Nationalistic Barriers

This article appeared in the South China Morning Post on December 13, 2007.

As US TreasurySecretary HenryPaulson attends thethird annual strategiceconomic dialoguein Beijing, theleading contenderfor the Democraticnomination forpresident, SenatorHillary Rodham Clinton, has argued thatthe United States is experiencing "a slowerosion" of its "economic sovereignty".Like her colleague Senator CharlesSchumer, she is particularly concernedabout China's rising economic might andits implications for US economic andnational security.

In the just-released report to Congressof the US-China Economic and SecurityReview Commission, a keyrecommendation is that Congress "enactlegislation to define currency manipulationas an illegal export subsidy and allow thesubsidy to be taken into account whendetermining penalty tariffs". If Congressenacted this recommendation next year,China would be the main target.

China's soaring current accountsurplus, which will reach US$400 billionthis year, and its treasure chest of nearlyUS$1.5 trillion in foreign exchange reserves,are taken as incontrovertible evidence thatthe yuan is substantially undervalued. Boththe European Union and America wantfaster appreciation of the yuan against theUS dollar. Treating "currencymanipulation" as an actionable subsidywhen deciding on anti-dumping andcountervailing duty cases, however, wouldrun counter to World Trade Organisationpractices.

Even if the less-onerous term "currencymisalignment" is used in the legislation,there are serious problems in calculating"fundamental" misalignment – becausenobody knows what the equilibrium yuan-US dollar exchange rate is.

What we do know is that China'scurrent account surplus exceeds 12 percent of gross domestic product, and is notsustainable. Either inflation or anappreciation of the nominal exchange ratewould eventually help bring about amore normal balance-of-paymentsposition. Beijing also needs to endfinancial repression and the forcedsavings it generates. It is not in China'slong-term interests to divert domesticsavings to accumulate low-yielding USdebt.

Of course, China is doing the US afavour by selling goods at artificiallylow prices and by keeping USinterest rates lower thanotherwise byaccumulatingbillions of dollars ofUS government debt.The falling US dollar,however, makes itcostly for China tocontinue to subsidiseAmerican goods andto hold so much USpublic debt. Beijinghas created asovereign wealth fundto begin diversifyingand to earn a higherreturn on its foreignexchange holdings.

It is unlikely thatBeijing will abandonthe dollar as its keyreserve currency. To doso would imposesevere capital losses onChina's US dollarholdings. Yet, there isno question that Chinamust slow the futureinflow of dollars andallow greater capitalfreedom. In remarks at the Cato Institute's25th annual monetary conference onNovember 14, in Washington, Yi Gang, assistant governor of the People'sBank of China, emphasised thatdiversification "should be proportional toreal economic transactions". He noted thatthe US dollar would remain "the maincurrency in our reserves, and that policy isvery firm".

Of course, if the dollar continues to falland the US economy slows next year,Beijing would be foolish to place all its betson the currency, and would diversify morerapidly. That expectation alone would havea negative impact on US asset markets andon the almighty US dollar.

It is easy for Senator Clinton andCongress to blame China for eroding USeconomic sovereignty. But the real threatto US prosperity is not China; it's theprofligate spending habits of Congress. Thedanger is not that China and otherforeigners are holding massive amounts ofUS public debt; it is that Congress iseroding the wealth of future Americans byoverspending and expanding debt limits.

Likewise, fear of the impact of sovereignwealth funds on US economic and nationalsecurity is largely misplaced. It would be farbetter for future US prosperity if Chinawere to diversify out of US public debt andinto private assets.

When China buys US government debt,it allows the federal government to growmore rapidly. And the debt is used mostlyfor consumption or redistribution, ratherthan for investments that yield net futurebenefits.

Yes, China should allow the yuan toappreciate in order to avoid inflation and toavoid destructive protectionism, andshould further open its capital markets. Butit is unfair to expect China to change itsinstitutions overnight, and misleading toblame the erosion of US economicsovereignty on China.

The concept of "economic sovereignty"smacks of economic nationalism. In a freesociety, the only sovereignty that makessense and is legitimate is the sovereignty ofeach individual to pursue his or hereconomic and personal choices – providedthe equal rights of others are not violated.When Congress fails to focus on thisprinciple of freedom and limitedgovernment, the world loses sight of whyAmerica is a great nation.