By special guest economist Andy Xie

Another round of the “strategic economic dialogue” between China and the United States has been held. It seems half of China’s ministers went to Washington for it. The dialogue, while useful for deepening mutual understanding, is unlikely to solve the central issue -- the bilateral trade imbalance. Globalization is its main cause. Indeed, the bilateral imbalance could be viewed as a triumph of globalization and a good thing. Rather, the overall trade deficit of the United States and the trade surplus of China are worrisome. They are due to structural differences in demographics, wealth levels and social welfare. To ease the tension, China should welcome American companies to dual-list in Shanghai. The imbalance could gradually be alleviated by structural reforms, a general decrease in health care expenditures in the United States, and capitalizing the social safety net in China. Ultimately, time will heal everything. Aging will eventually turn China into a deficit country.

China and the United States are highly complementary to each other. The United States is the first, major economy to enter the post-industrial era. Its wealth creation depends on innovation rather than capital accumulation. Its companies fan out globally to optimize production and distribution around the world. Some estimates put foreign sales by companies on the S&P 500 Index at nearly half the total. In contrast, China is creating wealth through capital accumulation and employment expansion. As global companies relocate manufacturing to China to take advantage of its cheap labor and infrastructure, China has gained employment and income.  China’s development strategy is mainly to integrate into the global economy through competitive labor and capital costs. It offers fantastic opportunities on both the supply and demand sides for global companies, mainly American.

Strong complementarities between the two, giant economies have triggered massive trade growth between them. According to U.S. customs data, bilateral trade has tripled in the past five years and increased by 12 times in the past 15 years. More impressive is that the trade growth has taken place under an on-and-off political relationship. This is entirely due to the powerful, mutual interests in this economic relationship. Both countries are quite money-driven.  If there is money to be made, the good trade relationship is likely to continue.

The debate about China’s trade in the United States has become much more negative in the past three years. Several talking points have become entrenched. First, many blame China’s currency value for the mushrooming trade deficit in the United States. Second, the piracy of U.S. intellectual property rights (IPR), such as DVDs and CDs, is robbing billions of dollars from U.S. companies. Third, the Chinese market is not open to the United States and, hence, the economic relationship is asymmetric, and the United States gains much less than China from the relationship.

These arguments have little merit. Their popularity reflects the psychological anxiety about China in the United States today. Without these arguments, other arguments would surface to threaten the economic relationship. I believe that, because the benefit to both is so large, the Sino-U.S. economic relationship will continue to blossom despite the negative noise. There will be some hiccups (such as the tariff on glossy paper from China). But the overall economic relationship will remain intact and subject to market forces.

Bilateral trade balance is not meaningful in the world today. Because of globalization, manufacturing optimization leads to decoupling between production and demand. Demand location is just one factor among many that global companies consider in choosing production location. China has become the world’s workshop in the last 10 years due to abundant labor and cheap infrastructure. On the other hand, the United States is the largest consumer market in the world due to its strong asset markets. The combination means a huge bilateral trade imbalance. The imbalance disappears if the United States brings down its asset prices through a high interest rate policy and China appreciates its currency massively to forfeit its position as the workshop of the world.

The Fed -- the U.S. central bank -- is very reluctant to raise interest rates. Indeed, the market expects it to cut interest rates. U.S. domestic policy is clearly not to discourage consumption demand. But U.S. asset prices could come down despite the country’s pro-consumption policy. The U.S. property market is coming down due to high inventory. Speculative demand had played a major role in the U.S. property market since 2001 and pushed up prices to unsustainable levels. As speculators get into liquidity problems, they are dumping holdings in the market. The potential supply from liquidating speculative holdings could be two years of demand. A strong labor market and buoyant stock market are cushioning the property market.  Otherwise, it would have crashed already. However, the United States may have an inflation problem. If the Fed is forced to raise interest rates again, the property market could crash and the U.S. economy would experience a recession in 2008.

