The Pacific Theater
The struggle between China and the United States, between the yuan and the dollar, is the centerpiece of global finance today and the main front in Currency War III. The evolution of this struggle begins with the emergence of China from a quarter century of economic isolation, social chaos and the doctrinaire suppression of free markets by the communist regime.
The modern Chinese economic miracle began in January 1975 with the Four Modernizations plan announced by Premier Zhou Enlai, which affected agriculture, industry, defense and technology. Implementation was delayed, however, due to disruptions caused by Zhou’s death in January 1976, followed by the death of Communist Party chairman Mao Zedong in September of that year and the arrest one month later of the radical Gang of Four, including Madame Mao, after a brief reign.
Mao’s designated successor, Hua Guofeng, carried forward Zhou’s vision and made a definitive break with the Maoist past at a National Party Congress in December 1978. Hua was aided in this by the recently rehabilitated and soon to be dominant Deng Xiaoping. Real change began the next year, followed by a period of experimentation and pilot programs aimed at increasing autonomy in decision making on farms and in factories. In 1979, China took the landmark decision to create four special economic zones offering favorable work rules, reduced regulation and tax benefits designed to attract foreign investment, especially in manufacturing, assembly and textile industries. They were the precursors of a much larger program of economic development zones launched in 1984 involving most of the large coastal cities in eastern China. Although China grew rapidly in percentage terms in the mid-1980s, it was working from a low base and neither its currency nor its bilateral trade relations with major countries such as the United States and Germany gave much cause for concern.
Today’s currency war is marked by claims of Chinese undervaluation, yet as late as 1983 the yuan was massively overvalued at a rate of 2.8 yuan to one dollar. However, this was at a time when exports were a relatively small part of Chinese GDP and the leadership was more focused on cheap imports to develop infrastructure. As the export sector grew, China engaged in a series of six devaluations over ten years so that, by 1993, the yuan had been cheapened to a level of 5.32 yuan to the dollar. Then, on January 1, 1994, China announced a reformed system of foreign exchange and massively devalued the yuan to 8.7 to the dollar. That shock caused the U.S. Treasury to label China a currency “manipulator” pursuant to the 1988 Trade Act, which requires the Treasury to single out countries that are using exchange rates to gain unfair advantage in international trade. That was the last time Treasury used the manipulator label against China despite veiled threats to do so ever since. A series of mild revaluations followed in response so that, by 1997, the yuan was pegged at 8.28 to the dollar, where it remained practically unchanged until 2004.
In the late 1980s, China suffered a significant bout of inflation, which prompted popular discontent and a conservative backlash led by old-guard communists against the economic reform and opening programs of Deng. Separately, a liberal protest movement, led by students and intellectuals seeking democratic reform, also contributed to political upheaval. These conservative and liberal movements collided violently and tragically in the Tiananmen Square massacre of June 4, 1989, when People’s Liberation Army troops, acting on orders from the Communist Party leadership, used live fire and tanks to clear human rights and prodemocracy protestors from the square in the center of Beijing adjacent to the old imperial Forbidden City. Hundreds were killed. There was a slowdown of the Chinese economy after 1989, partly as a result of efforts to curb inflation and partly as a foreign reaction to the Tiananmen Square massacre. This pause proved temporary, however.
In the 1990s, China finally broke the “iron rice bowl,” the welfare policy that had previously guaranteed the Chinese people food and some social services at the cost of slow growth and inefficiency. Something resembling a market economy began to appear, which meant that Chinese workers had the opportunity to do better for themselves but had no guaranteed support if they failed. The key to this new social contract was the steady creation of millions of jobs for the new job seekers. With memories of Tiananmen fresh in their minds and the historical memory of over a century of chaos, the leadership knew the survival of the Communist Party and the continuation of political stability depended on job creation; everything else in Chinese policy would be subordinate to that goal. The surest way to rapid, massive job creation was to become an export powerhouse. The currency peg was the means to this end. For the Communist Party of China, the dollar-yuan peg was an economic bulwark against another Tiananmen Square.
