Time to Restore a Balanced, Rules-Based Multilateral Trading System
Introduction: An Epic Trade Policy Challenge for the United States
The rules-based multilateral trade and financial system created at Bretton Woods in 1944 has been crumbling over the past decade. The WTO trading system to reduce trade barriers on a reciprocal, most-favored-nation basis has been replaced by a spreading network of bilateral and regional preferential trade agreements. And far more threatening, the IMF financial system, centered on convertible, non-manipulated exchange rates, has been undermined by rampant exchange rate mercantilism, principally by China and other Asian nations.
The trade impact of this decisive change in the rules-based multilateral economic system has been predominantly on the manufacturing sector, which accounts for two-thirds of global merchandise exports and three-quarters of U.S. exports, shares that have been growing over the past couple of years from the sharp decline in oil and other commodity prices. Manufacturing industry is also technology-intensive, which has long attracted mercantilist trade policies in advanced and newly industrialized nations to stimulate manufacturing production through ever-larger trade surpluses. And while oil and other commodity trade is principally driven by global supply and demand, trade in manufactures is highly price-sensitive, whereby exchange rates and trade barriers greatly influence trade competitiveness.
The result has been a radical geographic restructuring and a sharp rise in imbalances for trade in manufactures, with severe adverse impact on U.S. trade competitiveness. The U.S. share of global exports of manufactures plunged from 18% in 2000 to 12% in 2015, while the Chinese share quadrupled from 6% to 24%, and the EU share (in trade with non-members) was only down from 22% to 19%. Even more detrimental for U.S. manufacturing, from 2009 to 2015 the U.S. trade deficit in manufactures more than doubled from $300 billion to $650 billion, resulting in the loss of 2.5 million American manufacturing jobs, or a quarter of the sectoral labor force, while in the other direction the Chinese and EU trade surpluses in manufactures also more than doubled to over $1 trillion and $500 billion, respectively.
In broader financial terms, global current account imbalances are consequently on the rise, centered on the $450 billion U.S. deficit and the $300 billion or more Chinese and EU surpluses. Thus the rapid decline in U.S. trade competitiveness for manufactures is reinforcing a transition of the dollarized financial system of the past 70 years into an undefined multi–key currency relationship. The United States has fallen to a distant third place behind China and the EU for manufactured exports, while the protracted and growing U.S. current account deficit has resulted in three-quarters of a $20 trillion U.S. official debt being held by foreigners. These trends set the stage for a substantial decline in the dollar and the end of the dollarized financial system, which would provoke policy conflict and trade disruption.
This study analyzes this dramatic loss of U.S. trade competitiveness in the dominant manufacturing sector and its consequences for the world economic order, and is in two parts. Part One presents the radical changes in the geographic structure of trade in manufactures from 2000 to 2014, as well as in closely related business services. The soaring U.S. trade deficit and Chinese surplus through 2015 receive special attention, including a detailed look at the 10 largest high-technology sectors of trade where China has a very large and growing lead, especially in the IT sectors.
Part Two addresses in historical context the fatal decline of the existing multilateral trade and financial systems and projects two alternative courses ahead. The first and current course would be essentially to abandon the rules-based multilateral system in favor of market-driven developments, with governments reacting through mercantilist exchange rates and protectionist trade policies, which together would be highly disruptive for trade.
The second, proposed course would be a U.S.-led “new order” of policy obligations to restore a balanced, rules-based multilateral system. This strategy would begin with a clear and forceful U.S. statement that the current course of huge, protracted trade deficits in the dominant, technology-intensive manufacturing sector is no longer acceptable, and U.S. policy is to move promptly toward balanced trade. Implementation would integrate trade and exchange rate policies, including dispute procedures with interim trade sanctions against mercantilist exchange rate policies by trading partners with large trade and current account surpluses. In parallel, the many bilateral and regional free trade agreements would be consolidated within a WTO open-ended plurilateral free trade agreement linked to convertible exchange rates free of manipulation.
A critical theme throughout the Part Two policy analysis is indispensable U.S. leadership if the second, restoration course is to move forward. Successful restoration would center on agreement among the “Big Three”—the United States, the EU, and China—which together account for more than half of global exports of manufactures. This should be a common interest because the current course could be trade-disruptive for all. The other two, however, have overriding internal economic objectives and lack forward-looking global political vision. Chinese trade strategy is oriented toward a massive, Asia-centric trade surplus for technology-intensive manufactures, while the EU priority is to resolve financial imbalances within the eurozone, which benefit from an ever-larger trade surplus with non-members. The United States, in fact, played the dominant leadership role for the Bretton Woods launch and 60 years of successful implementation. But U.S. trade policy leadership has lost public support in recent years and can be rebuilt only through a new order trade strategy that would ensure fair and balanced trade for the United States, along the lines proposed here.
Such U.S. leadership, however, will be an epic trade policy challenge. Vested interests in the status quo by influential multinational companies and banks will strongly resist. The WTO and IMF institutional structures are also deeply beholden to current norms and procedures that essentially ignore the increasing trade and financial imbalances, especially among the Big Three. And the most important challenge, in political as well as economic terms, will be to achieve a far more balanced U.S.–China bilateral trade relationship. The political sage Machiavelli, in a quote on my office wall, observed 500 years ago, “Nothing is more difficult to carry out, nor more doubtful of success, nor more dangerous to handle, than to initiate a new order of things. For the reformer has enemies in all who profit by the old order, and only lukewarm defenders in all those who would profit by the new order.”
These words ring true in today’s world of trade relationships. The stakes, however, are high and the potential for trade disruption from continuing the existing old order is great. Bold U.S. trade policy leadership for a new order of trade relationships should therefore be launched, which this study attempts to stimulate during this election year.
Part One: The Decline of U.S. Trade Competitiveness for Manufactures, 2000-2015
Manufactures account for about two-thirds of global merchandise exports, and this share has been rising during the past couple of years from the sharp decline in oil and other commodity prices. Moreover, manufactures are at the center of the international trade and financial system, facing more extensive import and other trade barriers and far greater impact from mercantilist exchange rate policies. Trade in oil and other commodities, in contrast, is driven principally by global supply and demand.
Part One of this study thus addresses the dominant manufacturing sector of trade with a focus on the dramatic decline in U.S. trade competitiveness from 2000 to 2015. The U.S. share of global exports of manufactures plunged from 18% in 2000 to 12% in 2015, while the Chinese share quadrupled from 6% to 24%, and the EU share (in trade with non-members) was only down from 22% to 19%. Even more disturbing for the trading system has been the more than doubling of the U.S. deficit in manufactures from $300 billion in 2009 to $650 billion in 2015 and, in the other direction, the more than doubling of the Chinese and EU surpluses to more than $1 trillion and $500 billion, respectively. Moreover, 60% of the global U.S. deficit in 2015 was with China, with U.S. manufactured imports from China six times larger than U.S. exports to China.
This hugely unbalanced trade relationship among the “Big Three,” which also have the big three currencies, poses serious threats to both trade and financial relationships, as reflected in the equally disturbing contrast in the more broadly based current account balances: a rising U.S. current account deficit of $450 billion is principally the result of the growing $300 billion Chinese and EU surpluses. And as a result of prolonged, very large U.S. current account deficits, three-quarters of the 2017 U.S. $20 trillion official debt will be held by foreigners, interest on which will further increase the current account deficit as Treasury rates rise.
And yet American leaders have not given this trade policy challenge the top priority it deserves, including in official dialogue with China. Part Two of this study examines this policy failure and offers a forceful U.S. policy response to greatly reduce if not eliminate the U.S. trade deficit in manufactures. But first, Part One lays out the basic facts for trade in manufactures and integrated business services from 2000 to 2015, with the hope that this irrefutable, highly disturbing account will stimulate serious, forward-thinking action by the U.S. government.
The Declining U.S. Share of Global Exports of Manufactures, 2000-2014
Table 1 presents exports of manufactures by the 14 largest exporters, from 2000 to 2014, which together accounted for $8,168 billion, or 88%, of global exports in 2014. Three overriding relationships tell the extraordinary story of the course of trade in manufactures over only 14 years.
Table 1 – Leading Exporters of Manufactures
First, all 14 exporters are from the three dominant exporting regions: 8 in Asia, 3 in Western Europe, and 3 in North America. Turkey has had a customs union with the EU since 1995 and is therefore in the Western Europe region for trade in manufactures, as reflected in its 450% increase in manufactured exports. Moreover, if other, smaller Asian exporters are included, the 88% would rise above 90%, leaving less than 10% of global exports of manufactures by the rest of the world—South and Central America, Africa, the Middle East, and Eastern Europe, including Russia. This three-region concentration in export-orientated industrialization is, if anything, intensifying from export-driven trade strategies, making the other regions of the world even more dependent on exports of fuels, industrial raw materials, and agricultural commodities, which are vulnerable to disruptive swings in price and quantity. This important subject is worthy of in depth investigation, although it is largely beyond the scope of this study.
