China’s currency stance could cost it lost decades

China may be facing a confusing short circuit in its economic and political calculations that could seriously harm the nation over the next few years.

A huge and growing trade surplus seems to be the main obstacle driving China toward friction and conflict with much of the world. It is thus crucial for China to oppose the main narrative, as the official Global Times recently wrote:

“The enhanced competitiveness of Chinese enterprises arises from a comprehensive industrial system, sustained investment in technology, a massive market, and robust market competition – not from the so-called ‘artificially manipulated’ exchange rates.

Targeting the RMB will not solve the challenges facing Germany’s manufacturing sector, nor will it address the shortcomings in Europe’s innovation chain.”

It added: “German Chancellor Friedrich Merz stirred controversy over the RMB exchange rate, claiming that the currency was undervalued by as much as 30% and citing the 1985 “Plaza Accord” – which plunged Japan into its “lost decades” – as a solution.

Meanwhile, the EU is discussing trade defense tools in response to its trade deficit with China, industrial competition and supply chain dependence, with some European politicians attempting to portray China-EU economic and trade relations as a “systemic threat.”

This trend is not an isolated phenomenon; it reflects anxiety within the European manufacturing sector, protectionist impulses and the self-imagined dilemma of strategic autonomy.

The pressures facing European manufacturing stem not only from long-term factors – such as high energy prices, insufficient investment in innovation, and sluggish industrial policies – but also from immediate shocks, such as the spillover effects of the Ukraine crisis and the siphoning of US industrial subsidies.

The enhanced competitiveness of Chinese enterprises arises from a comprehensive industrial system, sustained investment in technology, a massive market, and robust market competition – not from the so-called “artificially manipulated” exchange rates.”

The argument has its reasons, however, as Michael Pettis noted, it “assumes that the RMB exchange rate belongs to China, and that for the EU or anyone else to intervene in the RMB exchange rate is an act of colonial oppression.”

From here, there are three sets of logical consequences that should be addressed properly; otherwise, future discussions with countries importing from China could become seriously difficult, as they will be based on very different grounds.

They are: the ownership of exchange rates, the legacy of the 1985 Plaza Accord and the 1973 oil clash with OPEC.

Contested exchange rates

A country’s exchange rate is like a door on a market square, a plaza, vis-à-vis other doors, other countries’ exchange rates. They do not work on their own but vis-à-vis everybody else’s rates. If there is a wall before the door, or the door is closed, there is no exchange rate to discuss, and trade is seriously undermined.

The point, then, is that rates may operate in an open square, where all doors (rates) are open, or they may operate under bilateral or multilateral agreements (the RMB against the US dollar, the Thai baht, etc.)

Not all doors are open in the same way. But if doors are a way to let people (or money) in and out, their opening depends not only on a single house but also on the other houses in the plaza. If it is different, communications could become troublesome.

If China owns its exchange rate, then every country does. If every country sets its own rate, all doors are closed, and the common square of exchange is empty. If the square has only bilateral agreements on exchanges, there are no general rules, and only superpowers dominate the square (the market). It could become very risky.

Smaller countries can coalesce against larger countries or a single large country. This happened between the 7th and 5th BC, when China saw a succession of hegemons (霸) who were all eventually defeated by alliances of other states.

Short of that, the world would need general rules with an established consensus to function. Or, as happened at the end of the 3rd century BC in China, there will be a global war in which one country will unify the world, all under Heaven (天下). All others will be exterminated 滅.

It may be a rational solution, but is it even possible, let alone desirable? Moreover, one can say the US is a hegemon. But its hegemony is based on consensus, not only on power and force. Doesn’t China like US hegemony? It should win global consensus, not only build power and force.

But can an authoritarian country win consensus? It can try to impose one, but that can backfire. So, to build its global consensus, China should be an open society. Otherwise, everything will be hard, no matter how many mistakes the US makes.

Rereading the Plaza Accord

Many in China have a highly political reading of the 1985 Plaza Accord, in which Japan and Germany agreed to reevaluate their currencies vis-à-vis the US dollar. The idea is that Japan was winning the trade war with America, but America managed to beat it by imposing a yen revaluation that crippled Tokyo right up to today.

It may be superficial and misleading. To give a few examples, in the 1980s, the total value of land in Japan was about two-thirds of that in America, despite Japan’s territory being about 26 times smaller.

Clearly, this indicator alone revealed problems in the trade relationship and the yen-dollar exchange rate. There was a structural problem: Japan couldn’t survive by exporting only to America while suppressing its domestic consumption.

A third factor was the technology race with the US in the 1980s. The Japanese lost it by betting on supercomputers, while the Americans chose to network computers. From there, the Americans launched the Internet and all the telecommunications revolutions up to today’s artificial intelligence.