By 1992, reactionary elements in China opposed to reform again began to push for a dismantling of Deng’s special economic zones and other programs. In response, a visibly ailing and officially retired Deng Xiaoping made his famous New Year’s Southern Tour, a personal visit to major industrial cities, including Shanghai, which generated support for continued economic development and which politically disarmed the reactionaries. The 1992 Southern Tour marked a second-stage takeoff in Chinese economic growth, with real GDP more than doubling from 1992 to 2000. However, the effect of this spectacular growth in the 1990s on U.S.-China economic relations was muted by the continuing U.S response to the Tiananmen Square massacre, which included economic sanctions and a general cooling of direct foreign investment by U.S. firms in China. A series of blunders and miscalculations, including the firing of a NATO cruise missile at the Chinese embassy in Belgrade in 1999, served to increase tensions. Economic relations were kept in an adversarial state by the April 2001 collision of a Chinese jet fighter with a U.S. reconnaissance plane, killing the Chinese pilot and causing the emergency landing of the U.S. plane on Chinese territory and temporary imprisonment of the crew.
Ironically, it was the al-Qaeda attacks on September 11, 2001, and China’s resulting firm support for the U.S.-led global war on terror that finally broke the ice and helped U.S.-China relations get back on track. Despite almost twenty-five years of significant economic progress by China, beginning in 1976, it was only in 2002 that U.S.-China bilateral trade and investment codependence kicked into high gear.
That year, 2002, also marked the beginning of Fed chairman Alan Greenspan’s experiment with sustained ultralow interest rates. Greenspan had started to cut rates in the summer of 2000 following the tech bubble collapse. The resulting decline of over 4.75 percent in the fed funds rate from July 2000 to July 2002 could be viewed as a normal cyclical easing designed to help the economy out of a rut. What happened next was an extraordinary period of over two additional years during which the effective fed funds rate never rose above 1.8 percent and dropped below 1.0 percent in December 2003. As late as October 2004, the effective fed funds rate was 1.76 percent, almost exactly where it had been in July 2002.
This low rate policy was justified initially as a response to the challenges of the 2000 tech bubble collapse, the 2001 recession, the 9/11 attacks and Greenspan’s fears of deflation. Yet it was primarily fear of deflation that caused Greenspan to keep rates low for far longer than would ordinarily be justified by a mild recession. China was now exporting its deflation to the world, partly through a steady supply of cheap labor. Greenspan’s low rate policy, partly intended to offset the effects of Chinese deflation in the United States, sowed the seeds of the full-scale currency war that emerged later in the decade.
Greenspan’s low rates were not only a policy response to potential deflation; they were also a kind of intravenous drug to Wall Street. The Federal Open Market Committee, the body that sets the fed funds target rate, was now acting like a meth lab for hyperactive deal junkies on the Street. Lower rates meant that all types of dubious or risky deals could begin to look attractive, because marginal borrowers would ostensibly be able to afford the financing costs. Low rates also set off a search for yield by institutional investors who needed higher returns than were being offered in risk-free government securities or highly rated bonds. The subprime residential loan market and the commercial real estate market both exploded in terms of loan originations, deal flow, securitizations and underlying asset prices due to Greenspan’s low rate policies. The great real estate bubble of 2002 to 2007 was under way.
In September 2002, just as the low rate policy was taking off, Greenspan gained an ally, Ben Bernanke, appointed as a new member of the Fed Board of Governors. Bernanke’s deeply rooted fear of deflation was even greater than Greenspan’s. Bernanke would quickly establish his deflation-fighting credentials with a speech to the National Economists Club in Washington, D.C., just two months after being sworn in as a Fed governor. The speech, entitled “Deflation: Making Sure ‘It’ Doesn’t Happen Here,” was widely noted at the time for its reference to Milton Friedman’s idea of dropping freshly printed money from helicopters to prevent deflation if necessary, and earned Bernanke the sobriquet “Helicopter Ben.”
Bernanke’s 2002 speech was the blueprint for the 2008 bailouts and the 2009 policy of quantitative easing. Bernanke spoke plainly about how the Fed could print money to monetize government deficits, whether they arose from tax cuts or spending increases, saying:
A broad-based tax cut . . . accommodated by a program of open market purchases . . . would almost certainly be an effective stimulant to consumption…. A money-financed tax cut is essentially equivalent to Milton Friedman’s famous “helicopter drop” of money….
