A Mute Strategic Economic Dialogue:
Wrong Issues, Wrong Timing, and Wrong Party  

Henry C.K. Liu
This article appeared in AToL of May 22. 2007

General Omar Bradley, a great soldier much admired by enlisted men, aptly characterized the Korean War as the wrong war, in the wrong place and against the wrong enemy.

The Strategic Economic Dialogue (SED) between the United States and China launched jointly by President George W. Bush and President Hu Jintao on September 20, 2006 is showing signs of turning into a dialogue on the wrong issues, wrong timing and with the wrong US Administration.

Reflecting the growing problems and opportunities in the expanding economic relationship between the US and China, the unprecedented dialogue at the highest official levels was intended to provide an overarching framework for ongoing productive bilateral exchanges of views on long-term strategic issues. It was also intended to be a forum for discussing ways the US and China can work together to address economic challenges and opportunities as “responsible stakeholders” in the international economic system.

The SED is now in clear danger of being conducted on the US side by the wrong (out-going Republican) administration after the US mid-term elections delivered the legislative branch of the US government to the Democratic Party. And as the 2008 presidential election approaches, the prospect of another Republican White House appears less than likely. The stated official intent of the SED is to discuss long-term strategic challenges, rather than seeking immediate solutions to the issues of the day. But the SED appears now to be used inappropriately by the anemic Bush administration to defuse imminent vindictive short-term punitive measures against a victimized China from a confrontational Democratic Congress unhappy with Republican trade policies.

The SED is also clearly being conducted with terribly wrong timing with the US presidential campaign heating up and with a Democratic Congress locked in bitter battle with a lame duck Republican administration suffering the lowest popularity rating in history. The high-purpose SED is forced to focus defensively on wrong issues of trivial bilateral operational trade friction, blaming China for instigating conditions that have produced an unsustainable US trade deficits when China has actually only been a powerless respondent to the dysfunctional terms of trade set by US economic policies, aggressively exploited by US transnational corporations and financial institutions for unfair profit.

President Bush’s September 20, 2006 Statement on the creation of the US-China SED demanded rightfully: “We must ensure that citizens of both countries benefit equitably from our growing economic relationship.” Whereas US-China trade has benefited the US economy more than the Chinese economy, much of the benefit has gone to the US corporate and financial sectors, rather than to workers of both trading countries equitably. President Bush asserts that “the essential goal of this dialogue is to ensure that the benefits of our growing economic relationship with China are fairly shared by citizens of both countries.” Yet the mal-distribution of the pains and gains of US-China trade in both countries has been mostly set unilaterally by US tax, economic and trade policies. China’s workers and peasants suffer from income disparity arising from global trade more severely than the US working class. More than 60% of China’s trade surpluses are traded by foreign companies, many of which are US companies.

The SED convenes semi-annually and alternatively in Beijing and Washington. President Bush has designated Secretary of the Treasury Henry M. Paulson to lead the US side of the dialogue. The National Economic Adviser and other members of the President’s Cabinet, including Commerce, US Trade Representative, State, Health and Human Services, the Environmental Protection Agency, and Energy will be participants, as well as the Chairman of Federal Reserve.  This team has only another 19 months, or 3 more meetings including the one on next Tuesday, to deal with a host of complex long-term bilateral strategic issues by reaching agreements with its Chinese counterpart that the next administration may not honor. As derivative risk analysts would say, China is enter into the next rounds of dialogue with unmanageable counterparty risk.

President Hu has designated Vice Premier Wu Yi to lead the Chinese side of the dialogue.  In that role, she has been given full decision-making authority across all aspects of the Chinese economy.  To demonstrate the importance of the SED, the Chinese government has created its largest and the highest ranking inter-ministerial working group which Vice Premier Wu Yi chairs, supported by the Foreign Minister, the Finance Minister and Deputy Secretary General of the State Council, as well as the Ministries of Commerce, Agriculture, Health, and Information Industries, various financial regulators, the National Development and Reform Commission, the People’s Bank of China and others. With US-China trade declining as share of China’s total global trade and with Chinese policy aims towards weaning China’s excessive dependence on export, the importance China has assigned to the SED looks more like the tail wagging the dog with every passing day.

Structural Flaw

One structural flaw in the organization of the SED is the exclusion of the legislative branch of both governments. This is a fatal flaw as the US government since the mid-term elections of 2006 has seen its legislative branch controlled by the loyal opposition which holds very different if not opposite views on US-China economic relations.