So, behind the Plaza Accord was the idea that world trade needs to reach an overall equilibrium — it can’t be based solely on the dynamics of a single country. Many Chinese scholars have worked on and explained what was really behind; see, for instance, Yu Jie, who did so in a series of books. (See: 于杰，管理美元:广场协议和人民币的天命 “Managing the US dollar, The Plaza agreement and the fate of the RMB” (2018))

Naturally, the world economic and trade order may not be fair, and it can be changed. Still, this can’t happen on the basis of one country’s unilateral demands, but within the framework of an overall vision of what world trade should be. This isn’t meant to excuse America.

It simply means that today America offers a global vision of trade, while other countries have proposed only partial changes that serve their own national interests. Those don’t work because there’s no comprehensive vision capable of garnering a broad consensus — only the ability to impose itself by power.

China, so far, has defended its interests, but it hasn’t presented an alternative trade order as the USSR did. Then, there’s the OPEC controversy, which shocked China in the early 1970s, just as China was beginning to build relations with America aimed at countering the Soviets.

The Chinese watched the same Henry Kissinger, who was negotiating with China to contain the USSR, also turn around and talk to the USSR about oil supplies meant to offset and circumvent OPEC’s oil blackmail. Was the US after the USSR, or was it willing to help the Soviets, provided its economy wouldn’t be harmed?

Some Chinese concluded that, for the US, political, ideological and strategic considerations regarding the USSR mattered less than commercial efficiency and access to raw materials such as oil.

This view likely inspired Deng Xiaoping’s famous 1992 remark: the Middle East has oil, China has rare earths. Economic performance was the real driver, they concluded. In both cases — OPEC and Japan — China came to believe that America had ultimately managed to bend them because neither could back up their commercial and economic interests with genuine military force.

China concluded that it needed to build military strength capable of resisting coercion whenever its commercial and industrial monopoly was threatened.

Here we are today: China doesn’t have a monopoly on rare earths, but it has a quasi-monopoly on their industrial processing, a dominant position in primary industry, and an unmatched quality-to-price ratio across nearly the entire industrial supply chain for capital and consumer goods.

They are all protected by armed forces that may not project power far from home but are more than capable of effective deterrence. This allows China to pursue its commercial interests without fear of being forced to yield, as OPEC or Japan were.

Lessons from Russia

On top of this, there’s another factor: the lesson from Russia. The dominant view in China today holds that Russia’s mistake was attempting political reforms that destroyed it.

The Boris Yeltsin decade was proof of this, while two decades of Putin supposedly showed that military strength and geopolitical cunning could overcome global headwinds. But today, in light of Russia’s political defeat in Ukraine, can this view still be sustained? Ukraine is a country with perhaps a third or even a fifth of Russia’s population.

Yet it has shown a determination and capacity for innovation that have not only allowed it to resist the Russian attack but, more recently, to launch a counteroffensive. It seems like a new Israel, eight decades later. Israel withstood and won against military pressure from most of the Arab world.

In contrast, Russia hasn’t shown a comparable capacity for innovation and has been leaning ever more heavily on China. But this dependence on China demonstrates to Beijing just how weak Russia is — and therefore that the Putin model for Russia was, and is, a failure.

In other words, Gorbachev may have made mistakes, Yeltsin may have done harm, but Putin may have set Russia back by hundreds of years. This failure should prompt deep reflection in Beijing — namely, that if the authoritarian model of tightly binding politics to economics doesn’t work, another path must be found.

The state can intervene during economic crises, but afterward, market rules must be restored; otherwise, the whole system stops functioning. In short, that’s what happened to Putin’s Russia. The same disregard for market rules underlies the misunderstandings about the Plaza Accord or exchange-rate issues.

Market rules can be ignored, but whoever does so does so at their own risk. Sooner or later, the market takes its revenge. Russia’s state decay should — and could — prompt China to deeply rethink its direction and approach to world trade relations.

Without full convertibility of the RMB and the opening of its domestic market, China will begin to suffer internally, even without caving to external trade pressures.

Urban and rural underemployment are rising, and the country’s internal problems could multiply over the next ten to 20 years. Back in the mid-1990s, I made a rough estimate of what China could have been without Mao’s 30 years, based on Japan’s GDP growth and Taiwan’s per capita GDP.

By the late 1970s or early 1980s, China’s GDP would already have rivaled America’s. In other words, Mao set China back like never before, giving everyone else an advantage. If China today doesn’t seriously confront — with market rules, not political fantasies — the question of its trade and exchange-rate interests, the country could still lose more decades.

At the end of the day, the US and the rest of the world can play along with China, avoid its blackmail over rare earths and other materials, and gradually decouple from its supply chain.

Despite technological progress, suppressing domestic Chinese demand could leave Chinese people poorer in a few decades. It’s hard to predict what will happen in a decade or two, but the reality in Russia should tell the Chinese that something very wrong can indeed occur.

This article was first published by Appia Institute and is republished with permission. Read the original here.