As President Xi Jinping visits Washington, a volatile global economy requires that the leaders of the world's two biggest powers keep their eyes on financial and investment cooperation — not squabble over currency.
- By Robert D. HormatsRobert D. Hormats is vice chairman at Kissinger Associates and former U.S. under secretary of state for economic growth, energy, and the environment.
This week, China’s President Xi Jinping makes his first state visit to the United States. Summits between American and Chinese presidents are always important events, but the timing of this meeting carries special significance.
Over recent months several consequential security, political, and economic issues have been prepared by U.S. and Chinese officials for the two leaders to discuss, but an unanticipated subject has captured public and governmental attention as the visit approaches. This, of course, is the recent volatility in China’s stock market — coupled with concerns about a greater than expected weakening of China’s growth rate, along with the recent devaluation of the Chinese renminbi (RMB).
The worldwide market reverberations of economic developments in China attest to the important international role now played by its economy, financial markets, and currency. A decade ago, such events would have had far fewer global repercussions — today, they are enormous.
But Presidents Obama and Xi are not likely to delve deeply into the reasons for the downturn in China’s economy or its stock markets. Such details might be addressed by other officials. And China’s president certainly will not be looking for U.S. advice — especially public advice — just as U.S. leaders do not invite pointers from foreign leaders regarding this country’s domestic economic policies.
And, while consequential, it is important that this matter not completely crowd out discussion of other significant issues. The Chinese stock market, after all, had risen dramatically over the last several quarters (prior to the drop), and markets typically experience downturns after sharp appreciations. China’s markets are still ahead of where they were when the nearly two-year-old rally began. Moreover, Americans should not exaggerate the direct impact on the U.S. economy; the International Monetary Fund (IMF) estimates that a 1 percent drop in China’s GDP would only mean a 0.1 percent drop in U.S. GDP.
What appears to have rattled markets in the United States and elsewhere, however, is the unexpectedness and suddenness of the market’s drop; many investors had grown accustomed to China’s continued stock market rise. This recent fall is coupled with questions about the actual extent of China’s economic slowdown, its effects on that country’s trading partners, and especially how a slowdown will affect the economies of nations that rely heavily on commodity exports — as Chinese demand for them shrinks.
The broader point here is not to suggest that the leaders dissect or debate the reasons for recent market and economic events in China, but rather that they utilize the current attention on the matter to emphasis the need to address a broader and more fundamental subject: because the economic policies of, and developments in, China and the United States so significantly affect one another, and the rest of the world, the two nations have a special responsibility and a mutual need to work together closely and on various investment, trade, currency, and capital markets issues. This cooperation is imperative — even though there are bound to be significant differences on other issues. The major question for the economic portion of their agenda will be how best to structure the discussion to produce an outcome that boosts the productivity of both nations and the global economy.
Hedging against volatility
Presidents Obama and Xi should aim to achieve two outcomes: The first should be to agree to establish a deeper and more frequent set of high-level discussions in the coming months and years about their respective domestic and international economic policies.
In the period immediately ahead, both countries will be undergoing significant transitions that could cause internal and international perturbations affecting domestic growth, capital flows, and currencies — and add to market volatility. Such high-level discussions could reduce potential frictions and misunderstandings during this period.
The United States, despite the Federal Reserve’s recent decision, will soon be emerging from a period of very low interest rates as it seeks to begin the process of raising the baseline to more normal levels. The question will be when and by how much, and what the impact will be here and abroad — as financial markets move into terra incognita. Of course, the extended U.S. election season will predictably produce a wide range of suggested policy changes by would-be future presidents in areas related to taxes and regulations; markets will try to game these out and anticipate their implications. Campaign debate will also involve the candidates’ views — some constructive, some not, and some downright negative — on how to manage the U.S.-China relationship.
Back in Beijing, China’s top leaders have announced that they will be accelerating their country’s transition from an economy heavily weighted toward state-supported investment, manufacturing, and exports toward a more market-driven economy with growth generated increasingly by consumer demand and services. That is a formidable task, but one necessary for China’s long-term growth and internal balance. During this period, however, economic and market uncertainties are almost inevitable. Will, for instance, these new sources of demand offset the fall in investment and exports? And if so, how soon will that offset take hold? And how much will high debt and excess capacity slow growth in the interim?
Both countries have a strong interest in these transitions progressing smoothly, generating sustainable growth and avoiding market volatility. Success for Beijing will help Washington accomplish its domestic goals, and vice versa. On the other hand, problems in one country are likely to cause problems for the other.
