U.S.-China Trade War: Coming Soon?

Mr. Smith, who owns a small import business, met recently with a buyer from a large discount store chain. The buyer showed him a photo of a competing store's product—a small table with a $100 list price—and asked, "Can you make me a table like this, with a few modifications and a much lower price?"

A few minutes later, Mr. Smith e-mailed the photo to a manufacturer in China, along with a description of the requested changes. Within two weeks, the Chinese manufacturer had evaluated the product, produced a prototype to Mr. Smith's specifications, and air-freighted it to Mr. Smith for review. After making a few minor design adjustments—and receiving a large purchase order from the discount store buyer—Mr. Smith e-mailed his final product order to China. The Chinese manufacturer was ready to produce a container-load of inexpensive tables in four to six weeks. When the tables arrived, the discount store advertised them for sale at $29.99—well below the competition's $100 price.

If you were an American manufacturer, could you compete with this?

Consumers in the United States are enjoying a virtual tsunami of inexpensive, high-quality manufactured goods coming from China, a nation that is now being called "the workshop of the world." Cheap labor and fast, flexible production combine to make Chinese manufacturers extremely competitive.

One other key factor helps China leverage its growing industrial prowess. The People's Bank of China has fixed a very low exchange rate for the nation's currency, the yuan (also called the renminbi). One U.S. dollar currently buys about eight yuan. An importer's dollars buy much more Chinese merchandise, compared to what a Chinese manufacturer could buy with yuan in the U.S., which makes Chinese-manufactured goods very inexpensive for American retailers and consumers. Correspondingly, American-manufactured goods seem unusually expensive to the Chinese.

This imbalance has brought about a huge balance of payments deficit between the U.S. and China. Americans buy far more from China than China buys from the U.S., so dollars pile up in China. In 2005, the U.S. deficit with China was a record $201.6 billion. Last June set a monthly record with a deficit of $14.5 billion, and the annual deficit in 2006 is expected to set another record.

Normally, in the wake of such a deficit, market forces would be expected to shift the dollar-yuan exchange rate, so that the dollar would buy fewer yuan and Chinese manufacturers would become less competitive abroad, and Chinese exports would decline. However, the Chinese government has fixed the yuan's exchange rate against the dollar. Although the yuan was allowed to appreciate slightly in 2005, the official exchange rate is still extremely low, helping to keep Chinese manufacturers competitive and the Chinese economy growing at a blistering pace of 8 to 12 percent per year, spurring the rest of the world to lodge protectionist complaints.

Many observers perceive that China's authoritarian government cannot maintain political stability without such a high growth rate, because of an implied social contract with Chinese consumers. Indeed, as long as China experiences growth and relative economic prosperity, its people seem to be willing to accept their government's authoritarian control of daily life—at least for now.

But what would happen if China's manufacturing sector became less competitive? What would happen if economic growth slowed or ceased? What would happen if China revalued the yuan? Chinese citizens might demand change from their government—leading to serious economic, social and political instability.

In the Same Boat

Faced with a trade surplus, China needs to do something with all those dollars. Like many other Asian countries, China buys massive amounts of dollar-denominated assets, particularly U.S. Treasury securities. China and Japan's combined holdings of U.S. Treasury notes amount to nearly one trillion dollars! China accounts for about one-fourth of that figure.

If China were to stop buying U.S. Treasury notes, there would be great economic pressure to revalue the yuan, thus damaging China's economy. Yet such extensive buying cannot continue forever. Alan Greenspan, former chairman of the U.S. Federal Reserve, has warned that the present situation will inevitably lead to instability in the Chinese monetary system.

The Chinese Communists may have an "Asian Tiger" by the tail. They cannot let go, but neither can they maintain the present situation indefinitely. Additionally, a variety of older, struggling, socialist economic sectors exist alongside China's new and dynamic capitalist enterprises. Some observers think China's state-owned banking system is dangerously weak because of decades-old bad loans that prop up inefficient state-run industries.

