April 20, 2005
The China Mess
By Lawrence Kudlow

There’s a lot of bad political and economic blood developing between China and Japan, and China and the U.S. None of it is going to lead to any good.

Anti-Japanese demonstrations have broken out in Shanghai and Hong Kong, with Chinese authorities looking on with winks and nods. The Chinese want Japan to apologize for aggression in the 1930s and 1940s, although Japan has done so about forty times in recent years. The Chinese also claim not to like Japan’s newly revised history textbooks on the subject. Then there’s the ongoing squabble about oil and gas reserves on some offshore islands.

But the problems here run much deeper. China doesn’t much like the fact that Japanese Prime Minister Koizumi is pulling his country even closer to the U.S. in the world terror war. This renewed U.S.-Japan alliance also implies that a free and democratic Taiwan will be protected against Beijing’s new “anti-secession” law.

Japan is also firm in supporting U.S. efforts to stop North Korea’s military and nuclear buildup. China dominates North Korea, so it could really put the pressure on Kim Jong Il to renegotiate a nuclear agreement. But China only says it will help with the North Korea problem and never seems to do very much.

China shows its two faces all the time. It praised the late Pope John Paul II upon his passing and then promptly jailed a Catholic bishop and a priest. It has been liberalizing its economy and reforming local government, but it is still a dictatorship without free national elections. Though it has taken steps to join the community of nations, it now appears to be launching a newly militant program of nationalism. Japan is the proximate target, but one ultimately suspects that all this is aimed at the U.S.

The U.S., however, isn’t helping matters by threatening to launch a currency- and trade-protection war against China. The U.S., Japan, and the rest of the G-7 nations are putting the heat on China to revalue, or “up-value,” the yuan and end its peg to the U.S. dollar. This is allegedly to correct global trade imbalances and stop “cheap” Chinese exports from flooding U.S. and European markets. But any meaningful currency adjustment would have to be a yuan revaluation of at least 25 percent. That would require significant tightening of Chinese monetary policy, which, in turn, would cause a big slowdown in Chinese economic growth.

Is that what we really want?

The threat of a currency war could be an unnoticed factor in the recent U.S. stock market plunge. A much slower China economy would take a percentage point or two off U.S. economic growth, especially in areas like commodities, cyclical industries, tech, transportation, shipping, and trucking. These are the exact market sectors that are getting hammered on Wall Street.

Have the U.S. Treasury, the G-7, and the IMF forgotten the recent history of misbegotten currency manipulation? When several Asian currencies were forced to de-link from the U.S. dollar in the 1990s, world deflation followed. Floating exchange rates were a big mistake then, and could be a big mistake now.

Treasury man John Snow insists on floating rates worldwide, but he forgets that emerging-country currencies don’t float -- they sink. Aren’t we yet persuaded that nations cannot devalue their way to prosperity? Or that currency stability is better than currency chaos?

China, remember, has a shaky banking system plagued with bad state-sponsored loans made to failing nationalized companies. A floating yuan might rise in the short run, but it could crash in the medium term as foreign investors withdraw their capital flows for fear of instability.

Fortunately, when Secretary of State Condoleezza Rice visited China recently, she avoided any mention of forcing a currency change. But John Snow, encouraged by Republicans, keeps pressing the unpopular point. Where’s the policy coordination inside the U.S. government?

Protectionist pressure on the Chinese is also rising. A trade-opening textile agreement has resulted in a temporary burst of Chinese clothing exports to the U.S. American clothing makers have had years to prepare for this, but instead they’re suing the U.S. government on so-called “anti-dumping” grounds. The Chinese government is meanwhile accusing the U.S., and rightly so, of reneging on the free-trade textile deal.

Why is the U.S. threatening economic warfare against China? Currency protection and trade protection not only blunt economic growth, they sour international political relations. If you add in the vexing problem of nuclear proliferation in North Korean and the historic ill-feelings between China and Japan, you’ve got a real geopolitical and economic mess brewing in northeast Asia. With no apparent solution in sight.

Lawrence Kudlow is a former Reagan economic advisor, a syndicated columnist, and the co-host of CNBC's Kudlow & Company.

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