Rebalancing the U.S.-China Relationship

China has become the world’s second largest economy, the main driver of global growth and an increasingly assertive economic power. The U.S. is by far the world’s largest economy and one of the richest. Even as their GDP levels gradually converge, a huge gulf remains between China and the U.S. in terms of their per capita incomes and their levels of institutional and financial development.

Nevertheless, China has used its growing economic might to gain enormous strategic advantage in a number of areas. It successfully seized the high ground in the debate on global imbalances by accusing the U.S. of taking irresponsible monetary policy actions that hurt other countries; this argument has resonated with many emerging markets that are bearing the brunt of capital flows fueled by cheap money in the U.S. and other advanced economies. China has also used its economic leverage to build partnerships with a number of advanced and emerging market economies that back China’s policies as they see its strong growth as important for their own success.

These developments have been aided by the defensive position that the U.S. has found itself in—as the epicenter of the global financial crisis and as a country with massive rising levels of public debt. The U.S. is also viewed as getting a free pass on its fiscal profligacy and excess consumption as it is the issuer of the main global reserve currency, a tenuous situation that persists perhaps only for want of alternative robust reserve currencies backed up by deep and liquid financial markets.

From the U.S. perspective, a number of irritants continue to plague its bilateral relationship with China. Chinese currency policy, which involves the central bank’s heavy intervention in the foreign exchange market to prevent the renmimbi from appreciating against the dollar and other currencies, has been blamed for making a major contribution to the U.S. trade deficit and to global current account imbalances. The U.S. has concerns that the Chinese government is blocking access of U.S. manufacturers and financial institutions to its fast-growing markets, unfairly subsidizing Chinese exporters, and hurting American manufacturers through its policy of indigenous innovation (which favors Chinese firms in government procurement of technology) and weak enforcement of intellectual property rights.

In recent months, the U.S. has sought to recalibrate its relationship with China by going on the offensive to regain control over the narrative on the sources of global imbalances and level the playing field with China. This approach culminated in a forceful speech by U.S. Treasury Secretary Timothy Geithner on January 12.

In his remarks, Secretary Geithner noted that China has become a major economic power and instituted many reforms. He pointed out that China still has a large reform agenda with elements that the U.S. cares about but are ultimately in China’s own interest. These elements include more open markets, fair trade practices, a more flexible exchange rate regime, and growth rebalancing to make the economy less dependent on exports and stoke private consumption.

Interestingly, Geithner also laid out a clear quid pro quo, noting that in order to attain its objectives in the bilateral relationship, China must adequately satisfy U.S. interests. China’s objectives include access to high technology products, investment opportunities and the same level of access to U.S. markets as “market economies”, a classification that has not yet been granted to China.

On currency policy, Geithner acknowledged that the renminbi has appreciated by about 3 percent in nominal terms relative to the dollar since mid-June 2010, when the currency was freed up after being frozen in place against the dollar during the two preceding years. Moreover, given the higher inflation rate in China relative to the U.S., the renminbi has appreciated more in real terms.

Notwithstanding this modest appreciation, Geithner stressed that the renminbi is far from being freely determined by market forces. He argued that this has adverse implications for China as it hampers effective and independent monetary policy, hurts the U.S. and other trading partners of China, and also has a negative impact on global financial stability by perpetuating global imbalances.

Two recent pieces of data portray a mixed picture on this issue. China posted a diminished trade surplus of $185 billion in 2010, well below its peak of $295 billion in 2008. On the other hand, accumulation of foreign exchange reserves in 2010 amounted to $448 billion, signaling massive intervention in foreign exchange markets to keep the renminbi from appreciating significantly.

The rhetoric from the Hill on this issue has recently eased up, as some key House Republicans do not currently view action against China on trade and currency policies as a legislative priority. There is likely to be continued pressure from Senate committees, where this is still a hot button issue. Much will depend on the jobs picture in the U.S., which is improving but still rather bleak.

Chances are the Chinese currency issue will continue to simmer but not come to a boil—unless the U.S. unemployment rate remains high, the bilateral trade deficit the U.S. runs with China begins to widen again, and U.S. firms make scant progress in getting greater access to Chinese markets.

On trade, the Obama administration has taken an aggressive approach. It has instituted unilateral trade measures against a few Chinese imports and has also taken a number of challenges of China’s trade policy to the World Trade Organization. More recently, the U.S. has taken direct actions to protect the competitive interests of its firms. For instance, to counter a Chinese company’s bid, the U.S. Export-Import Bank provided cheap financing to Pakistan Railways to boost General Electric’s bid to get a contract for supplying trains.

Such measures are intended to send a clear signal to China that the U.S. is willing to level the playing field by matching Chinese policies that run afoul of international norms and standards. With its actions and words, the Obama administration has signaled that it wants to deal with China on equal terms and will not back off from conflict where it feels that China is subverting the established rules of the game.

President Hu's remarks on the eve of his trip to Washington signal China's desire to develop a more productive relationship with the U.S. on equal terms. The remarks reveal a sense of growing confidence that, while China faces a number of domestic challenges in its own development, it is now in the driver's seat in global economic matters ranging from supporting world growth to pushing reforms of the international monetary system.

Hu's remarks show that China views itself as dealing with the U.S. from a position of relative strength. He makes it clear that China intends to move forward on opening its markets, freeing up its exchange rate and restructuring its political system, but at its own pace and will resist U.S. pressures for more rapid or broader reforms.

Hu acknowledges the potential flash points between the two countries but shows willingness to tackle these disagreements frontally in a spirit of broader cooperation rather than rancor. Whether the two countries can successfully manage the sources of bilateral tension remains to be seen but it is certainly a good omen that President Hu has chosen to take a conciliatory rather than confrontational tone before his meeting with President Obama.

The state of the China-U.S. bilateral relationship is important as it sets the tone for a number of global issues, including reforming the international monetary system, breaking the deadlock on trade talks and tackling climate change. Away from the limelight, cooperation between the two countries has actually been rather productive on a number of fronts. For instance, the G-20 agreement on coordinated fiscal stimulus during the worst of the financial crisis was strongly supported by both countries. The two countries have also played important roles in the governance reform and recapitalization of the International Monetary Fund. And of course both countries have a shared interest in keeping peripheral European economies from running aground and weakening the euro.

The leaders of the two countries clearly recognize the mutual benefits of a cooperative rather than conflicted relationship. Still, the relationship has to be tended carefully, by managing the sources of bilateral tension and emphasizing the long-term benefits of cooperation, in order to ensure that domestic political exigencies don’t trump rational collective policymaking on either side.

See more of the data and analysis on the U.S.-China bilateral economic relationship »

Prasad is the Tolani Senior Professor of Trade Policy at Cornell University. He is also a Senior Fellow at the Brookings Institution, where he holds the New Century Chair in International Economics, and is the former head of the IMF's China Division. Gu is a graduate student in the Department of Economics at Cornell University.

Note: This commentary, originally published on January 13, has been updated to reflect President Hu's remarks; the data have been updated in the PDF.