Only a recession could bring the U.S. trade deficit down sharply. Many policy wonks in the United States think that higher exports rather than lower imports would solve the U.S. trade deficit problem. This is just not realistic. U.S. exports are only half of imports. If U.S. imports grow at the speed of its nominal GDP growth rate of 6 percent, and its exports grow twice as fast, its trade deficit would remain constant over four years and would halve after 10 years. The U.S. economy is one-quarter of the global economy. It is unrealistic to believe that U.S. exports could grow twice as fast as imports for 10 years. A major reduction in the U.S. trade deficit would have to involve a reduction in imports, which only a U.S. recession would bring.

China could not give up its position as the workshop of the world. The labor market is still marked by vast underemployment. While experienced white collar workers are getting good wage increases, most blue collar workers and fresh graduates still experience low and stagnant wages. China’s employment expansion is still insufficient to cover labor force growth. A large proportion of middle-aged workers have been forced into early retirement to make way for younger workers. Domestic demand is too dependent on government-led, fixed asset investment and is not strong enough to sustain rapid employment growth on its own. China’s economic development still depends on the export-oriented manufacturing sector. This is why China will not appreciate its currency quickly. One possibility for a big revaluation is when heavy industry replaces light industry as the main drive for export growth. This will be possible in 10 years, but not now.

Even if China were to massively revalue the currency, it may shrink the bilateral trade imbalance but not the overall U.S. trade deficit. U.S. industries rarely compete against China’s. Some areas of competition exist, such as steel, paper and chemicals. But, they are too small to affect the overall bilateral balance. Hence, if China’s currency were to greatly appreciate, production would shift to other countries such as Vietnam and Mexico rather than the United States. Yuan appreciation may have little benefit for the U.S. manufacturing sector.

There is a big downside for the United States linked to a maximum revaluation of the yuan: It would cause the U.S. inflation rate to surge. Some argue that U.S. imports from China are less than 3 percent of its GDP and would not have a big impact on U.S. inflation. This is an incorrect view. China is a world price-setter. A huge surge in China’s export prices would lead to re-pricing manufacturing goods around the world. A 10 percent yuan appreciation may push the U.S. inflation rate up by one percentage point. A maxi-yuan appreciation is likely to force the Fed to raise interest rates, which would cause U.S. asset prices to decline and a recession to follow. It is not in the U.S. interest to pressure China to appreciate the yuan. But, because the media has sold the story to the U.S. public, the politicians have to push for it.

The Chinese market is already quite open to American businesses. From fast food to personal hygiene products and automobiles, American companies already command dominant positions in China. Even in banking, American financial institutions have made headway. Citigroup just bought control of Guangdong Development Bank. Bank of America is a strategic investor in China Construction Bank. However, the entry barriers remain high in industries that state-owned enterprises dominate. Telecommunications, media, energy and financial services remain quite closed to foreign capital in general. This is not a bilateral issue. China first has to work out how extensive state capital should be in controlling the economy.

Pirated DVDs and CDs are not as significant as many experts believe. Chinese income levels would not support massive demand for such products at American prices. American companies cannot cut the prices to match Chinese income due to the concern that the products would be shipped back to the United States. Hence, rooting out piracy may not mean more demand for legitimate products. Of course, I am not condoning piracy. To alleviate the tension, China could open the local content market to American companies. They can then price locally produced content at local prices.

The overall imbalances are indeed worrisome. The U.S. trade deficit reached ＄818 billion last year, twice as high as five years ago and five times more than 10 years ago. The U.S. has accumulated nearly 50 percent of its current GDP in trade deficit over the past 20 years and is adding another 6 percent to 7 percent every year. Of course, the United States needs to import capital to fund its deficit. Such a rapid increase in foreign liability makes the U.S. economy vulnerable to financial market sentiment. If foreigners don’t want to lend to the United States for some reason one day, it would cause an economic catastrophe for the United States and everyone else.

