Brexit, European tensions over the migrant crisis, and the rhetoric of the U.S. presidential campaign are just the latest flashpoints in the anti-globalization move across the world. Many blame China, the world’s second-largest economy, for economic ills from flagging industries to deflation in their home countries. Both U.S. presidential candidates Hillary Clinton and Donald Trump, for example, have charged China’s exports for harming U.S. jobs. Republican candidate Trump specifically accuses China of intentionally manipulating its currency to drive its exports and vows to impose countervailing duties as high as 45% on U.S. imports from China in return. He and other critics also say China is spreading deflation to the rest of the world through low-priced, subsidized exports.
In a weak global economy, citizens of every country may feel more vulnerable, especially to external forces beyond their control. Yet, some of the claims about China’s role in harming other economies are outdated, while others present a more realistic scenario, say Wharton School and other experts. “Trump should be glad China is ‘manipulating’ its currency,” says Minyuan Zhao, a Wharton management professor. “Otherwise, if it were up to market forces, the Chinese currency might have been more volatile or dropped much further in value than it is now.” Scott Kennedy, deputy director of the Freeman Chair in Chinese Studies at the Center for Strategic and International Studies (CSIS), a Washington, D.C. think tank, agrees. “Trump is about five to 10 years out of date in his concerns about the renminbi. There’s zip evidence China’s currency is undervalued now,” he says.
Deflationary pressures due to the slowing Chinese economy and industrial overcapacity, though, are a more possible threat. The export of products in Chinese industries with overcapacity, from steel to textiles, is depressing prices of those products and threatening competitors in other countries, say experts. But most of the effects are sector-specific at the moment, rather than a broad impact on prices across economies, and affect primarily countries that compete directly in those sectors, they say. “There’s no good evidence that China’s exports have had a macro effect on the global economy and brought down prices overall,” says Kennedy. Instead, says Derek Scissors, resident scholar at the American Enterprise Institute (AEI), a Washington, D.C. think tank: “The single biggest driver of global deflation is cheap oil,” a phenomenon that many experts say is due more to OPEC overproduction and the U.S. shale gas revolution than China’s slowing demand.
For now, stresses in China’s own economy provide a more accurate explanation for both its currency moves and deflationary pressures than any deliberate attempt to beggar its neighbors, say Wharton and other experts. China itself is in deflation because of a domestic economic downturn resulting from a global economic slowdown that has reduced demand for Chinese products. China’s rate of export growth has declined since 2010 and fell to zero or below for a few months this year, notes William Adams, senior international economist at the PNC Financial Group in Pittsburg, Pa. The reduction in both domestic and global demand, in turn, has prompted a drop in industrial prices and overcapacity. But closing foundering factories risks widespread unemployment and unrest. “It’s more a problem for China than the rest of world,” says Scissors.
“Trump is about five to 10 years out of date in his concerns about the renminbi. There’s zip evidence China’s currency is undervalued now.” –Scott Kennedy
Consequently, despite President Xi Jinping’s desire to shrink overcapacity, government-sponsored banks are keeping many failing firms alive by rolling over their debt, creating the potential for financial crisis, says Marshall Meyer, a Wharton emeritus professor of management. “There’s a lot to worry about in China’s economy, in particular, the debt level,” he says. “Should there be a breakdown in the banking and financial system, things become very unpredictable, especially since household savings are all in banks or the inflated real estate market.” Given the potential dangers, “stability is of the utmost importance,” and that explains both renminbi policy and the potential for deflation in China, says Wharton’s Zhao.
Renminbi Dynamics: Overvalued
Ironically, for all the criticism of it, the yuan is overvalued today, harming Chinese exports. “China is doing the opposite of what it’s criticized for,” says AEI’s Scissors. “Today, China is intervening in the credit market to keep the yuan artificially high. If they were not to intervene, the yuan would fall against the dollar, and there would be more deflationary pressure” in the world. PNC’s Adams agrees: “With China’s export industry weak and its economy in deflation — arguably worse than in other economies — a more market-determined exchange rate would mean a weaker, not stronger, yuan in relation to the dollar.” In its May 2016 report on world currencies, the Peterson Institute for International Economics, which has long advocated against an undervalued yuan, finds no misalignment in the currency.
Why is China keeping its currency from falling further? Since 2013, after nearly a decade of yuan appreciation against the U.S. dollar when the Chinese economy was going strong, China started allowing its currency to depreciate to stay in better tune with market realities. The move was a reflection of underlying domestic economic downturn, as domestic wages rose and China’s trade advantage shrank. Meanwhile, the U.S. dollar surged 20% against other floating currencies.
But the road to depreciation has not been smooth. In August 2015, the yuan took its biggest one-day dive since 1994 when global markets interpreted a yuan devaluation move as a salvo in global currency wars. Instead, the devaluation was an effort to allow the market greater say in setting exchange rates so that the International Monetary Fund (IMF) would include it in the basket of currencies in its Special Drawing Rights reserve currency. The IMF accepted the yuan as part of the SDR basket in December 2015.
Renminbi depreciation also set off a spate of capital outflows that started to drain China’s foreign reserves in a cycle that could easily spin out of control. In 2015, China’s foreign reserves stood at $3.3 trillion, compared with $3.8 trillion in 2014. “If people think the exchange rate will go down, they’ll ship their money out; then the rate goes down more in a self -fulfilling prophecy,” says Meyer. “The hot money that came into China for RMB appreciation and higher interest rates is going out now.”
Market volatility has since continued to dog Chinese economic policymakers. In January, new data showing the fifth straight month of slowing domestic manufacturing sent the Shanghai stock exchange plummeting by 6.9%, triggering a worldwide market rout. The yuan also tumbled in January.