The discussion of long-term structural issues in the SED is aimed at providing a stronger foundation for pursuing concrete results through existing bilateral economic dialogues and ensuring citizens of both countries benefit fairly from the growing bilateral economic relationship.  In reality, the SED, if it successfully restructures the currently dysfunctional terms of trade, may actually equalize the benefits in favor of China.

The SED intends to provide support and guidance for existing bilateral economic forums, which will remain essential to managing specialized aspects of the interdependent US-China economic relationship. High level SED discussions are expected to enhance, not diminish these existing functional forums.  Bilateral issues will continue to receive full attention from the US, including pressing China for floating exchange rates, greater protection of intellectual property rights, and increasing access to Chinese markets, all short-term symptoms of structurally flawed terms of trade set by the US, blamed on a demonized China by deep-rooted US bias, notwithstanding the stated intent of the SED “to discuss long-term strategic challenges, rather than seeking immediate solutions to the issues of the day”.

Themes of the discussions in the SED raised by the US have included: “building innovative societies, seizing the opportunities of global economic integration to assure sustained growth, and the economics of energy and conservation.”  The US pledges to support China in what it views as China’s alleged “goal of building a consumer-driven economy rooted in open markets”.

Yet to formulate US economic policy on China with this illusion regarding China’s national goal is the equivalent of relying on a compass with a defective magnetic needle for navigation. China’s national goal is to develop its economy through socialist market economy, not the open markets envisioned by Wall Street.

Paulson the Quiet American

Writing in the Washington Post on December 11, 2006, Secretary Paulson laid out his goal on A Broad Dialogue with China: “My highest priority as Treasury secretary is the long-term strength and competitiveness of the US economy. Managing our economic relationship with China to ensure both nations benefit is vital to our nation’s future prosperity. A market-based economy in China, with sustainable economic growth and full participation in rules-based international trade, is in our best interest -- and in the interest of the Chinese people.”

While Paulson's priorities for the US are correct from the US perspective, his assertion of a market-based economy being in the best interest of the Chinese people is controversial. After almost 3 decades of economic reform, there is now in Chinese policy circles a heated debate on the validity of a run-away market-based economy and its suitability to Chinese culture, historical conditions and national purpose. China remains committed to the belief that socialist construction, albeit requiring modification based on lessons from past errors, is the correct approach to the long-overdue revival of Chinese civilization. Paulson’s market model had been tried by misguided reformers of the late Qing dynasty by appeasing Western imperialism and by the Koumindang (Nationalists) rightists followed the advice of Washington after WWII. Both failed miserably, with China falling into chaos and foreign domination until socialism rose over China. China is not about to go down the same path again.

Paulson went on to say: “China is at a crucial juncture. Decisions it makes in the next few years will have long-lasting effects around the world. The United States and China each have a vision of how our relationship will evolve, and in many respects our visions are similar. We both want strong commercial ties that produce benefits for workers and consumers in America and China. We both want China to grow in a way that is sustainable economically and environmentally and that contributes to global prosperity. We both want China to be a responsible stakeholder in the global economy and in multilateral institutions.”

On the face of it, Paulson’s vision is a viable one. Yet the path to reaching Paulson’s goal does not necessarily mean China must follow the US model of development.  There is no question that within the limits of his personal commitment to capitalism, Paulson’s proposal for China is friendly, peaceful and well-intentioned. His own success in finance capitalism understandably provides him with a world view that finance capitalism is the best path to solving the world’s socio-economic problems. Yet, unless and until he recognizes the limits of the US model being suitable only to US culture and conditions, he runs the risk of becoming the economic version of Graham Greene’s The Quiet American, whose well-intentioned yet naïve idealism caused enormous damages of unintended consequences in global geopolitics during the Vietnam War era.

Shanghai Communiqué Renounces Policy of Transformation

In the 1972 Shanghai Communiqué, the US sides states: “The United States believes that the effort to reduce tensions is served by improving communication between countries that have different ideologies so as to lessen the risks of confrontation through accident, miscalculation or misunderstanding. Countries should treat each other with mutual respect and be willing to compete peacefully, letting performance be the ultimate judge. No country should claim infallibility and each country should be prepared to reexamine its own attitudes for the common good.”

The Chinese side states: “that the people of all countries have the right to choose their social systems according to their own wishes and the right to safeguard the independence, sovereignty and territorial integrity of their own countries and oppose foreign aggression, interference, control and subversion.”

The two sides jointly state: “There are essential differences between China and the United States in their social systems and foreign policies. However, the two sides agreed that countries, regardless of their social systems, should conduct their relations on the principles of respect for the sovereignty and territorial integrity of all states, non-aggression against other states, non-interference in the internal affairs of other states, equality and mutual benefit, and peaceful coexistence. International disputes should be settled on this basis, without resorting to the use or threat of force. The United States and the People’s Republic of China are prepared to apply these principles to their mutual relations.”