Second, among the three dominant exporting regions, the Asian share has risen sharply from 2000 to 2014, principally offset by a major decline in the North American share. As shown in the bottom three lines of the table, exports of the eight Asians grew by 249%, to $4,363 billion in 2014, while Western European export growth was 155%, to $2,120 billion, and North American growth lagged far behind at 75%, to $1,685 billion. As a result, the Asian share of exports by the 14 rose from 35% in 2000 to 53% in 2014, while the North American share dropped from 27% to 21%, and the Western European share was only down from 24% to 23%. The Asian century is thus already in full bloom for exports of manufactures.
The third and most politically charged changed relationship is by and among the “Big Three” exporters—China, the EU, and the United States—whose aggregate share of world manufactured exports rose from 45% in 2000 to 55% in 2014. Most important is the dramatic changing of places among the three, with Chinese export growth of 901%, EU growth of 143%, and U.S. export growth of only 79%, or about half the EU growth and less than a tenth of Chinese growth. As a result, the Chinese share of global exports quadrupled, from 6% in 2000 to 24% in 2014, the EU share declined from 22% to 19%, and the U.S. share plunged from 18% to 13% in 2014 and, as explained below, to 12% in 2015. In absolute terms, U.S. exports of $650 billion in 2000 were almost three times larger than Chinese exports of $220 billion, while by 2014, Chinese exports of $2,202 billion were almost double U.S. exports of $1,164 billion.
These export figures for the dominant manufacturing sector of trade raise a number of policy issues, principally related to trade among the advanced and newly industrialized exporters in the three regions. Even more disturbing and threatening for policy conflict, however, has been the rapid rise since 2009 in trade imbalances among the three regions, and most sharply among the Big Three.
The Soaring U.S. Trade Deficit in Manufactures, 2009-2014
The most definitive measure of the decline in U.S. trade competitiveness for manufactures is the soaring trade deficit since 2009. The trade balance is the bottom line for the impact on American production and jobs. Manufactured exports can have imported components and imports can have previously exported components, but this nets out in the bottom-line trade balance. As for the impact on U.S. jobs, estimates range from 4,000 to 10,000 American manufacturing jobs lost for each $1 billion increase in the trade deficit, depending largely on the mix of industries being examined. The midpoint of 7,000 jobs is used throughout this study as a reasonable approximation of the job loss from the growing trade deficit.
Table 2 presents the trade balances for manufactures in 2009 and 2014 for the same 14 largest exporters listed in Table 1. The central, overriding development is the huge increases in the trade imbalances in only five years, both among the three exporting regions and even more sharply among the Big Three. The surplus by the eight Asians rose by $697 billion, or 74%, the surplus by the three Europeans rose by $273 billion, or 101%, and in the other direction, the deficit by the three North Americans increased by $306 billion, or 73%. Six of the eight Asians and all three Europeans had growing surpluses, while for the North Americans, the United States and Canada had much larger deficits while the Mexican deficit of $16 billion declined to $8 billion. As for the Big Three, their rapidly growing trade imbalances overwhelm the other 11 imbalances. The Chinese surplus rose by $574 billion, or 128%, the EU surplus rose by $247 billion, or 108%, and the U.S. deficit was up by $267 billion, or 83%. Together, these soaring trade imbalances by the Big Three, as a share of the imbalances for all of the 14, rose from 61% in 2009 to 72% in 2014, with the next largest deficit increase of $47 billion by Canada and the next largest surplus increase of $82 billion by South Korea. This increasingly dominant rise in the Big Three trade imbalances for the price-sensitive and technology-intensive manufacturing sector will thus be a central policy issue in Part Two, not only for trade policy, but also for the financial relationship among their three key currencies.
Table 2 – Trade Balances in Manufactures
Table 3 provides a detailed look at U.S. exports and trade balances for manufactures for principal regions and trading partners in 2009 and 2014. Five salient geographic dimensions of U.S. trade emerge that are fundamental to a U.S. strategy to restore U.S. export competitiveness for manufactures:
- The three dominant exporting regions also dominate U.S. manufactured exports. U.S. manufactured exports to North America, Asia, and Western Europe were $957 billion in 2014, or 82% of global exports of $1,164 billion;
- Among the three regions, North America is well out in front as the number one region for U.S. exports. U.S. exports to North America in 2014 were $412 billion, compared with $306 billion to Asia and $239 billion to Western Europe. North America thus accounted for 35% of U.S. global exports of manufactures, well ahead of the 26% for Asia and the 21% for Western Europe, thanks largely to free trade and investment within NAFTA;
- The contrast in the U.S. trade balances among the three regions is far greater than for exports. The U.S. trade balance within North America in 2014 was a small surplus of $22 billion, with a moderate surplus with Canada offsetting a smaller deficit with Mexico. Trade with Asia, in stunning contrast, was in deficit by $577 billion, or 98% of the $588 billion global deficit, and the $149 billion deficit with Western Europe added substantially to the overall deficit with the three regions of $704 billion;
- As for bilateral balances, the three largest U.S. deficits in 2014 were with China, at $390 billion, the EU, at $137 billion, and Japan, at $86 billion. Manufactured imports from China of $470 billion were 5.9 times larger than the $80 billion of U.S. exports to China;
- The rest of the world, beyond the three dominant exporting regions, only accounted for 18% of U.S. manufactured exports in 2014, and the United States had a surplus of $116 billion. This reflects the large trade deficits in manufactures in these regions, although the surplus is relatively small compared with the huge deficits with Asia and Western Europe. Noteworthy is that U.S. manufactured exports to Brazil of $32 billion were only 3% of global exports and the $9 billion of exports to Russia were less than 1%.
Table 3 – U.S. Trade in Manufactures by Region and Principal Trading Partner ($billions)
An important dimension of the rising U.S. trade deficit in manufactures since 2009, presented in Table 4, is the deficit with the EU, up from $51 billion in 2009 to $137 billion in 2014. This increase is marked by a striking contrast between the more than tripling of the deficit for the four listed eurozone members, by $72 billion, from $32 billion in 2009 to $104 billion in 2014, dominated by the $46 billion increase in the deficit with Germany, and balanced trade with the non-eurozone United Kingdom, in surplus by $1 billion in 2014. The remainder of the EU also shows a substantial deficit increase of $18 billion since it principally involves trade with eurozone members. This contrast, highly unfavorable for U.S. trade, stems principally from an undervalued euro because of its uncertain future and very low euro interest rates.
Table 4 – U.S. Trade in Manufactures With Principal EU Members
Growing Asian Export Competition for Business Services, 2009-2014
Trade in manufactures and business services are deeply linked, often within manufacturing companies. U.S. exports of business services in 2014 of $171 billion were 15% as large as manufactured exports, and were in surplus by $43 billion, or 7% as large as the deficit for manufactures.1 This surplus has led some observers to conclude that a rising U.S. surplus for business services could progressively offset the growing deficit for manufactures. Chinese officials have likewise responded to U.S. complaints about the rising bilateral deficit for manufactures by saying that this is offset by a growing surplus for business services.
Such optimism, however, has never been justified by the facts.2 Since 2009, the United States has faced rapidly growing export competition from India and China, which make up, together with the EU and the United States, the “Big Four” exporters of business services. In 2014, they accounted for 63% of global exports of business services. Business services, like manufactures, are highly price- and therefore exchange rate–sensitive, indeed even more so. Export growth for manufactures requires a large upfront investment in a factory and the payment of transport costs to market. Business services companies, in contrast, need only rent office space and plug themselves in. Moreover, in recent years, for India and China, tens of thousands of business services professionals have graduated from U.S. universities and returned home, in many cases for lack of a permanent U.S. work visa, some with valuable Silicon Valley work experience.
Trade statistics for business services are far more limited compared with manufactures, but the WTO does provide statistics for principal trading nations for two broad categories of business services: telecommunications, computer, and information services and other business services, the latter including legal, management, R&D, engineering, and other technical services.
Exports and trade balances for the two categories together for the Big Four for 2009 and 2014 are presented in Table 5. U.S. exports grew by $54 billion, or 46%, over the five years, while Indian and Chinese exports grew much faster, by $39 billion (61%) for India and $44 billion (83%) for China. Thus by 2014, Indian and Chinese exports of business services of $200 billion were larger than the $171 billion of U.S. exports and growing much faster, while the EU remained by far the number one exporter, with $378 billion (as always, for exports to non-members). The increases in the trade surpluses are even more disturbing, with the United States in last place with only a $12 billion increase over the five years, compared with the EU surplus up by $65 billion, the Indian surplus up by $33 billion, and the Chinese surplus up by $26 billion, with the percentage growth in the surpluses even more striking: 39% for the United States, 87% for India, 97% for the EU, and 163% for China.
