Cracking the Currency Puzzle

By Sebastian Mallaby (THE WASHINGTON POST, 11/12/06):

Five years ago today, China joined the World Trade Organization. The experiment has gone astonishingly well: China has changed more than 3,000 regulations to comply with WTO requirements. And yet an awkward question hovers over Treasury Secretary Henry Paulson's China trip this week: How to deal with a country that appears to distort trade not through tariffs or quotas but through currency and savings policies?

This dilemma reflects a lopsidedness in the rules of globalization. To keep the trade playing field balanced, the WTO presides over a vast apparatus of quasi-law governing subsidies and tariffs; violators can be hauled in front of WTO tribunals. But there is no equivalent mechanism, other than a dormant provision buried in the charter of the International Monetary Fund, to punish countries that skew trade by manipulating their currencies. And there is no sanction at all for pursuing a growth strategy that relies on exports more than domestic consumption.

China has made the most of this vacuum. When it joined the WTO in 2001, its current account surplus (trade plus a few other cross-border payments) was a modest 1.3 percent of gross domestic product. As recently as 2004, when Congress was beating up China for its alleged manipulation of trade, it was possible to retort that China's surplus was just over half the size of Germany's. But this year China's surplus is expected to hit a breathtaking 8 percent or 9 percent of GDP. In absolute terms, it has overtaken Germany's surplus and even Japan's, despite the fact that Japan's GDP remains more than twice the size of China's.

How has China done this? Unlike Japan, it has not closed its economy. Instead, China's surplus reflects, first, a currency that's about a fifth undervalued and so encourages exports; and second, a reluctance to stimulate domestic consumption, which forces companies to sell a large slice of their output to foreigners.

The extraordinary growth of the Chinese surplus has created an unlikely echo of the left's complaints about globalization. The left frequently charges that the international system is unfair: It has rules to enforce open trade, but none to enforce decent labor standards. For years, free-traders have dismissed this as an apples-to-oranges comparison: There are international rules for trade because trade is a necessarily cross-border affair, whereas the appropriate level of labor protection varies among countries. But now economists with impeccable free-trade credentials are saying that there ought to be an international mechanism to enforce responsible exchange-rate policies, and never mind the fact that these have traditionally been viewed as the province of national governments.

The urge to pressure China over its currency policy makes more sense than the urge to punish it for its labor policy. China's dynamic economy has lifted well over 100 million people out of poverty, and excessive labor regulations that slowed growth would harm workers rather than helping them. But China's weak currency, allied with its reluctance to stimulate domestic consumption, damages its economy and workers as well as stirring up trouble for foreigners.

China's commitment to a weak currency limits its freedom to raise interest rates, since higher rates tend to suck in foreign capital and drive the exchange rate upward. This inhibits efforts to use the interest-rate tool to dampen the economy when it overheats -- which explains why China has experienced boom-bust cycles. Meanwhile, a growth strategy that relies on foreign rather than Chinese consumers is not great for the Chinese. China is saving rather than consuming, which means its living standards are lower than they could be.

Then there is the effect of China's policies on foreigners. The challenge of integrating a vast pool of cheap labor into the world trading system is compounded when a low exchange rate makes that labor even cheaper. And the challenge of dealing with America's mirror-image problem of low savings is rendered harder, too. If the United States boosts saving and cuts spending, there'll be a nasty recession unless foreigners buy more U.S. exports. China should let its currency rise so as to assist America's necessary adjustment.

Yet it's one thing to agree that China needs to revalue and quite another to conclude that globalization's rules should punish currency "manipulators." Various forms of currency management are common and sometimes even good -- lots of countries have used currency pegs to conquer inflation, and China's own peg was a bulwark against the turmoil of the East Asian crisis. As to China's savings addiction, American policymakers have to be cautious: China's savings excess is no more egregious than America's savings deficit.

So long as there is globalization, its rules will be debated. It will always feel odd that some aspects of the system are subject to quasi-law while others seem anarchic. But there's a perfectly good reason why trade, unlike labor standards or currency policies, is so intensively rules-based. For nearly all countries at nearly all times, cutting trade barriers make sense. But when it comes to labor standards or currency regimes, such generalization is impossible.