Of course . . . the government could . . . even acquire existing real or financial assets. If . . . the Fed then purchased an equal amount of Treasury debt with newly created money, the whole operation would be the economic equivalent of direct open market operations in private assets.
Bernanke was explaining how the Treasury could issue debt to buy private stock and the Fed could finance that debt by printing money. This is essentially what happened when the Treasury took over AIG, GM and Citibank and bailed out Goldman Sachs, among others. It had all been spelled out by Bernanke years earlier.
With Bernanke on the board, Greenspan had the perfect soul mate, and in time the perfect successor, in his antideflationary crusade. The Greenspan- Bernanke fear of deflation is the one constant of the entire 2002–2011 period. In their view, deflation was the enemy and China, because of low wages and its low production costs—from ignoring safety and pollution—was an important source.
Despite its economic miracle, China ran trade deficits with the world as late as 2004. This is not unusual in the early stages of a developing economy, when efforts at export success must be tempered by the need to import infrastructure components, industrial equipment, raw materials and technology with which to launch exports. China did run a bilateral trade surplus with the United States; however, this was not initially cause for concern. In 1997 the U.S. trade deficit with China was less than $50 billion. Then the deficit grew steadily, and in the space of three years, from 2003 to 2006, it exploded from $124 billion to $234 billion. This period, beginning in 2003, marks the intensification of concern about the U.S.-China bilateral trade relationship and the role of the dollar-yuan exchange rate in that relationship. In 2006, Senator Charles E. Schumer of New York called the U.S. trade deficit “a slow bleeding at the wrists for the U.S. economy” and pointed to China as a leading contributor.
China’s internal deflation is exported to the United States through the currency exchange rate and ends up threatening deflation in the United States. This begins with the Chinese policy decision to peg the exchange rate between the yuan and the dollar. The yuan does not trade freely on international currency markets in the same way that dollars, euros, sterling, yen and other convertible currencies do. The use of the yuan and its availability to settle transactions are tightly controlled by the People’s Bank of China, or PBOC, the country’s central bank.
When a Chinese exporter ships goods abroad and earns dollars or euros, it must hand over those currencies to the People’s Bank of China in exchange for yuan at a rate fixed by the bank. When an exporter needs some dollars or euros to buy foreign materials or other imports, it can get them, but the PBOC makes only enough dollars or euros available to pay for the imports and no more; the rest is kept by the bank.
The process of absorbing all the surplus dollars entering the Chinese economy, especially after 2002, produced a number of unintended consequences. The first problem was that the PBOC did not just take the surplus dollars, but rather purchased them with newly printed yuan. This meant that as the Fed printed dollars and those dollars ended up in China to purchase goods, the PBOC had to print yuan to soak up the surplus. In effect, China had outsourced its monetary policy to the Fed, and as the Fed printed more, the PBOC also printed more in order to maintain the pegged exchange rate.
The second problem was what to do with the newly acquired dollars. The PBOC needed to invest its reserves somewhere, and it needed to earn a reasonable rate of return. Central banks are traditionally ultraconservative in their investment policies, and the PBOC is no exception, preferring highly liquid government securities issued by the United States Treasury. As a result, the Chinese acquired massive quantities of U.S. Treasury obligations as their trade surplus with the United States persisted and grew. By early 2011, Reuters estimated that total Chinese foreign reserves in all currencies were approximately $2.85 trillion, with about $950 billion of that invested in
U.S. government obligations of one kind or another. The United States and China were locked in a trillion-dollar financial embrace, essentially a monetary powder keg that could be detonated by either side if the currency wars spiraled out of control.
The United States desperately urged China to increase the value of the yuan in order to reduce the growing U.S. trade deficits with China and slow the massive accumulation of dollar-denominated assets by the PBOC. These pleas met with very limited success. From 2004 through mid-2005 the yuan remained pegged at about 8.28 yuan to one dollar, about where it had been since 1997. Suddenly, over the course of two days in late July 2005, the yuan increased in value from 8.28 to 8.11 to the dollar, an increase of almost 3 percent. From that sudden upward revaluation, the yuan began a long, gradual revaluation over the next three years, eventually reaching the level of about 6.82 to one dollar in mid-July 2008.