US Must Accept
China as a Socialist Nation

The only way the US and China can productively cooperate is for the US to accept China as a socialist nation with Chinese characteristics and for China to accept the US as a capitalist nation. There is no need for the separate socio/economic systems of the two nations to converge. The US transformation policy of regime change by any means, violent or nonviolent, will not lead to full cooperation or peace.

The problem with Paulson’s vision is that two decades of global neo-liberal trade have not produced equitable benefits for workers in either country. And until the SED focuses on equitable distribution of the benefits of trade by restructuring the current dysfunctional terms of trade, both internationally and domestically, all the high-level bilateral dialogues will still not prevent social instability that translates into political instability in either country and conflicts between them.

To appease domestic political pressure from Congress, Paulson is forced to mis-identify, against his better judgment, mere symptoms as fundamental causes of trade imbalance: “We do have our differences. The United States believes China can do more to reduce its trade surplus. We are encouraging China to introduce greater flexibility for its currency, consistent with economic fundamentals. And China needs to do more to protect intellectual property rights.”

Paulson went on to identify “transparency and respect for the rule of law as core principles that affect all economic policy and trade issues. Commitments to these principles are essential to China’s maintaining the confidence of international businesses and of its own investors and entrepreneurs.” Yet China, with its alleged lack of transparency and deficiency in rule of law, is currently inundated by massive foreign capital inflow, which reveals Paulson’s assertion as pure ideological fixation.

He also asserts that “working on these principles across government ministries can enhance our ability to reach agreement on a number of key issues that we negotiate ministry-by-ministry.” The issue of transparency and rule of law are not issues of bureaucracy. They are philosophical/cultural issues that separate societies. From China’s perspective, the US system is not transparent and its respect for rule of law is highly selective. Yet China does not demand the US to change before it will trade with it. The US openly advocates trade as a means for regime change by peaceful evolution. There in lies the fundamental conflict in US-China economic relations.

For tens of centuries, China has traded with the rest of the world without insisting that its trade partners be reformed to be more like China. Must China now make itself a mirror image of the US in order to trade with it?

A Protectionist US Presses China to Open Markets

Paulson went on: “One of the most important topics for discussion is how to help China manage its transition to freer, more open markets, including capital markets. Every strong, vibrant economy in the world has open, competitive capital markets that attract investment and allocate resources to their most productive uses. Such markets will contribute to sustained economic growth and boost job creation in China. And strengthening and reforming financial markets will ultimately allow the Chinese to freely float their currency.”

Free and open markets have elicited powerful protectionist backlash in Paulson own backyard. Such free and open capital markets have produced recurring financial crisis around the world in past decades, and competition for markets by big powers have caused two world wars.

Market Already More Open than US’s

Still, according to the Institute for International Economics, China’s ratio of imports to GDP has soared from 5% in 1978 to 30% in 2005. By that measure, China is now twice as open to trade as the US and three times as open as Japan. China has in fact been the most rapidly growing market for US exports for the last 15 years: During 2000-2005, for example, US exports to China grew by 160% while its exports to the rest of the world rose by only 10%.

Paulson observes: “The Chinese government is committed to creation of a social safety net, including health and retirement programs that will contribute to balanced growth by giving Chinese workers and families the confidence to spend more. China’s high saving rate is a major contributor to the country’s large global trade surplus. Increasing consumption in China will benefit US and other exporters.”

US now an Underdevelopment Nation in Health Care and Retirement

The need for China to reconstruct its socialist, people-based economic policy and programs that had fallen into neglect since 1978 is critical and long overdue. Yet, the path to success in this task cannot be through deregulated market capitalism. The US itself is the clearest example of such structural failures, particularly in the two areas of health care and retirement that Paulson mentioned. The US has now become one of the world’s underdeveloped nations in these two vital socio-economic sectors.

Trade Surplus under Dollar Hegemony Prevents China from Saving

With regard to Chinese savings, Paulson betrays his misunderstanding of the problem. China’s huge foreign exchange surplus is not voluntary. It is the structural result of dollar hegemony in which the Chinese central bank must buy up the dollar inflow from both trade and investment with Chinese yuan. China cannot expand domestic consumption because Chinese wages and benefits are too low. Yet Chinese cannot raise wages faster because real wealth has been leaving the country through export trade while the yuan money supply is expanding through the central bank buying dollar inflows with yuan. The result is a liquidity bubble with too much currency chasing after a dwindling supply of real wealth that has been exported.

