffed American pressure to move more quickly. This week’s trip was essentially a draw. Though the yuan rose to new highs against the dollar Thursday, the move was accompanied by a statement from Chinese Vice Premier Wu Yi scolding her “American friends” for "not only having limited knowledge of, but harboring much misunderstanding about, the reality in China.”

So the issue of China's exchange rate is still a thorny one.

“When the Chinese say the exchange rate is a matter of sovereignty, when they say that the United States doesn't understand our greater China problems, basically what they are saying  is: 'Please, America don't presume to tell us what's in our own best interest,'" said John J. Tkacik, senior fellow in China policy at the Heritage Foundation.

In fact, a rapid move in the exchange rate could have some unpleasant consequences, according to Robert Sinche, head of global foreign exchange strategy at Bank of America.

“There a reason why people can walk into their local Kmart or Wal-Mart and buy things at relatively low prices that say, ‘Made in China’ on them,” he said. “I don’t understand why there are those who think having the exchange rate go up — and having U.S. consumers pay more for products from made in China — is a positive for the U.S. economy.”

Major Market Indices

A sudden change in the exchange rate with China — resulting in a weaker dollar — might help curb Chinese imports. But it would also have some nasty side effects for U.S. businesses and investors.

“It could mean more and more inflation as your dollars don’t go as far in overseas markets,” said Stuart Hoffman, chief economist at PNC Financial Services. “A sharply weaker dollar could also scare away foreign investors who are not anxious to invest in a currency that is declining sharply against their own.”

A sharp shift in currency values could also hurt China's emerging financial system — and the Western companies that rely on its growth to expand their business there.

"China virtually has no banking system. Yes, they have banks, but that doesn't mean they have a banking system," said Enzio von Pfeil, CEO of Commercial Economics Asia. "And they have no rule of law, and so everything that we sort of equate in the West with monetary policy and interest rates, none of it actually works in China. It is too backward yet at this stage."

Despite the debate over the effects of U.S. policy demands, there’s no doubt about China’s success as a global exporter. China’s trade imbalance with the U.S. continues to widen, hitting a record $24.4 billion in October, and is on track to hit $229 billion this year, up from $202 billion in 2005.

One reason those imbalances are growing is simple: The overall volume of foreign trade has grown rapidly as lower trade barriers, along with the rise of global shipping networks tracked by high-speed computer systems, have created a thriving global economy. Fifty years ago, foreign trade made up about 2 percent of world GDP; today it's more like 20 percent, according to United Technologies CEO George David.

“We’re more and more involved in each other's economies,” he said. “That's how China got lifted out of nowhere in the last 25 years.”

China has become involved in the U.S. economy is other ways. As the U.S. trade deficit with China grows, the Chinese government recycles the surplus by buying hundreds of billions of dollars worth of U.S. Treasury securities. China’s critics also warn that its growing hoard of U.S. debt gives Beijing too much influence on U.S. monetary policy. If China stops buying Treasuries, that could force interest rates higher and further weaken the U.S. dollar.

While China’s expanded holdings of U.S. debt is a sign its export success, Chinese officials point to the other side of the ledger: the extremely low U.S. savings rate. In theory, lower prices of Chinese goods should free up money that American consumers can stash away for a rainy day. But it hasn’t turned out that way.

Instead of saving, American consumers just buy more cheap Chinese goods with money that might otherwise be invested in U.S. Treasury bonds, reducing the amount of debt in foreign hands. In effect, American consumers are living off the savings of foreigners.

And despite widespread concern about its trade imbalance with China, with U.S. unemployment below 5 percent and inflation still relatively tame, it’s hard to identify any immediate economic harm caused by China’s currency and trade policies, said Sinche.

One longer-term solution is to encourage Chinese consumers to buy more U.S. products. That could be accomplished through tougher enforcement of U.S. patents and copyrights in China, where billion of dollars of illegal “knock-offs” of U.S. products help to widen the trade gap.

"We've got to protect intellectual property there," said Mickey Kantor, former Treasury secretary and U.S. trade representative in the Clinton administration. "We have to do something about agricultural access, which is limited in China because of their opaque rules. We have to do something about transparency, bribery and corruption and other issues because they have a frankly weak rule of law in China. There are things to be done there. It needs to move more quickly."

But just as American political leaders face pressure to make changes in China trade policies, Chinese leaders risk political consequences at home if they press too quickly for reforms.

"China can't stop exporting overnight or slow exports too much without jeopardizing its employment situation," said James Barth, a senior fellow and economist at the Milken Institute. "So China knows it has to have more balanced growth. It has to shift more towards consumption (and) rely less on exports, but it can't do that overnight. And that's the concern that China has — it's a domestic concern."

But as China continues to press for more time, there’s a real risk that political backlash in Washington could slow the overall growth of global trade, according to Fred Bergsten, director of the Institute for International Economics.

“With the advent of Democratic control in the U.S. Congress, there is a risk that the U.S. will not have any trade negotiating authority after the middle of next year and could not participate actively in world trade talks," he said. "So I think the risk of  protectionism coming into play is a significant risk to the world economy as a whole."

(CNBC and The Associated Press contributed to this report.)

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