Why some economists see a looming US-China trade war

From the halls of Congress to the World Trade Organization, US officials are increasingly criticizing China trade and currency policies – blaming them for America's huge trade deficit.

The storm clouds gathering over America’s trade relations with China darkened this week, prompting some observers to warn of a coming trade war between the world’s two largest economic powers.

As Treasury Secretary Timothy Geithner openly criticized China for keeping its currency undervalued, angry congressmen urged legislation that would punish China for artificially boosting its exports.

Adding to the threatening drumbeat, Washington lodged two new complaints against China at the World Trade Organization (WTO), charging that “China is breaking its trade commitments to the United States and other WTO partners,” according to a statement by US Trade Representative Ron Kirk.

These are all signs that major imbalances in world trade – where the US has the biggest deficits and China has the biggest surpluses – “make it inevitable we are going to end up in a messy situation,” says Michael Pettis, a professor of finance at Peking University in Beijing.

[Editor's note: The original version misidentified Mr. Pettis's current job title.]

Mr. Geithner spoke more clearly than ever before about US frustrations with the snail-like pace of Beijing’s moves to strengthen the value of its renminbi (RMB) currency.

“We are concerned, as are many of China’s trading partners, that the pace of appreciation has been too slow and the extent of appreciation too limited” he said. “We would have to see a very substantial change over time for that judgment to change.”

Since Beijing stopped tying the RMB to the US dollar last July, the Chinese currency has increased in value by about 1.5 percent. Some congressional critics of Beijing have claimed that the currency is overvalued by as much as 40 percent.

Geithner cautioned, however, against taking any steps that could spark retaliation from one of America’s most important trading partners.

Skepticism that a stronger RMB would reduce trade deficit

Some American economists say that boosting the value of the RMB, which would make Chinese exports more expensive abroad and US imports cheaper here, would help shrink the US trade deficit with China.

But the Chinese government warned against outside efforts to accomplish that. Foreign Ministry spokeswoman Jiang Yu said Thursday that “pressure cannot solve the issue. Rather, it may lead to the contrary.”

Leading Chinese economists have also cast doubt on US critics’ reasoning. At a conference Tuesday, Ding Yifan – an economist with a think tank that advises the Chinese government – warned that Washington would be unwise to touch off a trade war with its fastest-growing export market.

Nor is it clear that even a large appreciation in the value of the RMB would reduce the US trade deficit with China, argues Xiang Songzuo, deputy head of the International Monetary Institute at Beijing’s Renmin University.

In the three years before Beijing pegged its currency to the US dollar in July 2008, the RMB gained more than 20 percent against the dollar, he points out, “but the US trade deficit with China did not decrease. It increased.

“A policy of currency appreciation will not be of significant value to the US,” he insists.

Still, China 'reluctant' to enter a trade war

Even so, Prof. Xiang says, “Chinese leaders would be very reluctant to enter a trade war” with the United States. “America would also lose from such a war, but China worries more”, he adds.

That, he says, is because although Beijing is trying to derive more economic growth from domestic consumption, China’s economic performance is still heavily dependent on its export sector.

“Export industries employ so many people, and a drop in exports would mean a rise in unemployment which could cause very serious social unrest,” Xiang argues. “Social stability is Chinese leaders’ top priority, and the way to achieve it is fast economic growth to keep people working.”