America’s China Policy Is Not Working
The Dangers of a Broad Decoupling
When China hosted economic policymakers from the G-20 countries in Shanghai earlier this year, Chinese leaders hoped to present their vision for a new international economic order in which Beijing would take a place commensurate with its wealth. Instead, they found themselves reassuring the G-20’s jittery central bankers that China’s turbulent economy was not headed for a hard landing and that Beijing would not further devalue the yuan.
The episode was another reminder of the extent to which Chinese economic policymakers must now take global expectations into account. To do otherwise could weaken Beijing’s case for global economic leadership and hamstring its ability to wield influence abroad using its economic power. China’s 13th five-year plan, approved by the National People’s Congress earlier this month, demonstrated the country’s reluctance to acknowledge this reality and its preference, instead, for short-term measures aimed at improving its domestic economy.
BEIJING IN A BIND
China faces the so-called trilemma of international economics, which holds that a country cannot maintain more than two of the following three positions at the same time: a fixed exchange rate, an independent monetary policy, and free capital flows. Beijing has chosen to keep its exchange rate stable by drawing from its $3.2 trillion in foreign reserves, and Chinese leaders are clearly committed to an active monetary policy. On March 5, Chinese Premier Li Keqiang announced that monetary stimulus will be a key expansionary tool in Beijing’s efforts to reach a GDP growth target of between 6.5 and 7.5 percent in 2016. In addition, money growth will increase from 12 percent in 2015 to 13 percent in 2016, as Beijing injects an additional 17.9 trillion yuan (or around $2.75 trillion) in new financing relative to 2015’s 15.3 trillion yuan (or around $2.35 trillion). Over the course of this year, the government may also announce further changes to interest rates and bank reserve requirements to keep credit readily available. (China’s fiscal deficit, in contrast, will grow by a meager three percent, or $72 billion.)
Increasing the supply of money lowers interest rates, which reduces investor returns and encourages businesses to invest overseas—and all that behavior risks the further depreciation of the yuan. Having decided that protecting the currency is of paramount importance, Beijing has thus begun to place tighter controls on capital outflows. The government has also decreased the offshore supply of the yuan and strategically tightened the money supply when influential foreign hedge funds make large public bets against the currency. Clever investors have already found ways around the current restrictions, but it’s likely that the Chinese government will do what it can to prevent further capital flight, as Yu Yongding, a former member of the People’s Bank of China’s monetary policy committee, has predicted. Such controls are in keeping with China’s recent history, but they represent a blow to the expectations of foreign economic policymakers, who want China to liberalize cross-border capital flows, open its capital account, and further reform its domestic financial institutions.
STUCK AT HOME
What is more, the measures could put a dent in China’s aspirations to pursue economic statecraft through aggressive foreign investment. Consider China’s massive One Belt, One Road project, which aims to further the economic development of some 65 countries across Eurasia and East Africa through land and maritime infrastructure projects and expansive regional trade agreements. The initiative is China’s first serious foray into exporting its authoritarian capitalist model of development, and although much of the investment thus far has been state led, in the future, China’s private sector will need to finance a significant portion of its projects. Even if China were to exempt such investments from increased capital controls, the country’s private investors have bristled since the beginning at China’s lack of an overall business plan for One Belt, One Road and relatively poor understanding of the specific risks of each project. Slow economic growth will only add to their hesitation. More broadly, Chinese officials’ focus on guiding the yuan through the ongoing economic turbulence will preclude the liberalizing reforms needed to increase that currency’s liquidity and, in turn, allow for greater funding for the projects.
Most important, China’s ongoing economic problems, combined with the measures that Beijing has felt compelled to take to address them, have made One Belt, One Road’s task of absorbing China’s excess industrial capacity even more difficult. China will continue to support its capital-intensive investment growth model in the near term to ensure that manufacturing-heavy state-owned enterprises do not fail and give way to social unrest as millions of workers find themselves without jobs. To deal with overcapacity immediately, Beijing has chosen to aggressively consolidate manufacturing companies instead of waiting for its investments in One Belt, One Road to come to fruition. In the medium to long term, China is turning to innovation in manufacturing equipment and processes to move the sector up the value chain. Although the 13th five-year plan reiterated China’s commitment to One Belt, One Road and celebrated its investments in Central and South Asia, Chinese policymakers have not publicly made clear how these domestic moves relate to the One Belt strategy. In all likelihood, Beijing is in no hurry to explain further for fear that it will reveal that its domestic economic circumstances take precedence over its foreign investments, validating charges from countries along the One Belt, One Road route that the initiative is a nationalist project largely in China’s own interest.
