Hu's Difficult Road Home

China could ease the global imbalance, but leaders are boxed in by thorny economic realities

Protocol gaffes aside, Chinese President Hu Jintao's mid-April swing to the U.S. went well: Dinner at home with Bill Gates, praise from U.S. business for a raft of trade deals, and a polite hearing on Capitol Hill.

The fireworks began right after he left on Apr. 21. In its first criticism of China's currency policies, the Group of Seven industrialized nations urged Beijing to let the yuan rise to help ease serious "imbalances" in global finance. The markets viewed this as a warning over America's yawning $800 billion balance-of-payments deficit, and a signal that China, which accounts for one-quarter of that deficit, is largely to blame. The dollar tumbled against the euro and yen.

Hu won't find an easy way to satisfy the White House or the G-7. The Chinese know what they must do. Central bank chief Zhou Xiaochuan has outlined a plan for China to achieve balanced trade with the world "in two to three years," after a $102 billion surplus in 2005. It intends to boost domestic consumption and imports, cut its $854 billion in foreign reserves, lower domestic savings, and will let the yuan respond more to market signals. If Beijing follows through, says Allan B. Hubbard, President George W. Bush's economic policy assistant, "that is a very significant move."

But reality is boxing Beijing in. Take the currency. Manufacturers of toys to textiles are already watching profits shrink because of rising fuel and material costs. Even the 3% rise in the yuan since July is hurting some producers. "Margins either must stop shrinking or we will have to close our business," says Peter Wang, general manager of Zhi Qiao Garments Co., a supplier for Nike Inc. (NKE ) and Converse Inc. based in Panyu, Guangdong. (NKE ) A steeper upward revaluation might be justified by the economic fundamentals. Yet it could wipe out many of these factories and spur mass layoffs.


Making growth less dependent on exports will be tough, too. Domestic consumption last year accounted for just under 51% of gross domestic product, Morgan Stanley Chief Economist Stephen S. Roach notes, compared with 65% for most developed economies. And consumer buying is concentrated in cities, where incomes surged 9.6%, as incomes of the 800 million rural Chinese rose just 6.2%. That shows China's wealth isn't reaching the masses. Concerned about weak health and retirement plans, meanwhile, the Chinese are adding to their nearly $2 trillion in savings, which get funneled into loans to industries.

As a result of excessive lending to manufacturers, Beijing cannot control exports or overall growth. China's exports leapt 27% in the first quarter, while the economy expanded by a torrid 10.2%. A sharply higher yuan would cool the runaway growth, though the fallout would be scary. Hu oversees the world's most dynamic economy. But his options are surprisingly limited.

By Dexter Roberts, with Pete Engardio in New York

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