Table 5 – Exports and Trade Balances for Business Services
Table 6 provides the same information for trade in 2014 for the telecommunications, computer, and information services sector, which can be referred to as the information technology or IT sector, as will be related to U.S. and Chinese trade in IT goods in Table 9 below. U.S. exports of these IT business services of $34 billion are less than a third of the $117 billion of EU exports, and only 61% of the $56 billion of Indian exports, while Chinese exports of $20 billion are not that far behind. And the U.S. surplus of a meager $2 billion trails far behind the $9 billion Chinese surplus, the $52 billion Indian surplus, and the $53 billion EU surplus.
Table 6 – Exports and Trade Balances for Telecommunications, Computer, and Information Services, 2014
This is the composite picture, as data permit, of the sharp decline in U.S. trade competitiveness for price-sensitive business services over the past five years, which reinforces rather than offsets the far larger U.S. competitive decline for manufactures.
U.S. and Chinese Trade Imbalances in Manufactures Surge in 2015
The soaring U.S. trade deficit in manufactures from 2009 to 2014, and the accompanying rise in the current account deficit, entered a new and accelerated stage in 2015 with the global economic slowdown in GDP, which usually involves an even wider downward swing for the trade-intensive manufacturing sector. This disproportionately large adverse impact on trade is the result, in large part, of nations pursuing more mercantilist trade policies so as to alleviate decline in the domestic market through reduced imports and a larger trade surplus.
The multilateral trade figures for 2015 will not be posted by the WTO until October 2016, and the presentation here in Tables 7-9 is limited to U.S. and Chinese trade in manufactures, based on national trade figures.3 This is nevertheless a fitting conclusion for the Part One trade analysis since the United States and China are at the center of the highly unbalanced global trade accounts, with by far the largest trade deficit and surplus ever recorded. And the mercantilist dimension of the Chinese response to its lower GDP growth was especially large, with greatest adverse impact on the rising U.S. trade deficit.
Table 7 presents U.S. and Chinese global trade in manufactures for 2014 and 2015. In 2015, U.S. exports of manufactures were down 3%, imports rose by 3%, and the trade deficit soared by 16%, or $89 billion, to $650 billion.4 This equates to a trade-related loss of about 600,000 American manufacturing jobs, up from 400,000 jobs lost in 2014, and bringing the cumulative six-year loss to 2.5 million, about a quarter of the sectoral labor force.
Table 7 – U.S. and Chinese Global Trade in Manufactures, 2014-2015
Chinese trade statistics recorded a $59 billion, or 3%, decline in exports, of which $9 billion was iron and steel, but imports declined more sharply, by 9%, and the trade surplus consequently rose by 5%, or $48 billion, to $1,046 billion for the year. The very large decline in imports reflects a growing mercantilist dimension of Chinese policy, for example through financial incentives and directives to multinational companies to produce more of their formerly imported components in China.
Moreover, the 2015 increase in the Chinese surplus was significantly larger than the recorded $48 billion as a result of over-invoicing of imports toward the end of the year into Hong Kong and free trade zones in Shanghai and elsewhere to circumvent restrictions on the outflow of capital. In December 2015, compared with 2014, Chinese trade data recorded a 64% increase in imports from Hong Kong, while Hong Kong imports were up by only 1%, with almost all Hong Kong imports in transit to China.5 Chinese imports from Hong Kong in December 2015, likewise, increased by 70% from December 2014. Thus the recorded decline of 9% in manufactured imports for 2015 was actually significantly larger, as was the 5% increase in the trade surplus to $1,046 billion. The difference could well be in the tens of billions of dollars, clearly bringing the 2015 surplus to $1.1 trillion.
As for the overall comparison between U.S. and Chinese trade competitiveness for the manufacturing sector of trade, there has never been anything close to the current hugely unbalanced trade accounts. Chinese global exports of manufactures in 2015 were almost double U.S. exports, while the Chinese surplus together with the U.S. deficit of $1.8 trillion approaches 20% of world exports. Such enormously unbalanced trade for the two largest trading nations is clearly in need of major reduction through trade adjustment measures as discussed in Part Two.
Table 8 presents U.S. trade in manufactures in 2015 for principal trading partners. The deficit is dominated by China, with $387 billion, or 60% of the global deficit, with U.S. manufactured imports from China of $469 billion 5.8 times larger than the $82 billion of U.S. exports to China. Regionally, the deficit of the seven listed Asians totaled $587 billion, or 90% of the global deficit. Also noteworthy, the three listed Asian members of the Trans-Pacific Partnership (TPP) trade agreement—Japan, Malaysia, and Vietnam—recorded a deficit of $132 billion, with imports from Vietnam of $34 billion nine times larger than the $4 billion of U.S. exports to Vietnam.
Table 8 – U.S. Bilateral Trade in Manufactures, 2015
The five principal EU trading partners listed show a sharp distinction between the four members of the eurozone—Germany, France, Italy, and Spain—with a U.S. deficit of $113 billion, of which $73 billion was with Germany, and the non-eurozone United Kingdom, with only a $2 billion deficit. This reflects the undervalued euro to the dollar over the past several years for price-sensitive manufactures.
The NAFTA trade relationship with Canada and Mexico deserves to be highlighted in view of strong criticism of Mexican trade during recent electoral debates. The $405 billion of U.S. exports to NAFTA were almost double the $213 billion exports to the seven listed Asians, and triple the $134 billion to the five EU members. And the trade deficit differential is even more striking. The $11 billion NAFTA deficit, consisting of a $48 billion surplus with Canada and a $59 billion deficit with Mexico, is trivial compared with the $587 billion deficit with the seven Asians and the $115 billion deficit with the five EU members. There was a negative shift in the 2015 NAFTA balance, with the Canadian surplus down by $15 billion and the Mexican deficit up by $13 billion, but this shift reflects, in large part, very large trade deficits in manufacturers across the Pacific, and consequent large current account deficits by all three North Americans, and so the U.S. response to the growing trade deficit with Mexico needs to begin by confronting mercantilist Asian currencies, which should benefit all NAFTA members.
Finally, Table 9 presents U.S. and Chinese global exports and trade balances for the 10 largest high-technology sectors of trade in 2015, which accounted for 52% of total Chinese manufactured exports and 65% of U.S. exports. The rapid rise of Chinese technology-intensive exports is by far the most important qualitative development in the U.S.–China trade competitiveness relationship, which is shockingly demonstrated by these figures. For the 10 sectors, Chinese exports in 2015 of $1,127 billion were 50% larger than the $752 billion of U.S. exports. Even more disturbing, Chinese trade was in surplus by $354 billion while U.S. trade was in deficit by $357 billion, and the Chinese surplus has soared by 128% since 2009, as has the U.S. deficit by 166%.
Table 9 – U.S. and Chinese Exports of High-Technology Industries, 2015 ($billions)
The full picture of the rapid rise of Chinese export competitiveness in high-technology industries is revealed by the performance of the 10 individual industries. The only two industries where the United States maintains a large export lead are road vehicles, centered on the deeply trade-integrated North American automotive industry within NAFTA, dating back to the U.S.–Canada free trade Auto Pact of 1965, and other transport equipment, thanks largely to Boeing. But for road vehicles, the United States had a very large global deficit of $152 billion in 2015 as a result of deficits with Asia and Europe. The United States also had a lead in exports of medicines and pharmaceutical products, although the trade is relatively smaller, and the U.S. $36 billion global deficit is far larger than the $7 billion Chinese deficit.
The Chinese lead centers on the information technology (IT) industries—office and data processing equipment, telecommunications and sound recording, and electrical machinery and appliances, listed 5 through 7. Chinese exports for the three industries in 2015 of $773 billion were 3.6 times larger than the $213 billion of U.S. exports and, even more striking, Chinese exports were in surplus by $302 billion, compared with a U.S. deficit of $227 billion. These figures, together with the rapid growth in Chinese IT business services presented in Table 6, indicate that China has the most to gain from the 2015 WTO Information Technology Agreement, even though China was the most reluctant to open its market on a reciprocal basis.
For the three machinery industries, listed 2 through 4, Chinese exports of $175 billion in 2015 were larger than the $165 billion of U.S. exports, and again the Chinese surplus of $73 billion contrasts with a U.S. deficit of $48 billion. And at least to end on a positive note, for professional and scientific instruments, U.S. exports of $60 billion were slightly larger than the $58 billion of Chinese exports, while the U.S. $8 billion surplus stands in favorable contrast with the $22 billion Chinese deficit.