Unlike Japan and Germany where their governments have structured their economy to save rather than to consume, the Chinese trade surplus is not benefiting China fully because real domestic saving is not an option for China due to dollar hegemony. Despite a trade surplus, Chinese consumers simply do not have enough income and benefits to consume more.

In 2004, Chinese global surplus was only 8% of US global trade deficit, about the same as The Netherlands. The impact of WTO accession since 2004 has pushed China’s net global trade surplus up to over 20% of US trade deficit. In 2005, US bilateral trade deficit with China was around $200 billion, about 25% of US total global deficit. But such rise was not caused by the yuan being too low, but by China’s inability to channel its trade surplus into higher Chinese wages and benefits because of dollar hegemony.

Consumes Energy Only to Serve US Gluttony

Paulson correctly points out: “Energy is an issue with far-reaching effects. Both the pattern of China’s growth -- with its heavy dependence on industry -- and low domestic prices for energy have led to rapidly increasing energy use by China. Unfortunately, because of technological and infrastructure challenges, much of that energy is produced from sources that generate high levels of pollution. This harms the air and water we all share, and creates health problems for Chinese citizens.”

This is all true. Yet much of the energy waste and pollution is caused by China’s export sector. As pointed out in my earlier articles: when it comes to energy consumption, China is only the kitchen, the dining room is in the US.

Open Financial Markets with Currency Liberalization Dangerous

The US Securities Industry and Financial Markets Association (SIFMA), a lobby organization representation the shared interests of more than 650 securities firms, banks and asset managers, issued on March 7, 2007 a statement in support of Treasury Secretary Paulson’s speech before China’s Shanghai Futures Exchange calling for opening of Chinese financial and equity markets. The statement said: “Removing the roadblocks that prevent innovation, reform and modernization is essential to the success of the global financial marketplace. Such barriers hurt not only the international community being barred from entry, but also stunt the growth and development of the ‘protected’ economy by blockading expertise and innovation at the border. We congratulate Secretary Paulson and the Treasury Department for continuing this dialogue. Because financial reform is in China’s self-interest and is critical for achieving more balanced economic growth, we are optimistic that these talks [SED] will prove fruitful in the short term.  But, we must remain grounded in the understanding that immediate results can not be willed overnight.”

Yet freely convertible currency and open financial and equity markets are a dangerous combination that has destroyed many otherwise healthy economies in the past several decades.

Congressional Confrontation

US Senate Committee on Banking, Housing, and Urban Affairs held a hearing on “The Treasury Department’s Report to Congress on International Economic and Exchange Rate Policy (IEERP) and the US-China Strategic Economic Dialogue (SED)” on January 31, 2007 in which its new Democratic Chairman, Senator Schumer, said to Secretary Paulson: “I am currently chairing my first Joint Economic Committee hearing on the economy and the middle class, issues that I know you care about deeply, but I wanted to make a very brief statement about China’s currency practices. Although the pace of currency appreciation has quickened slightly, nearly all experts still agree that the Chinese yuan remains significantly undervalued; that this undervaluation is the result of deliberate intervention by the Chinese government in world currency markets; and that this policy gives Chinese products a tremendous advantage in the United States market.  Yet the Treasury Department has repeatedly used a technical and legalistic dodge to determine that China does not manipulate its currency.  You and I have talked about that, and you know that I disagree with your position because if it walks like a duck and quacks like a duck, it’s a duck.”

Senator Schumer then quoted Federal Chairman Bernanke that “what the Chinese are doing with their currency amounts to an export subsidy.  I think there is an emerging consensus that this is simply a fact, regardless of what official government reports may say, and regardless of how Administration officials might parse their words to dance around the real issues. … The simple fact is, Mr. Secretary, the Chinese could do more and should do more, and we have not been pushing them hard enough.  We need to push them harder, even if that means ruffling a few feathers.  The American workforce is counting on us. Last Congress, Senator Graham and I ruffled a few feathers with our bill, which we set aside at the very end of the Congressional session because we wanted to work with Senators Baucus and Grassley – the [Republican] Chairman and [Democrat] Ranking Member of the Finance Committee, albeit in reverse order than a few months ago – on a new currency bill that was WTO compliant.  I need for you to impress on your Chinese counterparts that if the pace of progress does not pick up, and more market reforms are not accomplished in the currency arena, then bipartisan legislation will pass the Congress that will put the President in an uncomfortable position. Last year, Senator  Graham and I were clear that we never intended for our bill to become law.  It was a shot across the bow.  But now the possibility for legislation in the 110th Congress is real, because the number of people who will vote for strong legislation exceeds the number of people who would have voted for an explicit tariff.  I hope that you recognize that reality and that you will communicate it forcefully.” It appears that the Congress has issued an ultimatum to replace the dialogue.

