China is under growing pressure from Asia, Europe and the U.S. to revalue its currency. Until recently, it even looked like we were about to embark on a sustained process of yuan revaluation fairly soon.
The Greek crisis may have changed that. The 15 percent slide in the euro’s value against the yuan over the past six months has eroded Chinese competitiveness in the market of its largest trading partner: the European Union. More importantly, many trade-deficit countries in Europe -- such as Greece, Portugal and Spain -- are having difficulty financing themselves. Without net capital inflows, these countries can no longer run current-account shortfalls.
Not surprisingly, concerns in China about euro weakness have fueled calls for caution in any decision to realign the currency. The yuan has already strengthened significantly in trade-weighted terms and the potential contraction in demand from China’s main trading partner could put serious pressure on Chinese exporters even before a yuan revaluation.
One school of thought says to allow more yuan appreciation might create a drag on the economy, just as the Chinese government is trying to wean itself off a massive, and perhaps toxic, dose of investment. China will probably be hurt by the impact of the Greek crisis, and it should try to limit the pain.
The reasoning sounds plausible and even responsible, but it might only exacerbate the problem for China over a longer horizon by increasing trade tensions, which historically have been especially damaging to surplus countries.
China plays a huge role in the global balance of payments. The Greek crisis and the larger European response will adversely affect existing trade. Limiting the damage for China necessarily means shifting the brunt of the adjustment to other countries.
Something similar happened in 1930 when the U.S., the leading trade-surplus nation at the time, foolishly used the Smoot-Hawley Tariff Act in an attempt to protect itself from the trade consequences of a collapse in the ability of European trade-deficit countries to finance themselves. U.S. protective measures implicitly required other deficit countries to absorb the full brunt of the impact, and this caused them to retaliate with tariffs, currency depreciations and import quotas.
What does all this have to do with Greece? For the foreseeable future, the major trade-deficit countries in Europe are going to find it very difficult to attract net new financing. At best they will be able, with official help, to refinance part of their existing liabilities.
New Capital Inflows
If they can’t attract net new capital inflows, they can’t run current-account deficits. There must be an equal, obverse reaction in the global balance of trade if there is a contraction in these large trade gaps, now equal to two-thirds that of the U.S. Either the trade surpluses of Germany and other European surplus countries must shrink by the same amount, or Europe’s overall surplus must expand by the same amount.
We will probably see a combination of the two, but a weaker euro -- as well as credit contraction, rising unemployment and a German reluctance to reverse policies that constrain domestic consumption -- will push most of the adjustment abroad via an expanding European current-account surplus.
If Europe’s current-account surplus grows, there must be a trade adjustment elsewhere. Either the current-account surplus of countries such as China and Japan must contract by the same amount, or the current-account deficits of countries such as the U.S. must grow (or some combination of both).
Should China resist a contraction of the current-account surplus by postponing a yuan revaluation, lowering real interest rates (which have already declined this year), slowing credit contraction, and otherwise trying to maintain exports -- let alone grow them -- most of the adjustment will be shifted to countries that don’t intervene in trade directly. The most obvious are current-account-deficit countries.
This would cause a sharp increase in their current-account deficits, but these countries are likely to resist by intervening in trade themselves. Unlike many other countries, the U.S. has limited ability to use interest rates or currency intervention to affect trade, so it must use tariffs. As happened in the 1930s, this would probably set off higher tariffs in other countries that couldn’t regain export competitiveness through currency intervention.
The Greek crisis is forcing a much more rapid adjustment in trade than the world is easily able to absorb. As in the 1930s, each country seems eager to pursue policies to avoid adverse trade effects, but these policies can only work by pushing the burden of adjustment onto other, equally unwilling, entities.
The only way to overcome a beggar-thy-neighbor crisis is if the major trading powers -- the U.S., China, Japan, Germany and the EU -- work out a plan in which the adjustment process is slowed as much as possible and the burden is shared. Is it possible for them to come up with something fair and equitable? Perhaps not, but unless they try, the world will adjust much more painfully.
(Michael Pettis is a finance professor at Peking University and is an associate at the Carnegie Endowment. The opinions expressed are his own.)
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