The Troubled Trade Policy Course Ahead
This concludes the detailed presentation of the dramatic decline in U.S. trade competitiveness for the technology-intensive manufacturing sector since 2000, capped by the soaring trade-related loss of American production and jobs since 2009, which accelerated in 2015. The manufacturing sector is not only the dominant sector of trade, but its technology-intensive content cannot be overemphasized for its impact on national economic performance. For the United States, manufacturing accounts for about 70% of R&D expenditures and 90% of new patents, which are the driving forces for productivity growth. Chinese manufacturing production, in particular, now double or more of U.S. production and increasingly concentrated in high-technology industries, is challenging U.S. technological leadership in key sectors through its export-oriented growth strategy and a $1+ trillion trade surplus in manufactures.
The consequences for this U.S. competitive decline for the troubled trade policy course ahead thus justify the study subtitle, With Technology-Intensive Manufactures at Center Stage. And these policy consequences, as addressed in Part Two of this study, fall into two categories of policy issues. The first category involves the direct impact on U.S. economic performance. How much will U.S. productivity growth and high-skill job creation be impaired by export-oriented growth in manufacturing by principal trading partners? For example, China is now achieving more rapid development and application of robotics for a wide range of industries.
The second category of issues relates to the fatal decline underway for the rules-based multilateral trade and dollarized financial systems, driven principally by the greatly reduced U.S. share of global exports together with the very large and growing current account deficit and consequent buildup of official U.S. foreign debt. This encompasses a more complicated set of policy issues, but based on the highly unbalanced shifts in trade and current account imbalances since 2009, a potentially disruptive end of the existing systems appears to be close upon us.
The short-term trade-related question is where the protracted U.S. decline in global competitiveness for manufactures is headed for 2016 and 2017. Perhaps the Chinese trade surplus will level off in 2016, but the greatly excessive trillion-dollar surplus will almost certainly continue, as will the more broadly based and growing Asian surplus, largely driven by Chinese export-oriented investment. There is also unlikely to be a major decline in the U.S. trade deficit, which currently transfers 40% of American consumption of manufactures to foreign production, principally in Asia.
The MAPI Foundation quarterly reports on U.S. and Chinese trade in manufactures for the first quarters of 2016 will shed light on these immediate trade developments, and should be of keen interest in this election year. But any short-term developments in trade should not detract from the critical need for fundamental reform to restore a balanced, rules-based multilateral trade and financial system, to which this presentation now turns.
Part Two: Restoring a Balanced, Rules-Based Multilateral Trading System
Part One documented the dramatic decline of U.S. trade competitiveness for the dominant manufacturing sector since 2000, driven principally by mercantilist, export-oriented growth strategies by Asian trading partners, centered on China, which alone accounts for 60% of the U.S. global trade deficit, with U.S. manufactured imports from China six times larger than U.S. exports to China.
Part Two analyzes the consequences of this huge trade imbalance between the two largest exporters of technology-intensive manufactures for the deeply troubled international trading system. Two alternative courses ahead are presented. The first is to continue the current course of unsustainably large trade imbalances within what is a non-functioning multilateral trading system headed toward policy conflict, with likely severe disruption of trade.
The second course would be to restore a balanced, rules-based multilateral system in compliance with disciplined policy obligations within the WTO and IMF. A U.S. strategy to this end is proposed that would begin with a clear and forceful U.S. statement that the current course of huge and protracted deficits for the dominant, technology-intensive manufacturing sector is no longer acceptable, and U.S. policy will be to move promptly toward balanced trade. To this end, a central objective for achieving fair and balanced trade, dating back to the 1944 Bretton Woods agreement, would be enforced obligations for convertible, market-based currencies free of manipulation. This integration of trade and exchange rate policies would then be used to consolidate the spreading network of bilateral and regional preferential trade agreements within a WTO-based, open-ended plurilateral free trade agreement.
A recurring theme throughout Part Two is essential U.S. leadership, which will be more difficult because of the greatly reduced U.S. share of global exports, and the most difficult dimension of this leadership challenge will be the U.S.–China relationship. Full Chinese participation in the proposed reform strategy will not be necessary at the outset, and initial U.S.–China disagreement could lead to interim U.S. trade sanctions against China. Such sanctions could be avoided, however, through full and frank discussion of the political realities of the current hugely unbalanced trade relationship for technology-intensive industries, driven by comparably unbalanced trade and exchange rate policies.
The presentation begins with a brief historical account of the Bretton Woods multilateral agreement and almost 60 years of successful implementation, which is followed by analysis of its fatal decline since 2000, including the unfolding end of the dollarized financial system. The two alternative courses ahead are then presented, with greater detail for the second course to restore a balanced, rules-based multilateral system. The final section addresses the indispensable U.S. leadership role and the critical importance of achieving mutual U.S.–Chinese support for a fair and balanced multilateral trading system.
The 1944 Bretton Woods Agreement for a Multilateral Trade and Financial System
Economic leaders from 44 nations gathered at Bretton Woods, New Hampshire, in July 1944 to replace the widespread “currency manipulation,” as the phrase was coined, and highly protectionist bilateral trade agreements of the 1930s, with a new multilateral system of increasingly open and balanced trade with reasonably stable exchange rates. The meeting took place in the midst of the economic destruction of the Second World War, and the need for a bold postwar economic recovery program was paramount in the minds of the delegates. Leadership for the new economic system centered on the United States and the United Kingdom, with roots dating back to the 1941 Atlantic Charter, when President Roosevelt and Prime Minister Churchill agreed on postwar goals, including the right of all nations to equal access for trade and raw materials.
The principal Bretton Woods result was to launch a multilateral financial system within the newly created IMF, with obligations to minimize competitive devaluations to achieve an unfair competitive advantage in trade. The highly able and experienced U.S. delegate, Harry Dexter White, observed: “Given the choice, every country prefers to have its currency undervalued rather than overvalued.”6 A dollarized system was adopted, with other currencies pegged to the dollar, requiring IMF approval for changes of more than 10%, and with the dollar convertible to gold. The anticipated large trade deficits by the European and other economies in the immediate postwar years were to be financed by the IMF, the newly created International Bank for Reconstruction and Development (now the World Bank Group), and the U.S. Marshall Plan.
Another central IMF financial obligation was that currencies were to be convertible for trade and other current account transactions. As for trade policy, a multilateral trading system was agreed in principle at Bretton Woods, and realized in 1949 with the creation of the General Agreement on Tariffs and Trade (GATT), to be engaged in progressive trade liberalization on a non-discriminatory, most-favored-nation basis.
Thus a highly creative and forward-looking agreement was reached at Bretton Woods, and it was successful beyond expectations for postwar economic recovery. Within 10 years, sustained, export-led growth was achieved by the major Western European economies, which led to the formation of the free trade European Economic Community in 1957, while there was a similar robust economic recovery for the war-torn Japanese economy. This extraordinary success, however, caused the initial dollar-pegged exchange rate system to be overtaken by events, with the result that the successful 60-year implementation of the Bretton Woods financial system became divided into two very distinct and fundamentally different stages, which have not been adequately understood in recent debate over the future course of financial relationships, and therefore benefit from a brief explanation.
Stage one of the Bretton Woods exchange rate system, with currencies closely pegged to the dollar to prevent competitive devaluation, did provide a stable financial setting for European and Japanese postwar economic recovery. By the early 1950s their currencies were fully convertible for current accounts, as required by the IMF, and by the 1960s they were achieving growing trade surpluses, centered on the price-sensitive manufacturing sector, offset by a rapidly growing U.S. trade deficit. The appropriate trade-adjustment policy response at this point would have been for the Europeans and Japan to appreciate their currencies, but they resisted such export-inhibiting action and there was no IMF obligation requiring them to do so. Meanwhile, political pressure was building in the United States, as is happening today, to do something to reduce if not eliminate its very large and growing trade deficit.
This was the deeply troubled political setting for the transition to stage two of the Bretton Woods financial system through a forceful U.S. initiative in August 1971. President Nixon had assembled a pro-active economic team, headed by Secretary of the Treasury and former Texas Governor John Connally and his highly able young Under Secretary Paul Volcker, with White House support from Henry Kissinger and his NSC staff. The United States proposed to its European and Japanese allies that the dollar-pegged exchange rate system, with the dollar convertible to gold, be replaced by convertible, market-based exchange rates as the principal policy instrument for adjusting trade imbalances. IMF Article IV was elaborated to define prohibited currency manipulation as protracted, large-scale official purchases of foreign exchange to gain an unfair competitive advantage in trade. To jumpstart the transition, the United States imposed an interim 10% surcharge on imports, which shocked trading partners, and became known as the “Nixon shock.”7
The Europeans and Japan reluctantly accepted the U.S. proposals and the second stage of the Bretton Woods exchange rate system was launched with dramatic financial and trade results. Over the next several years, market-based European exchange rates rose by more than 100% to the dollar and the Japanese yen rate rose even further, from 360 to the low 100s. As a result, the growing large U.S. trade deficit in manufactures reversed course and declined greatly. And so Bretton Woods stage two brought about far more balanced trade in price-sensitive manufactures among the industrialized nations, which lasted until the turn of the century.