The U.S. also faces serious problems because of its trade deficit with China. The U.S. government wants the Chinese to buy more from U.S. producers, and to this end has called for a revaluation of the yuan. But China has so far resisted. During his Asian tour in November 2005, U.S. President George W. Bush scheduled meetings with President Hu and Premier Wen of China, primarily to discuss economic concerns. Bush pressed for further revaluation of the yuan, and for increased import of U.S. goods.

Since then, the U.S. Congress has proposed punitive quotas or high tariffs on Chinese imports, if the Chinese do not revalue the yuan and import more U.S. goods. Most recently, U.S. Senators Lindsey Graham (R-SC) and Chuck Schumer (D-NY) announced last July that they would bring their trade deficit bill up for a vote by September 30 if China did not quickly overhaul its currency system. The bill mandates six more months of trade negotiations before imposing 27.5 percent tariffs on all goods imported from China. The Bush administration opposes the bill, which received 67 votes last year on a procedural question. Observers expect not only that it will pass if introduced, but that it could withstand a presidential veto.

The U.S. and China are economically interdependent, but this mutual dependence is not sustainable. China cannot maintain its high rate of economic and manufacturing growth without competitive access to the massive U.S. market. The U.S. cannot keep interest rates low—and offset the balance of payments deficit—unless China uses its excess dollars to buy U.S. debt in the form of Treasury securities. Economically, both nations are in the same boat, sailing toward a rocky reef, but unable to change course.

Could these two interdependent economies take each other down? A trade war between these two economic giants could seriously damage both nations' currencies and economies. Although China sells its goods to many countries, the U.S. is its biggest buyer.

If China were to sell its U.S. securities—or even just stop buying more of them—this would put great pressure on China to revalue the yuan, which in turn would damage China's price advantage in exports. This would dramatically slow down China's economic growth. Also, the loss of China as a buyer of U.S. debt could force an increase in U.S. interest rates and could prompt an American financial crisis.

Asian Tigers and Past Problems

There are parallels between China's present economic problems and the problems other "Asian Tiger" economies have experienced in the past. For instance, Japan in the 1980s was considered invulnerable economically, and Americans stood in awe of the banking, manufacturing and export prowess of "Japan Inc." However, Japan's banking system contained a huge volume of shaky loans, and the banks' accounting systems made it difficult for outside observers to analyze their loan portfolios. It turned out that Japanese banks were not accounting for their bad investments, unlike American banks which were required by the Federal Deposit Insurance Corporation to account for troubled loans as they occur.

As Japan discovered, postponing such problems only makes the final reckoning more difficult. The heady days of Japan's bubble economy in the 1980s led to economic quagmire and monetary deflation in the 1990s from which Japan has yet to recover fully.

Thailand suffered similarly from a currency crisis in 1997. Though a prosperous "Asian Tiger" economy in the early 1990s, the nation suffered from bad bank loans and from speculators hoping to cash in on perceived weakness of its currency, the baht. Because the baht had been linked closely to the U.S. dollar—like the yuan today—Thai exports sold cheaply on world markets.

The Thai economy had experienced spectacular growth during much of the 1990s—an 8 to 10 percent rate comparable to China's today—but its boom was based in part on heavy investment in real estate, financed by foreign borrowing. When the value of that real estate declined, banks were stuck with billions of dollars in bad loans. When the value of the dollar began to soar, lifting the baht with it, Thai exports slowed dramatically. Together, these factors led to the collapse of a once-vibrant economy.

Thailand's situation is of course not identical to China's, but the many similarities suggest that China is indeed vulnerable. Bad bank loans and an artificially low exchange rate have caused problems for other Asian economies, and it may soon be China's turn. One important difference, however, is that the U.S. economy is tied much more closely to China's than it was to Thailand's or Japan's.

Dollars or Euros?

The U.S. dollar has for many years been the world's international currency, and has been valued because of its perceived stability. Within the U.S., the Federal Reserve can control many factors affecting the dollar's value at home, such as short-term interest rates. However, it cannot control major factors affecting the dollar's value abroad, such as the trade deficit and the amount of overseas capital moving in and out of U.S. financial markets.

The trade deficit is a major contributor to the dollar's instability. In 2004, it was US$668.1 billion, and it is expected to soon top US$700 billion—with no decrease foreseeable! This deficit must be financed abroad, chiefly by Asian nations such as China and Japan. But how long will they—or can they— continue to finance it?

