China and its Discontents

This morning Situation Report quoted Bonnie Glaser on Gen. Dempsey’s upcoming trip to China to meet the new Chief of the PLA General Staff Fang Fenghui:

The CSIS’ Bonnie Glaser tells Situation Report that Dempsey will take advantage of an increasingly engaging military-to-military relationship with China. She thinks Dempsey will be talking with the PLA about nuclear and cyber issues and also, of course, about Korea. “I’m pretty sure that one of the things that will be discussed is a very long desire to try to launch a dialogue with the Chinese about the potential for instability in North Korea and what the responses might be,” she said. “The potential for chaos, insecure WMD facilities and of course the risk” of a conflict on the Korean Peninsula between the Republic of Korea, the U.S. and the Chinese are all top concerns. Past attempts to address the potential failure of the North Korean regime have failed. But now may be the time because the Chinese have grown impatient at North Korea’s noise-making, and talking with the U.S. could send a strong signal to the North Korean leader, she said.

“I think that what we have now is a window of opportunity with China’s high level of frustration with the North Koreans and their provocations,” she said.

It would be a very good thing if this were true. Whereas China only recently became willing to credibly enforce sanctions on its erstwhile ally, it has so far not engaged in crisis planning with the U.S. over potential North Korean instability. At some point a crisis on the Korean peninsula will rear its head, war will break out, and the DPRK will collapse, and this lack of joint-planning will make an already-bad situation ten times worse. If a crisis does occur, my bet is that the PLA will cross the Yalu River in order to secure their borders, prevent a massive flow of people into China, secure WMDs, and stabilize the area. What will be different from the original Korean War will be that, even though both the U.S. and China will be heavily involved in North Korea, neither side will want nor intend conflict with the other. This makes planning and communication essential.

The driving force behind the U.S. deficits and China’s surpluses lies not in exchange rates but in structural factors that built up over time. Three factors largely explain the emergence of China’s trade surpluses: surging U.S. consumption that fueled import demand, maturation of the East Asian production sharing network centered on China, and ratcheting up of China’s savings rates.

The story of the origins of the decline in U.S. household savings rates which was then exacerbated by growing fiscal deficits and together led to the excessive demand for imports is well known and still unresolved. This part of the story has little to do with China, but reflects the political gridlock in Washington.

Yukon Huang, of the Carnegie Endowment and former country director at the World Bank, writes at The Diplomat that the U.S. “must get over” the renminbi. While it is true that China gets the low-added value side of the production chain, and that if counted properly, our trade deficits with Japan, South Korea, et al would be much higher, I think he discounts the role of Chinese state policy in perpetuating the trade deficit. The Chinese, in effect, have subsidized our consumption: all dollars that flow into export businesses must by law be surrendered to the People’s Bank of China, which then invests it right back into U.S. treasuries because it doesn’t know how to spend its money fast enough (there are already questions about the quality of the infrastructure investments China has made). This is one of the primary reasons why the Chinese savings rate is so high–because it’s Chinese state policy. Sure, the average consumer has a high savings rate because of the volatility of the Chinese market (no social security/safety net, very few safe investments so much of those savings flows into real estate or low-interest savings accounts that don’t keep up with inflation–financial market liberalization is a topic for another day). But state-enforced savings far outweigh consumer savings. This investment in Treasury bonds, in turn, aids the U.S. in taking out more debt, and ultimately, for U.S. consumers to buy more things. It’s a vicious cycle of consumption.

Huang does give the right solution, however: increased Chinese consumption. But again, he seems to think this is mostly solved by individual consumers buying more things. He does suggest the Chinese state do one thing: relax the hukou residency permit rules, so that migrant workers can feel more secure in spending more money. This is all well and good (the Chinese hukou system is draconian; the lack of labor mobility is a huge drag on the Chinese economy), but the Chinese state can do a lot more: by spending more of the money it puts into Treasury bonds! If it’s having trouble disbursing the money in the form of infrastructure investments, fine! Use it to create a viable social safety net and universal healthcare! Pay school teachers more! Invest in the Chinese people, rather than trying to build the next big infrastructure monstrosity that will fall apart in five years anyway.