Beijing need not be resigned to a temporary halt to its international economic strategy.
China’s commitments to the Asian Infrastructure Investment Bank won’t be hit nearly as hard by the economic downturn as One Belt, One Road. With $100 billion in equity and 57 founding members, the AIIB is the keystone of China’s bid to challenge the Bretton Woods system, particularly the World Bank and its Asian subsidiary, the Asian Development Bank; it began operations in January and expects to grant its first loans by the middle of the year.
At the time of its inception, observers expected the AIIB to further internationalize the use of the yuan and serve as a profitable investment channel for China’s foreign exchange reserves. But the AIIB will in fact have little direct impact on the use of the yuan: Beijing has announced that all of the bank’s lending will be denominated in dollars, even though capital may also be raised in yuan and euros. What is more, although China is jealously guarding its foreign reserves to help stabilize the yuan, the $30 billion Beijing has pledged to the AIIB is a small enough sum so that even a severe slowdown in China would not affect its ability to continue to support the bank, which remains the most visible manifestation of China’s new global economic and diplomatic stature.
NOT OUT OF THE BRETTON WOODS?
As the economic downturn puts the brakes on some of China’s contributions to the international economic architecture, Beijing will once again find itself making a case for improved representation in the world’s established economic institutions.
Take, for example, China’s role at the World Trade Organization (WTO), where its status as a nonmarket economy will expire in December 2016. At that time, the higher tariffs that the United States and the European Union have levied on Chinese exports that the two determined to have been dumped at unfairly low prices will fall away—a boon for Chinese manufacturers. As was the case with the decision by the International Monetary Fund (IMF) to include the yuan in its basket of international currencies, achieving market economy status at the WTO is a matter of prestige for China. But the position of the United States and the European Union is that China’s nonmarket economy status should expire only if Chinese exporters can prove that they do not benefit from government subsidies and currency manipulation. That could prove difficult: although China has promised to further privatize some state-owned enterprises, which are the main recipients of state subsidies, it has made little progress in that respect, and it has continued to insulate the yuan from market volatility.
China’s slowing economy gives Beijing little reason to change this policy program in the medium term, which means that the United States and the EU will be able to argue to the WTO that China should not be granted market economy status. That would be misguided, because cross-border investment would greatly benefit if China were declared a market economy, as the country’s new risk and credit profile would open a broader swath of investment opportunities. A more sensible approach would be to grant China market economy status and to keep in place some defensive measures, such as heightened tariffs, during a transition period, until China demonstrates that it is fulfilling the expectations set for market economy countries.
China’s commitments to the Asian Infrastructure Investment Bank won’t be hit nearly as hard by the economic downturn as One Belt, One Road.
China is in friendlier territory at the IMF. Last year, Beijing achieved two major milestones: the yuan became a global reserve currency, and China’s voting share at the IMF increased to a level more commensurate with its economic strength. This year, both Beijing and the IMF will have a strong interest in making sure that the former move is not seen as a mistake. But Beijing’s pledge to give up some controls on the yuan, on which the currency’s inclusion in the IMF’s special drawing rights basket was conditioned, will be difficult to honor amid China’s ongoing economic problems. Faced with this prospect, Christine Lagarde, the IMF’s managing director, has acknowledged that the fund may grant China some flexibility so that the yuan stays strong—an important interest for the IMF, which has already expressed concern that a weakened Chinese currency could lead to a further slide in oil and commodities prices, pushing strained commodity exporters to ask for international assistance. The IMF also wants to avoid the doomsday scenario in which the depreciation of the yuan leads to massive capital flight from China and an economic crisis throughout the Asia-Pacific region. That said, the fund also recognizes that China needs to move forward on its economic reforms to ensure the long-term health of its financial system and will continue to look for progress even as Beijing is occupied with reviving its slumping economy.
None of this is to suggest that Beijing must be resigned to a temporary halt to its international economic strategy. By pursuing fiscal stimulus more aggressively, China could increase aggregate demand in the short term, accomplishing two important objectives. First, it would accelerate the economy’s shift to a consumption-driven growth model from its historical reliance on capital investments. Second, the government would be able to inject liquidity into the system without putting downward pressure on interest rates, which would help keep capital in the country. The problem with this essentially Keynesian approach to stimulus, of course, is that China has never taken it before, and the risk that Beijing would not be able to accurately calibrate and competently administer such a program is quite high. That kind of miscalculation, however, would be far preferable to adopting the wrong strategy altogether.