One important dimension of this successful transition to market-based exchange rates, of current relevance, was that the dollar decline of more than 50% relative to the European and Japanese currencies increased prices of imports for American consumers and doubled European and Japanese per capita dollar incomes to be much closer to the U.S. level. This impact from a decline in the dollar, however, was fully anticipated by the U.S. government as a central consequence of the transition to market-based exchange rates and more balanced trade. Today, in contrast, there are mixed opinions in the United States about a large decline in the dollar, and little anticipated joy in China and other Asian nations from the large rise in their dollar-denominated per capita incomes that would result from the end of their undervalued exchange rates.
As for the GATT trading system, it moved ahead successfully and separately from the financial system over more than 50 years, thanks to forceful U.S. leadership.8 But it was greatly supported by the 1971 shift in exchange rate policies. The first six “rounds” of GATT trade negotiations, through the 1967 Kennedy Round agreement that cut relatively high tariffs by 50% across the board, had greatly reduced import barriers to trade on a most-favored-nation basis. Momentum for this trade liberalization, however, was driven by U.S. leadership, which faltered in the late 1960s from the growing U.S. trade deficit, but was restored from the positive trade results of the 1971 stage two financial agreement. And this, in turn, contributed greatly to the successful Tokyo and Uruguay Round agreements, including the creation of the more comprehensive WTO trading system.
The bottom-line assessment for the first 60 years of the Bretton Woods multilateral trade and financial systems is thus highly favorable in achieving mutually beneficial growth in international trade and investment on a reasonably fair and balanced basis.
The Fatal Decline of the Multilateral Economic System Since 2000
This highly positive 60-year path of the Bretton Woods multilateral economic system, however, has reversed course toward fatal decline since the turn of the century, both for trade and finance, which have become increasingly interconnected.
The decline of the trading system has centered on the shift from multilateral trade liberalization on a most-favored-nation basis, within the WTO, to a spreading network of preferential bilateral and regional free trade agreements (FTAs), often in trade-distorting competition with one another. The WTO Doha Round, begun in 2001, languished at an impasse for its trade-liberalizing objectives, with a minor package of trade-facilitating measures of small trade consequence agreed in 2013, and then was essentially terminated in December 2015.
Part of the problem is institutional. A major result of the creation of the WTO was to bring developing countries more fully into the management structure, including one-nation-one-vote decisions on important issues, where a majority vote often consists of a large number of poorer countries with a small share of world trade, which are less engaged in or opposed to a trade-liberalizing economic strategy. For some decisions, a near-impossible consensus is required. In parallel, the trade-liberalizing leadership momentum of the industrialized grouping, which dominated negotiations of the GATT rounds, has decisively diminished.
Equally important for the decline of the multilateral, most-favored-nation trading system has been geopolitical shifts in trade strategies within the three principal industrialized regions through preferential trade agreements within the regions: NAFTA and other FTAs by the United States within the Western Hemisphere; EU FTAs to the east with the end of the Soviet economic bloc; and, more recently, various agreements in Asia, within the Association of Southeast Asian Nations (ASEAN), by China with South Korea and more broadly through a Free Trade Area of the Asia-Pacific (FTAAP), and getting underway by India as a rapidly growing regional trading power.
This regional fragmentation of the multilateral trading system into regional free trade blocs is not all bad, with broadly based trade-liberalizing results within the regions, which can lay the foundation for intraregional or multilateral free trade consolidation, as proposed below. The fatal danger for the multilateral trading system, however, is the deepening linkage between the trade and financial systems for price-sensitive trade in manufactures, with the strong preference of many nations to have undervalued currencies, as warned by Harry Dexter White 70 years ago.
These mercantilist exchange rate policies center on trade relations among the three industrialized regions and, most importantly, among the Big Three and their dominant global currencies. This is also where trade and financial policies become most deeply intertwined, with the greater policy challenge on the financial front, and which thus requires a more detailed explanation for understanding the policy course ahead. The two central forces driving the decline of the multilateral financial system are the disregard or rejection of IMF obligations for exchange rate policy and the end of the dollarized financial system that prevailed through the 1971 shift to market-based exchange rates, but is now approaching its terminal stage.
IMF obligations for exchange rate policy are contained in Articles VIII and IV. Article VIII, dating back to 1944, states that no member shall “impose restrictions on the making of payments and transfers for current account transactions” nor engage in “any discriminatory currency arrangements or multiple currency practices.” This obligation, as noted earlier, was implemented by the industrialized grouping by the early 1950s, but has still not been adopted by China and other newly industrialized economies as they have risen to prominence in international trade during the past decade. China, in particular, pegs its undervalued exchange rate to the dollar and tightly manages payments in its currency, principally limiting them to payments for its exports, and has discriminatory arrangements for these payments with some central banks, as explained below.
Article IV prohibits currency manipulation, more precisely defined in the 1970s as protracted, large-scale official purchases of foreign exchange to gain an unfair competitive advantage in trade. Such purchases have the direct and immediate effect of lowering the exchange rate below its market-based level, and again, while the industrialized grouping has basically fulfilled this obligation since the 1970s, newly industrialized economies, and China most importantly by far, have heavily engaged in such prohibited manipulation. China has made more than $3 trillion of official purchases over the past dozen years, which is protracted and large scale by any conceivable definition of the term.
Violations of both Articles VIII and IV have been obscured by a lack of transparency for official regulation of and intervention in currency markets, which has contributed to a nearly total absence of serious deliberations within the IMF of exchange rate policy obligations and their impact on trade. Recent IMF discussions have centered on External Sector Reports by the secretariat of the international accounts and policies of the larger economies. These reports encompass a wide range of “norms,” such as appropriate levels of exchange rates, temporary influences, and the performance of monetary, fiscal, healthcare, and other policies. This procedure has been appropriately summarized: “Too much judgment makes norm-setting a black box.”9 In any event, there has been no significant discussion of violations of exchange rate obligations. Moreover, the United States, by far the most adversely affected by such violations, has not raised the subject within the IMF, while the secretary of the Treasury, as required, has been reporting to the Senate Banking Committee every six months that no nation, including China, has been manipulating its currency in violation of IMF obligations.
As for the approaching demise of the dollarized financial system, in the fall 2014 edition of The International Economy, 24 financial experts were asked whether the dollar will remain the reserve currency.10 Most replied that the dollarized system will remain for a long time if not permanently, with responses such as, “The dollar will not be replaced,” “The U.S. dollar is far from being challenged,” and “I see no shift from the dollar.” Some others, however, saw a likely transition underway from the dollarized system: “A tectonic shift is beginning,” “The world is gradually evolving toward a multi-currency system,” and “We could eventually see a global system with three blocs.”
More recent developments clearly indicate that not only is such a multi–key currency relationship evolving, but also that it is closer upon us than most experts predicted only a year ago. There are great uncertainties, however, as to how this transition will unfold, largely related to the two alternative courses ahead presented in the following two sections, which will center on four interacting forces in play:
1. The financing of trade. This is the most clear and best-documented dimension of the decline of the dollarized financial system. Trade financing in the European region is shifting to the euro and other European currencies, while the share of Chinese trade financed in renminbi has soared from almost nothing in 2009 to about 25% in 2014. The renminbi has risen to become the fifth largest currency for international payments from 23rd in 2013. In December 2014, 45% of international payments were in dollars, 28% in euros, 8% in sterling, 3% in yen, and 2% in renminbi. Thus less than half of payments are now financed in dollars, and the dollar share will continue to decline.
China has actively promoted this shift to renminbi financing through the establishment of a network of clearing banks that makes its currency convertible for financing trade. Such financing had been carried out principally through Hong Kong, but in March 2014 the Bank of England and the People’s Bank of China signed such a clearing account agreement, and eight or more other accounts have been established in Europe and Asia, which are possibly in violation of the IMF prohibition on discriminatory currency arrangements. The 2015 China–South Korea FTA also encourages bilateral trade to be financed in their two currencies rather than dollars.
2. The rise of the euro and the renminbi as global currencies. The rise of EU and Chinese exports relative to U.S. exports, as presented in Part One, and the parallel surge of trade financing in their currencies should lead to a corresponding rise in holdings of euros and renminbi by creditors, both commercial and official through central bank reserve holdings. This has been slow in coming, however, especially for the renminbi, and for very different reasons for the two currencies. The dollar still accounts for a little more than 60% of reserve holdings compared with 25% for the euro and 1% or less for the renminbi.
The problem for the euro is not its availability as a convertible currency for reserve holdings but uncertainty about its future in the face of continued large trade and financial imbalances within the eurozone. Each time there is an internal financial crisis, as with the recent Greek crisis, there is a small shift in reserve holdings from euros to dollars, and then back into euros when the crisis subsides. Looking ahead, when the uncertainty about the future of the euro is resolved, one way or another, the EU share of global reserve holdings should rise significantly relative to the dollar, reflecting the substantially larger EU share of global trade.