Then the PBOC again slammed on the brakes and held the yuan steady around the 6.83 level for the next two years. In June 2010, a second round of revaluation commenced, which by August 2011 brought the yuan slowly but steadily above 6.40 yuan to the dollar. This rise in the dollar value of the yuan was hardly smooth and was never without acrimony. The rhetorical and political battles between China and the United States from 2004 to 2011 on the subject of exchange rates dominated U.S.-Chinese economic relations despite a host of other important bilateral issues, including Iran and North Korea.
It is intriguing to think about how imbalances such as the U.S. bilateral trade deficit with China and China’s massive accumulation of U.S. government debt would have evolved under the Bretton Woods system. China’s accumulation of U.S. debt would have begun the same way and there would always have been a desire to hold some amount of U.S. Treasury securities for diversification and liquidity-management reasons. But at some point, China would have asked to cash in some of its Treasury securities for
U.S. gold held in reserves, as was allowed under Bretton Woods. A relatively small redemption, say, $100 billion of Treasury notes, done in early 2008 when gold was about $1,000 per ounce, would have equaled 100 million ounces of gold, or about 2,840 metric tons. This amounts to 35 percent of the entire official gold supply of the United States. Indeed, a full redemption of all U.S. government securities by China would have wiped out the U.S. gold supply completely and left the United States with no gold and China the proud owner of over 9,000 metric tons. One can imagine Chinese naval vessels arriving in New York Harbor and a heavily armed U.S. Army convoy moving south down the Palisades Interstate Parkway from West Point to meet the vessels and load the gold on board for shipment to newly constructed vaults in Shanghai. No doubt such a scene would have been shocking to the American people, yet that imagined shock proves a larger point. America has, in fact, run trade deficits large enough to wipe out its gold hoard under the old rules of the game. Still, the idea of the gold standard was not to deplete nations of gold, but rather to force them to get their financial house in order long before the gold disappeared. In the absence of a gold standard and the real-time adjustments it causes, the American people seem unaware of how badly U.S. finances have actually deteriorated.
While this example may seem extreme, it is exactly how most of the world monetary system worked until forty years ago. In 1950, the United States had official gold reserves of over 20,000 metric tons. Due to persistent large trade deficits, at the time with Europe and Japan rather than China, U.S. gold reserves had dropped to just over 9,000 metric tons when Nixon closed the gold window in 1971. That drop of 11,000 metric tons in the twenty-one years from 1950 to 1971 went mostly to a small number of export powerhouses. Over the same period, German gold reserves rose from zero to over 3,600 metric tons. Italy’s gold hoard went from 227 metric tons to over 2,500 metric tons. France went from 588 metric tons to over 3,100 metric tons. The Netherlands, another rising gold power, went from 280 metric tons to almost 1,700 metric tons. Not all of these expanding gold reserves came from the United States. Another gold power, the United Kingdom, saw its gold reserves drop from over 2,500 metric tons in 1950 to only 690 metric tons by 1971. But in general, U.S. gold was moving from the United States to its trading partners as part of the automatic rebalancing contemplated by the Bretton Woods system.
China’s rise to export powerhouse status did not take place in this golden age of the 1950s and 1960s. It took place largely in the early twenty-first century, when claims were settled in paper IOUs or their electronic equivalents. This meant that China did not receive any official gold for its export success. It also meant that there was no effective check on the ability of the United States to print money, borrow and keep spending beyond its means. This borrowing and spending binge was encouraged by the ultralow interest rate policies of Greenspan and Bernanke. Absent a gold standard or some other monetary constraint to apply the brakes, China and the United States hurtled toward CWIII with no compass and no map for navigating paper claims of an unprecedented magnitude.
The principal accusation leveled by the United States against China, discussed repeatedly in the press but never formally alleged by the White House since 1994, is that China manipulates its currency in order to keep Chinese exports cheap for foreign buyers. But China’s export machine is not an end in itself—it is a means to an end. The real end of Chinese policy is one familiar to politicians everywhere—jobs. China’s coastal factories, assembly plants and transportation hubs are at the receiving end of a river of humanity that flows from China’s central and southern rural provinces, carrying tens of millions of mostly younger workers in search of steady work at wages only one-tenth of what a comparable job would pay in the United States.