China’s trade surplus surged in the past two years and is still rising rapidly. It has something to do with government control of fixed asset investment (FAI), which has been kept below the banks’ ability to finance. As exports continue to rise rapidly and imports are kept in line with FAI trends, the trade surplus has mushroomed. This factor will vanish when exports cool due to a U.S. economic downturn. But, in the long run, China’s trade surplus or current account surplus is on the rise. Similar to what happened to Japan and Taiwan in the 1980s, China is experiencing a productivity boom due to heavy industry development and urbanization, but spending is rising more slowly than income due to demographics that favor wealth accumulation over current expenditure. China’s surplus could peak above ＄1,000 per capita, as surpluses in Japan and Taiwan did. That would mean a surplus of more than ＄1 trillion per annum. Such a vast surplus would certainly cause international tension. More seriously for China, it would cause massive financial bubbles. China is in the middle of one such bubble now. When this one bursts, there will be more. Such bubbles could ruin China’s financial system and destabilize society.

Bursts of financial bubbles triggered political changes in East Asian countries. From Korea to Indonesia, ruling parties all fell when a big bubble burst. Indeed, the same happened in America and Europe in early 20th century. The 1929 stock market crash brought the Democratic Party to power for two decades in the United States. The crash toppled governments in Europe and brought radical parties to power. China is very worried about stability but may insufficiently appreciate that stability is a dynamic concept. A bubble increases stability in the short term but decreases it over the longer term. Tens of millions of families may lose everything when a bubble bursts. When they learn that a small group of insiders has made money from them, social upheaval could be triggered.

The best solution to ease the tension between the two countries is for China to accept American companies to dual-list in Shanghai. It can solve several problems at the same time. The United States has a financing problem for its deficit. The dollar is wobbly as a result. China is worried about surging foreign exchange reserves and is encouraging capital outflow. No solution is better than allowing high quality American companies to list in Shanghai. Chinese people can buy stocks in Shanghai to decrease foreign exchange reserves. It also could have the effect of cooling China’s stock market bubble. The U.S. stock market trades at 15 times earnings, one-third of Shanghai’s valuation. Many American companies (such as Yum!, P&G, Colgate and Boeing) already earn a big share of their profits in China. If Chinese investors can buy their stocks, they benefit from their business successes in China.

 In the long run, such a solution would help Shanghai become a premium international financial center. China’s current account surplus is likely to increase, rather than decrease, in the foreseeable future. The overall surplus may peak above ＄1 trillion per annum. Such vast surplus capital is the foundation for Shanghai to become an international financial center. Tokyo had this opportunity 20 years ago. Because Japan didn’t internalize its stock market, it missed the opportunity. Instead, surplus capital financed a vast bubble. It only weakened Japan’s financial system. As aging saps Japan’s capital surplus today, Tokyo is unlikely to grow as an international financial center. If China does not internalize its stock market as soon as possible, not only would Shanghai miss the opportunity to become an international financial center, but the surplus capital may lead to the same destructive bubble as in Japan.

The United States needs to stop the Iraq War and tackle its health care costs to bring down its trade deficit. The war has already cost half a trillion dollars and may cost another half a trillion before it is over. The United States is running such large external deficits that it cannot afford such wars anymore. It spends 15 percent of GDP on health care, twice the average for OECD countries.  Ballooning health care costs could explain most of the U.S. trade deficit. The Democratic Party took control of the Congress last year and may take the White House in 2008. At the top of its agenda are the Iraq War and health care. It appears that radical reforms to the U.S. health care system are coming. It seems that solutions to U.S. problems are on the way.

Trade friction is rarely resolved through government-to-government negotiations. The problem is often due to deep, structural factors that only time can heal. Government-to-government negotiations, however, are necessary to demonstrate that politicians are doing something. Such dialogues are mainly for show. The current strategic economic dialogue between China and the United States falls into this category.