The Senator went on: “Finally, Mr. Secretary, since you are the principal economic spokesperson for the Administration, I want to make one point regarding the challenges facing middle-class Americans, since that is the primary focus of my hearing as Chairman of the Joint Economic Committee.  This morning, Bob Rubin, Larry Summers, [former Democratic Treasury Secretaries] and Alan Blinder [former Fed Vice Chairman] are all talking about the economy and the challenges facing the middle class.  And just as he has for the past several years, the President is again making it clear through speeches the last couple of days that his number one economic priority is making his [anti-middle class] tax cuts permanent. Now, I’ve heard you talk about how you recognize that today’s economic growth is not being shared by all income groups, and I commend you for saying it publicly when it appears that so many members of the Administration have given that issue short shrift. … I urge you to get the senior members of this Administration to think more broadly about policies that can help the middle class in both the short run and the long run.”

Thus there is official recognition that the terms of trade in globalization has produce growth in the US that is not being shared by all income groups. This is a problem that also plagues China but it cannot be solved by China, only by US policy.

Dr. Albert Keidel of the Carnegie Endowment for International Peace, former deputy director for the Office of East Asian Nations at the US Department of the Treasury, presented testimony at a hearing on “The Treasury Department’s Report to Congress on International Economic and Exchange Rate Policy (IEERP) and the U.S.-China Strategic Economic Dialogue” for the U.S. Senate Banking, Housing and Urban Affairs Committee on Wednesday, January 31, 2007. Dr. Keidel said in his remarks that the US-China SED can be a very effective means for both sides to address trade issues and the US should use SED wisely.  He argues that the exchange rate of the yuan is not a causality in US-China trade imbalance and that focusing on the exchange rate of China’s currency is a risky distraction for US economic policy. Keidel also commented that China’s currency rate should not be blamed for the large and growing US current account deficit; he emphasized that the US has a large deficit with the global supply chain as a whole.  Dr. Keidel suggests that instead of focusing on China’s currency exchange rate, the US should focus on economic issues at home such as education, pension mobility and heath care in order to strengthen its own global competitiveness. He might add that instead of focusing on export to earn more dollars that cannot be used at home, China should invest more in its human asset through improved education, health care and environmental preservation.

Bush Pushes
China to Appease Congressional Opposition

A series of recent actions by the Bush administration in the area of bilateral trade have apparently caused tremendously negative impacts. The US Commerce Department recently imposed countervailing duties to be applied to economies such as China’s on industries that allegedly receive government subsidies. But Beijing's sharp response to the latest US decision to file WTO complaints on intellectual-property violations in China contrasted with the mild Chinese response about past US complaints on the Chinese auto-parts sector and the imposition of duties on Chinese coated paper, suggesting that bilateral trade disputes are entering a new bitter phase that may adversely affect bilateral political relations.

Forcing Chinese imports to the United States to rise in price through exchange-rate manipulation would only cause US inflation without lowering the trade deficit, as the trade imbalance would remain unchanged while the actual amount of goods exchanged would adjust.

Trade with US Increasingly Less Important for

Further, the share of Chinese exports to the US has been shrinking as a percentage of total Chinese exports, from 37% in 2000 to about 25% in 2006, being replaced by Chinese exports to markets outside the US. Chinese exports to the European Union remain stable at about 20%, and to East Asia they declined from 25% in 2000 to 20% in 2006. Exports to the rest of the world, such as the Middle East, Africa, and Central/Latin America, grew from 16% in 2000 to 30% in 2006 and are expected to grow more in coming years to pay for increases in imports in key commodities. While China's foreign reserves keep growing, most of the growth is now increasingly coming from other countries than directly from the US. The day is fast approaching when US-China trade, while continuing to be important, will cease to be the all-consuming factor in determining Chinese policy and US-China relations.

For the first time since World War II, Japan’s biggest trade partner is no longer the United States. In the fiscal year ended on March 31, 2007, China overtook the US as Japan's largest trading partner, with trading volumes reaching 25.43 trillion yen ($215 billion). Japan's trade with the US in the same period was 25.16 trillion yen. Japan's trade surplus widened to 74% from a year earlier at 1.633 trillion yen. Trade between the two Asian giants is boosted by Japanese firms shifting their manufacturing work to China to lower labor costs and to tap into China's fast-growing market, helped by a weaker yen.

