Andy Xie is a former Morgan Stanley analyst now living in China.


Put Down Trade Spats, Pick Up a Mirror
by Andy Xie
China and the United States should face domestic issues, from middle class support to Wall Street theft, and avert a trade war


A confrontation between China and the United States is looming sooner than I expected. Quite likely, the U.S. Treasury Department will name China a currency manipulator in its April report to Congress. Such a conclusion would require that the Obama administration impose punitive tariffs on Chinese imports.

China may be tempted to strike back with a trade-war volley. But such a move would be in China’s worst interests. China is the biggest beneficiary of globalization and must do everything possible to defend the global trading system. So its best response, in my view, would be to take the case to the World Trade Organization, even though any resolution would be a long time coming and would not help the current situation.

China also would be wrong to stoke a dispute with the United States in hopes of diverting attention from its domestic problems. China’s biggest challenge today is how fruits of its economic growth are divided, not how fast the economy is growing. And a key to this dividing game is held by the middle class, which deserves support.

Unfortunately, a middle class squeeze is under way that is a bigger threat to China’s economic development than slower export growth. High property prices have turned into an unfair tax on the middle class while, in numerous cases, powerful people are enriched. A bit more economic growth will not solve this problem. Meanwhile, low interest rates in an inflation era are actually taxing savers to benefit two classes of borrowers – state-owned enterprises and speculators. Thus, low interest rates are mainly a kind of middle class tax.

The United States is picking a fight with China because it can’t resolve internal problems. Since the financial crisis began, 9 million households have lost homes because they could not or did not want to make mortgage payments. Another 10 million households have negative equity in properties and could be forced or decide to give up homes. That’s 15 percent of all U.S. households. Meanwhile, the U.S. unemployment rate stands at around 10 percent, and the federal government’s deficit is more than 10 percent of GDP. The biggest state, California, faces bankruptcy.

How could a single economy face so many major problems all at once? The immediate cause was the credit-cum-property bubble burst, although the real villains in this case got away with the loot in the confusion after the big bang. Short-sellers were blamed for puncturing the bubble, but guilty parties with power were not.

Bubble Trouble

An asset bubble has many aspects. Most people understand it as the rollercoaster ride for prices. For example, Hong Kong’s property prices quadrupled between 1990 and ’97, then fell 75 percent between 1997 and ’03. In other words, it was a 13-year round trip. China’s A-share market index rose from 1,000 in 2005 to 6,100 in 2007 and fell to 1,600 in 2008 – a round trip that lasted three years.

Why are bubbles so harmful? Because three dynamics are at work:

1) Taking advantage of most bubbles are a few insiders who know how to rob ignorant people. This redistribution aspect can haunt an economy for years after a big bubble bursts.

For example, most subprime mortgage brokers knew they were lending to people who could not repay. Wall Street traders who bought mortgages from these brokers and sold them in pools or CDOs knew the brokers were incentivized to sell poor quality stuff. But the traders didn’t care because they received bonuses for selling the stuff to someone else. Fund managers who bought the CDOs probably knew they would go bad eventually. But they, too, decided to look toward annual bonuses for each year of performance.

The people who got hurt didn’t even know what was coming because they were savers who put money in pension funds, bought insurance products, or invested in bond funds.

The reallocation game isn’t restricted to the financial sector. Profits as a share of GDP from corporations – and not just the financial sector – reached historic highs during the bubble period, while relative wages slipped to all-time lows. Thus, the whole corporate sector was monetizing the bubble. And now, the U.S. corporate cash stash as a share of total assets is at a record high.

2) Money tends to be spent in the wrong way or overspent in a bubble. Economists call wrong spending “misallocation of resources,” which means the pie doesn’t expand as fast as it should. Overspending involves money that one thinks he has but actually doesn’t have. So when a bubble bursts, he’s chased by creditors.

These money factors amount to a hole in the economy that needs to be filled either through spending contraction or by increasing exports. Neither is easy. Cutting spending is, of course, unpleasant. Increasing exports is hard, too, because it requires devaluation. But unless domestic demand contracts, devaluation leads to inflation, erasing competitiveness gained by devaluation.

3) Capital destruction within the financial system is another factor that weighs down an economy for years after a bubble pops. The U.S. financial system reported losses of more than US$ 1 trillion during the crisis, creating a capital shortage that will restrict credit expansion for years to come. This is another headwind for the U.S. economy.

Action the U.S. government has taken so far shows it cannot resolve domestic problems. Americans consumed as much as US$ 3 trillion, or 20 percent of GDP, more than they could afford during the bubble. A retrenchment strategy would call for accepting a major downgrade in lifestyle. It would also require that consumption fall below the long-term sustainable level to regurgitate overspending of the past.