These newly arrived workers live in crowded dormitories, work seventy- hour weeks, take public transportation, eat noodles and rice and have few if any amenities or leisure pursuits. The little they manage to save is remitted back to the village or farm they came from to support aging parents or other relatives with no social safety net. Yet from the perspective of the rural Chinese, this life is the Chinese Dream, a twenty-first-century counterpart to the more expansive twentieth-century American Dream of a home, car and good schools that came along with a steady job in midcentury America. Of course, those rural immigrants to the cities just need to look around to see the Mercedes, Cadillacs and high-rise luxury apartments of China’s new rich to know there is something beyond the dormitory and the city bus.
No one knows better than the Chinese Communist Party leadership what would happen if those jobs were not available. The study of Chinese history is the study of periodic collapse. In particular, the 140-year period from 1839 to 1979 was one of almost constant turmoil. It began with the Opium Wars (1839–1860) and continued through the Taiping Rebellion (1850–1864), the Boxer Rebellion (1899–1901), the fall of the Qing Dynasty in 1912, the warlord and gangster period of the 1920s, civil war between nationalists and communists in the early 1930s, Japanese invasion and World War II (1931– 1945), the communist takeover in 1949, the Great Leap Forward (1958– 1961), the Cultural Revolution (1966–1976), and finally the death of Mao and the downfall of the Gang of Four in 1976. These events were not just noteworthy points in a chronological history but involved continuing episodes of external war, civil war, widespread famine, mass rape, terror, mass refugee migrations, corruption, assassination, confiscation, political executions and the absence of any effective political center or rule of law. By the late 1970s, Chinese culture and civilization were politically, morally and physically exhausted, and the people, along with the Communist Party, wanted nothing more than stability and economic growth. Liberal democracy and civil rights could wait.
This is why the Tiananmen Square demonstrations in 1989 were as troubling to the Chinese leaders as their violent suppression was shocking to the West. From their perspective, Tiananmen seemed to put China on the edge of chaos again after just ten years of growth and stability. The Chinese Communist Party leadership understood that the nineteenth-century Taiping Rebellion had begun with a single disappointed student and soon embroiled the southern half of the empire in a civil war resulting in twenty million deaths. Chinese history is proof that a social network does not require the Internet but spreads just as powerfully by word of mouth and by what the Chinese call dazibao, or big-character posters. The Chinese leaders also understood that the Tiananmen protests were fueled not just by prodemocracy sentiments but by student and worker resentment at higher food prices and slower job growth as China’s policy makers hastened to tamp down the economy to fight the inflation that had begun to take off in the late 1980s.
Of course, the United States also cared about job creation. The 2001 recession had been mild in statistical terms with regard to GDP and industrial output, but the number of unemployed in America spiked up sharply, from 5.6 million people at the end of 2000 to over 8.2 million at the end of 2001. Despite a technical recovery in 2002, the number of unemployed continued to grow and reached over 8.6 million people at the end of 2002. From there, it declined very slowly so that there were still over 7.2 million unemployed at the end of 2005. When the recession of 2007 began, America was still working off this high base of unemployed, and the total number skyrocketed to over 15.6 million unemployed by October 2009. Including those employed part-time but seeking longer hours and those not officially unemployed but desiring a job, the total number of unemployed and underemployed Americans at the end of 2009 stood at over 25 million men and women. Every one of those 25 million Americans has a face, a name and a family. In our statistical age, economists prefer to present this phenomenon in percentage terms, such as 6.0 percent unemployment for year-end 2002 and 9.9 percent for 2009, but reciting the actual numbers of affected persons— more than 25 million—helps to bring home the depths of the employment problem. America desperately needed to create jobs.
For a while, this human tragedy was masked by the easy money policies of Greenspan and Bernanke and the resulting euphoria of credit card spending, rising home prices, rising stock prices and large no-down-payment mortgages for all comers. Although there were some complaints about Chinese currency manipulation and lost American jobs in 2004 and 2005, these complaints were muted by the highly visible but ultimately nonsustainable prosperity of those years resulting from the easy money. When the music stopped abruptly in 2007 and the United States careened into the Panic of 2008, there was no longer a place for Chinese policy makers to hide.
