China Policy Isn't Just About the Yuan

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What, maybe you expected Treasury Secretary Hank Paulson to come home from China with a pledge from Beijing to let the yuan strengthen, say, 30 or 40 percent against the dollar? If so, you were probably disappointed with the results of this initial "strategic dialogue" meeting between American and Chinese economic policymakers. Instead, China merely agreed to make its currency more flexible. Then again, if you expected dramatic results, you've probably never done business in China. Any U.S. salesperson or marketing executive with experience there surely understood just where Paulson was coming from when he said that the two groups of officials "agreed on many principles" and that the talks fostered "mutual understanding and trust."

The Chinese negotiating style is all about establishing "principles" as the first step in a lengthy process. Another hallmark of Chinese negotiations is zhengti guannian, or "holistic thinking." Instead of chunking out a problem into more digestible bites, as an American negotiator might do, the Chinese tend to attack all the pertinent issues at once. It's an approach Americans concerned about trade imbalances–the U.S. trade deficit with China will be at least $225 billion this year–might keep in mind as our economic relationship with China develops.

Although many politicians are obsessed with getting the Chinese to let the yuan appreciate against the dollar, it's hardly a quick or complete fix. Even a 40 percent yuan appreciation–a level predicted by some economists if the currency were allowed to freely float–might knock only $40 billion, if that, off the deficit, according to one study (PDF). Plus there might be unintended consequences. And as Harvard economist Gregory Mankiw has pointed out, a hands-off policy by China might actually result in Chinese citizens moving some of their savings overseas. If they demanded dollars for yuan in an effort to diversify their currency holdings, the dollar might actually strengthen further against the yuan, making the trade deficit worse. Even the total elimination of the U.S. trade deficit with China would still leave a massive gap with the rest of the world.

So think holistically. Other issues are just as important as currency adjustments. One biggie is protection of intellectual-property rights. And there's reason to think China may be willing to move more aggressively on this issue than in the past. A recent Morgan Stanley analysis concluded that "as China's economic prowess has moved rapidly up the value chain in recent years–from low-value-added items such as toys and textiles to increasingly high-value-added technology products–there is a growing consensus forming within the Chinese leadership that IPR protection is now in its best interest, as well." In short, China is getting more worried about other nations stealing its technology.

Longer term, the Chinese realize the need to shift to more consumption-based growth from investment-based growth, as a way both to create a more stable economy and to avoid a massive protectionist backlash in the West. One thing the Chinese government could do is create a social safety net so workers wouldn't feel the need to save so much. As a recent World Bank report suggested, "Measures in social security and shifting government spending away from investment towards health, education, and social safety could help increase consumption's share in [gross domestic product], policies that would also help in redressing the surpluses on the current account." Who knows, if Paulson can't make any headway on Social Security reform here, he might have better luck in China.