US Strategic Policy yields to Political Expediency

The US administration’s unilateral decision to file two complaints against China with the WTO caused the Chinese government to express "deep regret and strong dissatisfaction" with the move. Zhang Yansheng, head of the International Economic Research Institute at the Economic Planning Ministry, said the tough US protectionist stance on its uncompetitive sectors would make it hard for China to compromise in the future. He said the US should act as “an ordinary member of WTO, rather than the lawmaker.”  Higher-level response came a few days later from Vice Premier Wu Yi who heads China’s SED with US Treasury Secretary Henry Paulson, warning that complaints to the WTO over commercial piracy in China will “badly damage” cooperation with Washington and bruise bilateral trade ties.

In an op-ed opinion article published in The Wall Street Journal on May 17, Vice Premier Wu Yi writes:  "Mutual benefit and win-win progress: These are what China-U.S. business and trade relations are all about, and these intrinsic qualities have made our trade ties strong and vibrant. China’s exports brings incontrovertible economic benefits to the US.” She cites a recent report: China: The Balance Sheet, jointly published by the Center for Strategic and International Studies and the Institute for International Economics, the rapid growth of the Chinese market boosts US exports; China’s exports to the US and its investments in American financial assets help restrain US inflation and interest rates, and thus permit faster economic growth and more job creation.

Madame Wu points out that since joining the World Trade Organization, China has become America’s fourth-largest export market. Over the same period, the growth rate of US exports to China was 3.7 times that of U.S. exports to other countries. Mutually beneficial business and trade relations also mean good returns on investment made by companies of both sides.  Between 1979, when the policy of reform and opening up was adopted in China, and the end of this March, 52,887 American investment projects were undertaken in China, with paid-in investment reaching $54.7 billion. US companies have steadily expanded market share in China through investment, with sales in China exceeding $75 billion in 2004. A survey conducted by the American Chamber of Commerce in China shows that in 2005, sales of US companies in China reached $61.1 billion, and $47.6 billion of US products made in China were exported. She cited Morgan Stanley as saying that four to eight million US jobs are closely associated with trade with China, and China’s low-cost exports have saved US consumers $600 billion dollars over the past decade and nearly $100 billion alone in 2004. Labor-intensive Chinese exports have enabled the US to focus on developing capital and advanced technology-intensive products. US employment data also shows that although the US lost three million manufacturing jobs between 1996 and 2005, the service sector created 15 million new jobs over the same period. Trade deficits are caused by a number of macroeconomic factors associated with economic globalization and “attempts to politicize trade issues should be resisted,” Wu writes.

Adjusts Macro Monetary Measures

Meanwhile, the People's Bank of China announced on May 18 that the one-year deposit and loan interest rates will be raised by 0.27 and 0.18 percentage points respectively, to 3.06% and 6.57% effective May 19.  The central bank will also raise banks' reserve requirement ratio by 0.5 percentage points to 11.5% effective June 5. Many banks already have even larger reserves however, as they have been swamped with deposits from China’s brisk economic growth and large trade surplus, and have had trouble finding ways to lend this money in a developing liquidity trap.

This is the first time in 10 years that the central bank simultaneously raised the benchmark interest rates and the bank reserve ratio.  The move aims to “strengthen liquidity management in the banking system, rationalize the growth of lending and investment and maintain price stability.”  The bank said it would continue to “keep the exchange rate basically stable at an adaptive and equilibrium level based on market supply and demand with reference to a basket of currencies.”

China has raised interest rates five times since 2004 and bank reserve ratio eight times since 2006. China’s central bank announced on May 18 that it would begin allowing the country’s currency to fluctuate more during each day’s foreign exchange trading, but again rebuffed demands from the US and the EU for a sustained rise in the currency.

The central bank also raised interest rates and demanded that commercial banks set aside more of their assets as reserves on lending. Both moves are aimed at reducing the risk of overheating in an economy that is growing at more than 11% annually and at taming speculation in domestic stock markets that have more than tripled since the beginning of last year.

Widening the daily trading band is the latest and most noticeable in a long series of steps by Chinese officials to gently awaken businesses to the risks that fluctuating currencies can pose. China pegged the yuan at 8.28 to the dollar from 1997 to 2005, lulling some businesses into ignoring currency risk.

Chinese officials think that faster appreciation of the yuan could threaten “social stability.” Chinese workers making goods like textiles that compete with exports from even lower-wage countries would be hurt if currency appreciation makes their products uncompetitive and costs them their jobs. Two-thirds of China’s population still lives in rural areas and the agricultural sector is barely competitive with imports at current currency levels, raising the prospect of increased rural unemployment if the yuan rose sharply and the price of food imports falls to threaten domestic producers.