The outlook for the renminbi as a global currency is far more important in view of its very large share of global trade and the current extremely small share of renminbi held by commercial and official creditors. The reason is simply that the currency is not convertible on current account as required by IMF Article VIII and has been manipulated frequently in violation of Article IV. Chinese policy is to have the renminbi become a major international currency, which would facilitate its trade and investment interests, and small, cautious steps have been taken in this direction, such as the agreements with central banks to finance Chinese exports. The “dim sum bond” market for convertible, renminbi-denominated debt outside China has risen from $1 billion in 2010 to $12 billion in 2013, and in November 2014 the Shanghai–Hong Kong Stock Connect was launched, allowing offshore investors to buy $49 billion in mainland stock shares. But these are very small amounts of financial assets, compared with multi-trillion-dollar official reserve holdings in dollars and euros, and are not fully convertible assets in currency markets. A fully convertible renminbi on current account, in enormous contrast, should lead to a shift of trillions of dollars from dollars to renminbi for reserve holdings and for commercial creditors whose business is largely financed in renminbi, and this would result in a large appreciation of the renminbi to the dollar.
3. The huge and rising official U.S. foreign debt and its impact on the current account balance. There has been extensive political discussion in the United States about the federal debt doubling from $10 trillion in 2008 to a projected $20 trillion in 2017, but almost no attention has been given to the fact that about three-quarters of this debt is held by foreigners, which could cause a more imminent adverse impact on the economy related to trade. In mid-2015, of $18.2 trillion total federal debt, $7.5 trillion was in official foreign holdings, mostly by central banks, and $6.2 trillion was held by commercial banks and other foreign creditors.11
Interest paid to foreigners on this official debt is recorded as a debit on the current account balance, but thanks to the extremely low Treasury rates of the past seven years, it has not been a major burden for the overall current account deficit. As Treasury rates finally rise, however, each 1% increase in payments on the $15 trillion foreign official debt amounts to a $150 billion increase in the current account deficit, and a 3% increase would double the current $450 billion deficit to $900 billion, or 5% of GDP. And this, in turn, would signal to markets a looming decline in the dollar, with a speculative shift out of the dollar to other currencies and further upward pressure on the Treasury rate. This shift would indeed have the characteristics of the “southern-tier syndrome” within the eurozone, as with the ongoing Greek crisis, except there are no IMF or European Central Bank creditors to bail out a $15 trillion U.S. official foreign debt.
4. The impact of government actions and reactions. How the three preceding forces in play will actually play out for the end of the dollarized financial system will depend largely on how governments react to the unfolding course of currency relationships and their impact on trade. A continued rise in the U.S. trade deficit in the politically sensitive and technology-intensive manufacturing sector could trigger a protectionist U.S. policy response leading to a broadly based trade war, disruptive swings in exchange rates, and highly adverse impact on trade. In contrast, a U.S.-led policy initiative to bring China and other chronic large trade and current account surplus nations into conformity with IMF exchange rate obligations, while consolidating preferential bilateral and regional trade agreements within a balanced, rules-based trading system, should produce far more positive results. These two alternatives are the substance of the next two sections.
The Current Course Toward Policy Conflict and Trade Disruption
The current course of a soaring U.S. trade deficit in manufactures, 60% with China and close to 100% with Asia, is not politically or economically sustainable, and is headed toward a protectionist backlash by the United States. This would be a controversial policy response. Foreign policy experts will resist on the grounds that the United States has more important foreign policy fish to fry with China, and a growing number of “American” manufacturing companies are, in fact, “multinational” companies, with profits largely oriented toward production in and exports from China, and thus dependent on an undervalued Chinese currency. But the continuing large trade-related loss of American manufacturing production and jobs is fueling the protectionist momentum. Leading presidential candidates on both sides of the political aisle call for action to reduce the trade deficit, and 78 senators unsuccessfully pressed the president to include a credible commitment against currency manipulation in the Trans-Pacific Partnership trade agreement.
In this uncertain political setting leaning more and more toward a protectionist reaction against China and other large deficit trading partners, markets will play an increasingly decisive role. The U.S. trade deficit for manufactures could continue to grow, as it did in 2015, while lower oil prices are leading to a decline in domestic oil production, which will increase imports. An even more important and troubling prospect for rapid growth in the U.S. current account deficit will be the rise in interest payments on the $15 trillion U.S. official foreign debt, described above.
No attempt is made here to specify how this U.S. protectionist reaction will unfold, except to make two points. First, this could happen fairly soon based on the unfolding course of events, likely over the coming one to five years, and should therefore be a high-priority policy challenge for whoever is elected president in 2016. And second, the trade policy conflict, although initially centered on the enormously lopsided trade relationship between the United States and China, will quickly broaden in geographic scope. Other Asian exporters, with exchange rates linked to the Chinese currency, will also be targets for whatever the initial U.S. protectionist actions. And other major trading partners, from the EU to Mexico, will be drawn into the trade-disrupting impact from a redirection to them of Chinese and other Asian exports to the United States, leading to mercantilist reactions on their part.
This is the current course toward trade policy conflict and trade disruption. The big question over coming months to ask the presidential candidates on both sides of the political aisle is what specifically they plan to do to reduce the huge and growing trade deficit for the technology-intensive U.S. manufacturing sector. One direction of response would be to take immediate protectionist actions against imports, perhaps together with export subsidies. The other category of response would be a broadly based initiative to restore a truly balanced, rules-based, multilateral trading system.
A Proposed Restoration of a Balanced, Rules-Based Multilateral Trading System
Far preferable to the preceding trade-disruptive protectionist scenario would be an initiative to restore a balanced, rules-based multilateral trading system. This, however, would require strong and sustained U.S. leadership since there are powerful interests, including within the United States, for maintaining the status quo despite the threatening trade-related prospect ahead. Moreover, such U.S. leadership would need broadly based bipartisan congressional support, which would only be possible through a credible strategy to bring the extremely large U.S. trade deficit in the technology-intensive manufacturing sector back into reasonable balance.
The U.S. initiative should therefore begin with a clear and forceful statement that the current course of unsustainably large U.S. trade deficits, resulting in a continued buildup of excessive official foreign debt, is no longer acceptable. Either a balanced, rules-based trading system needs to be restored or the United States will be forced to act unilaterally to achieve reasonable balance in its trade accounts. The initiative would then lay out the basic elements of a proposed restoration strategy.
Such a strategy offered here begins by linking full compliance of IMF exchange rate obligations to market access for U.S. imports, and then bringing this integrated trade and financial relationship within a WTO open-ended, plurilateral free trade agreement. Four specific components of the strategy would be:
1. Full compliance with IMF Articles VIII and IV obligations for exchange rate policy. Violations of these obligations have been driving the soaring U.S. trade deficit in price-sensitive manufactures over the past dozen years. The relationship centers on China, which has been in gross violation of both Article VIII—through a tightly managed, undervalued peg to the dollar—and Article IV—currency manipulation through protracted large-scale official purchases of foreign exchange. Other Asian exporters have also largely ignored their exchange rate obligations in order to remain competitive with China, their principal trading partner, with substantial mercantilist adverse impact on U.S. trade. Continued access for exports to the U.S. market would therefore be contingent on full and transparent compliance with IMF exchange rate obligations. The United States achieved this in 1971 with industrialized trading partners, and now trade and financial policy negotiations would be engaged with newly industrialized trading partners, most importantly China, to the same end.
In the process of these negotiations, Article IV currency manipulation would be more precisely defined in view of recent gross manipulation. Specifically, newly as well as mature industrialized nations with sustained current account surpluses should rarely if ever engage in official foreign exchange purchases.
Hopefully such linkage could be obtained through serious discussion related to the unsustainably large U.S. trade and current account deficits. Otherwise, the United States would be prepared to call for a WTO dispute panel under GATT Article XV, which obliges members not to use exchange rate policy in a way that diminishes reciprocal access to markets for trade, explaining how violations of IMF exchange rate obligations constitute an unfair import barrier and export subsidy. And following the precedent of the 1971 U.S. initiative, an interim import surcharge of 20% or more would be imposed on the principal violators of exchange rate obligations, pending resolution of the WTO dispute procedure.12
2. A WTO open-ended plurilateral free trade agreement. The trade / exchange rate policy linkage negotiations would move forward in parallel with a U.S.-led initiative to consolidate the spreading network of preferential bilateral and regional trade agreements within a WTO open-ended plurilateral free trade agreement, thus working to restore the multilateral, most-favored-nation trading system. The building blocks for this broadly inclusive plurilateral agreement would be bilateral and regional agreements already in place or under recent negotiation, including the TTP and the U.S.–EU FTA. This plurilateral FTA would almost certainly include the large majority of U.S. exports. NAFTA alone accounts for 35% of U.S. global exports of manufactures, and other Western Hemisphere FTA partners would bring this share close to 40%. Another 20% of U.S. exports goes to the EU, bringing 60% of U.S. exports to trading partners that would presumably support the free trade / exchange rate policy linkage.
