US China Trade: Why a Trade War Would Devastate the Chinese Economy

Foreign policy analysts doubt that Mitt Romney, if elected on Tuesday, would actually be able to carry through on his promise to help American workers by labelling China a “currency manipulator” on the first day of his administration.

They say that the ensuing retaliatory tariffs on artificially cheap Chinese goods would precipitate a trade war that would hurt the American economy, causing friction with the fastest-growing market for U.S. exports and setting U.S.-China relations back by more than a decade.

It is more likely that Romney would have to soften, or perhaps abandon, this stance if he enters the White House, they argue. After all, Obama made similar promises before he came to office, and yet the realities of one of the largest bilateral trading relationships in human history made these impracticable.  And then, some point out, there is uncertainty over whether or not the United States, as a member of the World Trade Organization (WTO), actually can unilaterally impose retaliatory tariffs on China.

As this debate carries on into the last few days of a tight election race, few people are asking a more fundamental question: Can China afford to enter into a major trade war with the United States?

The People’s Republic of China (PRC) is at a critical political juncture itself as it transitions to a new leadership. Two days after American voters go to the polls, the Chinese Communist Party (CCP), beleaguered by a weak economy and a string of high-profile corruption scandals, will unveil at its 18Party Congress in Beijing the members it has selected to head the country for the next ten years.

To facilitate a smooth and peaceful generational transfer of power, one that has occurred only three times in the PRC’s history, Chinese policymakers are struggling to calm domestic troubles. These include high inflation, poor health care, social inequalities and growing wealth disparities. The Communist Party clearly understands the stakes involved. Its legitimacy is under threat and the people want change. The first two generational power transfers each witnessed momentous turmoil that nearly brought the People’s Republic to an end: the Cultural Revolution and Tiananmen Square.

Since the onset of the global economic crisis, foreign demand for Chinese goods has decelerated at a worrisome pace, leading to a drop in China’s growth below 8% for the first time in more than a decade. Growth in the third quarter of this year registered only 7.4%, bringing the average for the first three quarters down to 7.7%. While this seems quite healthy and enviably, China considers 8% a critical threshold for maintaining social and political stability over the long term.  The benefits of rapid growth help to legitimize one-party rule.

Over the past 30 years, China’s economy has grown at an average rate closer to 10% a year.  It has achieved this with an economic strategy built on four pillars: exports, foreign direct investment, fixed-asset investment and domestic consumption. Of these, exports have been the dominant driver.  They have draw in foreign capital and supported investment in fixed assets and domestic consumption.

With an economy still heavily dependent on exports, China has a vested interest in seeing a stable and expanding U.S. economy. America is one of its biggest customers. China’s domestic consumption has not yet reached a level at which Beijing can say goodbye to the United States and sustain the rapid growth it desperately needs all on its own. Domestic consumption is still in its youth and far below where it is in the United States. What is more, millions of migrant workers in China depend on export manufacturing jobs for their livelihoods. China must therefore continue selling to the U.S. in a big way in the short term or else risk escalating social and political unrest at home.

Some argue that a trade war might incite China to start selling off the trillion dollars it holds in U.S. Treasury securities. But by doing so, it would do more harm to itself than good. China invests in U.S. Treasury debt because it has to. It is what allows it to hold down the value of its currency relative to the greenback, making its exports so attractive.  The arrangement pushes U.S. interest rates lower, creating more disposable wealth for Americans — real or imagined — which can be used to buy Chinese manufactured goods. China would incur huge losses in selling this debt; and even if it did go down that path, there are no attractive alternatives for investing its massive foreign currency reserves.

Talk of a major, sustained trade war may be overblown. There may be no better choice than to leave the value of China’s currency to the fate of mounting economic pressures. If truly undervalued, as some economists contend, China’s currency will inevitably be forced to appreciate. China cannot continue to subsidize the American consumer indefinitely. Beijing, in fact, has already been compelled to loosen its grip somewhat, in part to facilitate an economic re-balancing away from excessive exports and fixed-asset investment toward greater private consumption expenditure. As a result, China’s currency has gained 8.5%over the past four years.