By raising the benchmark regulated rate for one-year bank deposits by 0.27 percentage point, to 3.06%, and increasing the benchmark rate for one-year bank loans by 0.18 percentage point, to 6.57%, the government showed confidence that the banks had put enough of their bad-loan problems behind them to survive on slightly narrower profit margins. Higher deposit rates also make it a little more attractive for Chinese families to put their savings in banks, instead of risking them in China’s feverish stock markets.

But raising domestic lending rates could make it harder for China to allow further appreciation of the yuan. That is because the central bank is itself a borrower. It borrows yuan, by issuing bonds, to pay for its need to buy dollar inflows from currency markets, where it has accumulated $1.2 trillion in foreign exchange reserves, mainly dollars.

The central bank earns a higher interest rate on US Treasury securities than it pays on yuan-denominated bonds at home. The authorities use this profit from the interest rates spread to cover losses on the foreign exchange reserves, which are worth less and less in yuan as the yuan appreciates. This causes a boom in the bond market which rising bond prices unsupported by fundamentals.

The semiofficial China Business News newspaper reported on May 18 that the government had entrusted $3 billion to the Blackstone Group, the private equity firm, to invest abroad. Blackstone declined to comment, being in a “quiet” period before a planned initial offering on the New York Stock Exchange. It is widely expected that China will make larger use of “alternative investment” vehicles, which may add to systemic risk inn the global structured finance markets.

Labor Sees the Light

On May 18, the head of the Teamsters union, James Hoffa, in a dramatic gesture, arrived in Beijing to visit US-owned factories and to meet with Chinese union leaders and top Communist Party officials, as a first stop of a 10-day trip to China with members of several other large US labor unions, including the Service Employees International Union, the United Farm Workers and Change to Win, a coalition of unions that represents about six million US workers. “We felt it was time to get our head out of the sand and engage this enormous country,” Mr. Hoffa said at a news conference. “We’ve been behind the curve,” said Greg Tarpinian, executive director of Change to Win. “Nixon came in ’71. We’re coming in 2007.”  US union leaders say that encouraging union leaders in China may actually raise standards in China and around the world, thereby making US jobs more competitive. “I think a dialogue with them is very constructive,” Mr. Hoffa said. “You can’t ignore a union that claims to have 100 million workers.” The visit comes as China’s only official union is pressing multinational corporations like Wal-Mart and McDonald’s to allow unions in their Chinese factories and stores.

China’s union is helping to draft a new labor law that some US corporations are opposing. That proposed law, which has already been through a variety of drafts, may be passed as early as this summer, and US union leaders say they are angry that US companies are trying to oppose or weaken such a law.

Currency Speculators

Currency speculators are actively trading the yuan with the non-deliverable forward (NDF) market. An NDF is simply a contract to buy the yuan at anywhere from one week to several years into the future. A trader buys a “one-year forward” to bet on the currency will be worth more than the price of the forward at that time.  Chinese Mainland companies do not usually get to play since the NDF markets are offshore, so the market is generally made up of speculators and foreign companies doing business in or with China who feel the need to hedge their currency exposures. NDF prices have been moving from estimating the yuan will be 7.62 against the dollar in a year's time at the end of October, to 7.52 the last week of November. This suggests that speculators are betting again that the Chinese currency will appreciate more rapidly than before, in response to anticipated political pressure coming from overseas. The Democratic Party’s mid-term election win in the US has traders thinking that Washington is going to pick on China.

The average US working family now faces a 17% chance of losing 50% or more of its income vs. only 7% 30 years ago because of US tax and economic policies.  China has become the scapegoat of choice for the painful restructuring that a rich economy profiting handsomely from global trade needs to go through. Hedge funds are raiding the NDF market, looking for high returns after a year of low returns from low market volatility. Every change in market rules issued by the Chinese central bank represents a window of profit opportunity for the hedge funds. Chinese state-owned enterprises with insides information also trade NDF illegally, despite the ban of such activities by the State Administration of Foreign Exchange (SAFE).

Realistically Washington has not much leverage over Chinese currency policy. The lame-duck and unpopular Bush Administration has its hand full with Iraq, Iran and North Korea, investigations over scandals over cabinet members and high White House officials, immigration policy, pending loss of British subservient support, and doesnot really want to add China to its full plate of problems, except to appease a relentlessly anti-China Congress.

And the People's Bank still has a tough fight on its hands to keep all the liquidity from flooding into the economy and causing inflation. The yuan has moved 7% against the dollar so far. Yet no amount of yuan appreciation that China can afford will satisfy China critics in the US, because the yuan issue is only an excuse for deeper anti-China attitudes.