Long-term sustainability is possible if the U.S. trade deficit is small. Although the trade deficit was cut in half after the crisis, U.S. consumption probably is still above the long-term sustainable level. Moreover, export orders on the China side suggest U.S. retail sales have been picking up in the second quarter. This is good news for the short term but reflects the U.S. household sector’s reluctance to change an unaffordable habit. It seems pretty remote to expect consumers to regurgitate that US$ 3 trillion.

Ill-gotten bubble gains, if recovered, could help the economic recovery. So far, though, U.S. authorities have done very little to settle the score. U.S. government action looks suspiciously like a cover-up for wrongdoings during the bubble, and it’s a problem that the same people are in charge.

Not a single, significant player from Wall Street has gone to jail, despite mounting evidence of widespread fraud. Financial reform legislation has been delayed again and again. And the current reform bill includes so many measures contingent on studies that it would not bite for at least two years.

Expansion Option

The Obama administration scored a major victory in passing the biggest healthcare reform bill in four decades. It will provide health insurance to 32 million people who are not insured today and cost US$ 1 trillion over 10 years. Obama will go down in history as a significant president just for this.

But its impact is mainly in the area of social justice, not efficiency. The U.S. economy’s biggest problem is skyrocketing healthcare costs, and the reform won’t reverse that. Even though the administration aimed to cut costs and expand insurance coverage, politicking forced it to give up the first goal, demonstrating again that the U.S. system can’t solve problems through cutbacks.

What sells politically is problem-solving through expansion, in which no one is hurt and a rising tide washes all problems away. The only way to achieve this goal is by expanding exports. This is why the administration wants to double exports in five years. But Europe and Japan are so depressed that the United States could hardly export ore goods there.

The Chinese economy is also too small to absorb much. Of course, if China doubles or triples its currency value as Japan did after the Plaza Accord in 1985, its economy would be big enough to support U.S. export growth. But is China in a position to accept that? I seriously doubt it.

Japan was a developed economy in 1985, and about one-third of China’s population lives in a developed economy, mainly in coastal cities. Two-thirds are living in a developing stage, and an overvalued currency would block their path to economic development.

The Democratic Party may lose a lot of votes for passing healthcare legislation, but blaming China for U.S. economic problems could win votes in the November mid-term elections. Thus, pressure on China’s currency value will skyrocket before November.

But as long as China remains calm, pressure will dissipate over time. The United States has been selectively imposing tariffs on Chinese products over the past few months. Nothing will change in the near future, and a massive, across-the-board tariff on Chinese products is unlikely.

Most Chinese exports to the United States are designed, owned and sold by major U.S. corporations. IPhones, Nike sneakers, and HP PCs are good examples. A massive tariff would hit their profits and trigger a stock market collapse. It would bring down the U.S. economy and trigger a double-dip.

The U.S. government doesn’t have the courage to prosecute people who caused the bubble and brought down the economy, fearing negative economic consequences. Neither will it have the guts to do something against Chinese exports that would surely bring down its economy.

What the government can do is impose tariffs on Chinese products that are commodities still produced in the United States. Chemical and metal products fall into this category. But even if Chinese exports of these products are fully blocked, the impact would be limited, since China doesn’t have to depend on exports as in the past.

What Matters

A labor “shortage” is now emerging as a major turning point in China’s development. Wages will likely rise faster than GDP for years to come, which is the best news for growing domestic demand.

Low wages due to a labor surplus depressed China’s consumption development, but the labor market is now turning to an advantage for workers. An unlimited labor supply is a thing of the past. Consider, for example, that rural schools across the country are closing because they’re running out of students.

Another factor is that multinationals now rooted in China’s consumer market are increasingly relying on China for profits. This trend is strengthening China’s global bargaining power. Moreover, global stock markets will become more dependent on China’s economic performance.

For the United States, then, hurting China would be like hurting oneself. Time is on China’s side. China can wait out U.S. protectionism.

The global economy has shown signs of recovery, but it’s still not stable. The bursting of the credit bubble has been followed by even greater growth for two, separate bubbles – the U.S. Treasury market and China’s land market.

What to do? Cooling the land bubble would make the Chinese economy less vulnerable to any shock from U.S. protectionism. So interest rates should be raised as soon as possible.

Many analysts argue that raising interest rates would increase currency appreciation pressure. This argument is normally correct. But a great deal of hot money is already in China, chasing a bubble rather than paying interest. If China raises interest rates, hot money may exit for fear of a bubble burst, and appreciation pressure on the yuan may ease rather than strengthen.

China’s land bubble is vast and has far-reaching consequences for the country’s future. The bubble may spread to farmland in coming years, creating new complications. The bubble’s existence has been widely acknowledged, but no clear measures have been taken to control it, proving that powerful interests are behind it.

The bubble makes China vulnerable to shock. If trade friction with the United States drags on, hot money may leave en masse for fear of an economic collapse. And it may make the collapse self-fulfilling.