The situation is precarious. Were China to falter—and the U.S. to falter with it—nations would look for a more stable international currency. Were the U.S. to lose its economic preeminence, its pride, power and prestige would suffer accordingly. Politicians tend to deal with such difficulties as a problem of public perception, but the underlying economic realities cannot be talked away. Eventually, there comes a reckoning.

If the dollar declines in importance as the international currency, the United States could suffer considerable economic loss in addition to a loss of influence and prestige abroad. But which currency stands to gain from the dollar's loss? The euro.

In the late 1990s, economists often speculated that the euro would join the dollar as a favored international currency. However, the European Union's economic performance has been lackluster in recent years, and the mighty dollar has continued to dominate world trade.

In 1998, the European Union added ten new member states which have increased its population to more than 450 million people in 25 member states. The EU is now the world's largest single market, and will be increasingly well-equipped for the challenge of global competition.

It is hard to understate the euro's effect on the psychology of EU citizens and nations. A diverse continent where nations fought each other for centuries is now feeling the unifying effect of a common financial system. National currencies support national identities, and EU officials are now leveraging the euro's unifying effect to subordinate European national identities and foster instead a common European identity. Even the legal and tax systems are being "harmonized" among EU member states.

Many Europeans see the EU as a counterbalance to U.S. power, and some think that Europe should take a leadership role among world nations. If the euro were to join the dollar—or supplant it—as the favored international currency, EU power and prestige would be greatly elevated on the world stage, both economically and politically.

What Does the Bible Say?

Economists have likened the making of economic projections to "steering an automobile by looking in the rear view mirror." But God tells us, "I am God, and there is none like Me, declaring the end from the beginning, and from ancient times things that are not yet done, Saying, 'My counsel shall stand'" (Isaiah 46:9–10).

The Bible reveals that at the end of the present age—just before Christ's return—a great trading, political and social power will arise, consisting of a group of nations that come together for a short time to give their power and sovereignty to a great leader. This great power will ultimately fail, but its economic power will be built on trade (Revelation 18:3, 11–19).

Regular readers of Tomorrow's World understand that the prophecies concerning the house of Israel just before Christ's return tell the future of the U.S. and the British Commonwealth nations. While ancient Israel was set up as a theocracy, the U.S. is a secular democracy. Though it has no official religion, the U.S. was founded on a Judeo-Christian ethic by the consensus of its people. In recent years, however, many of those people have broadly rejected those traditional moral values. God warned long ago that "the Lord will greatly bless you in the land which the Lord your God is giving you to possess as an inheritance—only if you carefully obey the voice of the Lord your God, to observe with care all these commandments which I command you today. For the Lord your God will bless you just as He promised you; you shall lend to many nations, but you shall not borrow; you shall reign over many nations, but they shall not reign over you" (Deuteronomy 15:4–6).

Until recent years, the U.S. remained a net lender to the world, thanks to the great industrial output the nation was able to maintain. But that situation has changed. As a nation, the U.S. consumes much more than it produces. As a result, the U.S. is borrowing from abroad at a massive and unsustainable pace to cover its trade deficit. Foreign investors are also using their dollars to buy large quantities of U.S. stocks, bonds and real estate.

Wise King Solomon presided over a kingdom that was famously successful economically, and he warned that "the borrower is servant to the lender" (Proverbs 22:7). It is God who gives a nation "the power to get wealth" (Deuteronomy 8:18), and the U.S.' huge trade deficit shows that its wealth production is declining relative to its wealth consumption. God said that as He withdraws His blessing, the nation would become a net borrower. "He shall lend to you, but you shall not lend to him; he shall be the head, and you shall be the tail" (Deuteronomy 28:44). As of May 2006, foreign nations held $2.075 trillion of U.S. Treasury securities.

What will happen to the mighty U.S. dollar when the nation can borrow no more from other nations? Will trade and currency tensions between the U.S. and China precipitate a trade war or attacks on the dollar? If the U.S. becomes "the tail," who becomes "the head"? Tomorrow's World will continue to keep you informed about world events as they relate to Bible prophecies that are "declaring the end from the beginning."