The Democratic majority of the 110th Congress is led by what many from both parties view as confrontational leaders, Representative Nancy Pelosi and Senator Harry Reid. Both have strong records of opposition to perceived unfair trading practices, human rights violations, and other policies and behavior by Asian governments in general and China specifically. Pelosi and Reid are in the Democratic vanguard that is pressing for fundamental changes in US policies and practices amid a partisan atmosphere supercharged by preparations for the US presidential election of 2008.

Regime Change in the

For over a decade these Democratic politicians have been on the receiving end of the hard-edged policies and practices of the White House and the Republican congressional leadership. The Democratic congressional leaders are expected to pursue their agenda using the same kinds of tough, partisan, and openly confrontational tactics that have prevailed on Capitol Hill and in congressional-executive relations introduced by Republicans Newt Gingrich and Tom Delay two decades earlier that gave the Republicans their 1994 landslide in Congress.

After the 2006 elections, and it is “pay-back time” fro the Democrats. The Democratic majority is expected to employ the kinds of tactics used against them since the 1990s and also to take aim at the opposing party’s leader in the White House, seeking to discredit his rule in anticipation of electing a Democratic candidate for president in 2008. The new Democratic majority can be expected to pursue policies to reverse the free trade emphasis of the Bush administration. Free trader Thomas Friedman of the New York Times predicts a “civil war” in US politics over the massive US trade deficit and related economic issues, such as job loss and benefit inequities, with China. Voter anxiety over economic trends adverse to US populist interests was a key factor of Democratic victory in the last mid-term elections. Skepticism about the benefits of free trade is spreading widely on Capitol Hill, beyond the active “industry-based protectionists” in the rust belt.

The Anti-China Gang in Congress

House Speaker Pelosi built her political career on anti-China activism throughout the 1990s to link China’s access to US markets to Chinese human rights practices. The Democratic Chairman of the Subcommittee on Trade in the House Ways and Means Committee, Representative Sander Levin, and some other members of that and other economic policy committees also favor a tougher US stance on trade issues, especially with China, and on trade issues with Japan that affect key US industries, notably autos. Representative John Dingell, Chairman of the House Energy and Commerce Committee, is a strong defender of the US auto industry, which is fending off growing challenges from Japanese automakers in the US market. Thomas Lantos, Democratic Chairman of the House Committee on Foreign Affairs, has a long record of vocal opposition to alleged human rights violations, notably those by China. This stance meshes a tight fit with the views of House Speaker Pelosi.

The strong imperatives for change coming from the Democratic-controlled 110th Congress can force changes in US economic policies and practices in Asia, particularly China. A serious recession in the US almost certainly would strengthen congressional efforts to protect US jobs from alleged unfair competition from China, Japan, India, and other Asian economic powers.

hostility toward China

US hostility toward China is rooted in its anti-communist phobia.  Until this phobia is cure, there will be no peace between the two nations. On the other side, China needs to stop treating its socialist root apologetically like some skeleton in the closet. Chinese socialism has made its share of policy error through its protracted revolutionary history against domestic feudalism and Western imperialism, but such errors are inevitable milestones for constructive correction, not excuses to abandon socialist principles of cooperative equity. Market capitalism has also had made drastic errors that has impoverished billions of people around the world and stunted their growth for centuries for the benefit of a select few. Yet proponents of capitalism manage to accentuate the positives to adjust its flaws and shortcomings to perpetuate an economic system based on individual greed and exploitation of others.

All Eyes on China’s Iron Lady

Madame Wu has been described in the Western Press as China’s “Iron Lady”. It remains to be seen if the Iron Lady would live up to her reputation by displaying a good trader’s nerve of steel to resist US bullying. She is entering the SED with a very strong hand. The rules of the game have been set by the US so the US cannot complain about unfair rules. China has played the game under US rules well, thus it would be unsportsmanlike for the US to complain. US threats of punitive measures are mere empty threats from disingenuous politicians suffering from delusions of grandeur because irrational punitive measures against China would hurt the US economy more than they do China’s.

Strategically, China is in dire needs to shift its excessive reliance on exports toward domestic development but has been less than successful in its policy shift because of special-interest resistance from the influential export sector in Chinese domestic politics. If the Chinese export sector is cut down to size by US irrational belligerence, the strategic benefit to China would actually be substantial in the long run.

The Iron Lady should to tell the US that the age of the US lording over the rest of the world by treating trade with it as a special favor granted to poor nations is long gone. The exporting economies of the world are the ones granting the favor of trade to the US, the biggest debtor nation in the world. The main theme of the US-China Strategic Economic Dialogue should be that debtors are in no position to be belligerent.  The US, the world most advanced financial power, should understand this first law of finance.

May 21, 2007