Market volatility and capital outflows prompted by a more market-determined exchange rate have chastened China policymakers, who now seem to be pursuing a more controlled path to financial market liberalization as a result, say experts. Says Wharton’s Zhao: “The renminbi exchange rate is maintained at today’s level, to the credit of policymakers in China who believe stability is in the best interest of China and the rest of the world. Since depreciation may lead to panic, capital outflow and further depreciation, the government is trying at all cost to maintain stability.”
“Since depreciation [of the yuan] may lead to panic, capital outflow and further depreciation, the government is trying at all cost to maintain stability.” –Minyuan Zhao
Meanwhile, says Scissors, the yuan-dollar exchange rate has never had much impact on U.S. unemployment. Just before China devalued its currency in 1994, the U.S. unemployment rate stood at 6.5%, he says. After the devaluation, U.S. unemployment fell below 4%, instead of rising. In June 2005, just before the yuan’s steady rise, U.S. unemployment was 5.6% and then grew to 7% in 2014, instead of falling with the stronger yuan, because of the U.S. and global financial crisis. “The value of the yuan against the dollar has gone up, down, and sideways and jobs here remain almost entirely a function of what the U.S. does, not what the PRC does,” writes Scissors.
Deflation: A Bigger Specter
In contrast, say experts, China’s economic slowdown and resulting industrial overcapacity have a greater potential of harming world economies than its exchange rates. China, for example, produces half the world’s steel. “Because the product is traded globally, it is bringing worldwide deflationary pressure and has gotten the most attention,” says Scissors. The world has about 33% excess capacity in steel, according to the Organization for Economic Cooperation and Development (OECD), and steel prices have fallen from about $1,100 a ton in 2008 to about $350 to $400 a ton today, notes Wharton’s Meyer. In January, China vowed to lay off 1.8 million coal and steelworkers.
But other sectors with overcapacity may not have as wide an impact outside of countries that are direct competitors, such as South Korea and Japan in shipbuilding, and Vietnam and Bangladesh in textiles, says Scissors. The U.S. is not as affected as these countries, he notes. “Although there may be deflationary pressure, we [in the U.S.] don’t worry about it, because we don’t find it negative” in clothing and consumer electronics, where we enjoy lower prices, he says. However, says Kennedy of CSIS: “This concern about deflation will become more serious as China’s comparative advantage increasingly overlaps with that of industrialized countries, and China can do to semiconductors what it did to steel. A problem that is limited to specific industries at the moment could become a wider problem.”
China’s industrial overcapacity will take a long time to unwind if the country wants to avoid mass firm closures, unemployment and social instability, say experts. “It will be a slow cycle to play out,” says Adams. “There’s not enough pickup in global demand to absorb the excess production capacity in China and elsewhere in the world in the near term.” However, China’s investment in industrial production capacity is falling somewhat, he notes: In the industrial Northeast, it fell by 31% year over year in the first seven months of 2016, according to the National Bureau of Statistics. Says Scissors: “Overcapacity is really a labor force issue in China, where the labor force is getting older and shrinking. If China wants overcapacity to unwind in a very orderly fashion, it will happen at demographic speed, which is a matter of years or decades.”
Meanwhile, the cost of an orderly correction is a dangerous buildup in corporate debt, as failing firms receive more funds to keep going, and investment capital ends up propping up losing ventures, instead of building more viable enterprises that can speed China’s transition to a more sustainable consumption-based economy less dependent on heavy manufacturing and exports. Chinese President Xi is a proponent of shrinking excess capacity and corporate debt, but he faces political opposition from every side, says Meyer. “I’m moderately certain that Xi doesn’t want to pursue a race to the bottom [of global deflation], the economic equivalent of nuclear war that leaves everybody miserable,” says Meyer. “But Xi has more internal opposition than anything I’ve seen in years.” In addition, local politicians are fighting to keep their factories in business and people employed.
“You’ve got a debt bomb ready to detonate. The question: Does China’s debt bomb or industries in other countries collapse first?” –Marshall Meyer
Thus, if China finds itself in desperate straits, it could resort to a “doomsday option,” says Meyer, where it exports its overcapacity and deflation. “It won’t be a pretty picture for the rest of the world, but I’m not sure it would be a purposeful or deliberate strategy,” he says. Meyer says China’s first option is to cut capacity, and the second is to export capacity to new markets, such as Central Asia through the proposed “One Belt One Road” initiative. The third is to set up corporate operations overseas, which would then purchase input products from China. The final is wide-scale exporting of its overcapacity. “You’ve got a debt bomb ready to detonate,” says Meyer. “The question: Does China’s debt bomb or industries in other countries collapse first?”
Yet, to pick a trade war with China is not the wisest option, says Mauro Guillen, Wharton management professor and director of the Lauder Institute. “It doesn’t make sense to start a trade war between the U.S. and China, the two largest trading nations when there are already too many tensions and frictions in the global economy,” he says. “It will end badly for the global economy.” He notes that only three large economies have a trade surplus with China — Japan, South Korea and Taiwan — because China buys inputs from them to make its export products. “If you hurt China, you also hurt Japan, Korea and Taiwan, and that makes no sense from the U.S. national security perspective,” he says.
Ironically, for the U.S., the Trans-Pacific Partnership (TPP), derided by both U.S. presidential candidates, is America’s best weapon against China’s exports, says Meyer. “We’re going to lose jobs if we enter the trade agreement is what they [the U.S. presidential candidates] think,” he says. “What they should think is we’re going to trade with TPP countries or China is going to trade with them.”
In the end, both China and the U.S., the world’s two largest economies, must take responsible actions or risk bigger perils. “The world economy is now so integrated, if you hurt one country, you hurt everybody,” says Guillen.