To strengthen China’s position in the coming conflict with the United States, taming the land bubble is a must. Trade friction with the United States will command headlines and attention from policymakers. But China’s main challenges are internal. How to divide the pie created by economic development is critical to the country’s future. Many argue growth will solve all problems. I’m not sure about that.

Asset bubbles in China are mainly for taxing the middle class, and they stunt growth. No modern economy can be stable without a big, healthy middle class. As long as China’s middle class is vibrant and growing, external challenges cannot derail economic development. So the answer to China’s problems lies within. International confrontation offers no solutions.

Category: Think Tank

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

8 Responses to “Put Down Trade Spats, Pick Up a Mirror”

  1. rh32 says:

    Am I reading this right? “The U.S. economy’s biggest problem is skyrocketing healthcare costs.” I couldn’t disagree more. Our biggest problem is unemployment approaching 10%, underemployment at 16.5% and the state of commercial real estate loans due to reset in the coming year remaining on banks’ collective balance sheets. And if China’s currency is fairly valued, then how would de-pegging impinge the ability of undeveloped rural areas to develop?

  2. I would note that Unemployment is a cyclical issue (it gets better and worse) whereas healthcare costs are secular — they have only gotten worse over the past 1/2 century . . .

  3. rh32 says:

    When was the last economic “cycle” that we had these levels of record foreclosures, record corporate and individual bankruptcies, record unemployment, and record underemployment? I guess it’s convenient to explain these away as cyclical anomalies, but personal healthcare expenses rising between 4-8% a year seem insignificant when considering 42% of American households with mortgages are underwater.

  4. Casual Observer says:

    I think unemployment is a secular issue as well due to offshoring of not only manufacturing jobs but now also what are white collar jobs, global wage arbitrage, changes by every administration up to and including GW Bush on how unemployment is calculated, etc. If unemployment is a cyclical issue then pray tell, why is private employment and private wages at levels seen in the mid-late 1990s while federal/state and local employment has outstripped the the private sector in terms of net job growth and wages over the last 12 years. I guess things must be pretty good in New York and Washington but there is no way that unemployment is a cyclical issue in the rest of the country.

  5. Casual Observer says:

    No modern economy can be stable without a big, healthy middle class.

    Truer words to describe the situation the US is in, I cannot think of. Health care isn’t the biggest problem in the US. The largest chunk of most people’s expenses are home mortgages relative to income. As long as prices continue to remain sticky to the high side (relative to income) because of banks not eating the bad loans and holding these losses off the balance sheets as marked to fantasy and declining/stagnant wages for longer periods of time continues, the US and global economy economy will continue to be very unstable despite governments’ attempts to keep up appearances.

  6. Kekepana says:

    Friends in China tell me that the housing bubble can and will last a lot longer than we might think. Lack of adequate housing was a huge issue in the lead-up to Tienanmen Square, and my contacts tell me that unrest over housing is reaching similar levels now. Their conclusion is that Beijing will do nothing in the near-term to cut back on residential construction.

    I think Andy Xie is correct in his analysis of China’s response should the United States take punitive trade action for currency manipulation. They will likely take it to dispute settlement in the WTO, which I fear will overload the system. The WTO has the most effective international dispute settlement system going, but this opens a new area of trade law that the system was not designed to cope with. See my blog for a more thorough discussion of the impact of taking this dispute to the WTO (

  7. taipeir says:

    There are a lot of black-white assumptions in this article. For instance that if the US put tariffs on Chinese goods this would damaged their economy. If they were to put 10% tariffs on imports what would be the effect? The renminbi is already valued extremely low. The govt. could get significant revenue. American multinationals would think more about investing in production in the US, thereby creating jobs and helping spending power there. Consumers would still be able to get access to cheap goods. The corporations, which are sitting on big cash piles, would only be slightly affected and may see a benefit in some cases if they support the American market (still the world’s largest) to grow and recover more quickly.

    The arguments of ‘tariffs’ are bad is ridiculous when you’ve got one side cheating the system with a ridiculously low currency value in concordance with multinationals who benefit (temporarily- remember they helped to damage the US market using this system, their own biggest market). It’s all about the balance and value, not the automatic assumption
    ‘ tarriffs are bad’, this is a poorly thought argument, it’s time to rebalance to the other side.

  8. taipeir says:

    I also live in the China region and travel there often. In my opinion many people who are based in China are easily misled because there is a lack of openness in the media and over the last 10 years they have only known good times there. Local people are blinded by patriotism and optimism in this rapid growth. Expats live in a bubble in general, they also have never seen bad times there, many of them only having arrived in the last few years. All they have ever seen is one trend = UP. That doesn’t go on forever.

    The so-called ‘masssive demand for housing’ does not exist…look at China demographic peak of workers…it’s already started. Travel around China and see the enormous construction boom in progress in every city.

    In addition, many Chinese would prefer to live in their regional pronvincial city, not the major Eastern cities, they are too expensive for poor migrants and far from home. But at the moment ALL cities in China are experiencing a property bubble.