Political friction over economic issues between the US and China has faded for the time being, but its sources remain and may reappear at any time.

Currency issues have been at the center of relations between the US and China since the end of last year. Earlier this month the Obama administration chose not to name China as a ‘currency manipulator.’ Doing so would have opened the door to imposing heavy tariffs on Chinese imports. The next day, China’s State Administration of Foreign Exchange announced that it would not divest its US Treasury holdings.
However, it is clear that China will pay first attention to keeping its own domestic house in order, with international considerations being only secondary. This is the source of now-latent but continuing tension with the US over economic issues; and the international effects of Chinese domestic economic policy are not limited to the US.

Background to discord

Five weeks ago, just before the G-20 summit in Canada, China announced that it would relax controls on the yuan, allowing it to fluctuate against the dollar, in order to remove the topic from the meeting’s agenda. There was a one-day run-up, but the day after that the Chinese authorities intervened in the market to draft the currency back down, as a warning that they will not allow significant fluctuation even after taking it off the dollar peg.

Analysts expect the yuan to appreciate only gradually against the dollar, at a rate of 3-4 percent per year, with some periods of depreciation if there is a flight-to-safety event and the euro falls against the dollar. As a result, there would be little effect on political support in the US for trade restrictions and tariffs against Chinese goods.

Since Chinese economic statistics are reported on a year-on-year basis, when the government reported that GDP expanded 10.3 percent in the second quarter of this year, that amount was the increase over the second quarter of last year.

The first quarter statistic was 11.9 percent, and Credit Suisse’s chief economist for Asia (excluding Japan), Dong Tao, expects this to fall to 6.7 percent by the end of the year. That is lower than many other estimates, but there is a shared consensus that the rate of growth will decline.

Nearly 50% of China’s GDP comes from investment, and as stimulus-related projects are completed and real-estate investments shift toward lower margin projects like public housing, investment growth will slow.

Chinese housing: ‘bubble’ or not?

The economic policy tug-of-war within China itself is a political battle between Party officials in Beijing who would like to gain greater control of credit growth to put a lid on inflationary pressures and local officials who would like to continue using banks to fund investment projects in their regions to boost GDP growth and investment.

Beijing has the upper hand over the regions for now but this could change by the end of the year, as China’s political business cycle is one of growth generated by local expansionary policies that eventually leads to inflation, Beijing clamps down on credit growth to choke off inflation. After stagnation ensues, the center eases up on credit and then the regions begin to drive growth again.

A widespread concern is the Chinese real estate market. Fears are of a bubble that, if it crashes, could extend beyond China and affect the global recovery from the 2008 meltdown. The recent run-up in the Shanghai stock market has been partly driven by property developers. Consequently, any government tightening of fiscal policy or other restraint upon the real estate sector could negatively affect anticipated earnings and so also equities at large.

A housing bubble exists at the high-end of the market in some Chinese cities but may not be a nationwide bubble. Price inflation in the housing sector will likely continue so long as China’s financial system remains repressed and local governments remain overly reliant on property transactions fees for their funding.

Bases for future conflict

Domestically, some of the nascent middle class have made speculative investments in real estate, much like their American counterparts did earlier in the decade.

Any weakness in the housing market would affect not just the Shanghai stock market but also the Chinese economy as a whole. Housing accounts for about half of China’s steel demand, a third of the aluminum, and also a significant part of the cement industry. Were a housing bubble to burst, demand for all these primary materials would fall.

The housing sector is also a sensitive subject more broadly internationally because of the reliance on the Chinese market by raw materials producers, particularly metals and mining. Commodity demand from China is likely to be volatile between now and the end of 2011 as its economy slows.

Moreover, exports will face headwinds from a deleveraging U.S. consumer and EU fiscal austerity in the second half of 2010. This is significant because China’s central bank advisor Zhou Qiren recently said in an interview carried in a Japanese newspaper that Beijing will let the yuan weaken if exports fall sharply. That would bring the currency conflict with the US back front and center.

[A version of this article was first published by ISN Security Watch, 26 July 2010.]