The common goal should be to put in place a process that produces understanding — or avoids misunderstanding — about one another’s’ policies and path forward, and to find ways to avoid actions adverse to a smooth transition in the other. Discussions between China and the United States would need to avoid any hint of “interference” in one another’s domestic decisions. Neither country’s politics will permit that. Instead, they should be geared to helping the leaders and officials of each country better understand the major judgements that drive economic policy in the other and enable them to better factor developments in the other’s economy into their own projections and decisions.
Good communication will be particularly important to enable top U.S. and Chinese officials to signal to their counterparts if they perceive potentially disruptive policy measures on one another’s part — as well as to avoid one country reacting to a misreading of the other’s policies or intentions.
Bilateral investment, the global economic order, and SDRs
Such a dialogue will also be essential to raise the political priority and focus required to make more substantial progress on a bilateral investment treaty (BIT). A well-constructed BIT will be an essential step in ensuring a level playing field and reduced restrictions for new and existing U.S. investment in China. It will also facilitate continued flows of Chinese investment into the United States — which can make a substantial contribution to job creation and additional manufacturing capacity.
Such a dialogue will also permit a deeper set of conversations about the future structure of the international economic order. China has suggested changes in that order and proposed major new institutions, such as the Asian Infrastructure Investment Bank (AIIB). It also wants a greater voice in current international financial institutions consistent with its greater role in the global economy. The United States, for its part, wants to make sure that China’s evolving role in the global system does not compromise, and indeed reinforces, the market principles and fundamental rules that have successfully underpinned the global economic order for decades. A strategic dialogue between the two countries on the global economic order of the future is essential to identify areas of consensus.
In this context, a particularly important area for future discussion will be the role of the RMB. The Chinese currency continues to grow in importance in international trade and finance. And discussions are underway regarding inclusion of the RMB in the IMF’s basket of currencies known as Special Drawing Rights (SDRs).
The currency’s portion of international trade settlements already has risen dramatically: bond issuances denominated in RMB have skyrocketed; the number of national currencies linked to the RMB is steadily rising; and more and more avenues and instruments are being employed to move capital in and out of China.
Assuming Chinese authorities continue to undertake reforms that allow greater international use of the RMB, by reducing capital controls and allowing more two-way movement of funds, China’s internal capital markets and the institutions of the international financial system will both have to adjust — as international businesses, financial institutions, and central banks increasingly utilize the RMB. To be successful, for China and the world, this needs to include Beijing’s own efforts to utilize capital more efficiently and transparently in order to boost growth and jobs.
Rules, standards of transparency, regulatory practices, and agreed principles will need to be developed to ensure that the internationalization of the RMB is a smooth process in which both investors and the Chinese authorities feel a high degree of confidence. This process should be a significant topic for the enhanced dialogue between Washington and Beijing.
Much consultation between the two countries already takes place. China’s Finance Minister Lou Jiwei, his vice minister, Zhu Guangyao, and Central Bank Governor Zhou Xiaochuan are experienced financial experts with strong reputations among their American counterparts. Senior officials of the U.S. Treasury and China’s Ministry of Finance are in constant contact. So are officials of the Federal Reserve and the People’s Bank of China. These will and should, of course, continue.
But in a period during which markets around the world appear likely to be volatile, when major economic and financial reforms and transitions are underway in China, and while the Fed is considering when and how much to raise interest rates, a more intimate and regular set of bilateral discussions is in order. The annual Strategic and Economic Dialogue (S&ED) presents an opportunity for annual high-level consultations among top economic (as well as foreign policy) officials. However, its format is rigid and formulaic. A more informal, frequent, and agile forum — that enables high-level meetings, or even periodic phone conversations, among officials to take place when needed — is required for at least the next few transitional years.
Refocusing the G20
A second constructive outcome would be to revitalize and more effectively utilize the G20. The group of 20 major global economies should be positioned more effectively to address the policy, market, growth, financial, currency, and geopolitical uncertainties in virtually every part of the world. Addressing international challenges requires especially close cooperation between the United States and China in the G20. China’s role will be especially important: it will chair this group next year and the United States should aim to work with it as Beijing shapes the agenda.
Many other countries — such as Japan, Germany, France, India and other large emerging economies — must play a key role as well. All are vulnerable to economic and market disruptions and the G20 is critical to managing or avoiding them.
Due to internal economic and social stresses related to a combination of unemployment, immigration, slow growth, and growing tensions over unequal income distribution, economic nationalism is intensifying across the globe — in industrialized as well as emerging nations. Policies that respond to the forces of economic nationalism in one major country (protectionism, competitive currency devaluation, distortive subsidies, forced localization of production) can produce them in others.