Now U.S. politicians, led most noisily by Senator Charles Schumer, publicly attacked the pegging of the yuan-dollar exchange rate and blamed the Chinese for lost jobs in the United States. A bipartisan group of U.S. senators, including Schumer, wrote a letter to the Bush White House in 2008, stating, “The unfair price advantage that the undervalued [Chinese currency] gives Chinese firms has forced many American companies to declare bankruptcy or even go out of business, harming our workers, families and middle class.” Senator Schumer and his ilk were undaunted by the fact that there is scant evidence to support this linkage between jobs and exchange rates. It seems unlikely that the typical North Carolina furniture maker would be willing to work for the $118 per month made by his Chinese counterpart. Even if the yuan doubled in value, the Chinese furniture maker would earn only the equivalent of $236 per month—still not high enough to make his U.S. counterpart competitive. None of this mattered to the dollar demagogues. In their view, the Chinese currency was clearly to blame and now the Chinese must respond to their demands for revaluation.
The administration of President George W. Bush was well aware of this chorus of complaints but was also attuned to the importance of close relations with China on a number of other issues. China was the largest purchaser of Iranian oil exports and was therefore in a position to influence Iran in its confrontation with the United States over nuclear weapons development. China was an indispensible economic lifeline to the hermetically sealed regime of North Korea, with which it shared a common border, and so was also in a position to help the United States achieve its strategic goals on the Korean peninsula. Large U.S. corporations eyed the Chinese market enviously and were looking for direct market access through expansion, acquisitions or joint ventures with Chinese partners, all of which required Chinese government approvals. China had suffered a loss of face in 2005 when the China National Offshore Oil Corporation withdrew its takeover bid for U.S.-based Unocal Oil after the U.S. House of Representatives voted 398–15 to call on President Bush to review the bid on national security grounds. Such rejections could easily result in tit-for-tat denial of U.S. acquisitions in China. In short, America had as much to lose as to gain from any confrontation with China, and a continuing high-level expert dialogue seemed like a more fruitful approach.
President Bush addressed the need to keep U.S.-Chinese currency tensions under control by launching the China-U.S. Strategic Economic Dialogue in 2006. These meetings were continued by the Obama administration in expanded form and renamed the Strategic and Economic Dialogue (S&ED) to reflect the inclusion of the U.S. secretary of state and a Chinese state councilor with responsibility for foreign policy. The inclusion of foreign policy officials along with economic officials was a clear recognition of the interconnectedness of the geopolitical and financial aspects of national policy in the twenty-first century.
The Strategic and Economic Dialogue was one of several bilateral and multilateral forums designed in part to deal with the advent of a new currency war. It has helped to avoid an escalation in tensions over the currency manipulation charges, but has done nothing to make the issue go away. A series of bilateral summits between President Hu of China and President Obama of the United States were also convened, but neither the S&ED nor the bilateral summits have produced major progress.
The United States has now chosen the G20 as the main arena to push China in the direction of revaluation, both because of the possibility of attracting allies to join the effort and because the Chinese are more deferential to global opinion than to U.S. opinion alone. Recent significant progress on yuan revaluation has tended to occur not in conjunction with S&ED meetings but rather in advance of G20 meetings. For example, a small but still noteworthy revaluation of the yuan from 6.83 on June 15, 2010, to 6.79 on June 25, 2010, occurred immediately in advance of the G20 leaders’ summit in Toronto. Another rally in the yuan from 6.69 on November 1, 2010, to 6.62 on November 11, 2010, coincided with the G20 leaders’ summit in Seoul. This demonstrates that the Chinese are attentive to the G20 in ways that they may not be when it comes to other forums.
By the spring of 2011 the U.S.-China Pacific theater in the currency war was quiet. However, the core issues were still unresolved. Employment stress in both China and the United States meant that tensions could erupt at any time. A leadership change in China in 2012 and a presidential election in the United States the same year raised the specter of domestic political forces being a catalyst for further international confrontation.