The prospect for Asian trading partners is less clear. Japan and South Korea should be attracted to ensured free access to the North American and European markets, and they already have convertible exchange rates. Other East Asian large exporters of manufactures would have to make a difficult choice between free access to principal export markets together with strict exchange rate policy obligations and the threat of trade sanctions related to a GATT Article XV dispute procedure. Major prospective Asian participants would be India and Indonesia, with rapidly growing trade and a national interest in achieving a balance between trade with China and other industrialized regions.
In this context, a comment is in order about the recently concluded Trans-Pacific Partnership trade agreement between seven Asian and five Western Hemisphere nations. For the United States, there are a number of downsides in this complicated agreement, including the absence of exchange rate policy obligations as pressed by 78 senators, which will probably result in an increase in the U.S. trade deficit. On the plus side, however, free trade with Japan and several other Asians could be a useful building block for a broader, plurilateral FTA, as proposed here, while possible trade sanctions related to an Article XV dispute process for currency manipulation would apply to Asian TPP participants as well.
As for the rest of the world, Argentina and some other Western Hemisphere nations could well choose to join the plurilateral FTA, especially as they move toward more market-based, trade-competitive exchange rates. Other Western Europeans that already have FTAs with the EU would clearly want to join. The plurilateral FTA should also continue preferential market access for least-developed countries and accept greater exchange rate flexibility for countries whose exports are predominantly petroleum and other commodities.
As for the substantive scope of the plurilateral agreement, it would include across-the-board free trade in goods and services, non-discriminatory access for international investment as developed in regional FTAs, and other trade-related issues, such as protection of intellectual property and more open government procurement practices, as already adopted on a plurilateral basis within the WTO. It would not, however, be as far-reaching in policy scope as some bilateral and regional FTAs, while providing for more in-depth, limited participation agreements within the full plurilateral agreement. Management of the plurilateral FTA would be within the WTO framework, but with a separate managing body, weighted by trade composition, and specified dispute procedures, including for the exchange rate policy linkage.
3. The new, post-dollarized financial world. The previous two components of the restoration strategy would definitively mark the end of the dollarized financial system of the past seven decades, whereby the United States maintains a passive exchange rate policy while others often pursue mercantilist policies that drive up the U.S. trade deficit for price-sensitive manufactures, financed by large U.S. current account deficits and a rising official foreign debt.
The post-dollarized financial world would be a multi–key currency relationship centered on the IMF reserve currency grouping—the dollar, euro, yen, sterling, and renminbi as it moves toward convertibility—broadly complemented by other major trading nations also in compliance with IMF exchange rate obligations. It is uncertain, however, how this multi-currency relationship would play out during the initial years of transition. In 2015 and 2016, slower global economic growth has triggered large capital outflows from emerging market bloated investment sectors and mercantilist trade strategies to bolster domestic growth. Most importantly, China suffered a bursting stock market bubble that was grossly mismanaged through government intervention, leading to a massive capital outflow with downward pressure on the dollar-pegged Chinese currency. The tightly managed non-convertible currency, however, continues to be greatly undervalued as evident by the continued rise in the trade surplus for price-sensitive manufactures. Thus Chinese exchange rate mercantilism is temporarily centered on the non-convertible dollar peg, but this will shift back to include targeted government purchases once the capital outflow has run its course.
More broadly, current financial turmoil should greatly diminish to the extent that Asian exporters adopt IMF obligations for convertible currencies without mercantilist manipulation. The assessment offered here is that as all major currencies become convertible and free of manipulation, financial relationships should tend to stabilize in a relatively short period of time, with more balanced trade relationships as a result of three principal changes from existing, highly unbalanced trade and financial relationships. The first would be far more market-oriented exchange rates as the principal trade adjustment mechanism, with far less official intervention in currency markets. As the lead model, the United States has exercised almost no official market intervention since 1971 when it ended its gold conversion commitment, and other official reserve currencies should likewise move toward far smaller intervention, in compliance with their IMF obligations. From this, there would also be less need for reserve holdings, and a coordinated process should be adopted for the orderly drawdown of the current very high levels of reserves, which are largely the result of currency manipulation. Such a coordinated drawdown of excessive reserves was in fact discussed post-1971, but was overtaken by more heavily managed exchange rates.
The second change would be in the dollar relative to the currencies of major trade surplus trading partners. The direction of change—a decline in the dollar—is clear as others cease currency manipulation and reduce their current account surpluses, but the degree of decline is highly uncertain. If the United States increases export competitiveness for manufactures through policy reforms and higher national productivity growth compared with Asian and European competitors, the dollar decline would be smaller, although a major shift from current lagging U.S. productivity growth is doubtful anytime soon. Higher energy prices and resumed growth in U.S. shale oil and natural gas production would also be positive for the dollar rate. In the other direction, however, a decline in foreign dollar holdings as overall reserve levels are reduced and both official and commercial creditors shift out of dollars into more balanced holdings of other currencies, including a progressively more convertible renminbi, would act to lower the dollar rate. And as noted earlier, each 1% increase in interest paid on the $15 trillion U.S. official foreign debt would add $150 billion to the U.S. current account deficit, which would work to stimulate a market-based shift out of the dollar and a consequent decline in the dollar exchange rate. The judgment here, highly speculative, is that the decline in the dollar would be large, possibly 30-50%, relative to large trade surplus Asian trading partners, which would bring a large and welcome decline in the U.S. trade deficit in manufactures. Indeed, this is what happened in the 1970s when Western European and Japanese trading partners stopped their currency manipulation and their exchange rates to the dollar soared by 100% or more.
The third and least clear change in financial relationships would be the convertibility course for the Chinese currency, which can be referred to as the trillion-dollar Chinese trade surplus dilemma. Over time, this dilemma will play a central role in the proposed strategy to restore a balanced, rules-based multilateral trading system, and is thus worthy of a separate, key component presentation here.
4. The trillion-dollar Chinese trade surplus dilemma. China has more than $3 trillion of currency reserves plus a large buildup of “sovereign wealth funds” that amount to official foreign investment of excess reserve holdings. This huge official international financial surplus continues to rise through a $300 billion current account surplus driven by a $1+ trillion trade surplus in manufactures, which accounts for 60% of the U.S. $650 billion trade deficit.
This is the trillion-dollar Chinese trade surplus dilemma for trade between the two largest industrial powers and exporters of manufactures, and a substantial decline of the enormous trade imbalances of both nations goes to the heart of the restoration strategy proposed here. It is not, however, an unrealistic challenge to confront if seriously addressed by the two governments, in view of two unfolding developments within the Chinese economy.
The first unfolding development in China is a restructuring of the economy away from export-oriented manufacturing to domestically oriented consumption of services. This restructuring, however, is moving very slowly. In 2015, Chinese GDP grew by 6.9%, while growth in manufactures was not far behind at about 5%. The Chinese problem for manufactures is extensive overcapacity and a lackluster domestic market, which has caused China to turn even more mercantilist in its trade strategy. In 2015, the trade surplus in manufactures, which equates to about a third of Chinese manufacturing production, grew by more than 5% when taking account of the over-invoicing of imports.
The second unfolding development is the Chinese objective for the renminbi to become a major global currency within the IMF, which China judges to be in its economic self-interest. China was designated an official reserve currency in November 2015, to join the dollar, euro, yen, and sterling, but this role should include full implementation of IMF exchange rate policy obligations for currency convertibility without manipulation, which has not yet been implemented significantly, as explained earlier.
The big question for the Chinese trillion-dollar trade surplus dilemma therefore is how soon and to what extent will these two developments move forward? And it is in these highly uncertain circumstances that the United States would launch high-level bilateral negotiations with China about inclusion in the U.S. plurilateral FTA initiative. In addition to exchange rate obligations, Chinese inclusion would involve reciprocal market access for trade and investment. In effect, China would have to fully accept developed country status within the trading system as a member of the plurilateral FTA.
It is possible, and indeed likely, that China would not be prepared to be a full initial participant in the plurilateral FTA, but the agreement could be successfully launched even if China were not an initial participant. For the United States, 80% of U.S. manufactured exports could still be included in the initial agreement, with only 8% of manufactured exports going to China thanks to the lopsided bilateral trade account. And China would be welcome as an observer in the plurilateral FTA process.
But China could initially reject any major trade-balancing actions on its part. The United States, however, should then insist on immediate steps by China for exchange rate and trade policy measures that would lead to a substantial decline in the hugely unbalanced bilateral trade relationship. To this end, the United States has considerable trade bargaining leverage, with manufactured imports from China six times larger than U.S. exports to China. The United States would also state its intent, if necessary, to proceed to a GATT Article XV dispute procedure, including interim import sanctions, which would add to the pressure for a prompt, substantial bilateral agreement.
