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The results of the Pew Survey, recently cited in the Financial Times, capture the essence of the tension between the US and China. The survey found that a majority of American believe the Chinese economy is larger than the US economy. Not only is that patently untrue, but it is not even a close call. The US economy is more than three times as big in nominal terms and is still likely close to twice as large at some measures of fair value.

With high US unemployment, high stakes in the November election and genuine frustration over a range of economic and political issues, the US Congress is once again taking up the China issue.

Yet imagine the upcoming sequence of events. Around April 10th, the PRC will report March trade figures. A number of high ranking PRC officials have hinted that a deficit may be reported. Now, of course, no one believes that if a trade deficit is reported that it really reflects underlying trends. Instead, the data may be skewed by a number of factors that are unlikely to be sustained. But it may very well be a deficit nonetheless.

Within a week of those figures, the US Treasury is expected to make its semiannual report about manipulation in the currency market. No country has been cited by the US for several years, but there is a risk that the Obama Administration will cite China this year.

The Obama Administration appears to be edging toward a confrontation, and the President himself has warned as much. But as is often the case, foreign policy is also about domestic politics. By taking a tougher stance toward China, Obama will find support among both parties in Congress and may help garner support for the other free-trade agreements pending. Yet if the US does cite China as a manipulator in the foreign exchange market, China could very well cancel the Strategic Economic Dialogue talks scheduled for May and further strain the already precarious relationship. Ironically, fixed exchange rates used to be the orthodoxy and even today, free floating exchange rates appear to be the rare exception. Fixed exchange rates cannot be tantamount to manipulation.

Fred Bergsten of the Peterson Institute in Washington and a long-time advocate of the US getting tougher, first on Japan and now on China, outlined a provocative three-prong strategy before the House Ways and Means Committee last week: 1) US Treasury cites China as a manipulator; 2) the US requests the IMF initiate a special dialogue with China to assess the degree of currency misalignment; 3) the US pursues a case at the WTO against China related to its currency policy.

Press reports indicate that Bergsten understands that the US probably would lose the WTO case. However, he thought there could be a moral victory in publicizing the issue and in shaming the Chinese. This seems to be a poor basis for US policy. Surely the issue is well known and shaming one's adversary is hardly an effective strategy. Nevertheless, it does illustrate a key point: the US lacks sufficient leverage over China to get it to comply. Bergsten's proposed strategy, which a number of legislators are thought to take seriously, may not just be ineffective but dangerous as well. Just like a lawyer is trained to not to ask questions of a witness that they don't know the answer to, the high risk that the case is lost at the WTO would give China a large victory and serve to undermine the G7 efforts to cajole others into seeing the virtues of flexible currencies. Also pursuing a case that is likely to be lost would further play into the image of Americans as particularly litigious.

Another "perception" problem is that many observers see China as a single entity. Yet, although it is a one-party state, there are different interest groups represented in the upper echelons of the government. Several weeks ago, a couple highly respected observers said a Chinese move seemed imminent. It would seem they talked with the same pro-appreciation camp--probably the central bank itself. On the other hand, the Commerce Department seems to prefer a steady currency. Yuan appreciation is not the proper or effective tool to address trade imbalances. Chinese officials, recalling the US-Japanese experience, see that, in such a situation, no amount of currency appreciation would satisfy some of those voices in the US.

Disclosure: No positions

Source: What to Expect From the U.S.-China Relationship