Recent reports suggest that China has made a dramatic proposal to address the central issue of imbalanced trade. This would eliminate entirely its bilateral trade surplus with America within six years. Since this surplus reached $380bn in 2018 on trade in goods and services, and may exceed $500bn by 2024, this idea could have a large effect on global trade flows and world gross domestic product.
Noah Smith dismisses this new Chinese suggestion as a massive red herring because its implementation would clash with other objectives of President Xi Jinping’s administration. But it is clearly at the centre of the latest talks so it deserves analysis.
The basic idea is that China would directly stimulate purchases of American goods, closing the bilateral trade imbalance without the need for US tariffs on imports from China. At the extreme, China would boost its American imports by the entire $500bn while leaving its trading flows with the rest of the world unchanged. Even a smaller version of this plan would be significant.
In theory, this looks like an attractive idea, since it would involve an increase in global demand if China financed the purchases by fiscal or monetary expansion. Economists have typically argued for such expenditure-increasing initiatives by other countries with chronic trade surpluses, such as Germany and Japan.
In simple national accounting terms, China would reduce its overall savings ratio by boosting domestic demand, say through fiscal expansion. Imports to China would rise by the same amount, leaving Chinese GDP unchanged.
In the US, there would be a rise in exports and GDP. Assuming a multiplier of 1.5, the level of US GDP could rise by 2.5-3 per cent when the plan is fully implemented over six years.
This would be less damaging for the global economy than a war of escalating tariffs, which would increase inflation, reduce real demand and disrupt supply chains.
However, this assumes that the extra US exports to China are genuinely incremental and are not just diverted from other markets. It also assumes that the US economy has enough spare capacity to produce these extra exports without causing inflation, tighter US monetary policy and a rising dollar. If these caveats fail to hold, as would probably be the case in the real world, the benefits to the US economy would be much smaller.US-China trade war: who has the upper hand?
The plan would increase US exports to China by at least threefold. This looks implausibly large. Furthermore, these additional US exports would come partly from high technology sectors, triggering even greater American complaints about forced technology transfers to China.
The plan could also create collateral financial problems. If China directly increases imports from the US by about $500bn, the initial effect would be to worsen its global current account balance by the same amount.
In an earlier era, when China was running a huge current account surplus, that would have been considered a good outcome. But that era has changed. China’s current account was almost exactly in balance in 2018, so the change in the bilateral position versus the US, all else equal, could take China into an overall current account deficit of about half a trillion dollars.
Why would this cause a problem? One issue is that, at times, China also runs a very large deficit on net capital flows. For example, from mid-2014 to early 2017, when the capital account was liberalised and the renminbi was expected to depreciate, net private capital outflows exceeded $1tn. These outflows have now diminished, but could return, if in smaller scale.
This means that, under the new plan, the current account plus private capital account outflows could shift into heavy deficit, implying that other capital inflows will be needed to balance the books. China is aiming to deepen and open its domestic financial markets, attracting inflows of long-term portfolio flows from the advanced economies. But it will take a long time to create enough financial capacity in China to handle the scale of the necessary inflows.
A structural deficit in China’s balance of payments (ex official flows) could therefore lead to downward pressure on the renminbi, exporting deflationary pressures to other economies, and causing American complaints about currency manipulation.As a last resort, China could support its currency by running down its foreign exchange reserves, which are still more than $3tn. But this would involve selling their holdings of US Treasuries, adding to recent market concerns about the effects of quantitative tightening by the Federal Reserve. All this could cause global financial instability.
In order to avoid some of these problems, China could adopt a different approach, which would be to increase imports from the US by substituting them for goods currently purchased from other economies. Switching energy purchases towards the US would, for example, seem relatively straightforward. In principle, China might also raise tariffs on items such as German manufactured goods and Brazilian soyabeans, while eliminating tariffs on American goods. However, such a wholesale repudiation of multilateral World Trade Organization principles would cause a new set of losers and almost certainly tariff retaliations from the likes of the eurozone and Japan.
Although fraught with difficulties, a new trade agreement to restore peace between the US and China by focusing on higher US exports as the main vehicle to close the bilateral imbalance would probably be better than a tariff war, for both global demand and supply chains.
But the negotiators are stuck in a “second best” world. An export purchase plan would be hard to implement and could create problems elsewhere in the global trade and financial system. A rising dollar could undermine the whole plan.
The “first best” system would involve global free trade and flexible exchange rates on a multilateral basis. But that does not appear to be on the agenda, while President “I happen to like tariffs” Trump remains at the helm.