These are the proposals for restoring a balanced, rules-based, and increasingly multilateral trading system. The U.S. leadership role for such a restoration has been a recurring theme throughout the presentation, and it is therefore fitting to conclude with a more in-depth commentary on the indispensable U.S. leadership role if the restoration is to be achieved.
The Indispensable U.S. Leadership Role
Henry Kissinger’s recent, monumental World Order13 traces the course of nation state relationships as defined and launched by the Treaty of Westphalia in 1648, stressing the importance of balanced power relationships to maintain a peaceful, rules-based system of sovereign states. His focus is on political relationships and the tragic wars that occurred when one participant—France, Germany, the Soviet Union—became overly powerful and felt beyond rules-based nation state constraints. The Kissinger book, however, treats economic relationships lightly, and this study therefore constitutes an adjunct work for the economic order as created at Bretton Woods in 1944, a rules-based trade and financial system among nation states, and their often-troubled power relationships that have intensified since 2000. A parallel can indeed be drawn that China, with a $1+ trillion annual trade surplus in manufactures and more than $3 trillion in the central bank, now feels itself beyond rules-based trade and financial constraints.
The Kissinger book also stresses the critical role of leadership for maintaining an orderly nation state system, and is most detailed for the U.S. leadership role during 20th-century hot and cold wars: “American leadership has been indispensable, even when it has been exercised ambivalently.”14 And again, such American leadership has long characterized the course of the Bretton Woods economic system and will remain indispensable for restoring a balanced world economic order in the immediate years ahead.
Restructuring of a balanced, rules-based trading system will center on the Big Three—the United States, China, and the EU—but the other two are beset by overriding national economic interests and lack the forward-looking political vision necessary to confront the serious and likely fatal challenges facing the world economic order. Chinese economic strategy remains heavily committed to a massive trade surplus in technology-intensive industries despite the broader economic goal of restructuring toward domestic service-sector consumption, while a top EU economic priority is to resolve financial crises within the eurozone, which benefits from a large trade surplus with non-members.
In this global political and economic context, U.S. leadership to restore a balanced, rules-based trading system, as proposed here, is indispensable and needs to be based on three integrated dimensions. The first, as introduced earlier, is to restore broadly based, bipartisan political support within the United States, which can only be achieved through a credible trade strategy to greatly reduce the protracted very large trade and current account deficits. Without such broadly based domestic political support, U.S. proposals for fundamental change in the existing trade and financial systems will falter and the national security and commercial interests opposed to such action-oriented change will block serious consideration. And this, in turn, will result in further momentum toward protectionist actions and collapse of what remains of the multilateral system.
The second leadership dimension is that the United States will have to build a coalition of like-minded major trading nations to achieve trade/financial policy integration within a plurilateral FTA as proposed here. U.S. manufactured exports are headed down toward 10% of global exports, and only together with other principal exporters will the FTA strategy come together in trade and financial terms. Such a coalition is eminently feasible, however, given strong U.S. leadership. Within NAFTA, both Canada and Mexico also face exchange rate–related mercantilist competition from Asian exporters, and they already basically adhere to the trade/financial linkage. Likewise for the EU. As for Asians, as explained earlier, Japan, South Korea, and some others could be strongly attracted to ensured duty-free access for exports to the U.S. and other industrialized markets, and thus a more balanced trade relationship with China. Asian positive interest, however, will depend largely on the third dimension of the U.S. leadership challenge, namely a strong and credible U.S. bilateral approach to China for fundamental change of direction for its mercantilist trade and exchange rate policies.
The U.S. strategy for China has been presented in detail in the previous section, but its importance for the overall U.S. leadership role cannot be overstated. It has to be firm and sustained, including the possibility of interim U.S. import sanctions, which would have helpful spillover impact for reducing other Asian currency manipulation. In-depth negotiations with China could also have broader positive political impact, however, through discussion of mutual geo-economic interests by the two global economic superpowers to develop a balanced, rules-based world economic order among sovereign states, with intellectual roots dating back to 1648.
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This concludes the presentation of the global restructuring of world trade underway and proposals for restoring a balanced, rules-based multilateral trading system, including the essential U.S. leadership role. It has been pointed and at times provocative in form, in order to stimulate serious discussion during this election year. Let the election debate over the extremely large and growing U.S. trade deficit in technology-intensive manufactures begin!
About the Author
Ernest Preeg holds a Ph.D. in economics from the New School for Social Research and is currently Senior Advisor for International Trade and Finance at the MAPI Foundation. His engagement with international trade began by sailing from ordinary seaman up to chief mate in the American merchant marine. His government positions included member of the U.S. delegations to the Kennedy and Uruguay Rounds of trade negotiations, Deputy Assistant Secretary of State for International Finance and Development, Chief Economist at USAID, White House Executive Director of the Economic Policy Group, and American Ambassador to Haiti. His publications include Traders and Diplomats: An Analysis of the Kennedy Round under the General Agreement on Tariffs and Trade (The Brookings Institution, 1970); Economic Blocs and U.S. Foreign Policy (National Planning Association, 1974); Traders in a Brave New World: The Uruguay Round and the Future of the International Trading System (University of Chicago Press, 1995); The Emerging Chinese Advanced Technology Superstate (MAPI and the Hudson Institute, 2005); India and China: An Advanced Technology Race and How the United States Should Respond (MAPI and CSIS, 2008); Twilight of the Dollar With Technology-Intensive Manufacturing at Center Stage (MAPI, 2013); and The Decline of U.S. Export Competitiveness for Manufactures and Its Consequences for the World Economic Order (MAPI, 2014).
1. See Gary Hufbauer, et al., Framework for the International Services Agreement (Peterson Institute for International Economics, April 2012)
2. For a more detailed analysis, see Ernest H. Preeg, U.S. Trade Surplus in Business Services Peaks Out (MAPI Foundation, 2014). The briefer presentation here updates the trade figures through 2014, reinforcing the conclusions in the earlier analysis.
3. The definition of manufactures from these sources, SITC 5-8, is slightly broader than the WTO definition, which is SITC 5-8 minus two small sectors that account for less than 5% of U.S. manufactured exports.
4. These trade figures indicate that the U.S. share of global exports of manufactures declined to 12% in 2015. In 2014, as shown in Table 2, the U.S. share was 12.5%, which was rounded up to 13%. In 2015, however, the 3% decline in U.S. exports together with significant export growth by some Asian and other exporters, reduced the 12.5%, with a rounding down to 12% for 2015.
5. The Financial Times, January 27, 2016, "Invoice inflation adds to China capital flight."
6. See Ben Steil, The Battle of Bretton Woods: John Maynard Keynes, Harry Dexter White, and the Making of the New World Order (Princeton University Press and the Council on Foreign Relations, 2013), p. 33. Harry Dexter White is best known for his personal tragedy when it was revealed toward the end of the Bretton Woods deliberations that he was a Soviet intelligence agent. White had been highly respected and was in line to be the first managing director of the IMF when the scandal broke. Indeed, as a historical footnote, if White and successor Americans had headed the IMF instead of the Europeans who rose to the post-scandal occasion, IMF policy orientation over the decades would likely have been more favorable to the United States, especially as related to exchange rate policy.
7. The State Department was left in the dark about the Nixon shock until the weekend before the Monday public announcement. I was engaged in these issues for a couple of years through the announcement as senior advisor to the under secretary of state for economic affairs, investment banker Nat Samuels, who was on vacation in New England that weekend in an era without cellphones or email. Economics Bureau acting head Jules Katz and I were thus caught in the middle of the highly strained dialogue over the shock announcement to our allies between the White House / Treasury and the equally shocked, NATO-oriented European Bureau at State. Indeed, a memorable weekend!
8. This leadership was always contingent on broadly based bipartisan congressional support. For example, President Kennedy selected former Republican Secretary of State Christian Herter to be the first U.S. Trade Representative, to negotiate the ambitious Kennedy Round. Similar bipartisan support characterized U.S. trade policy for Presidents Nixon, Reagan, and Clinton, but is sadly lacking today.
9. From a presentation by Joseph Gagnon, "Comments on the IMF's 2013 External Sector Report," during a meeting on this subject at the Peterson Institute for International Economics, September 27, 2013.
10. "Will the Dollar Remain the Reserve Currency? Is the rising chorus to replace the dollar a reflection of far deeper problems in the world financial system?" The International Economy, Fall 2014, p. 16-31.
11. See the Treasury Bulletin, Table OFS-2, "Ownership of U.S. Treasury Securities," September 2015.
12. The IMF does not have a dispute mechanism, requiring the WTO route. GATT Article XV, however, calls for full consultation with the IMF.
13. Henry Kissinger, World Order (Penguin Press, 2014).
14. Kissinger, op. cit., p. 373.