The problem many governments face today is that often traditional policies to boost growth and job creation, absorb immigrants, and improve economic opportunity are not working very well or are unavailable for use on a significant scale. Most central banks already maintain very low interest rates and will find it difficult, and probably not very effective, to lower them further. Many governments also have amassed large amounts of debt: China, the United States, Japan, and much of the European Union fall into that category. Substantial amounts of additional government spending will meet market or political resistance in many countries. This is almost certainly the case in Washington and various European capitals — as well as in most large emerging economies.
This leaves exchange rates as the most convenient policy instrument — and, for some, the “default position — in numerous countries. For various policymakers, it will be tempting to use currency policy as a tool to boost exports and curb imports, thereby increasing domestic growth and employment. Indeed, currency devaluation could occur in numerous way: by specific actions of governments to re-peg downward the value of their currency vis a vis the currencies of their trading partners, as China recently did; by simply refraining from currency intervention (i.e. not buying their currency with their reserves as it floats downward) thus allowing it to decline driven by market forces; or, by lowering domestic interest rates, thereby discouraging investors from holding financial instruments in that currency (which many countries accused the United States of doing during the last several years of quantitative easing).
Some of these measures are well intended and entirely consistent with market forces; others are specifically aimed at artificially boosting competitiveness. In some cases, it’s difficult to tell the difference. But the collective process can be destabilizing.
The problem is that every country cannot lower exchange rates all at once. Competitive exchange rate devaluation, especially if the moves by governments or the market are abrupt, tend to produce extreme financial volatility and chill long-term investment — as investors shy away from countries in which they think the currency they buy today will be worth less tomorrow. If the process spins out of control, countries may be forced to stop the fall by raising interest rates, which would slow growth. Or they would be forced to use large amounts of their foreign currency reserves to buy their currency to stem the collapse.
For the United States, this situation will produce a particular problem. A great deal of attention has been focused on China’s recent devaluation, even though it followed a period of currency increases and has only declined since then by roughly 2-3 percent (considerably less than the decline in the euro, prior to that). There has been controversy about whether China should have taken any devaluation at all. Authorities in the United States argue that the RMB was already undervalued even before such actions, whereas the IMF had found it to be appropriately valued and complemented Beijing on moving to a more market-oriented currency regime.
Concerns about Beijing’s devaluation, however, go beyond China. To be sure, this devaluation improves the price competitiveness of Chinese goods and services against those produced in the United States and elsewhere. But it alone is not enough to have a major impact on many traded items or to make Chinese companies significantly more competitive. There are, nonetheless, various other ramifications. China’s Asian neighbors have felt compelled to follow on, and some have subsequently lowered the value of their currencies to avoid losing competitiveness. Meanwhile, falling markets have pushed other currencies lower as well (for example, the Indonesian rupiah and the Malaysian ringgit). At the same time, money flows into the United States have increased as America’s capital markets have been seen as a safe haven for Europeans, Asians, and others in the current, uncertain global environment. Thus, the dollar has strengthened not just against the RMB, but against most other major currencies as well. As a result, American goods and services are becoming less competitive across a wide range of countries — which will slow U.S. exports, increase imports, and weaken domestic growth prospects. That combination of factors is why the currency issue is so politically charged here.
There is a risk that a stronger dollar also will undermine support in some quarters in the United States for the extremely important Trans-Pacific Partnership (TPP) trade agreement. Several members of Congress are pushing for strong currency provisions in TPP that may be difficult to negotiate.
There are also risks that rising economic nationalism will produce protectionist trade policies — especially in those countries that experience sharply widening trade deficits or rising unemployment. That outcome was largely avoided in aftermath of the 2008 global financial crisis. Again, the G20 played a key role. But economic nationalism is considerably stronger now than it was then, and there is less confidence in other techniques for restoring growth. The risk, therefore, is greater.
China and the United States worked well together in the context of the G20, and bilaterally, during the dark days of 2008. Their policies were instrumental in avoiding a much worse plunge in the global economy and in world financial markets — as well as in leading the international recovery. The two countries would both benefit from working closely again. So far, the impact on markets an economies of recent volatility is not nearly as bad as in 2008 — and the situation for most countries and financial institutions is much better. But vigilance and leadership are needed to avoid its worsening.
Developing a mutually supportive approach, and forging a consensus with other G20 countries on ways to come through this current period without nationalistic trade policies or mutually destructive currency devaluations would serve the interests of both China and the United States — and the global economy. A joint commitment to do that would be a good outcome for the coming summit.
Photo credit: Feng Li/Getty Images